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FALCONSTOR SOFTWARE INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) 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 In 2012, we continued to reposition the Company to put our past troubles behind us and to put in place the proper management, employees and plans for future success. The most significant event of 2012 for the Company was our resolution of the investigations by the United States Attorney's Office for the Eastern District of New York ("USAO") and by the Securities and Exchange Commission. In June, 2012, we entered into a Deferred Prosecution Agreement ("DPA") with the USAO. In conjunction with the DPA, a Criminal Complaint was filed against the Company. The USAO agreed, as part of the DPA, to defer prosecution of that complaint for eighteen months. If we comply fully with the DPA, the charges will be dismissed at the conclusion of the eighteen month period. Among other things, the DPA requires us to continue to comply with various control changes we had made in response to the discovery that improper payments had been made to one customer by three former employees. The DPA also mandates that we do not commit any criminal acts. If we fail to comply with the DPA, the USAO has the right to prosecute the complaint and to file additional charges if we have committed any new criminal acts. In addition, we agreed to forfeit $2.9 million. We paid $1.2 million during the third quarter of 2012 and we will pay the remaining $1.7 million in December, 2013. We agreed with the SEC to the entry of a Consent Judgment (CJ) to settle a civil action filed by the SEC. Pursuant to the CJ, we agreed not to violate the anti-fraud and registration provisions of Sections 17(a)(2), 5(a) and 5(c) of the Securities Act of 1933, and the books and records provisions of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934. We further agreed to pay a civil penalty of $2.9 million to the SEC. This fine was paid in full during the second quarter of 2012. The resolution of these investigations is a milestone for the Company. This should enable us to move on from the events of the past and concentrate on the Company's future. We will no longer be distracted by the substantial time and effort it took to complete the investigations. We can now dedicate our resources - both capital and human - to efforts that we hope will positively impact our bottom line. In addition, it reduces the potential of our competitors to raise concerns about the Company's business conduct and long-term viability. They will again have to compete based on the merits of their products compared to ours. This is a competition that we believe we are well-positioned to win. With regard to the Company's reputation following these unfortunate events, we are proud that neither the DPA nor the settlement with the SEC required us to institute any new controls. Rather, both the USAO and the SEC referenced the numerous new or enhanced controls that we previously implemented after the commencement of our internal investigation We believe that this is a validation of the path taken by Company management. The Company, along with our former CFO, Jim Weber, and the estate of ReiJane Huai, our former Chairman and CEO, also remains a defendant in a class action lawsuit brought by stockholders (the "Class Action"). In January, 2013, we reached an agreement in principle to settle the Class Action for $5.0 million and a Stipulation and Agreement of Settlement was filed with the court on March 13, 2013. The Class Action is more fully described in Part 1, Item 3 - Legal Proceedings of this annual report on Form 10-K. If the settlement is approved by the court, it should limit one more legacy distraction. In connection with the Class Action and a derivative action lawsuit that was dismissed in March 2013, we have been involved with discussions with the companies that provide our Directors and Officers Insurance ("D&O Insurance") coverage. The D&O Insurance in place at the time that the two actions were commenced was divided into $5.0 million layers, each written by a different insurer. The D&O Insurance should provide us with recovery of fees spent defending the two actions and the costs of settlement or damages. However, some of the insurers have raised questions with regard to the validity of the insurance agreements due to the presumed knowledge of wrongful acts by certain former Company officers at the time the insurance was purchased. In October 2012, we reached a settlement with the insurer of the first $5.0 million layer of our D&O Insurance pursuant to which the insurer agreed to pay us $3.9 million in full satisfaction of its obligations. There can be no assurance that we will be able to recover any additional funds from the additional insurance companies. Even if we are able to recover under the additional layers of our D&O Insurance, we will still be responsible for the $1.1 million gap between the recovery from the first insurer and the attachment point of the next $5.0 million layer. 31-------------------------------------------------------------------------------- Table of Contents With regard to our business operations, in 2012 we focused on having the correct management team in place and refining our goals for our products going forward. Since September, 2010, we have hired new leadership in the following roles: Chief Executive Officer; Chief Financial Officer; Chief Technical Officer; Vice President Sales & Marketing - North America; Vice President Sales & Marketing - EMEA; Vice President Sales & Marketing - APAC; and Vice President of Global Support. With this team in place, we reviewed our personnel, our products and our expenses. Among other decisions, we undertook a global reduction in force in July, 2012, that eliminated thirty five positions from our then existing headcount to better align our expense structure with our anticipated revenues. Our revenues are now primarily generated by our FalconStor-branded gateway appliances and complete turn-key appliances with integrated disks, and licenses of our stand-alone software products. The appliances integrate our software with standard hardware configurations. The integrated products were created in response to feedback we received from our resellers and the end users suggested that we could increase sales if we offered turn-key appliances. This has proven to be correct. We are pleased that we have been able to absorb a cumulative decrease in total revenues from OEMs over the past three years of approximately $22.0 million (representing successive over 25% annual declines). Overall, product revenues decreased 16% from $49.5 million for the year ended December 31, 2011 to $41.4 million for the year ended December 31, 2012. We attribute the decline in product revenues to four main factors. First, we did not launch any new products in 2012. Second, we had continued turnover in our sales force, particularly in North America, as our new sales leaders put their teams in place. Third, macroeconomic conditions around the world contributed to the overall softness in IT spend. Last, sales from our legacy OEMs continued to decline. Our product revenues from FalconStor-branded solutions decreased 15% over 2011. Product revenues from OEMs declined 25% from 2011. We do not expect to exit the OEM business entirely. OEMs can be valuable partners for us in a number of ways. Among these are: allowing penetration of markets, both geographical and industry-sector, where we do not have sufficient resources or history; providing feedback on product development and quality; and providing distribution channels for products that we may be de-emphasizing in our FalconStor-branded product line. We expect that an OEM relationship in China will continue to be a source of revenue to the Company. Support and services revenue increased 2% from $33.4 million for the year ended December 31, 2011 to $34.1 million for the same period in 2012. The increase in support and services was primarily attributable to an increase in maintenance and technical support services. Net loss for the year ended December 31, 2012 was $15.0 million, compared with a net loss of $23.4 million for the year ended December 31, 2011. As discussed more fully below, included in our net loss for the year ended December 31, 2012 was an income tax provision of $0.8 million compared with an income tax provision of $1.2 million for the year ended December 31, 2011. We had stock-based compensation expense - which relates to stock options and restricted stock we grant to employees, officers and directors as part of our incentive compensation plan, and to some consultants as payment for services - of $4.6 million in 2012 and $ 5.5 million in 2011, which is reflected in the net results for each year. Typically, we look to operating income as another measure of our progress. This number enables us to measure and to compare our results of operations from one year to the next. Operating loss for 2012 was $13.7 million, compared with an operating loss of $22.2 million in 2011. These numbers again include stock-based compensation expense. Included in the operating loss is a $0.3 million reduction of investigation, litigation and settlement related costs in 2012 compared to costs of $10.3 million in 2011 related to investigation, litigation and settlement related costs. 