| FALCONSTOR SOFTWARE INC Item 1A Risk Factors |
| 9 ITEM 1A RISK FACTORS DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWAR E MARKET AND OUR RELIANCE ON OUR PARTNERS, WE MAY HAVE DIFFICULTY ACCURATEL Y PREDICTING REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES The rapidly evolving nature of the network storage software market i n which we sell our products, the degrees of effort and success of our partners &apos sales and marketing efforts, and other factors that are beyond our control , reduce our ability to accurately forecast our quarterly and annual revenue |
| However, we must use our forecasted revenue to establish our expense budget |
| Most of our expenses are fixed in the short term or incurred in advance o f anticipated revenue |
| THE MARKET FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE STIL L MATURING, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS W E EXPECT The continued adoption of Storage Area Networks (SAN) and Network Attache d Storage (NAS) solutions is critical to our future success |
| The markets for SA N and NAS solutions are still maturing, making it difficult to predict thei r potential sizes or future growth rates |
| If these markets develop more slowl y than we expect, our business, financial condition and results of operation s would be adversely affected |
| THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS STILL MATURING, AND OUR BUSINES S WILL SUFFER IF IT DOES NOT CONTINUE TO DEVELOP AS WE EXPECT The continued adoption of disk-based backup solutions, such as ou r VirtualTape Library software, is critical to our future success |
| The market fo r disk-based backup solutions is still maturing, making it difficult to predic t its potential size or future growth rate |
| If this market develops more slowl y than we expect, our business, financial condition and results of operation s would be adversely affected |
| 9 THE MARKET FOR IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OU R BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT The rapid adoption of IP-based Storage Area Networks (SAN) is important t o our future success |
| The market for IP-based SANs is still unproven, making i t difficult to predict the potential size or future growth rate |
| We are uncertai n whether a viable market for our products will develop or be sustainable |
| If thi s market fails to develop, or develops more slowly than we expect, our business , financial condition and results of operations would be adversely affected |
| WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS AND SMALL OFFICE/HOM E OFFICE MARKETS We have announced plans to offer products for the small/medium busines s (SMB) and small office/home office (SOHO) markets |
| We may not be able to desig n or offer products attractive to the SMB and the SOHO markets, or to reac h agreements with OEMs and resellers with significant presences in the SMB an d SOHO markets |
| If we are unable to penetrate the SMB and SOHO markets, we wil l not be able to recoup the expenses associated with our efforts in these market s and our ability to grow revenues could suffer |
| IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANC E IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER The network storage software market continues to evolve and as a resul t there is continuing demand for new products |
| Accordingly, we may need to develo p and manufacture new products that address additional network storage softwar e market segments and emerging technologies to remain competitive in the dat a storage software industry |
| We are uncertain whether we will successfully qualif y new network storage software products with our customers by meeting custome r performance and quality specifications or quickly achieve high volume productio n of storage networking software products |
| Any failure to address additiona l market segments could harm our business, financial condition and operatin g results |
| OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED B Y CUSTOMERS IN OUR MARKETS Our current products are only one part of a storage system |
| All component s of these systems must comply with the same industry standards in order t o operate together efficiently |
| We depend on companies that provide othe r components of these systems to conform to industry standards |
| Some industr y standards may not be widely adopted or implemented uniformly, and competin g standards may emerge that may be preferred by OEM customers or end users |
| I f other providers of components do not support the same industry standards as w e do, or if competing standards emerge, our products may not achieve marke t acceptance, which would adversely affect our business |
| OUR PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED DEMAND FO R OUR PRODUCTS OR COSTLY LITIGATION Our IPStor platform is complex and is designed to be deployed in large an d complex networks |
| Many of our customers have unique infrastructures, which ma y require additional professional services in order for our software to wor k within their infrastructures |
| Because our products are critical to the network s of our customers, any significant interruption in their service as a result o f defects in our product could result in damage to our customers |
| These problem s could cause us to incur significant service and engineering costs, diver t engineering personnel from product development efforts and significantly impai r our ability to maintain existing customer relationships and attract ne w customers |
| In addition, a product liability claim, whether successful or not , would likely be time consuming and expensive to resolve and would diver t management time and attention |
