sec document

-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Rq36TJfs9pKZLY6mntc8wBTRLF7ACJbp7atuc/RBEQhtrkgeMLHVlpV9FQld4JPR DI13gEPZhpGjPxnjbT1KlA== 0000921895-07-001702.txt : 20070809 0000921895-07-001702.hdr.sgml : 20070809 20070808182248 ACCESSION NUMBER: 0000921895-07-001702 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 20070630 FILED AS OF DATE: 20070809 DATE AS OF CHANGE: 20070808 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: 071037203 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_06302007.htm sec document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended June 30, 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 July 25,
2007 was 50,527,050 and 49,661,850.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

Page

PART I. Financial Information 3

Item 1. Condensed Consolidated Financial Statements 3

Condensed Consolidated Balance Sheets at June 30, 2007
(unaudited) and December 31, 2006 3

Unaudited Condensed Consolidated Statements of Operations for the
Three and six months ended June 30, 2007 and 2006 4

Unaudited Condensed Consolidated Statements of Cash Flows for the six
months ended June 30, 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 16

Item 3. Qualitative and Quantitative Disclosures about Market Risk 25

Item 4. Controls and Procedures 25

PART II. Other Information 26

Item 1. Legal Proceedings 26

Item 1A. Risk Factors 26

Item 4. Submission of Matters to a Vote of Security Holders 28

Item 5. Other Information 28

Item 6. Exhibits 29

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

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

June 30, 2007 December 31, 2006
------------- -----------------
ASSETS (unaudited)
Current assets:
Cash and cash equivalents ...................................... $ 26,225,644 $ 15,605,329
Marketable securities .......................................... 29,931,899 25,354,259
Accounts receivable, net of allowances of $7,185,360 and
$6,016,298, respectively...................................... 20,506,847 24,134,257
Prepaid expenses and other current assets ...................... 2,044,561 1,244,937
------------- -------------

Total current assets ....................................... 78,708,951 66,338,782

Property and equipment, net of accumulated depreciation of
$11,879,963 and $10,221,780, respectively ..................... 7,107,128 5,960,317
Goodwill ......................................................... 3,512,796 3,512,796
Other intangible assets, net ..................................... 380,169 407,316
Other assets ..................................................... 2,028,606 2,011,433
------------- -------------

Total assets ............................................... $ 91,737,650 $ 78,230,644
============= =============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ............................................... $ 1,700,825 $ 1,432,510
Accrued expenses ............................................... 5,288,812 6,505,536
Deferred revenue ............................................... 14,116,551 11,466,552
------------- -------------

Total current liabilities ........................... 21,106,188 19,404,598

Other long-term liabilities ...................................... 133,184 137,317
Deferred revenue ................................................. 4,030,451 3,645,482
------------- -------------

Total liabilities ................................... 25,269,823 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, 50,480,810 and 49,085,539 shares issued,
respectively and 49,615,610 and 48,220,339 shares
outstanding, respectively .................................... 50,481 49,086
Additional paid-in capital ..................................... 109,983,633 99,282,308
Accumulated deficit ............................................ (37,208,864) (38,033,857)
Common stock held in treasury, at cost (865,200
shares at both June 30, 2007 and December 31, 2006 ) ......... (5,780,163) (5,780,163)
Accumulated other comprehensive loss, net ...................... (577,260) (474,127)
------------- -------------

Total stockholders' equity ................................. 66,467,827 55,043,247
------------- -------------
Total liabilities and stockholders' equity ................. $ 91,737,650 $ 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 June 30, Six Months Ended June 30,
------------------------------ ------------------------------
2007 2006 2007 2006
------------ ------------ ------------ ------------

Revenues:
Software license revenue ................................... $ 11,980,480 $ 8,726,021 $ 22,417,985 $ 14,402,710
Maintenance revenue ........................................ 4,535,780 2,908,514 8,869,319 5,499,517
Software services and other revenue ........................ 1,234,284 1,033,692 2,803,918 1,974,320
------------ ------------ ------------ ------------
17,750,544 12,668,227 34,091,222 21,876,547
------------ ------------ ------------ ------------

Operating expenses:
Amortization of purchased and capitalized
software .............................................. 24,286 101,333 49,822 253,055
Cost of maintenance, software services and other
revenue ............................................... 2,462,050 2,320,065 5,206,338 4,304,662
Software development costs .............................. 5,341,481 4,905,137 10,857,666 9,512,240
Selling and marketing ................................... 7,500,433 5,686,742 14,469,184 10,590,747
General and administrative .............................. 1,922,723 1,390,140 3,860,503 2,711,434
------------ ------------ ------------ ------------
17,250,973 14,403,417 34,443,513 27,372,138
------------ ------------ ------------ ------------
Operating income (loss) ............................. 499,571 (1,735,190) (352,291) (5,495,591)
------------ ------------ ------------ ------------

Interest and other income, net ............................. 594,376 384,009 1,093,747 670,660
------------ ------------ ------------ ------------

Income (loss) before income taxes ................... 1,093,947 (1,351,181) 741,456 (4,824,931)

Provision (benefit) for income taxes ....................... (285,621) (46,386) (83,537) 116,750
------------ ------------ ------------ ------------

Net income (loss) ................................... $ 1,379,568 $ (1,304,795) $ 824,993 $ (4,941,681)
------------ ------------ ------------ ------------

Basic net income (loss) per share .......................... $ 0.03 $ (0.03) $ 0.02 $ (0.10)
============ ============ ============ ============

Diluted net income (loss) per share ........................ $ 0.03 $ (0.03) $ 0.02 $ (0.10)
============ ============ ============ ============

Weighted average basic shares
outstanding ............................................. 49,378,812 48,047,291 48,988,778 48,026,914
============ ============ ============ ============

Weighted average diluted shares
outstanding ............................................. 53,007,181 48,047,291 50,802,963 48,026,914
============ ============ ============ ============

See accompanying notes to unaudited condensed consolidated financial statements.

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

Six Months Ended
June 30,
2007 2006
------------ ------------
Cash flows from operating activities:
Net income (loss) ........................................................... $ 824,993 $ (4,941,681)
Adjustments to reconcile net income (loss) to net cash provided
by operating activities:
Depreciation and amortization ........................................... 1,813,510 1,828,762
Share-based payment compensation ........................................ 4,128,106 4,660,622
Loss on marketable securities ........................................... -- 28,855
Loss on foreign currency exchange ....................................... -- 41,670
Tax benefit from stock option exercises ................................. -- (10,467)
Provision for returns and doubtful accounts ............................. 2,382,410 1,917,634
Changes in operating assets and liabilities:
Accounts receivable ..................................................... 1,247,952 538,581
Prepaid expenses and other current assets ............................... (798,235) (89,291)
Other assets ............................................................ (16,823) (134,275)
Accounts payable ........................................................ 246,209 (24,756)
Accrued expenses ........................................................ (1,278,200) 141,179
Deferred revenue ........................................................ 3,025,123 1,483,756
------------ ------------

Net cash provided by operating activities ............................ 11,575,045 5,440,589
------------ ------------

Cash flows from investing activities:
Sale of marketable securities ............................................... 42,494,822 35,377,326
Purchase of marketable securities ........................................... (47,053,285) (43,209,250)
Purchase of property and equipment .......................................... (2,797,221) (1,703,124)
Purchase of software licenses ............................................... (15,000) (168,000)
Purchase of intangible assets ............................................... (81,614) (121,533)
------------ ------------
Net cash used in investing activities ..................................... (7,452,298) (9,824,581)
------------ ------------

Cash flows from financing activities:
Proceeds from exercise of stock options ..................................... 6,574,614 1,100,272
Payments made to acquire treasury stock ..................................... -- (1,671,572)
Tax benefit from stock option exercises ..................................... -- 10,467
------------ ------------

Net cash provided by (used in) financing activities ....................... 6,574,614 (560,833)
------------ ------------

Effect of exchange rate changes on cash and cash equivalents ................... (77,046) 59,332
------------ ------------

Net increase (decrease) in cash and cash equivalents ........................... 10,620,315 (4,885,493)

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

Cash and cash equivalents, end of period ....................................... $ 26,225,644 $ 13,911,480
============ ============

Cash paid for income taxes ..................................................... $ 264,213 $ 25,000
============ ============

The Company did not pay any interest for the six months ended June 30, 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 more 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 accompanying unaudited interim condensed consolidated financial
statements have been prepared, without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission ("SEC"). Certain
information and note disclosures normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have been condensed or omitted pursuant to such rules
and regulations relating to interim financial statements.

In the opinion of management, the accompanying unaudited interim condensed
consolidated financial statements reflect all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial position
of the Company at June 30, 2007, and the results of its operations for the three
and six months ended June 30, 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
$13.7 million and $11.0 million at June 30, 2007 and December 31, 2006,
respectively. Marketable securities at June 30, 2007 and December 31, 2006
amounted to $29.9 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 maintenance, software service and other 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 June 30, 2007, the Company had two customers
that together accounted for 40% of revenues, and two customers that together
accounted for 25% of the accounts receivable balance at June 30, 2007. For the
three months ended June 30, 2006, the Company had two customers that together
accounted for 32% 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 $857,074 and $767,739 for the three months
ended June 30, 2007 and 2006, respectively. Depreciation expense was $1,658,183
and $1,504,257 for the six months ended June 30, 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 $54,405 and $45,468 for the three months ended
June 30, 2007 and 2006, respectively. Amortization expense was $108,760 and
$90,648 for the six months ended June 30, 2007 and 2006, respectively. The gross
carrying amount and accumulated amortization of other intangible assets as of
June 30, 2007 and December 31, 2006 are as follows:

June 30, December 31,
2007 2006
----------- -----------
Patents:

Gross carrying amount $ 1,104,706 $ 1,023,093
Accumulated amortization (724,537) (615,777)
----------- -----------
Net carrying amount $ 380,169 $ 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 $148,756 and $183,578, net of accumulated
amortization of $5,058,675 and $5,008,853 is included in other assets as of June
30, 2007 and December 31, 2006, respectively. Amortization expense was $24,286
and $101,333 for the three months ended June 30, 2007 and 2006, respectively and
$49,822 and $253,055 for the six months ended June 30, 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 assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. The Company 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 and restricted stock awards are expected to be fulfilled with new
shares of common stock.