32-------------------------------------------------------------------------------- Table of Contents We continued to work to decrease our operating expenses in 2012. Besides watching our expenditures, we undertook a review of our workforce and made strategic reductions in our headcount that eliminated thirty five positions from our then existing headcount to better align our expense structure with our anticipated revenues. Overall our operating expenses decreased 18% or $15.1 million to $68.4 million in 2012 from $83.6 million in 2011. Included in our operating results for both 2012 and 2011 was a reduction of $0.3 million and costs of $10.3 million, respectively, related to investigation, litigation and settlement related costs. Our gross margins were 73% for 2012 as compared with 74% in 2011. Operating margin is a measure of operating efficiency. We incur research and development expenses before the product is offered for licensing. These expenses consist primarily of personnel costs for engineering and testing, but also include other items such as the depreciation and amortization of hardware and software used in development. We also have expenses for software support, sales and marketing, and general and administrative functions. Our operating margin increased to (18%) in 2012 from (27%) in 2011. The impact of investigation, litigation and settlement related costs on operating margin in 2012 was 0% compared with (12%) in 2011. The key factors we look to for our future business prospects are: · our ability to establish and to expand relationships with resellers, and sales and re-orders by those resellers; · growth in deferred revenue; · the development and sales of our new products; · re-orders from existing customers; and · the growth of the overall market for data protection and storage solutions. We anticipate that in 2013 product revenue by resellers and, to a lesser extent, direct licenses to end users, should grow. We expect to see the results of our investments in new leadership and in our sales force and our marketing teams. We also have instituted, and we will be instituting further, support, training and incentive programs intended to increase sales by resellers. Many enterprises look to value added resellers or solution providers to assist them in making their information technology purchases. These resellers typically review an enterprise's needs and suggest a hardware, software, or combined hardware and software solution to fulfill the enterprise's requirements. We continue to enhance our reseller program. Our "Business Partner" program for our resellers was rolled out in EMEA in 2012. We had previously instituted it in the Americas and APAC in 2011. This program provides enhanced sales collateral, training, and, in some cases, financial incentives, for our resellers. As service providers to companies, resellers' reputations are dependent on satisfying their customers' needs efficiently and effectively. Resellers have wide choices in fulfilling their customers' needs. If resellers determine that a product they have been providing to their customers is not functioning as promised, or is not providing adequate return on investment, or if the customers are not satisfied with the level of support they are receiving from the suppliers, the resellers will move quickly to offer different solutions to their customers. Additional sales by resellers are therefore an important indicator of our business prospects. In 2012, we signed agreements with new resellers worldwide. The type of resellers with whom we are signing agreements has continued to evolve. While we still sign agreements with strong local and regional resellers, we have also entered into reseller agreements with national and multi-national resellers who have their own distribution networks. The enhanced distribution and marketing networks offered by these larger resellers should help us to continue to grow our sales. We also terminated relationships with resellers who we believed were not selling our products at the levels we expected in 2012. We will continue to enter into relationships with resellers and to discontinue relationships with resellers with whom we are not satisfied. 33-------------------------------------------------------------------------------- Table of Contents Our deferred revenues consist primarily of amounts attributable to future support and maintenance of our products. The level of deferred revenue is an important indicator of our success. Maintenance and support for our products is sold for fixed periods of time. Maintenance and support agreements are typically for one year, although some agreements are for terms in excess of one year. If we do not deliver the support needed by end users of our products or by our OEM partners and resellers, then they will not renew their maintenance and support agreements. If end users stop using our products, they also will not renew their maintenance and support agreements. Our deferred revenue decreased 11% from 2011 to $24.1 million in 2012. The main reason for the decline was a result of the phasing out of our products by our legacy OEMs over the past few years. In addition, since our product sales declined as a result of the global economic conditions, we sold fewer new maintenance and support contracts. We expect to continue to be affected by seasonality of the information technology business on a quarterly basis. 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. We did not experience this typical seasonality in 2012. We believe that this was an aberration based on global economic conditions and the internal revamping our sales force. We anticipate that our quarterly results for 2013 will show the effects of historical seasonality. Share-based compensation expense continued to have a negative impact on our earnings in 2012. On an on-going basis we weigh the impact of the expense on our consolidated financial statements against the impact of discontinuing the grant of equity-based compensation to our worldwide workforce. It continues to be our view that the opportunity to participate in the growth of our Company is an important motivating factor for our current employees and a valuable recruiting tool for new employees. We will thus continue to apply the criteria and the methodology we have used in the past to determine grants of stock options or other equity-based compensation to our employees. For the management of our business and the review of our progress, we will continue to look to our results excluding share-based compensation expense. We will use these non-GAAP financial measures in making operating decisions because they measure the results of our day-to-day operations and because they provide a more consistent basis for evaluating and comparing our results across different periods. The primary risks to our success come from product development. For more information on the risks we face, please see Part I, Item 1A, Risk Factors, of this filing. We need to provide a continuing series of new products and improvements to existing products. Innovation in the data protection market is key to survival. Customers expect that data protection software will become both more capable and easier to manage over time. If we are unable to deliver new, innovative products in a reasonable time frame, we will fall behind our competitors. Innovation requires adequate resources and the right people. If we do not have enough resources or the right people, we will fall behind. RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2012 COMPARED WITH THE YEAR ENDED DECEMBER 31, 2011 Total revenues for the year ended December 31, 2012 decreased 9% to $75.4 million, compared with $82.9 million for the year ended December 31, 2011. During 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 positions worldwide from various departments. The restructuring charges related to the 2012 reduction totaled approximately $0.8 million. During 2011, we completed a restructuring which was composed of a workforce reduction of approximately 25 positions worldwide from various departments and the closing of a satellite facility. The restructuring charges related to the 2011 reduction totaled approximately $0.8 million. The restructuring charges for both 2012 and 2011 have been segregated from each of the respective expense line items and are included within "restructuring costs" in our consolidated statement of operations. Our cost of revenues decreased 4% to $20.7 million for the year ended December 31, 2012, compared with $21.5 million for the year ended December 31, 2011. Included in our cost of revenues for the years ended December 31, 2012 and 2011 were $0.2 million and $0.5 million, respectively, of share-based compensation expense. Our operating expenses decreased 18% from $83.6 million for the year ended December 31, 2011 to $68.4 million for the year ended December 31, 2012. Included in the operating results for the year ended December 31, 2012, was a net reduction of $0.3 million of investigation, litigation and settlement costs and $0.8 million of restructuring costs. Included in the operating results for the year ended December 31, 2011 was $10.3 million of investigation, litigation, and settlement related costs and $0.8 million of restructuring costs. The $10.3 million was comprised of $2.8 million of legal fees and an accrual of $7.5 million for certain costs associated with the then outstanding resolution of the investigations. In addition, included in our operating expenses for the years ended December 31, 2012 and 2011 were $4.4 million and $5.1 million, respectively, of share-based compensation expense. Net loss for the year ended December 31, 2012 was $15.0 million, compared with a net loss of $23.4 million for the year ended December 31, 2011. Included in our net loss for the year ended December 31, 2012 was an income tax provision of $0.8 million compared with an income tax provision of $1.2 million for the year ended December 31, 2011. The income tax provision of $0.8 million and $1.2 million were primarily attributable to the impact of our effective tax rate on our pre-tax losses for the years ended December 31, 2012 and 2011, respectively. No tax benefits were recognized during either period for our domestic losses due to the full valuation allowance over our domestic deferred tax assets. 