| Further, if we are unable to fix the errors o r other problems that may be identified in full deployment, we would likel y experience loss of or delay in revenues and loss of market share and ou r business and prospects would suffer |
| If we are unable t o fix the errors or other problems that may be discovered, we would likel y experience loss of or delay in revenues and loss of market share and ou r business and prospects would suffer |
| 10 FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH EN D USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES We have entered into agreements with resellers and OEM partners to develo p storage appliances that combine certain aspects of IPStor or VTL functionalit y with third party hardware to create single purpose turnkey solutions that ar e designed to be easy to deploy |
| OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIV E QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES Prior to offering our products for sale, our OEM customers typicall y require that each of our products undergo an extensive qualification process , which involves interoperability testing of our product in the OEMapstas system a s well as rigorous reliability testing |
| This qualification of a product by an OE M does not assure any sales of the product to the OEM Despite this uncertainty , we devote substantial resources, including engineering, sales, marketing an d management efforts, toward qualifying our products with OEMs in anticipation o f sales to them |
| If we are unsuccessful or delayed in qualifying any products wit h an OEM, such failure or delay would preclude or delay sales of that product t o the OEM, which may impede our ability to grow our business |
| These OEM customers and resellers hav e limited resources and sales forces and sell many different products, both in th e network storage software market and in other markets |
| The OEM customers an d resellers may choose to focus their sales efforts on other products in th e network storage software market or other markets |
| For the year ended December 31, 2005, w e had two customers who together accounted for 31prca of our revenues |
| While w e believe that we will continue to receive revenue from these clients, ou r agreements with these clients do not have any minimum sales requirements and w e cannot guarantee continued revenue |
| If our contracts with these partners ar e terminated, or if the volume of sales from these clients significantly declines , it would have a material adverse effect on our operating results |
| In addition, as of December 31, 2005, two customers accounted for a tota l of 28prca of our outstanding receivables |
| While we currently have no reason t o question the collectibility of these receivables, a business failure o r reorganization by these customers could harm our ability to collect thes e receivables and could damage our cash flow |
| There will thus be a delay before we learn whether licensing revenu e from these OEMs has met, exceeded, or fallen short of our expectations |
| Th e reporting schedule from these OEMs also means that our ability to respond t o trends in the market could be harmed as well |
| For example, if, in a particula r quarter, we see a significant increase or decrease in revenue from our channe l sales or one of our other OEM partners, there will be a delay in our ability t o determine whether this is an anomaly or a part of a trend |
| However, we must us e our forecasted revenue to establish our expense budget |
| As a result, we may not be able to decrease our expenses in a timely manner to offse t any shortfall in revenue or to increase our sales, marketing or suppor t headcounts to take advantage of positive developments |
| Problems with our partners &apos hardware coul d negatively impact our business |
| WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WIT H STRATEGIC INDUSTRY PARTNERS Part of our strategy is to partner with major third-party software an d hardware vendors who integrate our products into their offerings and/or marke t our products to others |
| These strategic partners often have customer o r distribution networks to which we otherwise would not have access or th e development of which would take up large amounts of our time and othe r resources |
| There is intense competition to establish relationships with thes e strategic partners |
| Some of our agreements with our OEM customers grant to th e OEMs limited exclusivity rights to portions of our products for periods of time |
| This could result in lost sales opportunities for us with other customers o r could cause other potential OEM partners to consider or select software from ou r competitors for their storage solutions |
| In addition, the desire for produc t differentiation could cause potential OEM partners to select software from ou r competitors |
| We cannot guarantee that our current strategic partners, or thos e companies with whom we may partner in the future, will continue to be ou r partners for any period of time |
| If our software were to be replaced in an OE M solution by competing software, or if our software is not selected by OEMs fo r future solutions, it would likely result in lower revenues to us and woul d impede our ability to grow our business |
| CONSOLIDATION IN THE NETWORK STORAGE INDUSTRY COULD HURT OUR STRATEGI C RELATIONSHIPS In the past, companies with whom we have OEM relationships have bee n acquired by other companies |
| These acquisitions caused disruptions in the sale s and marketing of our products and in 2005, acquisitions of two of our OE M partners had an impact on our revenues |
