Edgar Filing: FALCONSTOR SOFTWARE INC

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K

|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the fiscal year ended December 31, 2006.

|_| TRANSITION REPORT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934

For the transition period from __________ to __________

Commission file number 0-23970

FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 77-0216135
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

2 HUNTINGTON QUADRANGLE, SUITE 2S01 11747
MELVILLE, NEW YORK (Zip code)
(Address of principal executive offices)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 631-777-5188

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: None

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: Common Stock, $.001
par value

Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes |_| No |X|

Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes |_| No |X|

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|

Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act.

Large Accelerated Filer |_| Accelerated Filer |X| Non-Accelerated Filer |_|

Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|

Aggregate market value of Common Stock held by non-affiliates of the
Registrant as of June 30, 2006 was $173,209,810 which value, solely for the
purposes of this calculation excludes shares held by Registrant's officers and
directors. Such exclusion should not be deemed a determination by Registrant
that all such individuals are, in fact, affiliates of the Registrant. The number
of shares of Common Stock issued and outstanding as of February 21, 2007 was
49,129,542 and 48,264,342, respectively.

DOCUMENTS INCORPORATED BY REFERENCE:

The information required by Part III of Form 10-K will be incorporated by
reference to certain portions of a definitive proxy statement which is expected
to be filed by the Company pursuant to Regulation 14A within 120 days after the
close of its fiscal year.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

2006 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

Page

PART I.

Item 1. Business........................................................ 4
Item 1A. Risk Factors.................................................... 10
Item 1B. Unresolved Staff Comments....................................... 19
Item 2. Properties...................................................... 19
Item 3. Legal Proceedings............................................... 19
Item 4. Submission of Matters to a Vote of Security Holders............. 19

PART II.

Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters............................................. 20
Item 6. Selected Consolidated Financial Data............................ 21
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 24
Item 7A. Qualitative and Quantitative Disclosures About Market Risk...... 34
Item 8. Financial Statements and Supplementary Data..................... 36
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure............................. 59
Item 9A. Controls and Procedures......................................... 59
Item 9B. Other Information............................................... 59

PART III.

Item 10. Directors and Executive Officers of the Registrant.............. 59
Item 11. Executive Compensation.......................................... 60
Item 12. Security Ownership of Certain Beneficial Owners and Management.. 60
Item 13. Certain Relationships and Related Transactions.................. 60
Item 14. Principal Accountant Fees and Services.......................... 60

PART IV.

Item 15. Exhibits and Financial Statement Schedules...................... 61

SIGNATURES................................................................. 63

PART I

ITEM 1. BUSINESS

OVERVIEW

FalconStor Software, Inc. ("FalconStor", the "Company", "we", "our" or "us") is
a leader in disk-based data protection solutions that maximize business
continuity and data center efficiency within all IT infrastructures, integrating
seamlessly to ensure rapid data recovery while simplifying storage management.
FalconStor's comprehensive data protection solutions, developed on a single
platform, IPStor(R), include award-winning, easy-to-deploy storage
virtualization, Continuous Data Protection (CDP), VirtualTape Library (VTL) with
Single Instance Repository (SIR), and Replication software solutions and related
implementation, maintenance, and engineering services. In addition, FalconStor's
PrimeVaultSM services provide customers with a safe secondary location to which
they can replicate their data securely and cost-effectively for rapid recovery
and archiving. From the Fortune 1000 to small and medium-size businesses,
customers across a vast range of industries worldwide have implemented
FalconStor solutions in their production IT environments in order to meet their
most stringent recovery time objectives (RTO) and recovery point objectives
(RPO), as well as to manage their storage infrastructures with minimal total
cost of ownership (TCO) and optimal return on investment (ROI).

The FalconStor IPStor data protection platform is designed to empower IT
administrators and end users to recover data easily to any point in time in the
event of hardware failure, data corruption, deletion, or catastrophic site-level
disaster, allowing rollback or failover to a known-good, immediately useable
state. To ensure that businesses maintain reliable access to their vital
applications, and to facilitate accurate data restoration while concurrently
minimizing downtime, the uniquely application-aware FalconStor solutions are
engineered to work seamlessly with database, email, and file systems so that
redundant sets of active data are generated with transactional and point-in-time
integrity. Because this eliminates the need for the time-consuming consistency
checks that traditionally create long periods of downtime during a recovery
process, business productivity is measurably enhanced.