34-------------------------------------------------------------------------------- Table of Contents The overall 9% decrease in total revenues was primarily due to a 16% decrease in product revenue for the year ended December 31, 2012, compared with the same period in 2011. This was partially offset by a 2% increase in support and services revenue for the year ended December 31, 2012, compared with the same period in 2011. Product revenues from OEM partners decreased 25%, while product revenues from non-OEM partners decreased 15% for the year ended December 31, 2012, compared with the same period in 2011. As we have previously reported over the past several years, product revenues from our legacy OEM partners continued to decline due to consolidation within the industry and end-of-life programs implemented by these legacy OEM partners. We do not anticipate that any of our legacy OEM partners will contribute over 10% of our annual revenues for the foreseeable future. During 2012, we continued our focus and emphasis on the FalconStor-branded business. As a result of overall macroeconomic conditions, we experienced significant competitive pricing practices from our competitors, customers delaying or postponing IT spending and the overall uncertainty in the marketplace. These factors have all contributed to the overall decrease in our non-OEM product revenues. In addition, the recently concluded government investigation also contributed to the challenges and disruptions we faced in our business. Overall, our total operating expenses have decreased, primarily due to a decline in (i) our overall salary and personnel costs as part of our continued cost savings initiatives and our focus on improved operational efficiencies , and (ii) a $10.6 million decrease in costs associated with the government investigations, litigation, and settlement related costs incurred during the year ended December 31, 2012, compared with the same period in 2011. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook. Revenues Year ended December 31, 2012 2011 Revenues: Product revenue $ 41,358,621 $ 49,470,139 Support and services revenue 34,052,348 33,400,463 Total Revenues $ 75,410,969 $ 82,870,602 Year-over-year percentage growth Product revenue -16 % -5 % Support and services revenue 2 % 8 % Total percentage growth -9 % 0 % Product revenue Product revenue is comprised of sales of licenses for our software integrated on industry standard hardware creating an integrated solution, and for our stand-alone software applications. The products are sold through our OEMs, and through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users (collectively "non-OEMs"). These revenues are recognized when all the applicable criteria under Generally Accepted Accounting Principles in the United States are met. Product revenue decreased 16% from $49.5 million for the year ended December 31, 2011 to $41.4 million for the year ended December 31, 2012. These amounts are net of a benefit of $0.7 million recognized during the years ended December 31, 2012 and 2011, respectively, resulting from the impact of our collection efforts of previously reserved accounts receivable. Product revenues from OEM partners decreased 25%, while product revenues from non-OEM partners decreased 15% for the year ended December 31, 2012, compared with the same period in 2011. As we have previously reported over the past several years, product revenues from our legacy OEM partners continued to decline due to consolidation within the industry and end-of-life programs implemented by these legacy OEM partners. We do not anticipate that any of our legacy OEM partners will contribute over 10% of our annual revenues for the foreseeable future. During 2012, we continued our focus and emphasis on the FalconStor-branded business. As a result of overall macroeconomic conditions, we experienced significant competitive pricing practices from our competitors, customers delaying or postponing IT spending and the overall uncertainty in the marketplace. These factors have all contributed to the overall decrease in our non-OEM product revenues. In addition, we believe the recently concluded government investigation also contributed to the challenges and disruptions we faced in our business. Product revenue from our non-OEM partners represented 88% and 87% of our total product revenue for the years ended December 31, 2012 and 2011, respectively. Product revenue from our OEM partners represented 12% and 13% of our total product revenue for the years ended December 31, 2012 and 2011, respectively. 35-------------------------------------------------------------------------------- Table of Contents We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook. Support and services revenue Support and services revenue is comprised of (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenues derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Support and services revenue increased 2% from $33.4 million for the year ended December 31, 2011 to $34.1 million for the same period in 2012. The increase in support and services was primarily attributable to an increase in maintenance and technical support services. Maintenance and technical support services increased from $30.3 million for the year ended December 31, 2011 to $31.0 million for the same period in 2012. As we are in business longer, and as we license more integrated solutions and stand-alone software applications to new customers and grow our installed customer base, we expect the amount of maintenance and technical support contracts we have to grow as well. The anticipated growth in our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the year ended December 31, 2012, the growth in maintenance revenue in the non-OEM channel business was primarily offset by (i) a decline in maintenance revenue from certain legacy OEM customers due to consolidation in the industry, (ii) the decrease from non-OEM product revenues during the current year, which are generally sold with maintenance, and (iii) deeper discounts provided on product in the current economic and competitive environment. Professional services revenues remained consistent at $3.1 million for the years ended December 31, 2012 and December 31, 2011. The professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that are performed during the period. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions. Cost of Revenues Year ended December 31, 2012 2011 Cost of revenues: Product $ 8,215,152 $ 8,386,864 Support and service 12,446,921 13,130,045 Total cost of revenues $ 20,662,073 $ 21,516,909 Total Gross Profit $ 54,748,896 $ 61,353,693 Gross Margin: Product 80 % 83 % Support and service 63 % 61 % Total gross margin 73 % 74 % 36-------------------------------------------------------------------------------- Table of Contents Cost of revenues, gross profit and gross margin Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of purchased and capitalized software, shipping and logistics costs, and share-based compensation expense. Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense. Cost of product revenue for the year ended December 31, 2012 decreased $0.2 million, or 2%, to $8.2 million, compared with $8.4 million for the same period in 2011. The overall decrease in cost of product revenue was attributable to a decrease in hardware costs as a result of fewer appliance units being sold, compared with the same period in 2011. Our cost of support and service revenues for the year ended December 31, 2012 decreased $0.7 million, or 5%, to $12.4 million, compared with $13.1 million for the same period in 2011. The decrease in cost of support and service revenue was primarily related to a decrease in compensation costs due to the overall change in the mix of our headcount within support and services as compared to the same period in 2011 and a decrease in share-based compensation expenses which decreased to $0.2 million for the year ended December 31, 2012, compared with $0.5 million for the year ended December 31, 2011. Total gross profit decreased $6.6 million, or 11%, from $61.4 million for the year ended December 31, 2011, to $54.7 million for the year ended December 31, 2012. Total gross margin decreased slightly to 73% for the year ended December 31, 2012, compared with 74% for the year ended December 31, 2011. The decrease in our total gross profit for the year ended December 31, 2012, compared with the same period in 2011, was primarily due to a 9% decrease in our total revenues. Generally, our total gross profits and total gross margins may fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and service mix of sales. Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for each of the years ended December 31, 2012 and 2011. Share-based compensation expense included in the cost of support and service revenue decreased to $0.2 million from $0.5 million for the years ended December 31, 2012 and December 31, 2011, respectively. Share-based compensation expense related to cost of support and service revenue was less than 1% for the year ended December 31, 2012 and 1% for the year ended December 31, 2011. Operating Expenses Research and Development Costs Research and development costs consist primarily of personnel costs for product development personnel, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $2.6 million, or 12%, to $18.6 million for the year ended December 31, 2012, from $21.2 million in the same period in 2011. The decrease in research and development costs was primarily the result of a decline in salary and personnel costs as the result of lower research and development headcount. We believe we continue to provide adequate levels of resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options. Share-based compensation expense included in research and development costs decreased to $0.7 million from $1.3 million for the years ended December 31, 2012 and December 31, 2011, respectively. Share-based compensation expense included in research and development costs was equal to 1% and 2% of total revenue for the years ended December 31, 2012 and 2011, respectively. Selling and Marketing Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based compensation expense, 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 decreased $3.6 million, or 9%, to $36.0 million for the year ended December 31, 2012, from $39.6 million for the year ended December 31, 2011. The decrease in selling and marketing expenses was primarily attributable to (i) a decrease in commissions due to the 16% decline in product revenue compared with the same period in 2011, (ii) a decrease in salary and personnel costs, including share-based compensation expenses, as a result of lower sales and marketing headcount, and (iii) a decrease in costs associated with the recruitment and hiring of additional sales personnel in 2011. Share-based compensation expense included in selling and marketing was $1.7 million for the year ended December 31, 2012 and $2.0 million for the year ended December 31, 2011. Share-based compensation expense included in selling and marketing expenses was equal to 2% of total revenue for the years ended December 31, 2012 and 2011, respectively. 37-------------------------------------------------------------------------------- Table of Contents General and Administrative General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense, public company related costs, directors and officers insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased $1.6 million, or 14%, to $13.3 million for the year ended December 31, 2012, from $11.7 million for the same period in 2011. The overall increase within general and administrative expenses related to increases in (i) personnel related costs including share-based compensation expense, (ii) bad debt expense, (iii) professional fees, and (iv) various administrative costs. Share-based compensation expense included in general and administrative expenses was $2.0 million for the year ended December 31, 2012, compared with $1.7 million for the year ended December 31, 2011. Share-based compensation expense included in general and administrative expenses was equal to 3% of total revenue for the year ended December 31, 2012 and to 2% of total revenue for the year ended December 31, 2011. Investigation, Litigation and Settlement Related Costs During 2012, we recorded a $0.3 million reduction of investigation, litigation and settlement related costs. The reduction was comprised of (i) a $1.7 million reduction in the accrual for certain costs associated with the resolution of the government investigations and (ii) a recovery of $0.3 million of legal expenses previously incurred related to the class action and derivative lawsuits, partially offset by (i) $1.5 million of legal expenses related to the class action and derivative lawsuits as well as for the potential settlement of the class action lawsuit that are not or may not be recoverable through insurance and (ii) $0.2 million of legal fees incurred related to the resolution of the government investigations. Investigation costs for the year ended December 31, 2011, totaled $10.3 million, which consisted of $2.8 million of legal and professional fees and an accrual of $7.5 million for certain costs associated with the possible resolution of the government investigations. See Part I, Item 3 - Legal Proceedings of this annual report on Form 10-K, for a more detailed description of the investigations. We expect our operating expenses will continue to be adversely impacted during 2013 due to professional and service provider fees, and other costs, resulting from the ongoing stockholder lawsuits. Restructuring costs During 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 positions worldwide from various departments. These actions were intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy, to drive operational efficiencies and to support the anticipated revenue levels we expect to achieve on a go forward basis. The total amount incurred with respect to severance under the 2012 Plan was $0.8 million. Actions under the 2012 Plan were substantially completed by the end of the third quarter of 2012. During 2011, we completed a restructuring which was composed of a workforce reduction of approximately 25 positions worldwide from various departments and the closing of a satellite facility. The total amounts incurred with respect to severance and facilities abandonment under the 2011 Plan were $0.8 million and less than $0.1 million, respectively. Actions under the 2011 Plan were substantially completed by the end of the third quarter of 2011. For further information, refer to Note (13) Restructuring Costs, to our consolidated financial statements. Interest and Other Income (Loss) We invest our cash primarily in money market funds, commercial paper, government securities, and corporate bonds. As of December 31, 2012, our cash, cash equivalents, and marketable securities totaled $29.9 million, compared with $37.8 million as of December 31, 2011. Interest and other income (loss) decreased $0.6 million to a loss of ($0.5) million for the year ended December 31, 2012, compared with $0.1 million of income for the same period in 2011. The decrease in interest and other income was primarily due to foreign currency losses of ($0.6) million and interest income of $0.1 million during the year ended December 31, 2012, compared with $0.1 million of interest income partially offset by $0.1 million of foreign currency losses. 38-------------------------------------------------------------------------------- Table of Contents Income Taxes Our provision for income taxes consists of federal, state and local, and foreign taxes. For the year ended December 31, 2012, we recorded an income tax provision of $0.8 million on our pre-tax loss of $14.2 million, consisting primarily of state and local and foreign taxes. For the year ended December 31, 2011, we recorded an income tax provision of $1.2 million on our pre-tax loss of $22.2 million, consisting of primarily state and local and foreign taxes. During 2010, we concluded that our domestic deferred tax assets were no longer realizable on a more-likely-than-not basis and, therefore, we recorded a full valuation allowance against our domestic deferred tax assets. During the years ended December 31, 2012 and 2011, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our net domestic deferred tax assets for the full years of 2012 and 2011. RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2011 COMPARED WITH THE YEAR ENDED DECEMBER 31, 2010 Total revenues for the year ended December 31, 2011 increased less than 1% to $82.9 million, compared with $82.8 million for the year ended December 31, 2010. During 2011, we completed a restructuring which was composed of a workforce reduction of approximately 25 positions worldwide from various departments and the closing of a satellite facility. The restructuring charges totaled approximately $0.8 million and have been segregated from each of the respective expense line items and are included within "restructuring costs" in our consolidated statement of operations. Our cost of revenues remained relatively consistent at $21.5 million for the years ended December 31, 2011 as compared with $21.4 million for the year ended December 31, 2010. Included in our cost of revenues for the years ended December 31, 2011 and 2010 was $0.5 million and $1.1 million, respectively, of share-based compensation expense. Our operating expenses increased 6% from $79.0 million for the year ended December 31, 2010 to $83.6 million for the year ended December 31, 2011. Included in the operating results for the year ended December 31, 2011 were (i) $0.8 million of restructuring costs, and (ii) $10.3 million of costs associated with the then outstanding government investigations that commenced during the second half of 2010. The $10.3 million was comprised of $2.8 million of legal fees, and an accrual of $7.5 million for certain costs associated with the then outstanding government investigations. Included in the operating results for the year ended December 