The Company accounts for stock option grants to non-employees in accordance
with SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, and EITF Issue No.
96-18, ACCOUNTING FOR EQUITY INSTRUMENTS THAT ARE ISSUED TO OTHER THAN EMPLOYEES
FOR ACQUIRING, OR IN CONJUNCTION WITH SELLING, GOODS OR SERVICES, which require
that the fair value of these instruments be recognized as an expense over the
period in which the related services are rendered.

(m) FINANCIAL INSTRUMENTS

As of June 30, 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 and six months ended June 30,
2006, all common stock equivalents were excluded from diluted net loss per share
for the periods. As of June 30, 2007 potentially dilutive common stock
equivalents included 9,856,588 stock options and shares of restricted stock
outstanding.

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

Three Months Ended June 30, 2007 Three Months Ended June 30, 2006
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ---------- ---------- ----------- ---------- --------
Basic EPS $ 1,379,568 49,378,812 $ 0.03 $(1,304,795) 48,047,291 $ (0.03)
========== ========
Effect of dilutive securities:
Stock Options 3,628,369 --
----------- ---------- ---------- ----------- ---------- --------
Diluted EPS $ 1,379,568 53,007,181 $ 0.03 $(1,304,795) 48,047,291 $ (0.03)
=========== ========== ========== =========== ========== ========

Six Months Ended June 30, 2007 Six Months Ended June 30, 2006
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ---------- ---------- ----------- ---------- --------
Basic EPS $ 824,993 48,988,778 $ 0.02 $(4,941,681) 48,026,914 $ (0.10)
========== ========
Effect of dilutive securities:
Stock Options 1,814,185 --
----------- ---------- ---------- ----------- ---------- --------
Diluted EPS $ 824,993 50,802,963 $ 0.02 $(4,941,681) 48,026,914 $ (0.10)
=========== ========== ========== =========== ========== ========

(p) COMPREHENSIVE INCOME (LOSS)

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

Three Months Ended June 30, Six Months Ended June 30,
2007 2006 2007 2006
---- ---- ---- ----
Net Income (loss) $ 1,379,568 $(1,304,795) $ 824,993 $(4,941,681)
----------- ----------- ----------- -----------
Other comprehensive income (loss):
Foreign currency translation
adjustments (83,667) 93,063 (124,879) 104,502

Unrealized gains (loss) on investments (4,719) (29,759) 19,177 (18,880)

Benefit plan adjustment 2,569 -- 2,569 --
----------- ----------- ----------- -----------
Other comprehensive income (loss) (85,817) 63,304 (103,133) 85,622
----------- ----------- ----------- -----------
Comprehensive income (loss) $ 1,293,751 $(1,241,491) $ 721,860 $(4,856,059)
=========== =========== =========== ===========

(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
statements.

In September 2006, the FASB issued SFAS No. 157, FAIR VALUE Measurements 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
statements.

(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. As of May 14, 2007, no
additional options will be available for grant under 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 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 to which options may be granted is less than five
percent (5%) of the number of outstanding shares of stock, then the number of
shares of stock available for issuance under the Plan shall be increased so that
the number equals five percent (5%) of the shares of stock outstanding. In no
event shall the number of shares of stock subject to the Plan in the aggregate
exceed twenty million shares, subject to adjustment as provided in the 2006
Plan. On July 1, 2007, the total number of outstanding shares of the Company's
common stock totaled 49,615,610. Pursuant to the 2006 Plan, as amended, the
total shares available for issuance under the 2006 Plan thus increased by
2,170,731 shares to 2,480,781 shares available for issuance as of July 1, 2007.

On May 8, 2007, the Company's stockholders approved 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 six months ended
June 30, 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
Cancelled (97,467) $ 6.95
---------- -----------

Outstanding at March 31, 2007 9,804,155 $ 5.77 6.45 $45,595,769
---------- ----------- ----------- -----------
Granted 330,000 $ 11.07
Exercised (396,918) $ 6.16
Cancelled (132,149) $ 7.19
---------- -----------
Outstanding at June 30, 2007 9,605,088 $ 5.91 6.30 $44,607,190
========== =========== =========== ===========
Options exercisable at June 30, 2007 7,096,560 $ 5.23 5.46 $37,642,505
---------- ----------- ----------- -----------

Stock option exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the three months ended June
30, 2007 and 2006 was $2,446,812 and $304,157, respectively. The total cash
received from stock option exercises for the six months ended June 30, 2007 and
2006 was $6,574,614 and $1,100,272, respectively. The total intrinsic value of
stock options exercised during the three months ended June 30, 2007 and 2006 was
$1,931,508 and $148,810, respectively. The total intrinsic value of stock
options exercised during the six months ended June 30, 2007 and 2006 was
$8,240,820 and $1,623,237, 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
June 30, June 30,

2007 2006
---- ----
Cost of maintenance, software services
and other revenue $ 224,454 $ 356,159
Software development costs 756,294 1,078,138
Selling and marketing 714,610 684,686
General and administrative 242,663 277,119
---------- ----------
$1,938,021 $2,396,102
========== ==========

Six Months Ended Six Months Ended
June 30, June 30,

2007 2006
---- ----

Cost of maintenance, software services
and other revenue $ 509,303 $ 699,549
Software development costs 1,679,950 2,133,099
Selling and marketing 1,433,527 1,345,538
General and administrative 505,326 482,436
---------- ----------
$4,128,106 $4,660,622
========== ==========

The Company did not recognize any tax benefits related to share-based
compensation expense during the three and six months ended June 30, 2007. During
the three and six months ended June 30, 2006, the Company recognized $10,467 of
tax benefits related to share-based compensation expense.

In 2006, the Company granted options to purchase 25,000 shares of common
stock to certain non-employee consultants in exchange for professional services.
During the three months ended June 30, 2007, the Company granted options to
purchase 6,000 shares of common stock to certain non-employee consultants in
exchange for professional services. The aggregate fair value of these options
are determined using the Black-Scholes method as of each balance sheet date, and
are being expensed over their respective period of services to be provided. The
related cumulative aggregate expense totaled $58,370 through June 30, 2007, of
which $19,607 and $40,455 were recognized during the three and six months ended
June 30, 2007, respectively.

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. During the three months ended June 30, 2007, the Company
granted 26,500 shares of restricted stock to certain Outside Directors and
employees at a fair value per share at date of grant of $11.10 per share. As of
June 30, 2007, no restricted shares have vested or been forfeited. There were no
restricted shares issued or outstanding as of June 30, 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 June 30, 2007 and 2006, there was approximately $9,848,541 and
$12,152,329, respectively, 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 were to 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. As of June 1, 2007, none of the
warrants had vested and the rights to exercise the warrants expired on such
date.

(3) SEGMENT REPORTING

The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the three and six
months ended June 30, 2007 and 2006, and the location of long-lived assets as of
June 30, 2007 and December 31, 2006, are summarized as follows:

Three Months Ended June 30, Six Months Ended June 30,
2007 2006 2007 2006
----------- ----------- ----------- -----------
United States $12,325,435 $ 8,603,774 $24,070,183 $14,898,771
Asia 2,174,322 2,117,520 4,060,086 3,499,868
Other international 3,250,787 1,946,933 5,960,953 3,477,908
----------- ----------- ----------- -----------

Total revenues $17,750,544 $12,668,227 $34,091,222 $21,876,547
=========== =========== =========== ===========

June 30, December 31,
2007 2006
----------- -----------
Long-lived assets:

United States $11,108,005 $10,113,633
Asia 1,612,252 1,498,534
Other international 308,442 279,695
----------- -----------
Total long-lived assets $13,028,699 $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 and six months ended June 30, 2007. During the three and six months
ended June 30, 2006, the Company purchased 250,000 shares of its common stock in
open market purchases for a total cost of $1,671,572. As of June 30, 2007, the
Company had repurchased a total of 865,200 shares for $5,780,163.

(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 June 30, 2007:

2007 ................................................ $1,051,373
2008 ................................................ 1,895,160
2009 ................................................ 1,836,775
2010 ................................................ 1,472,522
2011 ................................................ 1,370,573
Thereafter .......................................... 718,740
----------
$8,345,143
==========

The Company is subject to various legal proceedings and claims, asserted or
unasserted, which arise in the ordinary course of business. While the outcome of
any such matters cannot be predicted with certainty, such matters are not
expected to have a material adverse effect on our financial condition or
operating results.

(6) INCOME TAXES

For the three and six months ended June 30, 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. The provision includes U.S.
federal alternative minimum taxes and state minimum taxes that are expected to
be incurred primarily as a result of the limitations on the Company's 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 and foreign
taxes. During the six months ended June 30, 2007, the Company's income tax
benefit of $83,537 includes discrete items for (i) $57,058 related to state
income taxes incurred in periods prior to 2007, (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, and (iii) $0.3 million of benefit associated with
disqualifying dispositions of incentive stock options.

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.

Through March 31, 2007, the Company maintained a full valuation allowance
against its net 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. As discussed above, the Company recognized $0.3
million of tax benefits associated with disqualifying dispositions of incentive
stock options during the three and six months ended June 30, 2007 as a result of
continued positive operating results and improved projections for taxable
income. The Company believes that if positive evidence from its earnings trends
continue in subsequent quarters, it is likely that the Company will recognize a
significant portion of its deferred tax assets, through a reduction in its
deferred tax valuation allowance in the near term. 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.
If the entire deferred tax asset were realized, approximately $6.0 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.

The Company's total unrecognized tax benefits as of January 1, 2007 were $4.4
million, which, if recognized, would affect the Company's effective tax rate.
Total accrued interest and penalties as of January 1, 2007 were $22,193. During
the three months ended June 30, 2007, there were no additional unrecognized tax
benefits identified. 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 second quarter of 2007 showed solid growth from the
same period in the prior year. Both our revenues and our gross margins
increased.

Revenues for the second quarter of 2007 increased 40% to $17.8 million
compared with revenues of $ 12.7 million in the second quarter of 2006. Revenues
from both our OEM partners and our resellers increased from the same period last
year.