Designed to contain escalating costs, FalconStor solutions enable companies to
aggregate heterogeneous, distributed storage capacity and centralize
administration of both storage resources and business-critical data services
such as backup, snapshot, replication, and migration. Companies benefit from
lower administrative overhead, elimination of storage over-provisioning,
boundless scalability, and the ability to make cost-effective storage allocation
and purchasing decisions. Moreover, FalconStor's commitment to an open
software-based approach to storage networking entails any-to-any connectivity
via native support for industry standards (including Fibre Channel, iSCSI, SCSI,
CIFS, NFS, and emerging standards such as InfiniBand) and delivers unified
support for multiple storage architectures (SAN, NAS, and DAS). As a result,
FalconStor solutions provide companies of any size and complexity with the
freedom to leverage the high performance of IP/iSCSI-, Fibre Channel or
InfiniBand-based networks and to implement their choice of state-of-the-art
equipment, based on any standard protocol from any storage manufacturer, without
rendering their existing or future investments obsolete.

Recognizing the strong value proposition of FalconStor's proven, cutting-edge
technology, multiple Tier-1 partners utilize FalconStor's innovative software
products - including CDP, VTL, Network Storage Server (NSS) and DiskSafe(TM)-to
power their storage appliances and bundled solutions. FalconStor's products have
been certified by such industry leaders as Adaptec, Alacritech, ATTO Technology,
Bell Microproducts, Brocade, Cisco, Engenio Information Technologies, EMC,
Emulex, Fujitsu, Gadzoox, Hewlett Packard, Hitachi Data Systems, Hitachi
Engineering Co., Ltd., Huawei, Huawei-3COM, IBM, Intel, LSI Logic, Brocade
Corporation, Microsoft, NEC, Network Appliance, Nexsan, Novell, NS Solutions
Corporation (subsidiary of The Nippon Steel Corporation, Japan), Oracle, Pillar
Data, QLogic, Quantum, Sony, Sun Microsystems, Voltaire, and VMware.

Further validation of FalconStor solutions comes from the agreements FalconStor
has with many Tier-1 original equipment manufacturers (OEMs) and others to
integrate FalconStor technology with those companies' products. In the past
year, many of our OEM partners have renewed contracts and pursued a visible
market presence with FalconStor, leveraging both brands for market presence.

FalconStor was incorporated in Delaware as Network Peripherals, Inc., in 1994.
Pursuant to a merger with FalconStor, Inc., in 2001, the former business of

Network Peripherals, Inc., was discontinued, and the newly re-named FalconStor
Software, Inc., continued the storage software business started in 2000 by
FalconStor, Inc. FalconStor's headquarters are located at 2 Huntington
Quadrangle, Suite 2S01, Melville, NY 11747. The Company also maintains offices
throughout Europe and Asia.

PRODUCTS AND TECHNOLOGY

The FalconStor IPStor platform is a network infrastructure software platform
that provides the most reliable and complete disk-based platform for delivering
data protection solutions. FalconStor data protection solutions accelerate or
eliminate the backup window which allows users to recover data in 30 minutes,
anytime, anywhere, with 100% data integrity. FalconStor offers the following
core products: VTL with SIR for de-duplications, CDP, NSS and Replication for
disaster recovery and remote branch office protection. The IPStor platform and
subsequent solutions share several key technologies that foster seamless
integration and offer a competitive edge.

o ONE INDEPENDENT, OPEN PLATFORM - Built on the IPStor storage
virtualization platform, FalconStor's solutions are completely
independent of any storage or connectivity, delivering comprehensive
data protection.

o RAPID RECOVERY - Unique to FalconStor is the ability to return a
file, full system, or entire array to service in 30 minutes and, in
some cases, 5 minutes or less. This is due to the application-aware
snapshot ability of TimeMark(R) technology as well as bare metal
recovery capabilities.

o AFFORDABLE, SCALABLE PROTECTION FROM THE DATA CENTER TO THE REMOTE
OFFICE - FalconStor data protection technology scales from the data
center to the remote office or single user laptop. FalconStor and
its partners have deployed solutions as small as a 2TB desktop
network storage server and as large as multiple-petabyte
architectures. FalconStor's MicroScan(TM) technology eliminates
redundant data across the network. This eliminates 70%-90% of the
bandwidth requirements, making disk based protection for remote or
disaster recovery sites highly affordable and practical.

FalconStor's data protection solutions address the full spectrum of data
protection business problems, from the need to accelerate backup to the need to
recover data after a disaster. Customers today are facing massive data growth,
often exceeding 60% a year. Backup windows have not only shrunk; for many
organizations they have disappeared altogether. Traditional backup has also been
plagued with media and hardware failures. These are issues addressed by
FalconStor VTL. In addition, the time to recover is also shrinking, so companies
need more recovery points and times, rather than the once a day offered by daily
backup. For this they turn to the FalconStor CDP solution. To improve the
day-to-day management they face with the explosive storage growth, customers use
the FalconStor NSS to virtualize, provision, and protect their data. And for
protecting remote office data and disasters, FalconStor has built a highly
efficient Replication solution that integrates with VTL, CDP, and NSS. Because
all of these solutions are built from a single platform, IPStor, deployment is
simplified and businesses benefit from the peace of mind that FalconStor
solutions work together in an easily managed and highly efficient fashion, with
high data availability and rapid recovery always paramount.