| If additional OEM customers ar e acquired, the new parents might choose to stop offering solutions containing ou r software |
| Even if the solutions continued to be offered, there might be a los s of focus and sales momentum as the companies are integrated |
| THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENS E COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS The network storage software market is intensely competitive even durin g periods when demand is stable |
| Some of our current and potential competitor s have longer operating histories, significantly greater resources, broader nam e recognition and a larger installed base of customers than we have |
| Thos e competitors and other potential competitors may be able to establish or t o expand network storage software offerings more quickly, adapt to ne w technologies and customer requirements faster, and take advantage of acquisitio n and other opportunities more readily |
| Our competitors also may: o consolidate or establish strategic relationships among themselves to lowe r their product costs or to otherwise compete more effectively against us ; or o bundle their products with other products to increase demand for thei r products |
| In addition, some OEMs with whom we do business, or hope to do business , may enter the market directly and rapidly capture market share |
| If we fail t o compete successfully against current or future competitors, our business , financial condition and operating results may suffer |
| FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATIN G RESULTS Achieving our anticipated growth will depend on a number of factors, som e of which include: 12 o retention of key management, marketing and technical personnel; o our ability to increase our customer base and to increase the sales of ou r products; and o competitive conditions in the network storage infrastructure softwar e market |
| We cannot assure you that the anticipated growth will be achieved |
| The failur e to achieve anticipated growth could harm our business, financial condition an d operating results |
| OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS The operating results of our business depend in part on the overall deman d for network storage software |
| Because our sales are primarily to major corporat e customers, any softness in demand for network storage software may result i n decreased revenues |
| OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OU R STOCK PRICE TO DECLINE Our previous results are not necessarily indicative of our futur e performance and our future quarterly results may fluctuate significantly |
| Our future performance will depend on many factors, including: o the timing of securing software license contracts and the delivery o f software and related revenue recognition; o the seasonality of information technology, including network storag e products, spending; o the average unit selling price of our products; o existing or new competitors introducing better products at competitiv e prices before we do; o our ability to manage successfully the complex and difficult process o f 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 o r modify |
| As a result, the fixed nature of our expenses will magnify any advers e 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 ma y be volatile in the future |
| For example, during the past twelve months ende d December 31, 2005, the closing market price of our common stock as quoted on th e NASDAQ National Market System fluctuated between dlra5dtta23 and dlra9dtta67 |
| The marke t price of our common stock may be significantly affected by the followin g factors: o actual or anticipated fluctuations in our operating results; o failure to meet financial estimates; 13 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 technica l innovations, acquisitions, strategic partnerships, joint ventures o r capital commitments; o loss of one or more key OEM customers; and o departures of key personnel |
| The stock market has experienced extreme volatility that often has bee n unrelated to the performance of particular companies |
| These market fluctuation s may cause our stock price to fall regardless of our performance |
| OUR RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT W E RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE The Financial Accounting Standards Board ( "e FASB "e ) has required companie s to recognize the fair value of stock options and other equity-based compensatio n to employees as compensation expense in the statement of operations |
| We mus t implement this FASB standard effective in the first quarter of 2006 |
| While w e are still evaluating the impact of this requirement, there will be a negativ e impact on our results of operations |
| WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHIC H MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY Our Board of Directors has the authority, without further action by th e stockholders, to issue up to 2cmam000cmam000 shares of preferred stock on such term s and with such rights, preferences and designations, including, withou t limitation restricting dividends on our common stock, dilution of the votin g power of our common stock and impairing the liquidation rights of the holders o f our common stock, as the Board may determine without any vote of th e stockholders |
| Issuance of such preferred stock, depending upon the rights , preferences and designations thereof may have the effect of delaying, deterrin g or preventing a change in control |