Our revenues grew 9% from the previous quarter and were higher than our
revenues in every quarter in the Company's history, other than the fourth
quarter 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 14% of our revenues, in the second 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 management structure 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.

We had net income of $1.4 million for the three months ended June 30, 2007.
This positive result includes $1.9 million of share-based compensation expense
related to SFAS No. 123(R). Cash flows from operations in the second 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 June 30, 2007 increased 63%, compared with the balance
at June 30, 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 $2.8 million, or 20%, compared with the
second quarter of 2006. Operating expenses include $1.9 million in share-based
compensation expense for the second quarter of 2007, and $2.4 million in
share-based compensation expense for the second 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 86% for the second quarter of 2007 from 81%
for the second quarter of 2006. Share-based compensation expense within cost of
maintenance, software services and other revenue was 1% of revenue in the second
quarter of 2007 and 3% in the second quarter of 2006.

We plan to continue adding research and development, sales and support
personnel, both in the United States and worldwide, as necessary. We also plan
to continue investing in infrastructure, including both equipment and property.

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

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED JUNE 30, 2007 COMPARED WITH
THE THREE MONTHS ENDED JUNE 30, 2006.

Revenues for the three months ended June 30, 2007 increased 40% to $17.8
million compared with $12.7 million for the three months ended June 30, 2006.
Our operating expenses increased 20% from $14.4 million for the three months
ended June 30, 2006 to $17.3 million for the three months ended June 30, 2007.
Included in our operating expenses for the three months ended June 30, 2007 and
2006 was $1.9 and $2.4 million, respectively, of share-based compensation
expense in accordance with SFAS No. 123(R). Net income for the three months
ended June 30, 2007 was $1.4 million compared with a net loss of $1.3 million
for the three months ended June 30, 2006. The growth in revenues was due to
significant increases in our software license and maintenance revenues as well
as moderate increases in software services and other revenues. Revenue
contribution from our OEM partners increased in absolute dollars and as a
percentage of our total revenue for the quarter ended June 30, 2007 as compared
with the same period in 2006. Revenue from resellers and distributors also
increased in absolute dollars for the three months ended June 30, 2007 as
compared with the same period in 2006. Expenses increased in all aspects of our
business to support our continued growth. During the three months ended June 30,
2007, we continued to increase the number of employees and to invest in our
infrastructure by increasing our capital expenditures particularly with
purchases of equipment for support of our existing and future product lines. We
increased the number of employees from 330 as of June 30, 2006 to 394 employees
as of June 30, 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 37% from $8.7 million for the three
months ended June 30, 2006 to $12.0 million for the three months ended June 30,
2007. Continued growth of market acceptance and increased demand for our
products has resulted in increased sales from our OEM partners and 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 in future periods.

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. During the three months ended June 30, 2007 and 2006, we had
transactions in which we purchased hardware and bundled this hardware with our
software and sold this bundled solution to our customer. A portion of the
contractual fees is recognized as revenue when the hardware or software is
delivered to the customer based on the relative fair value of the delivered
element(s). Maintenance, software services and other revenue increased 46% to
$5.8 million for the three months ended June 30, 2007 from $3.9 million for the
three months ended June 30, 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 $1.6
million from $2.9 million for the three months ended June 30, 2006 to $4.5
million for the three months ended June 30, 2007. Software services and other
revenue increased approximately $0.2 million from $1.0 million for the three
months ended June 30, 2006 to $1.2 million for the three months ended June 30,
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 June 30, 2007, we had $0.1 million of purchased software licenses,
net of accumulated amortization of $5.1 million that are being amortized over
three years. For the three months ended June 30, 2007, we recorded $24,000 of
amortization related to these purchased software licenses. As of June 30, 2006,
we had $0.3 million of purchased software licenses, net of accumulated
amortization of $4.9 million and recorded approximately $100,000 of amortization
for the three months ended June 30, 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 June 30, 2007 increased by 6% to $2.5
million compared with $2.3 million for the three months ended June 30, 2006. The
increase in cost of maintenance, software services and other revenue was
principally due to the increase in personnel and related costs for the three
months ended June 30, 2007 as compared with the same period in 2006. As a result
of our increased sales from maintenance and support contracts, we hired
additional employees to provide technical support. Consequently, our cost of
maintenance, software services and other revenue will continue to grow in
absolute dollars as our revenues from these services also increase.

Gross profit for the three months ended June 30, 2007 was $15.3 million or
86% of revenue compared with $10.2 million or 81% of revenue for the three
months ended June 30, 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 in absolute dollars to $0.2
million from $0.4 million for the three months ended June 30, 2007 and 2006,
respectively. Share-based compensation expense was equal to 1% and 3% of revenue
for the three months ended June 30, 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 9% to $5.3 million for the three months ended June
30, 2007 from $4.9 million for the three months ended June 30, 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 June
30, 2007 as compared with the same period in 2006. Share-based compensation
expense included in software development costs decreased in absolute dollars to
$0.8 million from $1.1 million for the three months ended June 30, 2007 and
2006, respectively. Share-based compensation expense included in software
development costs was equal to 4% and 9% of revenue for the three months ended
June 30, 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 32% to $7.5
million for the three months ended June 30, 2007 from $5.7 million for the three
months ended June 30, 2006. The increase in selling and marketing expenses was
primarily due to (i) higher commissions paid as a result of our 40% increase in
revenue, and (ii) higher salary costs and personnel related costs as a result of
increased sales and marketing headcount during the three months ended June 30,
2007 as compared with the same period in 2006. Share-based compensation expense
included in selling and marketing remained consistent in absolute dollars at
$0.7 million for both the three months ended June 30, 2007 and 2006. Share-based
compensation expense included in selling and marketing expenses was equal to 4%
and 5% of revenue for the three months ended June 30, 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 anticipate that as we continue to grow sales, our sales and
marketing expenses will continue to increase in support of such sales growth.

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 38% to $1.9
million for the three months ended June 30, 2007 from $1.4 million for the three
months ended June 30, 2006. The increase in general and administrative expenses
was primarily due to (i) higher professional fees as a result of the
implementation of FIN No. 48 and other tax related planning activities which
commenced for fiscal year 2007, and (ii) increased compensation and personnel
related costs as a result of increased headcount to support our general and
administrative needs for the three months ended June 30, 2007 as compared with
the same period in 2006. Share-based compensation expense included in general
and administrative decreased in absolute dollars to $0.2 million from $0.3
million for the three months ended June 30, 2007 and 2006, respectively.
Share-based compensation expense included in general and administrative expenses
was equal to 1% and 2% of revenue for the three months ended June 30, 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 $0.6 million for the three months ended June 30, 2007 compared with
$0.4 million for the three months ended June 30, 2006. This increase is
primarily due to increased cash balance as of June 30, 2007 as compared with the
same period in 2006, as well as increased interest rates, which resulted in a
higher average cash balance invested at greater interest rates.

INCOME TAXES

For the three months ended June 30, 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 June
30, 2007 consists primarily of foreign taxes and U.S. federal alternative
minimum taxes and state minimum taxes that are expected to be incurred 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 and foreign taxes. For the three
months ended June 30, 2007, we recorded an income tax benefit of $285,621, which
includes approximately $0.3 million of tax benefits recognized associated with
disqualifying dispositions of incentive stock options as a result of our
continued positive operating results and improved projections for taxable
income. We believe that if positive evidence from our earnings trends continue
in subsequent quarters, it is likely we will recognize a significant portion of
our deferred tax assets through a reduction in our deferred tax valuation
allowance in the near term.

RESULTS OF OPERATIONS - FOR THE SIX MONTHS ENDED JUNE 30, 2007 COMPARED WITH SIX
MONTHS ENDED JUNE 30, 2006.

Revenues for the six months ended June 30, 2007 increased 56% to $34.1
million compared with $21.9 million for the six months ended June 30, 2006. Our
operating expenses increased 26% from $27.4 million for the six months ended
June 30, 2006 to $34.4 million for the six months ended June 30, 2007. Included
in our operating expenses for the six months ended June 30, 2007 and 2006 was
$4.1 and $4.7 million, respectively, of share-based compensation expense related
to stock-based compensation in accordance with SFAS No. 123(R). Net income for
the six months ended June 30, 2007 was $0.8 million compared with a net loss of
$4.9 million for the six months ended June 30, 2006. The growth in revenues was
due to significant increases in our software license and maintenance revenues as
well as moderate increases in software services and other revenues. Revenue
contribution from our OEM partners increased in absolute dollars and as a
percentage of our total revenue for the six months ended June 30, 2007 as
compared with the same period in 2006. Revenue from resellers and distributors
also increased in absolute dollars for the six months ended June 30, 2007 as
compared with the same period in 2006. Expenses increased in all aspects of our
business to support our continued growth. During the six months ended June 30,
2007, we continued to increase the number of employees and to invest in our
infrastructure by increasing our capital expenditures particularly with
purchases of equipment for support of our existing and future product lines. We
increased the number of employees from 330 as of June 30, 2006 to 394 employees
as of June 30, 2007.

REVENUES

SOFTWARE LICENSE REVENUE

Software license revenue increased 56% from $14.4 million for the six
months ended June 30, 2006 to $22.4 million for the six months ended June 30,
2007. Continued growth of market acceptance and increased demand for our
products has resulted in increased sales from our OEM partners and 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 in future periods.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenue increased 56% to $11.7
million for the six months ended June 30, 2007 from $7.5 million for the six
months ended June 30, 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 $3.4 million from $5.5 million for the six months ended June
30, 2006 to $8.9 million for the six months ended June 30, 2007. Software
services and other revenue increased approximately $0.8 million from $2 million
for the six months ended June 30, 2006 to $2.8 million for the six months ended
June 30, 2007. This increase is primarily due to the increase in hardware we
bundled with our software. We expect maintenance, software services and other
revenues to continue to increase.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

As of June 30, 2007, we had $0.1 million of purchased software licenses,
net of accumulated amortization of $5.1 million that are being amortized over
three years. For the six months ended June 30, 2007, we recorded $50,000 of
amortization related to these purchased software licenses. As of June 30, 2006,
we had $0.3 million of purchased software licenses, net of accumulated
amortization of $4.9 million and recorded approximately $0.3 million of
amortization for the six months ended June 30, 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 for the six
months ended June 30, 2007 increased by 21% to $5.2 million compared with $4.3
million for the six months ended June 30, 2006. The increase in cost of
maintenance, software services and other revenue was primarily due to (i) the
increased cost of hardware as a result of the increased number of transactions
in which we bundled purchased hardware with our software and sold the bundled
solution, and (ii) the increase in personnel and related costs for the six
months ended June 30, 2007 as compared with the same period in 2006. As a result
of our increased sales from maintenance and support contracts, we hired
additional employees to provide technical support. Consequently, our cost of
maintenance, software services and other revenue will continue to grow in
absolute dollars as our revenues from these services also increase.