FalconStor sells its solutions as software only or pre-installed on
FalconStor-supplied hardware appliances. Software only solutions are available
as pre-packaged Software Appliance Kits or from an itemized price list in the
forms of Enterprise, Standard, and Express Editions.

SOFTWARE PRODUCTS

NETWORK STORAGE SERVER (NSS)

FalconStor's flagship product, NSS powered by IPStor, provides advanced storage
networking and best-in-class business continuity/disaster recovery (BC/DR)
functionality to all segments of the enterprise, small and medium-size business
(SMB), and small office/home office (SOHO) markets. NSS is comprised of an
extensive set of state-of-the-art network storage services designed to deliver
rapid data recovery and an open, unified SAN and NAS infrastructure across
heterogeneous environments. NSS aggregates storage capacity, provisioning, and
services to application servers via all industry-standard protocols with speed,
security, reliability, interoperability, and scalability.

VIRTUALTAPE LIBRARY (VTL)

FalconStor VTL is the industry-leading, revolutionary backup/recovery solution
that saves money and time by using disk to emulate an extensive range of
physical tape libraries. Integrating seamlessly with existing backup software
and policies, and with FalconStor CDP solutions, VTL enhances backup
reliability, speed, availability, and recoverability, while consolidating
management of backup resources. VTL backup to disk-based virtual tape ensures
backup/restore success by eliminating the media/mechanical errors and manual
intervention traditionally associated with tape backup. Remote offsite
replication of virtual tapes provides disaster protection, while automated data
export to physical tape is supported for archiving purposes. Software-based
encryption technology prevents unauthorized access to data exported to physical
tapes and in transit during replication, without imposing any overhead on the
backup process. VTL is fast and easy to deploy--comparable to adding a new tape
drive or library to an existing backup environment.

In 2006 FalconStor introduced the Single Instance Repository (SIR) as a
de-duplication enhancement to VTL. Because backup by nature copies data over and
over again, de-duplication minimizes storage and bandwidth needs. By eliminating
duplicate copies, VTL with SIR allows customers to keep more data online,
longer. Instead of a month of data on disk for recovery, they can now keep
several months or more.

CONTINUOUS DATA PROTECTION (CDP)

CDP solutions maintain 24x7x365 availability and usability of data in the event
of an unplanned hardware failure, deletion, or software error, or planned
downtime. Combining application-aware TimeMark snapshots and continuous
journaling functions, CDP enables customers to recover data to any point in
time. CDP eliminates the backup window entirely, by enabling customers to use
the CDP copy as the target for the backup software.

REPLICATION

FalconStor Replication provides rapid, reliable recovery in the event of
catastrophic site failure, such as a fire, power outage, or flood in the main
data center. Disk-to-disk disaster recovery solutions become more affordable and
available to customers of all sizes. Customer benchmarks have indicated that
FalconStor Replication technology can eliminate 70% to 90% of the redundant data
typically replicated by other solutions. When combined with VTL or CDP,
Replication technology delivers a highly efficient remote office protection
solution.

DISKSAFE(TM)AND FILESAFE(TM)

FalconStor DiskSafe and FileSafe are host-resident software tools that protect
DAS-based application servers and end user desktops or laptops, as well as
servers using third-party storage networks, by enabling them to replicate entire
local disks (DiskSafe) or individual files and directories (FileSafe) to
CDP-managed storage for automated backup, off-site data storage, and rapid,
user-initiated data recovery. DiskSafe technology captures the information
necessary to boot the designated machine in the event of a virus or spyware
attack, application malfunction, or hard disk crash. DiskSafe and FileSafe are
integral components of FalconStor's CDP solutions, facilitating the transfer of
replicated data over the network to a centralized FalconStor data management
appliance for both redundant nearline storage and remote disaster recovery (DR)
purposes.

APPLICATION-AWARE SNAPSHOT AGENTS

FalconStor Snapshot Agents automate and minimize quiesce time during data
replication, backup, and other snapshot-based operations to ensure transactional
integrity and point-in-time consistency of databases and messaging stores for
fast time-to-recovery. Snapshot Agents are available for IBM(R) DB2(R) UDB,
Informix(R), Microsoft(R) SQL Server, Oracle(R), Pervasive.SQL(R), Sybase(R),
IBM Lotus Notes(R)/Domino, Microsoft(R) Exchange, Microsoft(R) VSS, Novell(R)
GroupWise(R), VMWare(R), and many file systems.