31, 2010 was $1.6 million of costs associated with the then outstanding government investigations. The $1.6 million was comprised completely of legal fees. In addition, included in our operating expenses for the years ended December 31, 2011 and 2010 were $5.1 million and $7.5 million, respectively, of share-based compensation expense. Net loss for the year ended December 31, 2011 was $23.4 million, compared with a net loss of $35.4 million for the year ended December 31, 2010. Included in our net loss for the year ended December 31, 2011 was an income tax provision of $1.2 million, compared with an income tax provision of $17.6 million for the year ended December 31, 2010. The income tax provision of $1.2 million was primarily attributable to the impact of our effective tax rate on our pre-tax losses for the year ended December 31, 2011. The income tax provision of $17.6 million recorded during the year ended December 31, 2010, was the result of a full valuation allowance recorded on substantially all of our existing domestic deferred tax assets as a result of our inability to utilize our domestic deferred tax assets on a more-likely-than-not basis in future periods. Overall, the increase in total revenues was primarily due to an increase in support and service revenues for the year ended December 31, 2011, compared with the same period in 2010. In total, our product revenues decreased 5%. Product revenues from our non-OEM partners increased 6%, while product revenues from our OEM partners decreased 42% for the year ended December 31, 2011, compared with the same period in 2010. The overall increase in our non-OEM product revenues was primarily attributable to the continued focus and emphasis on our FalconStor-branded business. However, throughout 2011, the Company experienced several disruptions which adversely impacted our non-OEM product revenue growth. First, during the first half of 2011, our North American sales organization was in a period of transition. We recruited substantially an entire new sales team which led to lower than anticipated product revenues from North America during this period due to the time required to develop and train a new sales force. Second, during mid-2011, our European operations were impacted as a result of the ongoing uncertainties and disruptions in the overall European economy, and changes in senior management of the European operations. Finally, the then outstanding government investigations and uncertainties surrounding the potential outcome of these investigations all adversely impacted our overall non-OEM product revenue growth. In addition, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009 and which we have previously reported. Overall, our total operating expenses increased $4.6 million, or 6% to $83.6 million for the year ended December 31, 2011, as compared with $79.0 million for the same period in 2010. This increase was primarily due to additional costs of (i) $8.6 million associated with the then outstanding government investigations, and (ii) $0.8 million of restructuring costs incurred during the year ended December 31, 2011 as compared with the same period in 2010. 39-------------------------------------------------------------------------------- Table of Contents Revenues Year ended December 31, 2011 2010 Revenues: Product revenue $ 49,470,139 $ 51,905,096 Support and services revenue 33,400,463 30,938,650 Total Revenues $ 82,870,602 $ 82,843,746 Year-over-year percentage growth Product revenue -5 % -15 % Support and services revenue 8 % 10 % Total percentage growth 0 % -7 % Product revenue Product revenue decreased 5% from $51.9 million for the year ended December 31, 2010 to $49.5 million for the year ended December 31, 2011. These amounts are net of a benefit of $0.7 million recognized during the year ended December 31, 2011, compared with an expense of $0.7 million in the same period in 2010, resulting from the impact of our collections of previously reserved accounts receivable. Product revenue represented 60% and 63% of our total revenues for the years ended December 31, 2011 and 2010, respectively. Product revenues from our non-OEM partners increased 6%, while product revenues from our OEM partners decreased 42% for the year ended December 31, 2011, compared with the same period in 2010. The overall increase in our non-OEM product revenues was primarily attributable to the continued focus and emphasis on our FalconStor-branded business. However, throughout 2011, the Company experienced several disruptions which adversely impacted our non-OEM product revenue growth. First, during the first half of 2011, our North American sales organization was in a period of transition. We recruited substantially an entire new sales team which led to lower than anticipated product revenues from North America during this period due to the time required to develop and train a new sales force. Second, during mid-2011, our European operations were impacted as a result of the ongoing uncertainties and disruptions in the overall European economy. Finally, the then outstanding government investigations and the uncertainties surrounding the potential outcome of these investigations all adversely impacted our overall non-OEM product revenue growth. Additionally, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009 and which we have previously reported. Product revenue from our non-OEM partners represented 87% and 78% of our total product revenue for the years ended December 31, 2011 and 2010, respectively. Product revenue from our OEM partners represented 13% and 22% of our total product revenue for the years ended December 31, 2011and 2010, respectively. Support and services revenue The increase in support and services revenue was primarily attributable to maintenance and technical support services, which increased from $27.6 million for the year ended December 31, 2010 to $30.3 million for the same period in 2011. Professional services revenues decreased from $3.3 million for the year ended December 31, 2010 to $3.1 million for the same period in 2011. The professional services revenue varies from period to period based upon (i) the number of integrated solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that were completed during the period. 40-------------------------------------------------------------------------------- Table of Contents Cost of Revenues Year Ended December 31, 2011 2010 Cost of revenues: Product $ 8,386,864 $ 9,291,236 Support and service 13,130,045 12,147,715 Total cost of revenues $ 21,516,909 $ 21,438,951 Total Gross Profit $ 61,353,693 $ 61,404,795 Gross Margin: Product 83 % 82 % Support and service 61 % 61 % Total gross margin 74 % 74 % Cost of revenues, gross profit and gross margin Cost of product revenue for the year ended December 31, 2011 decreased $0.9 million, or 10%, to $8.4 million, compared with $9.3 million for the same period in 2010. The decrease in cost of product revenue was primarily attributable to (i) decreased hardware and shipping costs as the result of the 5% decline in product revenues, and (ii) decreased amortization of purchased software costs during the year ended December 31, 2011 compared with the same period in 2010. Our cost of support and service revenues for the year ended December 31, 2011 increased $1.0 million, or 8%, to $13.1 million compared with $12.1 million for the same period in 2010. The increase in cost of support and service revenue is primarily related to costs associated with the hiring of management for both our support and services divisions, as well as an overall change in the mix of our headcount within support and services as compared with the same period in 2011. Total gross profit remained consistent at approximately $61.4 million for each of the years ended December 31, 2011 and 2010. Total gross margin also remained consistent at 74% for each of the years ended December 31, 2011 and 2010. Generally, our total gross profits and total gross margins may fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and service mix of sales. Share-based compensation expense included in the cost of product revenue was less than 1% of revenue for each of the years ended December 31, 2011 and December 31, 2010. Share-based compensation expense included in the cost of support and service revenue decreased to $0.5 million from $1.1 million for the years ended December 31, 2011 and December 31, 2010, respectively. Share-based compensation expense related to cost of support and service revenue was equal to 1% for both the years ended December 31, 2011 and 2010, respectively. Operating Expenses Research and Development Costs Research and development costs decreased $5.7 million, or 21%, to $21.2 million for the year ended December 31, 2011 from $26.9 million in the same period in 2010. The decrease in research and development costs was primarily the result of (i) a decline in salary and personnel costs, including share-based compensation expenses, as a result of lower research and development headcount, and (ii) an increase of approximately $0.9 million related to the capitalization of costs associated with software development. Share-based compensation expense included in research and development costs decreased to $1.3 million from $3.0 million for the years ended December 31, 2011 and December 31, 2010, respectively. Share-based compensation expense included in research and development costs was equal to 2% and 4% of total revenue for the years ended December 31, 2011 and 2010, respectively. Selling and Marketing Selling and marketing expenses decreased $1.2 million, or 3%, to $39.6 million for the year ended December 31, 2011, from $40.8 million for the same period in 2010. The decrease in selling and marketing expenses was primarily due to lower headcounts, specifically within North America, during the first half of 2011, as the result of a transition within the North American sales force. These decreases were offset in part by the costs associated with the recruitment and hiring of (i) additional sales management in all of our regions, and (ii) costs related to the increased sales and sales support personnel within North America. Share-based compensation expense included in selling and marketing decreased to $2.0 million from $3.4 million for the years ended December 31, 2011 and 2010, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 2% and 4% of total revenue for the years ended December 31, 2011and 2010, respectively. 