Gross profit for the six months ended June 30, 2007 was $28.8 million or
85% of revenue compared with $17.3 million or 79% of revenue for the six months
ended June 30, 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 in absolute dollars to $0.5 million from
$0.7 million for the six months ended June 30, 2007 and 2006, respectively.
Share-based compensation expense was equal to 1% and 3% of revenue for the six
months ended June 30, 2007 and 2006, respectively.

SOFTWARE DEVELOPMENT COSTS

Software development costs increased 14% to $10.9 million for the six
months ended June 30, 2007 from $9.5 million for the six months ended June 30,
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
six months ended June 30, 2007 as compared with the same period in 2006.
Share-based compensation expense included in software development costs
decreased in absolute dollars to $1.7 million from $2.1 million for the six
months ended June 30, 2007 and 2006, respectively. Share-based compensation
expense included in software development costs was equal to 5% and 10% of

revenue for the six months ended June 30, 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 increased 37% to $14.5 million for the six
months ended June 30, 2007 from $10.6 million for the six months ended June 30,
2006. The increase in selling and marketing expenses was primarily due to (i)
higher commissions paid as a result of our 56% increase in revenue and (ii)
higher salary costs and personnel related costs as a result of increased sales
and marketing headcount during the six months ended June 30, 2007 as compared
with the same period in 2006. Share-based compensation expense included in
selling and marketing increased slightly in absolute dollars to $1.4 million
from $1.3 million for the six months ended June 30, 2007 and 2006, respectively.
Share-based compensation expense included in selling and marketing expenses was
equal to 4% and 6% of revenue for the six months ended June 30, 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 anticipate that as we continue to grow sales, our sales and
marketing expenses will continue to increase in support of such sales growth.

GENERAL AND ADMINISTRATIVE

General and administrative expenses increased 42% to $3.9 million for the
six months ended June 30, 2007 from $2.7 million for the six months ended June
30, 2006. The increase in general and administrative expenses was primarily due
to (i) higher professional fees as a result of the implementation of FIN No. 48
and other tax related planning activities which commenced for fiscal year 2007,
and (ii) increased compensation and personnel related costs as a result of
increased headcount to support our general and administrative needs for the six
months ended June 30, 2007 as compared with the same period in 2006. Share-based
compensation expense included in general and administrative remained consistent
in absolute dollars at $0.5 million for both the six months ended June 30, 2007
and 2006, respectively. Share-based compensation expense included in general and
administrative expenses was equal to 1% and 2% of revenue for the six months
ended June 30, 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 $1.1 million for the six months ended June 30, 2007 compared with
$0.7 million for the six months ended June 30, 2006. This increase is primarily
due to increased cash balance during the six months ended June 30, 2007 as
compared with the same period in 2006, as well as increased interest rates,
which resulted in a higher average cash balance invested at greater interest
rates.

INCOME TAXES

For the six months ended June 30, 2007 and 2006, our provision for income
taxes consists of U.S. and foreign taxes in amounts necessary to align our
year-to-date tax provision with the effective tax rate we expect to achieve for
the full year. The provision includes U.S. federal alternative minimum taxes and
state minimum taxes that are expected to be incurred 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 expense for income tax purposes that has been recognized for
financial statement purposes and foreign taxes. During the six months ended June
30, 2007, our income tax benefit of $83,537 includes discrete items for (i)
$57,058 related to state income taxes incurred in periods prior to 2007, (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, and (iii) $0.3 million of benefit associated with
disqualifying dispositions of incentive stock options as a result of our
continued positive operating results and improved projections for taxable
income. We believe that if positive evidence from our earnings trends continue
in subsequent quarters, it is likely we will recognize a significant portion of
our deferred tax assets through a reduction in our deferred tax valuation
allowance in the near term.

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 June 30, 2007,
based primarily upon our cumulative losses, a valuation allowance has been
recorded against deferred tax assets to record such assets at an amount that we
believe is more-likely-than-not recoverable. We believe that if positive
evidence from our earnings trends continue in subsequent quarters, it is likely
we will recognize a significant portion of our deferred tax assets through a
reduction in our deferred tax valuation allowance in the near term. If the
entire deferred tax assets were realized, approximately $6 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 and six months
ended June 30, 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.

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,
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
June 30, 2007 increased by $15.2 million compared with December 31, 2006. Our
cash and cash equivalents totaled $26.2 million and marketable securities
totaled $29.9 million at June 30, 2007. As of December 31, 2006, we had
approximately $15.6 million in cash and cash equivalents and $25.4 million in
marketable securities.

We continued to invest in our infrastructure to support our long-term
growth during the six months ended June 30, 2007. We made investments in
property and equipment and we increased the number of employees during the first
half 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 and six months ended June 30,
2007. During the three and six months ended June 30, 2006, we repurchased
250,000 shares at an aggregate purchase price of $1.7 million.

Net cash provided by operating activities totaled $11.6 million for the six
months ended June 30, 2007, compared with $5.4 million for the same period in
2006. Net cash provided by operating activities of $11.6 million was primarily
derived from: (i) a decrease in accounts receivables of $3.6 million; (ii) an
increase in deferred revenue of $3 million; (iii) non-cash charges of $1.8
million for depreciation and amortization; (iv) $4.1 million related to
share-based compensation expense; and (v) our net income of $0.8 million for the
six months ended June 30, 2007. These amounts were partially offset by: (i) a
decrease in accrued expenses of $1.3 million; and (ii) an increase in prepaid
and other assets of $0.8 million. The cash provided by operating activities for
the six months ended June 30, 2006 was mainly comprised of: (i) a decrease in
accounts receivable of $2.5 million; (ii) an increase in deferred revenue of
$1.5 million; (iii) non-cash charges of $1.8 million for depreciation and
amortization; (iv) an increase in accrued expenses of $0.1 million; and (iv)
$4.7 million related to share-based compensation expense. These amounts were
partially offset by: (i) our net loss of $4.9 million for the six months ended
June 30, 2006; and (ii) an increase in other assets of $0.1 million.

Net cash used in investing activities was $7.5 million for the six months
ended June 30, 2007, was comprised of: (i) net purchases of marketable
securities of $4.6 million; (ii) purchases of property and equipment of $2.8
million; and (iii) purchases of software licenses and intangible assets of $0.1
million. Net cash used in investing activities was $9.8 million for the six
months ended June 30, 2006, was comprised of: (i) net purchases of marketable
securities of $7.8 million; (ii) purchases of property and equipment of $1.7
million; and (iii) purchases of software licenses and intangible assets of $0.3
million.

Net cash provided from financing activities was $6.6 million for the six
months ended June 30, 2007. We received proceeds from the exercise of stock
options of $6.6 million. Net cash used in financing activities was $0.6 million
for the six months ended June 30, 2006. It was comprised of purchases of
treasury stock of $1.7 million partially offset by the proceeds from the
exercise of stock options of $1.1 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 June 30, 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 June 30, 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 June 30, 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 June 30, 2007, we had
one customer who accounted for 26% of our revenues and one customer who
accounted for 14% 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 June 30, 2007, two customers accounted for a total of
25% of our outstanding receivables, 15% and 10%, respectively. While we
currently have no reason to doubt 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 first and second quarters 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
June 30, 2007, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $6.06 and $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 variance in actual results as compared to 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 or addition 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, THE EXERCISE OF WHICH
WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF OUR
COMMON STOCK, AND A SMALLER NUMBER OF RESTRICTED SHARES OF STOCK, THE VESTING
OF WHICH WILL ALSO DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE
OWNERSHIP OF OUR COMMON STOCK.

As of June 30, 2007, we had an aggregate of 9,856,588 outstanding options
to purchase our common stock and outstanding restricted shares. If all of these
outstanding options were exercised, and all of the outstanding restricted stock
vested, the proceeds to the Company would average $5.76 per share. We also had
903,689 shares of our common stock reserved for issuance under our stock plans
with respect to options (or restricted stock) that have not been granted
(excluding an additional 2,170,731 shares of common stock reserved for issuance
under the 2006 Plan as of July 1, 2007, see Note 2 to the financial statements.)
On August 7, 2007, 66,000 of the restricted shares vested.

The exercise of all of the outstanding options 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.

THE ABILITY TO CORRECTLY PREDICT OUR FUTURE EFFECTIVE TAX RATES COULD IMPACT
OUR ABILITY TO ACCURATELY FORECAST FUTURE EARNINGS.

We are subject to income taxes in both the United States and the various
foreign jurisdictions in which we operate. Judgment is required in determining
our provision for income taxes and there are many transactions and calculations
where the tax determination may be uncertain. Our future effective tax rates
could be affected by changes in our (i) earnings or losses; (ii) changes in the
valuation of our deferred tax assets; (iii) changes in tax laws; and (iv) other
factors. Our ability to correctly predict our future effective tax rates based
upon these possible changes could significantly impact our forecasted earnings.

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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company held its annual meeting of stockholders on May 8, 2007. 44,823,639
shares of Common Stock, 91% of the outstanding shares, were represented in
person or by proxy.

ReiJane Huai was elected to serve as a director of the Company for a term
expiring in 2010 with 44,556,438 shares voted in favor, 267,201 shares withheld
and 0 broker non-votes.

Lawrence S. Dolin was elected to serve as a director of the Company for a term
expiring in 2010 with 44,493,692 shares voted in favor, 329,947 shares withheld
and 0 broker non-votes.

The terms of office of Company directors Steven L. Bock, Patrick B. Carney,
Steven R. Fischer, and Alan W. Kaufman did not expire prior to this annual
meeting of stockholders and each remains a director of the Company.