| In addition, certain "e anti-takeover "e provisions of the Delaware General Corporation Law, among other things, ma y restrict the ability of our stockholders to authorize a merger, busines s combination or change of control |
| Further, we have entered into change o f control agreements with certain executives, which may also have the effect o f delaying, deterring or preventing a change in control |
| WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCIS E OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS &apos PERCENTAGE OWNERSHIP O F OUR COMMON STOCK As of December 31, 2005, we had outstanding options and warrants t o purchase an aggregate of 10cmam950cmam908 shares of our common stock at a weighte d average exercise price of dlra5dtta29 per share |
| We also have 1cmam006cmam314 shares of ou r common stock reserved for issuance under our stock option plans with respect t o options that have not been granted |
| The exercise of all of the outstanding options and warrants and/or th e grant and exercise of additional options would dilute the then-existin g stockholders &apos percentage ownership of common stock, and any sales in the publi c market of the common stock issuable upon such exercise could adversely affec t prevailing market prices for the common stock |
| Moreover, the terms upon which w e would be able to obtain additional equity capital could be adversely affecte d because the holders of such securities can be expected to exercise or conver t them at a time when we would, in all likelihood, be able to obtain any neede d capital on terms more favorable than those provided by such securities |
| OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER , TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS In August, 2003, our business was interrupted due to a large scal e blackout in the northeastern United States |
| While our headquarters facilitie s contain redundant power supplies and generators, our domestic and foreig n operations, and the operations of our industry partners, remain susceptible t o fire, floods, power loss, power shortages, telecommunications failures , break-ins and similar events |
| 14 Any interruption in power supply or telecommunications would b e particularly disruptive to our PrimeVault backup and disaster recover y operations |
| If PrimeVault customers are unable to access their data, confidenc e in our ability to provide disaster recovery and backup services will be damage d which will impair our ability to retain existing customers, to gain ne w customers and to expand our operations |
| Terrorist actions domestically or abroad could lead to busines s disruptions or to cancellations of customer orders or a general decrease i n corporate spending on information technology, or could have direct impact on ou r marketing, administrative or financial functions and our financial conditio n could suffer |
| The United States, through the Bureau of Industry Security, place s restrictions on the export of certain encryption technology |
| These restriction s may include: the requirement to have a license to export the technology; th e requirement to have software licenses approved before export is allowed; an d outright bans on the licensing of certain encryption technology to particula r end users or to all end users in a particular country |
| If we are subject t o restrictions on our ability to license products to certain end users, this coul d negatively impact our business |
| THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OU R OPERATING RESULTS We sell our products worldwide |
| Accordingly, our operating results coul d be materially adversely affected by various factors including regulatory , political, or economic conditions in a specific country or region, trad e protection measures and other regulatory requirements, and acts of terrorism an d international conflicts |
| Our international sales are denominated primarily in US dollars |
| A n increase in the value of the US dollar relative to foreign currencies coul d make our products more expensive and, therefore, potentially less competitive i n foreign markets |
| Additional risks inherent in our international business activitie s generally include, among others, longer accounts receivable payment cycles , difficulties in managing international operations, decreased flexibility i n matching workforce to needs as compared with the US, and potentially advers e tax consequences |
| Such factors could materially adversely affect our futur e international sales and, consequently, our operating results |
| Our success is dependent upon our proprietary technology |
| Currently, th e IPStor software suite is the core of our proprietary technology |
| We have on e patent issued, and multiple pending patent applications, numerous trademark s registered and multiple pending trademark applications related to our products |
| We cannot predict whether we will receive patents for our pending or futur e patent applications, and any patents that we own or that are issued to us may b e invalidated, circumvented or challenged |
| In addition, the laws of certai n countries in which we sell and manufacture our products, including variou s countries in Asia, may not protect our products and intellectual property right s to the same extent as the laws of the United States |
| We also rely on trade secret, copyright and trademark laws, as well as th e confidentiality and other restrictions contained in our respective sale s contracts and confidentiality agreements to protect our proprietary rights |
| These legal protections afford only limited protection |
| OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVE D IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS In recent years, there has been significant litigation in the Unite d States involving patents, trademarks and other intellectual property rights |
| 15 We were already subject to one action, which alleged that our technolog y infringed on patents held by a third party |
| While we settled this litigation , the fees and expenses of the litigation as well as the litigation settlemen t were expensive and the litigation diverted managementapstas time and attention |
| An y additional litigation, regardless of its outcome, would likely be time consumin g and expensive to resolve and would divert managementapstas time and attention an d might subject us to significant liability for damages or invalidate ou r intellectual property rights |
| Any potential intellectual property litigatio n against us could force us to take specific actions, including: o cease selling our products that use the challenged intellectua l property; o obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology or trademark, whic h license may not be available on reasonable terms, or at all; or o redesign those products that use infringing intellectual property o r cease to use an infringing product or trademark |
| DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OU R ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION Many of our products are designed to include software or othe r intellectual property licensed from third parties, including "e Open Source "e software |
| At least one intellectual property rights holder has alleged that i t holds the rights to software traditionally viewed as Open Source |
| It may b e necessary in the future to seek or renew licenses relating to various aspects o f these products |
| There can be no assurance that the necessary licenses would b e available on acceptable terms, if at all |
| The inability to obtain certai n licenses or other rights or to obtain such licenses or rights on favorabl e terms, or the need to engage in litigation regarding these matters, could have a material adverse effect on our business, operating results, and financia l condition |
| Moreover, the inclusion in our products of software or othe r intellectual property licensed from third parties on a nonexclusive basis coul d limit our ability to protect our proprietary rights in our products |
| THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS Our success depends upon the continued contributions of our key employees , many of whom would be extremely difficult to replace |
| Worldwide competition for skille d employees in the network storage software industry is extremely intense |
| If w e are unable to retain existing employees or to hire and integrate new employees , our business, financial condition and operating results could suffer |
| I n addition, companies whose employees accept positions with competitors ofte n claim that the competitors have engaged in unfair hiring practices |
| We may b e the subject of such claims in the future as we seek to hire qualified personne l and could incur substantial costs defending ourselves against those claims |
| WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM , OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS We have made, and may continue to make, acquisitions of other companies o r their assets |
| Integration of the acquired products, technologies and businesses , could divert managementapstas time and resources |
| Further, we may not be able t o properly integrate the acquired products, technologies or businesses, with ou r existing products and operations, train, retain and motivate personnel from th e acquired businesses, or combine potentially different corporate cultures |
| If w e are unable to fully integrate the acquired products, technologies or businesses , or train, retain and motivate personnel from the acquired businesses, we may no t receive the intended benefits of the acquisitions, which could harm ou r business, operating results and financial condition |
| IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AN D ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FO R FUTURE PERIODS COULD BE MATERIALLY AFFECTED The preparation of consolidated financial statements and relate d disclosure in accordance with generally accepted account principles require s management to establish policies that contain estimates and assumptions tha t 16 affect the amounts reported in the consolidated financial statements and th e accompanying notes |
| Note 1 to the Consolidated Financial Statements in thi s Report on Form 10-K describes the significant accounting policies essential t o preparing our financial statements |
| The preparation of these financia l statements requires us to make estimates and judgments that affect the reporte d amounts of assets, liabilities, revenues and expenses, and related disclosures |
| We base our estimates on historical experience and assumptions that we believ e to be reasonable under the circumstances |
| Actual future results may diffe r materially from these estimates |
| We evaluate, on an ongoing basis, our estimate s and assumptions |
| LONG TERM CHARACTER OF INVESTMENTS Our present and future equity investments may never appreciate in value , and are subject to normal risks associated with equity investments i n businesses |
| These investments may involve technology risks as well a s commercialization risks and market risks |
| UNKNOWN FACTORS Additional risks and uncertainties of which we are unaware or whic h currently we deem immaterial also may become important factors that affect us |