41-------------------------------------------------------------------------------- Table of Contents General and Administrative General and administrative expenses increased $2.1 million, or 22%, to $11.7 million for the year ended December 31, 2011 from $9.6 million for the same period in 2010. The overall increase within general and administrative expenses related to increases in (i) personnel related costs, and (ii) various administrative costs. Share-based compensation expense included in general and administrative expenses increased to $1.7 million from $1.2 million for the years ended December 31, 2011 and 2010, respectively. Share-based compensation expense included in general and administrative expenses was equal to 2% and 1% of total revenue for the years ended December 31, 2011and 2010, respectively. Investigation costs Investigation costs for the year ended December 31, 2011, totaled $10.3 million, which consisted of $2.8 million of legal and professional fees, and an accrual of $7.5 million for certain costs associated with the then outstanding resolution of the government investigations. Investigation costs for the year ended December 31, 2010, totaled $1.6 million, which related to legal and professional fees. See Part I, Item 3 - Legal Proceedings of this annual report on Form 10-K, for a more detailed description of the investigations. Restructuring costs During 2011, we completed a restructuring which was composed of a workforce reduction of approximately 25 global positions from various departments and the closing of a satellite facility (the "2011 Plan"). These actions were intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy and drive operational efficiencies. The total amounts incurred with respect to severance and facilities abandonment under the 2011 Plan were $0.8 million and less than $0.1 million, respectively. Actions under the 2011 Plan were substantially completed by the end of the third quarter of 2011. For further information, refer to Note (13) Restructuring Costs, to our consolidated financial statements. Interest and other income (loss) As of December 31, 2011, our cash, cash equivalents, and marketable securities totaled $37.8 million, compared with $37.3 million as of December 31, 2010. Interest and other income (loss) increased $0.3 million to $0.1 million for the year ended December 31, 2011, compared with ($0.2) million for the same period in 2010. The increase in interest and other income (loss) was primarily due to foreign currency losses of $0.1 million incurred during the year ended December 31, 2011 compared with foreign currency losses of $0.3 million for the same period in 2010. Income Taxes For the year ended December 31, 2011, we recorded an income tax provision of $1.2 million on our pre-tax loss of $22.2 million, consisting of primarily state and local and foreign taxes. For the year ended December 31, 2010, we recorded an income tax provision of $17.6 million. During 2010, we concluded that our domestic deferred tax assets were no longer realizable on a more-likely-than-not basis, therefore, we recorded a discrete item of approximately $16.3 million related to an increase in a valuation allowance on our domestic deferred tax assets previously recognized. During the year ended December 31, 2011, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our net domestic deferred tax assets for the full year 2011. 42-------------------------------------------------------------------------------- Table of Contents LIQUIDITY AND CAPITAL RESOURCES Cash flow information is as follows: Years Ended December 31, 2012 2011 2010 Cash provided by (used in): Operating activities $ (5,268,470 ) $ 3,138,766 $ (1,728,504 ) Investing activities 7,235,301 (5,400,465 ) 3,634,373 Financing activities 738,184 920,106 409,889 Effect of exchange rate changes (311,241 ) (243,268 ) (225,731 ) Net increase (decrease) in cash and cash equivalents $ 2,393,774 $ (1,584,861 ) $ 2,090,027 Our principal sources of liquidity are cash flows generated from operations and our cash, cash equivalents, and marketable securities balances. Our cash and cash equivalents and marketable securities balance as of December 31, 2012 totaled $29.9 million, compared with $37.8 million as of December 31, 2011. Cash and cash equivalents totaled $18.7 million, restricted cash totaled $0.8 million, and marketable securities totaled $10.5 million at December 31, 2012. As of December 31, 2011, we had $16.3 million in cash and cash equivalents and $21.5 million in marketable securities. As of December 31, 2012, the Company had $0.8 million of restricted cash. The restricted cash serves as collateral related to deposit service indebtedness with the Company's commercial bank. Over the past two years, we have been in an ongoing period of transition, which included various senior management changes, new sales leadership in all of our regions, changes within our North American sales force structure, and restructurings. Most recently, during the third quarter 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 positions worldwide from various departments. These actions were intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy, drive operational efficiencies and support the anticipated revenue level we expect to achieve on a go forward basis (see Note (13) Restructuring Costs to our consolidated financial statements for further information.) We continually evaluate the appropriate headcount levels to properly align all of our resources with our current and long-term outlook. We will continue to evaluate potential software license purchases and acquisitions, and if the right opportunity presents itself, we may use our cash for these purposes. As of the date of this filing, we have no agreements, commitments or understandings with respect to any such license purchases or acquisitions. As discussed further in Part I, Item 3 - Legal Proceedings of this annual report on Form 10-K, in June 2012, we settled charges arising from investigations conducted by the United States Attorney's Office and the Securities and Exchange Commission for a total of $5.8 million. During 2012, the Company paid $4.1 million of the $5.8 million investigation settlement, with the balance of $1.7 million due in December 2013. In addition, as discussed further in in Part I, Item 3 - Legal Proceedings of this annual report on Form 10-K, we are among the defendants named in class action and derivative lawsuits. In accordance with our by-laws and Delaware law, we have been paying for the costs of defense of these actions for the other named defendants. If liability is ultimately assessed some of the other named defendants may be entitled to claim indemnification from us. We have incurred, and continue to incur significant expenses, primarily for legal counsel, due to the class action and derivative lawsuits. In January, 2013, the parties to the Class Action reached an agreement in principle to settle the Class Action. Pursuant to a Memorandum of Understanding signed by counsel for the class plaintiffs and by counsel for all defendants, the Company will pay $5.0 million to settle the Class Action. This amount includes damages, plaintiffs' attorneys' fees, and costs of administration of the settlement. The Company expects to pay this settlement with a combination of cash on hand and insurance proceeds. In accordance with the Memorandum of Understanding, a stipulation of settlement and a joint motion for preliminary approval of the settlement will be submitted to the court for its approval. Final settlement of the Class Action is subject to certain conditions and to approval by the court. We cannot predict if or when the court might approve the settlement. Certain of the defendants may be entitled to indemnification by the Company under the laws of Delaware and/or our by-laws. In addition, we may be entitled to seek the recovery of certain costs and payments from certain former Company employees. On March 5, 2013, the Derivative Action was dismissed as to all defendants except for Jason Lin. 43-------------------------------------------------------------------------------- Table of Contents At various times from October 2001 through February 2009 our Board of Directors has authorized the repurchase of up to 14 million shares of our outstanding common stock in the aggregate. We did not repurchase any of our outstanding common stock during the years ended December 31, 2012, 2011 and 2010. Since October 