The amendment to the FalconStor Software, Inc., 2006 Incentive Stock Plan was
approved with 19,734,009 shares voted in favor, 7,089,838 shares voted against,
62,846 shares abstained, and 17,936,946 broker non-votes.

The Company's 2007 Outside Directors Equity Compensation Plan was approved with
23,557,476 shares voted in favor, 3,263,116 shares voted against, 66,101 shares
abstained, and 17,936,946 broker non-votes.

The selection of KPMG LLP as the independent registered public accounting firm
for the Company was ratified with 44,680,339 shares voted in favor, 105,223
shares voted against, 38,017 shares abstained and 0 broker non-votes.

ITEM 5. OTHER INFORMATION

On August 6, 2007, the Company's Board of Directors approved amendments to
the employment agreement between ReiJane Huai and the Company. These amendments
were made as a result of recent guidance on Section 409(A) of the Internal
Revenue Code provided by the Internal Revenue Service. The amendments do not
have any impact on the value of payments that Mr. Huai may receive under the
agreement.

On August 6, 2007, the Company's Board of Directors approved amendments to
the FalconStor Software, Inc., 2005 Key Executive Severance Protection Plan (the
"Plan"). Most of these amendments were made as a result of recent guidance on
Section 409(A) of the Internal Revenue Code provided by the Internal Revenue
Service and do not result in any change in the amount payable to any participant
in the Plan. One amendment provides that upon a Change of Control, as defined in
the Plan, all restrictions on any shares of restricted Company stock held by any
Participant shall automatically lapse.

On August 6, 2007, the Company's Board of Directors approved an amendment
to Section 9.1 of the Company By-Laws. The amendment was made to conform to a
recent rule passed by the Securities and Exchange Commission that requires that
all listed securities on the NASDAQ be eligible for a Direct Registration
Program ("DRP") operated by a clearing agency registered under Section 17A of

the Exchange Act. The amendment provides for the issuance of the Company's stock
to meet the requirements of NASDAQ's DRP.

On August 7, 2007, the Compensation Committee of the Company's Board of
Directors made grants of restricted shares of Company Common Stock to certain
officers, including the Chief Financial Officer, the Vice President for Business
Development and the Vice President and Co-Founder (the "Named Officers"). Each
of the Named Officers received 28,000 restricted shares of stock which will vest
in accordance with the Company's 2006 Incentive Stock Plan.

ITEM 6. EXHIBITS

3.1 Amendment to By-laws of FalconStor Software, Inc., dated August 6,
2007.

10.1 Second Amended and Restated Employment Agreement, dated November 7,
2005 between Registrant and ReiJane Huai, as amended, August 6, 2007.

10.2 FalconStor Software, Inc., 2005 Key Executive Severance Protection
Plan, as amended, August 6, 2007.

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)

August 8, 2007

EX-3.1 2 ex31to10q04637_06302007.htm sec document


                                                                     Exhibit 3.1


                                    AMENDMENT

                                       TO

                                     BY-LAWS

                                       OF

                            FALCONSTOR SOFTWARE, INC.

          Article Five, Section 5.1 of the By-Laws of Falconstor Software,  Inc.
(the  "Corporation")  shall be deleted in its  entirety and be replaced by a new
Article Five, Section 5.1 to read as follows:

          The    Corporation's    stock   may   be   certificated   or
          uncertificated,  as provided  under the General  Corporation
          Law of the State of  Delaware,  and shall be  entered in the
          books and records of the  Corporation and registered as they
          are issued.  Any certificates  representing  shares of stock
          shall be in such form as the Board of Directors  prescribes,
          and  shall  certify  the  number  and class of shares of the
          Corporation owned by the stockholder. Each certificate shall
          be  signed  by or in  the  name  of the  Corporation  by the
          President or a Vice  President,  and by the  Secretary or an
          Assistant  Secretary,  or  the  Treasurer  or  an  Assistant
          Treasurer,  certifying  the number of shares owned by him or
          her.  Any  of  or  all  the  signatures  appearing  on  such
          certificate  or  certificates  may  be a  facsimile.  If any
          officer, transfer agent or registrar who has signed or whose
          facsimile signature has been placed upon a certificate shall
          have ceased to be such officer,  transfer agent or registrar
          before such  certificate is issued,  it may be issued by the
          Corporation with the same effect as if he were such officer,
          transfer agent or registrar at the date of issue.

Dated August 6, 2007

EX-10.1 3 ex101to10q04637_06302007.htm sec document


                                                                    Exhibit 10.1


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

          SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT made this 7th day of
November, 2005 (hereinafter referred to as this "Employment Agreement"), by
FalconStor Software, Inc., a Delaware corporation (hereinafter referred to as
the "Corporation"), and ReiJane Huai with an address at 3 Carlisle Drive, Old
Brookville, NY 11545 (hereinafter referred to as the "Employee").

          WHEREAS, the Employee desires to continue to be employed by the
Corporation as President and Chief Executive Officer ("CEO"), and the
Corporation desires that the Employee continue to be so employed, upon the terms
and conditions hereinafter set forth.

          NOW, THEREFORE, in consideration of the premises and the mutual
covenants and agreements hereinafter set forth, the parties intending to be
legally bound, agree as follows:

          1. TERM OF EMPLOYMENT. The Board hereby employs the Employee as
President and CEO, and the Employee hereby agrees to serve the Corporation in
such capacity for the period commencing on September 1, 2004 (the "Effective
Date") and ending on December 31, 2007 (hereinafter referred to as the
"Employment Period"), unless sooner terminated as hereinafter provided.

          2. SCOPE OF DUTIES. The Employee shall serve as a President and CEO.
The Employee shall report and be solely responsible to the Board of Directors of
the Corporation (the "Board"). The Employee's performance shall be reviewed by
the Board annually.

          3. TIME TO BE DEVOTED TO EMPLOYMENT. The Employee shall, except during
vacation periods or absences due to temporary illness, devote substantially all
of his professional and business time, attention and energies to his duties and
responsibilities hereunder, and except for business trips which shall be
necessary or desirable in the Corporation's business, shall render such services
at the principal office of the Corporation. Nothing herein contained or in
Section 10 hereof shall prevent or be construed as preventing the Employee from
holding or purchasing five (5%) percent or less of any class of stock or
securities of a corporation which is listed on a national securities exchange or
regularly traded in the over-the-counter market, or making other investments or
participating in business ventures not in competition with the business of the
Corporation, as long as such investments and business ventures shall not require
any time during normal business hours and do not conflict with his duties or
obligations to the Corporation as provided in this Employment Agreement.

          4. DIRECT COMPENSATION. (a) In consideration for services rendered and
to be rendered by the Employee hereunder during the Employment Period, the
Employee shall receive a salary of Two Hundred and Seventy-Five Thousand
($275,000) Dollars per year, or such greater amount as the Board shall determine




from year to year based on the Employee's performance (the "Base Salary"), which
shall be paid semi-monthly in arrears or at such other intervals as other
employees are paid.

          (b) The Employee shall be entitled to receive a cash bonus (i) for the
period from September 1, 2004 through December 31, 2005 (the "First Bonus
Period") in an amount equal to 2.50% of the Corporation's net operating income
for such period as determined by reference to the Corporation's income
statements, but without giving effect to (a) Statement of Financial Accounting
Standard 123R, or (b) such other extraordinary, non-recurring and/or other
unusual items as determined by the Compensation Committee of the Company's Board
of Directors and agreed by a majority of the independent directors of the
Company's Board of Directors (hereinafter referred to as the "Operating Income")
during the First Bonus Period, (ii) for the fiscal year of the Corporation
ending December 31, 2006 (the "Second Bonus Period") in an amount equal to the
product of (A) the Applicable Percentage (as defined below) and (B) the
Operating Income for the Second Bonus Period and (iii) for the fiscal year of
the Corporation ending December 31, 2007 (the "Third Bonus Period") in an amount
equal to the product of (A) the Applicable Percentage and (B) the Operating
Income for the Third Bonus Period. Each bonus payable to the Employee shall be
paid within 75 days after the last day of the applicable Bonus Period. For
purposes hereof, "Applicable Percentage" shall mean (I) 1.50%, if the percentage
obtained by dividing (x) the Operating Income for the Second Bonus Period or the
Third Bonus Period, as the case may be, by (y) the shareholders equity of the
Corporation during the Second Bonus Period or the Third Bonus Period, as the
case may be, as determined by reference to the annual audited balance sheet of
the Corporation for the year ending as of the end of such Bonus Period
(hereinafter referred to as "Shareholders Equity") is less than or equal to 5%,
(II) 2.00%, if the percentage obtained by dividing (x) the Operating Income for
the Second Bonus Period or the Third Bonus Period, as the case may be, by (y)
the Shareholders Equity is more than 5% but less than or equal to 10%, (III)
2.25%, if the percentage obtained by dividing (x) the Operating Income for the
Second Bonus Period or the Third Bonus Period, as the case may be, by (y) the
Shareholders Equity is more than 10% but less than or equal to 15%, (IV) 2.50%,
if the percentage obtained by dividing (x) the Operating Income for the Second
Bonus Period or the Third Bonus Period, as the case may be, by (y) the
Shareholders Equity is more than 15% but less than or equal to 20% and (V)
3.00%, if the percentage obtained by dividing (x) the Operating Income for the
Second Bonus Period or the Third Bonus Period, as the case may be, by (y) the
Shareholders Equity is more than 20%. The cash bonus for the Third Bonus Period
shall be paid no later than March 15, 2008.

          5. FRINGE BENEFITS. (a) The Employee shall be entitled to participate
in any and all fringe benefits and/or plans, generally afforded to other
employees of the Corporation (to the extent the Employee otherwise qualifies
under the specific terms and conditions of each such benefit), including,


                                       2


without limitation, group disability, life insurance, medical insurance and
pension plans (401K) which are, or which may become available generally to
senior personnel of the Corporation. The Employee shall be entitled to four (4)
weeks of vacation time during each year of the Employment Period.

          (b) If the Corporation has a group disability plan in force at the
time the Employee's employment terminates, the Corporation shall offer the
Employee the opportunity to continue disability coverage at the Employee's own
expense for such period as the Employee desires; provided, that the Employee
shall be required to make all insurance premium contributions.

          (c) Upon termination of the Employee's employment, the Corporation
shall offer the Employee the opportunity to continue the Employee's health
insurance coverage in effect immediately prior to such termination or health
insurance coverage generally available at such time to executives of the
Corporation, at the Employee's own expense, for such period as the Employee
desires; provided, that the Employee shall be required to make all insurance
premium contributions.

          6. TERMINATION OF EMPLOYMENT. During the Employment Period, the
Employee's employment may be terminated by the Board on the occurrence of any
one or more of the following events:

          (a) The death of the Employee;

          (b) For "Cause", which shall mean (i) the willful failure by the
Employee to substantially perform his duties hereunder (including the breach of
any provision of Section 9 and/or 10 hereof), for reasons other than death or
disability; (ii) the willful engaging by the Employee in misconduct materially
injurious to the Corporation; or (iii) the commission by the Employee of an act
constituting (A) common law fraud against the Corporation or (B) a felony; or

          (c) If the Employee is unable substantially to perform the Employee's
duties and responsibilities hereunder to the full extent required by the Board
by reason of illness, injury or incapacity for three consecutive months, or for
more than four months in the aggregate during any period of twelve calendar
months (such condition constituting "disability" for the purposes of this
Employment Agreement); provided, however, that the Corporation shall continue to
pay the Employee's then current Base Salary until the Company acts to terminate
the Employee. The Employee agrees, in the event of a dispute under this Section
6(c), to submit to a physical examination by a licensed physician selected by
the Board and consented to by the Employee.

          7. DEATH BENEFIT. In addition to all other insurance and similar death
benefits generally made available to employees of the Corporation, if the
Employee's death occurs during the term of the Employment Period, the
Corporation shall provide a death benefit to the estate of the Employee equal to
the Employee's then current annual Base Salary at the date of death. Such death
benefit shall be payable as may be determined by the Corporation, but not less
often than six (6) equal monthly installments, payable on the last day of each
month, commencing in the month subsequent to the month in which the death
occurs.


                                       3


          8. SEVERANCE PAYMENT. (a) If the Corporation and the Employee do not
enter into a renewal agreement to be effective January 1, 2008, for a period of
at least two years and containing similar terms and conditions to those set
forth herein, then the Corporation will pay the Employee, as additional
compensation, an amount equal to the Employee's then current annual Base Salary,
as determined under Section 4(a), payable semi-monthly in arrears for the twelve
months ending December 31, 2008; such compensation is hereinafter referred to as
the "Severance Payment".

          (b) Notwithstanding the provisions of Section 8 (a) above, the
Employee will not receive the Severance Payment if,

                  (i) the Corporation declines to enter into a renewal agreement
with the Employee because the Employee breached the confidentiality and/or
non-compete provisions of this Employment Agreement or any other material terms
or conditions of his employment;

                   (ii) the Employee has been terminated for Cause hereunder;

                   (iii) the Employee declines to enter into a renewal agreement
          with the Corporation, and the Corporation has offered a renewal
          agreement for a period of not less than two years, containing similar
          terms and conditions as discussed herein; or

                   (iv) the Employee has received a change of control payment
          from the Corporation that provides change of control benefits that are
          at least equal to the amount that would be received by the Employee
          pursuant to Section 8(a) above.

          (c) If the Employee's employment is terminated for Cause, the
Corporation's sole obligation hereunder shall be to pay the Employee (i) any
accrued and unpaid Base Salary as of the date of termination, (ii) an amount
equal to such reasonable and necessary business expenses incurred by the
Employee in connection with the Employee's employment on behalf of the
Corporation on or prior to the date of termination, but not previously paid to
the Employee, and (iii) if the basis for such termination arises under clause
(i) of the definition of "Cause," his base Salary (at the rate in effect on the
date of termination) through the twelve-month anniversary of the date of
termination in accordance with the normal payroll practices of the Corporation
with respect to Base Salary.

          (d) If at the time his employment is terminated the Employee is a
"specified employee" within the meaning of Section 409A of the Internal Revenue
Code and the regulations thereunder, to the extent required to comply with
Section 409A, payment of the Severance Payment and the Non-Renewal Severance, as
applicable, shall not commence until one day after the day which is six months
following the termination date, with the first payment equaling six months of
Base Salary. Reimbursements pursuant to this Section 8 shall be made on or
before the last day of the Employee's taxable year following the taxable year in
which the expense was incurred.


                                       4


          9. DISCLOSURE OF INFORMATION. All memoranda, notes, records or other
documents made or compiled by the Employee or made available to him during the
term of his employment concerning the business of the Corporation shall be the
Corporation's property and shall be delivered to the Corporation on the
termination of the Employee's employment. The Employee shall not use for himself
or others, or divulge to others, any proprietary or confidential information of
the Corporation, obtained by him as a result of his employment, unless
authorized by the Corporation. For purposes of this Section 9, the term
"proprietary or confidential information" shall mean all information which is
known only to the Employee or to the Employee and employees, former employees,
consultants or others in a confidential relationship with the Corporation and
relates to specific matters such as trade secrets, customers, potential
customers and vendor lists, pricing and credit techniques, program codes,
software design know-how, research and development activities, private
processes, and books and records, as they may exist from time to time, which the
Employee may have acquired or obtained by virtue of work heretofore or hereafter
performed for or on behalf of the Corporation or which he may acquire or may
have acquired knowledge of during the performance of said work, and which is not
known to others, or readily available to others from sources other than the
Employee or officers or other employees of the Corporation, or is not in the
public domain. In the event of a breach or a threatened breach by the Employee
of the provisions of this Section 9, the Corporation shall be entitled to an
injunction restraining the Employee from disclosing, in whole or in part, the
aforementioned proprietary or confidential information of the Corporation, or
from rendering any services to any person, firm, corporation, association or
other entity to whom such proprietary or confidential information, in whole or
in part, has been disclosed or is threatened to be disclosed. Nothing herein
contained shall be construed as prohibiting the Corporation from pursuing any
other remedies available to the Corporation for such breach or threatened
breach, including the recovery of damages from the Employee.

          10. RESTRICTIVE COVENANTS. (a) The Employee hereby acknowledges and
recognizes the highly competitive nature of the Corporation's business and
accordingly agrees that, in consideration of the premises contained herein, he
will not from and after the date hereof and during the Employment Period until
the Designated Date (as hereinafter defined): (i) directly or indirectly engage
in any Competitive Activity (as hereinafter defined), whether such engagement
shall be as an officer, director, employee, consultant, agent, lender,
stockholder, or other participant or (ii) assist others in engaging in
Competitive Activity. As used herein, the term "Competitive Activity" shall mean
and include the development and/or marketing of computer hardware and/or
software for Storage Networking applications and other similar systems.


                                       5


          (b) As used in this Section 10, the "Designated Date" shall mean the
following:

                   (i) if the Employee terminates his employment with the
Corporation prior to the expiration of the Employment Period (other than as a
result of a breach by the Corporation of a material term or condition of this
Employment Agreement), then the "Designated Date" shall mean the second (2nd)
anniversary of the effective date of such termination;

                   (ii) if the Corporation terminates the employment of the
Employee under this Employment Agreement for Cause, then the "Designated Date"
shall be the second (2nd) anniversary of the effective date of such termination;

                   (iii) if the Corporation, during the Employment Period,
terminates the employment of the Employee without Cause, then the "Designated
Date" shall mean the effective date of such termination; or

                   (iv) if the Corporation offers the Employee a renewal
agreement pursuant to Section 8(a) hereof and the Employee does not accept such
agreement, then the "Designated Date" shall mean December 1, 2009.

          (c) It is the desire and intent of the parties that the provisions of
this Section 10 shall be enforced to the fullest extent permissible under the
laws and public policies applied in each jurisdiction in which enforcement is
sought. Accordingly, if any particular provision of this Section 10 shall be
adjudicated to be invalid or unenforceable, such provision of this Section 10
shall be deemed amended to delete from the portion thus adjudicated to be
invalid or unenforceable, such deletion to apply only with respect to the
operation of such provisions of this Section 10 in the particular jurisdiction
in which such adjudication is made and, further, only to the extent required in
order for this Section 10 to be enforceable.

          (d) With respect to Inventions (including but not limited to software)
made or conceived by the Employee, whether or not during the hours of his
employment or with the use of the Corporation's facilities, materials or
personnel, either solely or jointly with others during the Employee's employment
by the Corporation:

                   (i) The Employee shall inform the Corporation promptly and
fully of such Inventions by written report, setting forth in detail the
procedures employed and the results achieved. A report shall be submitted by the
Employee upon completion of any studies or research projects undertaken on the
Corporation's behalf whether or not in the Employee's opinion a given project
has resulted in an Invention.

                   (ii) The Employee shall apply, at the Corporation's request
and expense, for the United States and/or foreign letters patent or other
registrations either in the Employee's name or otherwise, as the Corporation
shall desire.

                   (iii) The Employee hereby assigns and agrees to assign to the
Corporation all of his right and interest to any and all such Inventions and to
make applications for United States and/or foreign letters patent or other
registrations granted upon such Invention.


                                       6


                   (iv) The Employee shall acknowledge and deliver promptly to
the Corporation, without charge to the Corporation, but at its expense, such
written instruments and do such other acts in support of his inventorship, as
may be necessary in the opinion of the Corporation to obtain and maintain United
States and/or foreign letters patent or other registration and to vest the
entire right in such Inventions, patents and patent applications in the
Corporation. The Employee agrees that if the Corporation is unable because of
the Employee's mental or physical incapacity or unavailability or for any other
reason to secure the Employee's signature to apply for or to pursue any
application for any United States or foreign patents or copyright registrations
covering Inventions assigned to the Corporation as above, the Employee hereby
irrevocably designates and appoints the Corporation and its duly authorized
officers and agents as the Employee's agent and attorney in fact, to act for and
in the Employee's behalf and stead to execute and file any such applications and
to do all other lawfully permitted acts to further the application for,
prosecution, issuance, maintenance or transfer of letters patent or copyright
registrations thereon with the same legal force and effect as if originally
executed by the Employee. The Employee hereby waives and irrevocably quitclaims
to the Corporation any and all claims, of any nature whatsoever, which the
Employee now or hereafter may have for infringement of any and all proprietary
rights assigned to the Corporation.