2001, we have repurchased a total of 8,005,235 shares at an aggregate purchase price of $46.9 million. As of December 31, 2012, we had the authority to repurchase 5,994,765 shares of our common stock based upon our judgment and market conditions. See Note (7) Stockholders' Equity to our consolidated financial statements for further information. Net cash (used in) provided by operating activities totaled ($5.3) million, $3.1 million and ($1.7) million for the years ended December 31, 2012, 2011 and 2010, respectively. The changes in net cash (used in) provided by operating activities for each of the years ended December 31, 2012, 2011 and 2010 is the result of recording a net loss of $15.0 million, $23.4 million and $35.4 million, respectively, adjusted for: (i) the impact of non-cash charges, particularly relating to depreciation, amortization, stock-based compensation, provision for returns and doubtful accounts and deferred income taxes; and (ii) adjustments for net changes in operating assets and liabilities, primarily changes in our accounts receivable, prepaid expenses, inventory, accounts payable, accrued expenses and deferred revenues. Net cash provided by (used in) investing activities totaled $7.2 million, ($5.4) million and $3.6 million for the years ended December 31, 2012, 2011 and 2010, respectively. Included in investing activities for each year are the sales and purchases of our marketable securities, which include the sales, maturities and reinvestment of our marketable securities. The net cash provided by (used in) investing activities from the net sales of securities was $11.1 million, ($2.0) million and $6.6 million for the years ended December 31, 2012, 2011 and 2010, respectively. These amounts will fluctuate from year to year depending on the maturity dates of our marketable securities. The cash used to purchase property and equipment was $2.5 million, $2.2 million and $2.7 million for the years ended December 31, 2012, 2011 and 2010, respectively. The cash used in the capitalization of software development costs was $0.5 million, $1.0 million and $0.1 million for the years ended December 31, 2012, 2011 and 2010, respectively. The cash used in changes of restricted cash was $0.8 million for the year ended December 31, 2012. We continually evaluate potential software license purchases and acquisitions, and we may continue to make such investments if we find opportunities that would benefit our business. We anticipate continued capital expenditures, including capitalized software costs, as we continue to invest in our infrastructure and expand and enhance our product offerings. Net cash provided by financing activities totaled $0.7 million, $0.9 million and $0.4 million for the years ended December 31, 2012, 2011 and 2010, respectively, resulting from proceeds received from the exercise of stock options. During the year ended December 31, 2012, the remaining $0.7 million (at par value) of our auction rate securities were called by the issuer at par value. As of December 2011, $0.7 million, (at par value) of our auction rate securities and were classified as long-term investments in our consolidated balance sheet at December 31, 2011. We currently do not have any debt and our only significant commitments are related to our employment agreement with James P. McNiel, our President and Chief Executive Officer, the $1.7 million remaining payment to the United States Attorney's Office, which is due in December 2013 and our office leases. In addition, on January 20, 2013, we announced we had reached a proposed settlement of the Class Action lawsuit between the Company and class plaintiffs for $5.0 million which is pending approval by the court. On March 13, 2013, the parties to the Class Action submitted a Stipulation and Agreement of Settlement asking the court to approve a settlement of the Class Action agreed to by the parties. We cannot predict if or when the court might approve the settlement. We have an operating lease covering our corporate office facility that we recently extended to February 2017. We also have several operating leases related to offices in the United States and foreign countries. The expiration dates for these leases range from 2013 through 2017. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2012: 44-------------------------------------------------------------------------------- Table of Contents Year ending December 31, 2013 $ 2,708,548 2014 2,329,788 2015 1,728,939 2016 1,639,594 2017 298,416 Thereafter - $ 8,705,285 In addition, as of December 31, 2012, our liability for uncertain tax positions totaled $2.5 million. Due to the uncertainty relating to the timing of future payments, such amounts are not presented in the above schedule. We believe that our current balance of cash, cash equivalents, restricted cash and marketable securities, and our expected cash flows from operations, will be sufficient to meet our cash requirements for at least the next twelve months. However, any projections of future cash needs and cash flows are subject to substantial uncertainty. See Part I, Item 1A - Risk Factors. Off-Balance Sheet Arrangements As of December 31, 2012 and 2011, we had no off-balance sheet arrangements. Critical Accounting Policies and Estimates Our critical accounting policies and estimates are those related to revenue recognition, accounts receivable allowances, deferred income taxes, accounting for share-based payments, goodwill and other intangible assets, software development costs, fair value measurements and litigation. Revenue Recognition. As discussed further in Note (1) Summary of Significant Accounting Policies, to our consolidated financial statements, we recognize revenue in accordance with the authoritative guidance issued by the FASB on revenue recognition. Product 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, a customer purchase order, and/or a royalty report summarizing software licenses sold for each software license resold by an OEM, distributor, or reseller to an end user. Product 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 with extended payment terms. When a customer purchases our integrated solutions and/or licenses software together with the purchase of maintenance, we allocate a portion of the fee to maintenance based upon vendor-specific objective evidence ("VSOE") of the fair value of the contractual optional maintenance renewal rate. If professional services are included in our multi-element software arrangements, we allocate a portion of the fee to these services based on its VSOE of fair value which is established using rates charged when sold on a stand-alone basis. Accounts Receivable. We review accounts receivable to determine which receivables are doubtful of collection. In making the determination of the appropriate allowance for uncollectible accounts and returns, we consider (i) historical return rates, (ii) specific past due accounts, (iii) analysis of our accounts receivable aging, (iv) customer payment terms, (v) historical collections, write-offs and returns, (vi) changes in customer demand and relationships, (vii) actual cash collections on our accounts receivables and (viii) concentrations of credit risk and customer credit worthiness. When determining the appropriate allowance for uncollectable accounts and returns each period, the actual customer collections of outstanding account receivable balances impact the required allowance for returns. We recorded total provision expenses of approximately $0.4 million, $0.1 million and $1.2 million for the years ended December 31, 2012, 2011 and 2010, respectively. These amounts are included within our consolidated statement of operations in each respective year. 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. Income Taxes. As discussed further in Note (6) Income Taxes, to our consolidated financial statements, in accordance with the authoritative guidance issued by the FASB on income taxes, we regularly evaluate our ability to recover deferred tax assets, and report such deferred tax assets at the amount that is determined to be more-likely-than-not recoverable. Deferred tax assets and liabilities are recognized for 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. In determining the period in which related tax benefits are realized for financial reporting purposes, excess share-based compensation deductions included in net operating losses are realized after regular net operating losses are exhausted. 45-------------------------------------------------------------------------------- Table of Contents We account for uncertain tax positions in accordance with the authoritative guidance issued by the FASB on income taxes, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return, should be recorded in the financial statements. Pursuant to the authoritative guidance, we 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. In addition, the authoritative guidance addresses de-recognition, classification, interest and penalties on income taxes, accounting in interim periods, and also requires increased disclosures. Accounting for Share-Based Payments. As discussed further in Note (8) Share-Based Payment Arrangements, to our consolidated financial statements, we account for share-based awards in accordance with the authoritative guidance issued by the FASB on stock compensation. 