                   (v) The Corporation shall also have the royalty-free right to
use in its business, and to make, use, and sell products and/or services derived
from any Inventions, discoveries, concepts and ideas, whether or not patentable,
including, but not limited to applications, methods, formulas and techniques, as
well as improvements or know-how, whether or not within the scope of Inventions,
but which are obtained, created or made by the Employee during the Employment
Period, without payment of any additional compensation to the Employee.

                   (vi) For the purposes of this Employment Agreement,
"Inventions" means discoveries, concepts and ideas, whether patentable or not,
including but not limited to processes, methods, formulas and techniques as well
as improvements or know-how.

          (e) If there is a breach or threatened breach by the Employee of the
provisions of this Section 10, the Corporation shall be entitled to an
injunction restraining him from such breach. Nothing herein contained shall be
construed as prohibiting the Corporation from pursuing any other remedies
available for such breach or threatened breach or any other breach of this
Employment Agreement.

          (f) The Employee hereby warrants and represents that he is not
prohibited by any agreement or the order of any court from entering into and
carrying out the terms of this Employment Agreement. In particular, the Employee
warrants and represents that the scope of his activity is not restricted in any
way with respect to the design, development, enhancement, sale, marketing and/or
promotion of computer software and hardware.


                                       7


          11. (a) NOTICES. All notices required or permitted to be given under
the provisions of this Employment Agreement shall be in writing and delivered
personally or by certified or registered mail, return receipt requested, postage
prepaid to the following persons at the following addresses, or to such other
person at such other address as either party may request by notice in writing to
the other party to this Employment Agreement:

                        If to the Employee:

                            ReiJane Huai
                            3 Carlisle Drive,
                            Old Brookville, NY 11545

                        If to the Corporation:

                            FalconStor Software, Inc.
                            2 Huntington Quadrangle
                            Suite 2S01
                            Melville, New York 11747

              (b) CONSTRUCTION. This Employment Agreement shall be construed in
accordance with, and be governed by, the laws of the State of New York for
contracts entered into and to be performed in New York.

              (c) SUCCESSOR AND ASSIGNS. This Employment Agreement and the
various rights and obligations arising hereunder shall inure to the benefit of
and be binding upon the Employee and his heirs, executors and administrators and
upon the Corporation and its successors (including, without limitation, by way
of merger) and assigns. This Employment Agreement is personal in nature and may
not be assigned or transferred by the Employee without the prior written consent
of the Corporation.

              (d) ENTIRE AGREEMENT; AMENDMENT AND RESTATEMENT. This instrument
contains the entire understanding and agreement between the parties relating to
the subject matter hereof, and neither this Employment Agreement nor any
provision hereof may be waived, modified, amended, changed, discharged or
terminated, except by an agreement in writing signed by the party against whom
enforcement of any waiver, modification, change, amendment, discharge or
termination is sought. This Employment Agreement amends, restates and supersedes
the Amended and Restated Employment Agreement dated September 1, 2004 between
the Corporation and the Employee.

              (e) COUNTERPARTS. This Employment Agreement may be executed
simultaneously in counterparts, each of which shall be deemed an original, and
both of which counterparts shall together constitute a single agreement.

              (f) ILLEGALITY. Without limitation of Section 10(c) hereof, if any
one or more of the provisions of this Employment Agreement shall be invalid,
illegal or unenforceable in any respect, the validity, legality and
enforceability of the remaining provisions contained herein shall not in any way
be affected or impaired thereby.


                                       8


              (g) CAPTIONS. The captions of the sections hereof are for
convenience only and shall not control or affect the meaning or construction of
any of the terms or provisions of this Employment Agreement.

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

                                        FalconStor Software, Inc.

                                        By: /s/ Jim Weber
                                            ------------------------------------
                                            Jim Weber
                                            Vice President and Chief Financial Officer

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

EX-10.2 4 ex102to10q04637_06302007.htm sec document


                                                                    Exhibit 10.2


                            FALCONSTOR SOFTWARE, INC.

                          2005 KEY EXECUTIVE SEVERANCE
                                 PROTECTION PLAN


                        EFFECTIVE AS OF DECEMBER 1, 2005

                            AS AMENDED AUGUST 6, 2007



                                TABLE OF CONTENTS


SECTION 1    ESTABLISHMENT OF PLAN

SECTION 2    DEFINITIONS

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

SECTION 3    ELIGIBILITY

    3.1      Participation
    3.2      Duration of Participation

SECTION 4    SEVERANCE BENEFITS

    4.1      Right to Severance Benefit
    4.2      Amount of Severance Benefit
    4.3      Options
    4.4      Restricted Stock

SECTION 5    TERMINATION OF EMPLOYMENT

    5.1      Written Notice Required
    5.2      Termination Date

SECTION 6    ADDITIONAL PAYMENTS BY THE COMPANY

    6.1      Gross-Up Payment


                                       i


    6.2      Determination By Accountant
    6.3      Notification Required
    6.4      Repayment
    6.5      Timing of Payment

SECTION 7    SUCCESSORS TO COMPANY

    7.1      Successors
    7.2      Sale of Operating Companies

SECTION 8    AMENDMENT AND PLAN TERMINATION

    8.1      Amendment and Termination
    8.2      Form of Amendment

SECTION 9    MISCELLANEOUS

    9.1      Indemnification
    9.2      Employment Status
    9.3      No Duty of Mitigation
    9.4      No Setoff
    9.5      Benefits Under Other Plans
    9.6      Validity and Severability
    9.7      Governing Law; Choice of Forum
    9.8      409A

APPENDIX I
APPENDIX II


                                       ii



                            FALCONSTOR SOFTWARE, INC.
                  2005 KEY EXECUTIVE SEVERANCE PROTECTION PLAN

                        EFFECTIVE AS OF DECEMBER 1, 2005

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

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

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

                         SECTION 1 ESTABLISHMENT OF PLAN

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

                              SECTION 2 DEFINITIONS

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

2.1   BASE SALARY

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

2.2   BOARD

          The Board of Directors of the Company.

2.3   BONUS AMOUNT

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



2.4   CAUSE

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

2.5   CHANGE IN CONTROL

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

          (a) An acquisition (other than directly from the Company) of any
voting securities of the Company (the "Voting Securities") by any "Person" (as
the term "person" is used for purposes of Section 13(d) or 14(d) of the
Securities Exchange Act of 1934, as amended (the "Exchange Act")), immediately
after which such Person has "Beneficial Ownership" (within the meaning of Rule
13d-3 promulgated under the Exchange Act) of more than fifty percent (50%) of
(1) the then-outstanding shares of common stock of the Company (or any other
securities into which such shares of common stock are changed or for which such
shares of common stock are exchanged) (the "Shares") or (2) the combined voting
power of the Company's then-outstanding Voting Securities; PROVIDED, HOWEVER,


                                       2


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);

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

          (c) The consummation of:

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

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

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


                                       3


                   (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;

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

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

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

2.6   COMPANY

          "Company" shall mean FalconStor Software, Inc.


                                       4


2.7   EFFECTIVE DATE

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

2.8   EMPLOYER

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

2.9   EXECUTIVE OFFICER

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

2.10  GOOD REASON

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

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

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

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

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

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


                                       5


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

2.11  NOTICE OF TERMINATION

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

2.12  OTHER EXECUTIVES

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

2.13  OPERATING COMPANIES

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

2.14  PARTICIPANT

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

2.15  PERMANENT DISABILITY

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

2.16  PLAN

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

2.17  SEVERANCE BENEFITS

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


                                       6


                              SECTION 3 ELIGIBILITY

3.1   PARTICIPATION

          Executive Officers shall automatically become Participants in this
Plan in Group III when designated Executive Officers by the Board. Other
Executives shall become Participants in the Plan if they are designated by the
Board or Compensation Committee thereof as Participants. Participants shall be
identified on Appendix II of the Plan. The Company shall amend Appendix II from
time to time as necessary to include new Participants in the Plan or remove
Participants from the Plan who are no longer eligible to participate in the
Plan, in each case in accordance with the terms and conditions of the Plan.

3.2   DURATION OF PARTICIPATION

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

                          SECTION 4 SEVERANCE BENEFITS

4.1   RIGHT TO SEVERANCE BENEFITS

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

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


                                       7


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

4.2   AMOUNT OF SEVERANCE BENEFIT

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

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

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

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

                   (b) for the period of months, as specified for each
Participant Designation Level in the table below, subsequent to the
Participant's termination of employment, the Company shall at its expense
continue on behalf of the Participant and his or her dependents and
beneficiaries, the basic life insurance, flexible spending account, medical and
dental benefits which were being provided to the Participant immediately prior
to the Change in Control (or, if greater, at any time thereafter). The benefits
provided in this Subsection 4.2(b) shall be no less favorable to the
Participant, in terms of amounts and deductibles and costs to him or her, than
the coverage provided the Participant under the plans providing such benefits at


                                       8


the time Notice of Termination is given. The Company's obligation hereunder to
provide the foregoing benefits shall terminate to the extent the Participant
obtains replacement coverage under a subsequent employer's benefit plans at an
equal or higher level. The amount of the foregoing benefits and reimbursements
provided in a Participant's taxable year cannot affect the amounts provided in
any other taxable year. To the extent the foregoing requires reimbursements be
paid to a Participant, the reimbursement must be made on or before the last day
of the Participant's taxable year following the taxable year in which the
expense was incurred. The Company also shall pay a lump sum equal to the amount
of any additional income tax payable by the Participant and attributable to the
benefits provided under this subparagraph (b) at the earlier of (i) the time
such tax is imposed upon the Participant and (ii) the end of the Participant's
taxable year next following the taxable year in which the Participant remits the
taxes;

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

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

4.3   OPTIONS

          Notwithstanding any provision in the Company's 2000 Stock Option Plan,
as amended, or any other Company Incentive or Non-Qualified Stock Option Plan,
or in this Plan, in the event there is a Change of Control, the Company shall,
at no cost to the Participant, replace any and all stock options granted by the
Company and held by the Participant at the time of the Change of Control,
whether or not vested, with an equal number of unrestricted and fully vested
stock options to purchase shares of the Company's Common Stock (the "Option
Replacement"). With respect to the Option Replacement, all options will become
fully vested. The Option Replacement shall satisfy the requirements of Treasury
Regulation Section 1.409-1(b)(5)(v)(D).