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. The expected option term is the number of years that we estimate that the stock options will be outstanding prior to exercise. The estimated expected term of the stock awards issued has been determined pursuant to SEC Staff Accounting Bulletin SAB No. 110. Additionally, we estimate forfeiture rates based primarily upon historical experience, adjusted when appropriate for known events or expected trends. We may adjust share-based compensation expense on a quarterly basis for changes to our estimate of expected equity award forfeitures based on our review of these events and trends and recognize the effect of adjusting the forfeiture rate for all expense amortization in the period in which we revised the forfeiture estimate. If other assumptions or estimates had been used, the share-based compensation expense that was recorded for the years ended December 31, 2012, 2011 and 2010 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. Goodwill and Other Intangible Assets. As discussed further in Note (1) Summary of Significant Accounting Policies, to our consolidated financial statements, we account for goodwill and other intangible assets in accordance with the authoritative guidance issued by the FASB on goodwill and other intangibles. The authoritative guidance requires an impairment-only approach to accounting for goodwill and other intangibles with an indefinite life. Absent any prior indicators of impairment, we perform an annual impairment analysis during the fourth quarter of each of our fiscal years. As of each of December 31, 2012 and 2011, we had $4.2 million of goodwill. As of each of December 31, 2012 and 2011, we had $0.2 million (net of accumulated amortization), of other identifiable intangible assets. We do not amortize goodwill, but we assess for impairment at least annually and more often if a trigger event occurs. We amortize identifiable intangible assets over their estimated useful lives. We evaluate the recoverability of goodwill using a two-step process based on an evaluation of the reporting unit. The first step involves a comparison of a reporting unit's fair value to its carrying value. In the second step, if the reporting unit's carrying value exceeds its fair value, we compare the goodwill's implied fair value and its carrying value. If the goodwill's carrying value exceeds its implied fair value, we recognize an impairment loss in an amount equal to such excess. We evaluate the recoverability of other identifiable intangible assets whenever events or changes in circumstances indicate that its carrying value may not be recoverable. Such events include significant adverse changes in business climate, several periods of operating or cash flow losses, forecasted continuing losses or a current expectation that an asset or asset a group will be disposed of before the end of its useful life. As of December 31, 2012 and 2011, we did not record any impairment charges on either our goodwill or other identifiable intangible assets. 46-------------------------------------------------------------------------------- Table of Contents Software Development Costs. As discussed further in Note (1) Summary of Significant Accounting Policies, to our consolidated financial statements, we account for software development costs in accordance with the authoritative guidance issued by the FASB on costs of software to be sold, leased or marketed. As of December 31, 2012 and 2011, we had $1.2 million and $1.0 million, respectively, of software development costs, net of amortization. The authoritative guidance requires that the costs associated with the development of new software products and enhancements to existing software products be expensed as incurred until technological feasibility of the product has been established. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established and assumptions are used that reflect our best estimates. If other assumptions had been used in the current period to estimate technological feasibility, the reported product development and enhancement expense could have been affected. Annual amortization of capitalized software costs is the greater of the amount computed using the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product or the straight-line method over the remaining estimated economic life of the software product, generally estimated to be five years from the date the product became available for general release to customers. Software development costs are reported at the lower of amortized cost or net realizable value. Net realizable value is computed as the estimated gross future revenues from each software solution less the amount of estimated future costs of completing and disposing of that product. Because the development of projected net future revenues related to our software solutions used in our net realizable value computation is based on estimates, a significant reduction in our future revenues could impact the recovery of our capitalized software development costs. We amortize software development costs using the straight-line method. Fair Value Measurement. As discussed further in Note (4) Fair Value Measurements, to our consolidated financial statements, we determine fair value measurements of both financial and nonfinancial assets and liabilities in accordance with the authoritative guidance issued by the FASB on fair value measurements and disclosures. In the current market environment, the assessment of the fair value of our marketable securities, specifically our debt instruments, can be difficult and subjective. The volume of trading activity of certain debt instruments has declined, and the rapid changes occurring in the current financial markets can lead to changes in the fair value of financial instruments in relatively short periods of time. The FASB authoritative guidance establishes three levels of inputs that may be used to measure fair value. Each level of input has different levels of subjectivity and difficulty involved in determining fair value. Level 1 - instruments represent quoted prices in active markets. Therefore, determining fair value for Level 1 instruments does not require significant management judgment, and the estimation is not difficult. Level 2 - instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments. Level 3 - instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities. The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. All of our marketable debt instruments classified as Level 3 are valued using an undiscounted cash flow analysis, a non-binding market consensus price and/or a non-binding broker quote, all of which we corroborate with unobservable data. Non-binding market consensus prices are based on the proprietary valuation models of pricing providers or brokers. These valuation models incorporate a number of inputs, including non-binding and binding broker quotes; observable market prices for identical and/or similar securities; and the internal assumptions of pricing providers or brokers that use observable market inputs, and to a lesser degree non-observable market inputs. Adjustments to the fair value of instruments priced using non-binding market consensus prices and non-binding broker quotes, and classified as Level 3, were not significant as of December 31, 2011. There were no instruments classified as Level 3 as of December 31, 2012. 47-------------------------------------------------------------------------------- Table of Contents Other-Than-Temporary Impairment After determining the fair value of our available-for-sale debt instruments, gains or losses on these investments are recorded to other comprehensive income, until either the investment is sold or we determine that the decline in value is other-than-temporary. Determining whether the decline in fair value is other-than-temporary requires management judgment based on the specific facts and circumstances of each investment. For investments in debt instruments, these judgments primarily consider the financial condition and liquidity of the issuer, the issuer's credit rating, and any specific events that may cause us to believe that the debt instrument will not mature and be paid in full; and our ability and intent to hold the investment to maturity. Given the current market conditions, these judgments could prove to be wrong, and companies with relatively high credit ratings and solid financial conditions may not be able to fulfill their obligations. Litigation. As discussed further in Note (12) Litigation, to our consolidated financial statements, in accordance with the authoritative guidance issued by the FASB on contingencies, the Company accrues anticipated costs of settlement, damages and losses for claims to the extent specific losses are probable and estimable. The Company records a receivable for insurance recoveries when such amounts are probable and collectable. In such cases, there may be an exposure to loss in excess of any amounts accrued. If, at the time of evaluation, the loss contingency related to a litigation is not both probable and estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and estimable and, the Company will expense these costs as incurred. If the estimate of a probable loss is a range and no amount within the range is more likely, the Company will accrue the minimum amount of the range. Impact of Recently Issued Accounting Pronouncements See Item 8 of Part II, Consolidated Financial Statements - Note (1) Summary of Significant Accounting Policies - New Accounting Pronouncements. |