          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


                                       9


such stock on the Nasdaq National Market or other market on which the Company's
Common Stock is then traded on the date on which the Participant entitled to a
Severance Benefit.

4.4   RESTRICTED STOCK

          Notwithstanding any provision in the Company's 2006 Incentive Stock,
or any other Company Incentive or Non-Qualified Stock Option Plan, or in this
Plan, in the event there is a Change of Control, all restrictions on all shares
of restricted Company stock previously granted to each Participant, including,
without limitation, those relating to the Participant's tenure with the Company,
shall lapse and the shares shall have no further restrictions.

                       SECTION 5 TERMINATION OF EMPLOYMENT

5.1   WRITTEN NOTICE REQUIRED

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

5.2   TERMINATION DATE

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

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

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

                  SECTION 6 ADDITIONAL PAYMENTS BY THE COMPANY

6.1   GROSS-UP PAYMENT

          (a) Other than Severance Benefits due under Section 4.3, hereof, and
subject only to Section 6.1(b) hereof, in the event it shall be determined that
any payment or distribution of any type by the Company or any of its affiliates
to or for the benefit of the Participant, whether paid or payable or distributed
or distributable pursuant to the terms of this Plan or otherwise (the
"Payments"), would be subject to the excise tax imposed by Section 4999 of the
Internal Revenue Code of 1986, as amended (the "Code"), or any interest or
penalties with respect to such excise tax (such excise tax, together with any


                                       10


such interest and penalties, are collectively referred to as the "Excise Tax"),
then the Participant shall be entitled to receive an additional payment (a
"Gross-Up Payment") in an amount such that after payment by the Participant of
all taxes (including any interest or penalties imposed with respect to such
taxes), including any income taxes, employment taxes and Excise Tax, imposed
upon the Gross-Up Payment, the Participant retains an amount of the Gross-Up
Payment equal to the Excise Tax imposed upon the Payments. Payment of the
Gross-Up Payment shall be made in accordance with Section 6.3.

          (b) Notwithstanding Section 6.1(a), in the event that a reduction to
the Payments in respect of a Participant of 10% or less would cause no Excise
Tax to be payable, the Participant will not be entitled to a Gross-Up Payment
and the Payments shall be reduced (but not below zero) to the extent necessary
so that the Payments shall not be subject to the Excise Tax. Unless the
Participant shall have given prior written notice specifying a different order
to the Company to effectuate the foregoing, the Company shall reduce or
eliminate the Payments, by first reducing or eliminating the portion of the
Payments which are not payable in cash and then by reducing or eliminating cash
payments, in each case in reverse order beginning with payments or benefits
which are to be paid the farthest in time from the date of the Change in
Control. Any notice given by the Participant pursuant to the preceding sentence
shall take precedence over the provisions of any other plan, arrangement or
agreement governing the Participant's rights and entitlements to any benefits or
compensation.

6.2   DETERMINATION BY ACCOUNTANT

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


                                       11


6.3   NOTIFICATION REQUIRED

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

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

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

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

                   (d) permit the Company to participate in any proceedings
          relating to such claim; PROVIDED, HOWEVER, that the Company shall bear
          and pay directly all costs and expenses (including additional interest
          and penalties) incurred in connection with such contest and shall
          indemnify and hold the Participant harmless, on an after-tax basis,
          for any Excise Tax or income tax, including interest and penalties
          with respect thereto, imposed as a result of such representation and
          payment of costs and expenses, which costs and expenses shall be
          reimbursed no later than the end of the Participant's taxable year
          following the Participant's taxable year in which the proceeding is
          completed. Without limitation on the foregoing provisions of this
          Section 6.3, the Company shall control all proceedings taken in
          connection with such contest and, at its sole option, may pursue or
          forgo any and all administrative appeals, proceedings, hearings and
          conferences with the taxing authority in respect of such claim and
          may, at its sole option, either direct the Participant to pay the tax
          claimed and sue for a refund, or contest the claim in any permissible
          manner, and the Participant agrees to prosecute such contest to a
          determination before any administrative tribunal, in a court of
          initial jurisdiction and in one or more appellate courts, as the
          Company shall determine; PROVIDED, HOWEVER, that if the Company
          directs the Participant to pay such claim and sue for a refund, the
          Company shall advance the amount of such payment to the Participant
          (unless otherwise prohibited by applicable law), on an interest-free
          basis and shall indemnify and hold the Participant harmless, on an


                                       12


          after-tax basis, from any Excise Tax or income tax, including interest
          or penalties with respect thereto, imposed with respect to such
          advance or with respect to any imputed income with respect to such
          advance; and PROVIDED, FURTHER, that any extension of the statute of
          limitations relating to payment of taxes for the taxable year of the
          Participant with respect to which such contested amount is claimed to
          be due is limited solely to such contested amount. Furthermore, the
          Company's control of the contest shall be limited to issues with
          respect to which a Gross-Up Payment would be payable hereunder and the
          Participant shall be entitled to settle or contest, as the case may
          be, any other issue raised by the Internal Revenue Service or any
          other taxing authority.

6.4   REPAYMENT

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

6.5   TIMING OF PAYMENT

          All amounts owing under Section 6.1 shall be made no later than the
end of the Participant's taxable year next following the Participant's taxable
year in which the Excise Tax, or taxes imposed on the Gross-Up Payment, as
applicable, is remitted.

                         SECTION 7 SUCCESSORS TO COMPANY

7.1   SUCCESSORS

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


                                       13


7.2   SALES OF OPERATING COMPANIES

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

                    SECTION 8 AMENDMENT AND PLAN TERMINATION

8.1   AMENDMENT AND TERMINATION

          Prior to a Change in Control, the Plan may be amended or modified in
any respect, and may be terminated, in any such case, by resolution adopted by
two-thirds of the Board; PROVIDED, HOWEVER, that no such amendment, modification
or termination which would adversely affect the benefits or protections
hereunder of any individual who is a Participant as of the date such amendment,
modification or termination is adopted shall be effective as it relates to such
individual unless no Change in Control occurs within one year after such
adoption, any such attempted amendment, modification or termination adopted
within one year prior to a Change in Control being null and void ab initio as it
relates to all such individuals who were Participants prior to such adoption (it


                                       14


being understood that the removal of Participants from participation in the Plan
shall, for purposes of this proviso, constitute an adverse action for the
Participants so removed); PROVIDED, FURTHER, HOWEVER, that the Plan may not be
amended, modified or terminated, (i) at the request of a third party who has
indicated an intention or taken steps to effect a Change in Control and who
effectuates a Change in Control or (ii) otherwise in connection with, or in
anticipation of, a Change in Control which actually occurs, any such attempted
amendment, modification or termination being null and void ab initio. Any action
taken to amend, modify or terminate the Plan which is taken after the execution
of an agreement providing for a transaction or transactions which, if
consummated, would constitute a Change in Control shall conclusively be presumed
to have been taken in connection with a Change in Control. From and after the
occurrence of a Change in Control, the Plan may not be amended or modified in
any manner that would in any way adversely affect the benefits or protections
provided hereunder to any individual who is a Participant in the Plan on the
date the Change in Control occurs.

8.2   FORM OF AMENDMENT

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

                             SECTION 9 MISCELLANEOUS

9.1   INDEMNIFICATION

          The Company shall pay as they become due all legal fees, costs of
litigation and other expenses incurred in good faith by any Participant as a
result of the Company's refusal or failure to provide the Severance Benefits to
which the Participant becomes entitled under this Agreement, as a result of the
Company's contesting the validity, enforceability or interpretation of this
Agreement or the Participant's right to Severance Benefits hereunder. The
Participant shall be conclusively presumed to have acted in good faith unless a
court makes a final determination not otherwise subject to appeal to the
contrary.

9.2   EMPLOYMENT STATUS

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


                                       15


9.3   NO DUTY OF MITIGATION

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

9.4   NO SETOFF

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

9.5   BENEFITS UNDER OTHER PLANS

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

9.6   VALIDITY AND SEVERABILITY

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

9.7   GOVERNING LAW; CHOICE OF FORUM

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


                                       16


9.8   409A

          If at the time a Participant's employment is terminated the
Participant is a "specified employee" within the meaning of Section 409A of the
Code and the regulations thereunder, to the extent required to comply with
Section 409A, payment of the Severance Benefits shall not commence until one day
after the day which is six months following the Termination Date, with the first
payment equaling the full amount of such Severance Benefits.

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

                                           FALCONSTOR SOFTWARE, INC.





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

ATTEST:


By /s/ Seth R. Horowitz
   -----------------------------
Title: Corporate Secretary


                                       17

EX-31.1 5 ex311to10q04637_06302007.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 control over financial  reporting,  or
                   caused such internal  control over financial  reporting to be
                   designed  under  our  supervision,   to  provide   reasonable
                   assurance  regarding the  reliability of financial  reporting
                   and the  preparation  of  financial  statements  for external
                   purposes in accordance  with  generally  accepted  accounting
                   principles;

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

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

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

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

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



     Date:    August 8, 2007                     /s/ Reijane Huai
                                                 -------------------------------
                                                 ReiJane Huai
                                                 Chief Executive Officer
                                                 (principal executive officer)

EX-31.2 6 ex312to10q04637_06302007.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 control over financial  reporting,  or
                   caused such internal  control over financial  reporting to be
                   designed  under  our  supervision,   to  provide   reasonable
                   assurance  regarding the  reliability of financial  reporting
                   and the  preparation  of  financial  statements  for external
                   purposes in accordance  with  generally  accepted  accounting
                   principles;

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

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

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

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

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



     Date:    August 8, 2007                 /s/ James Weber
                                             -----------------------------------
                                             James Weber
                                             Chief Financial Officer
                                             (principal financial and
                                             accounting officer)

EX-32.1 7 ex321to10q04637_06302007.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 June 30,
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
                                                         August 8, 2007

EX-32.2 8 ex322to10q04637_06302007.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 June 30,
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
                                             August 8, 2007

-----END PRIVACY-ENHANCED MESSAGE-----