OFFSITE, ONLINE DATA PROTECTION FACILITY

PrimeVaultSM by FalconStor is an offsite, online data protection service for
organizations that either do not have their own disaster recovery sites or wish
to replicate their data to an additional site for a supplementary layer of
redundancy. PrimeVault grants small, medium, and large businesses the ability to
protect and archive their data to a secure facility at an affordable and
predetermined price based on individualized needs. By cutting the costs of
deploying and maintaining an alternate site, PrimeVault makes alternate sites
practical for most, if not all businesses. PrimeVault services are sold directly
to FalconStor customers or through partners.

PrimeVault offerings include:

o Rapid 24x7x365 data recovery with maximum BC/DR capabilities

o Immediate BC/DR solution deployment

o Cost-effective, flexible pricing

o Minimal upfront IT investment and operating overhead

o Rapid deployment and compliance with minimal implementation
costs

o Seamless scalability of offsite data storage as business expands

o Offsite replication of virtual tapes

o Data export from virtual to physical tapes with offsite archiving for
compliance or other purposes

o End-to-end security

o Encryption for data replication, virtual tapes, and data
storage

o Closed-circuit video surveillance 24x7x365

o Encrypted, multi-point verified access to facility

BUSINESS STRATEGY

FalconStor intends to maintain its position as a leading provider of disk-based
data protection solutions serving enterprises and SMBs worldwide. FalconStor
intends to achieve this objective through the following strategies:

DISK-BASED DATA PROTECTION LEADERSHIP

FalconStor intends to continue to leverage the protocol-agnostic, unified
architecture, and robust data protection technology of its solutions to maintain
a leadership position in the enterprise disk-based data protection software
market. The disk-based data protection market is rapidly growing. IDC forecasts
the VTL market will reach $1.2B by 2011, a 30% CAGR. Polls by Gartner at their
customer summits show CDP to be adopted by 17% to 19% of the customers in 2007.
FalconStor plans to continue its leadership in this market through its deep
commitment to research and development and continued rapid technology
innovation.

EXPAND PRODUCT OFFERINGS

In the spring of 2006, FalconStor released CDP, complementing the already
successful TimeMark snapshot technology. This along with the Continuous
Replication delivers a remote data center and remote branch office offering. For
the SMB market, FalconStor released Express versions of our products, sold by
our OEM partners and also used by our enterprise customers for remote office
data protection.

In addition, FalconStor introduced SIR de-duplication technology as an
enhancement to its VTL offering for improved storage and network efficiency. We
expect many VTL solutions to be sold with this critical functionality.
FalconStor also enhanced its VTL with optimized scalability to meet the needs of
the largest enterprises. In 2006 the largest VTL cluster managed 1.5PB of
storage. As our customers grow, we expect their requirement for scalability to
grow as well.

EXPAND CORPORATE VISIBILITY

In late 2006, FalconStor made significant steps in increasing its market
presence and awareness. First, we invested in experienced marketing staff. A new
Chief Marketing Officer was hired along with additional staff for product and
partner marketing. Second, we increased our engagement with the press and
analyst community to bring our comprehensive disk based data protection message
to the market. This broad effort will continue throughout 2007, as we hone our
message and market deliverables. We are relying significantly on our success
with customers and partners throughout the world. Third, we increased our
investment in our partners, both OEMs and channel, for joint marketing and field
engagement.

EXPAND TECHNOLOGIES AND CAPABILITIES THROUGH STRATEGIC ACQUISITIONS AND
ALLIANCES.

FalconStor believes that opportunities may exist to expand its technological
capabilities, product offerings, and services whether through acquisitions of

businesses or software technology, or through strategic alliances. FalconStor
will focus on opportunities that enable it to acquire or to license:

o Important enabling technology;

o Complementary applications;

o Marketing, sales, customer and technological synergies; and/or

o Key personnel.

SEEK OEM RELATIONSHIPS WITH INDUSTRY LEADERS. FalconStor intends to continue to
enter into OEM agreements with strategic switch, storage, appliance, and
operating system vendors. Besides accelerating overall market growth, the OEM
relationships should continue to bolster FalconStor's product recognition,
corporate credibility, and revenue stream.

EXPAND INSIDE AND FIELD SALES ORGANIZATION

FalconStor intends to expand its worldwide sales force in 2007. Field sales
expansion should provide increased coverage for end user opportunities and
partners. FalconStor is increasing its investment in partners with additional
training, lead generation and market development. Inside sales has been added
for lead generation and incremental revenue opportunities for current end users
and mid-size businesses.

IDENTIFY AND NURTURE NEW GROWTH DRIVERS

FalconStor has made key investments in several areas, from which we expect
growth in the coming years. We believe we are uniquely positioned to take
advantage of the rapid storage growth in China. OEM relationships with
Huawei-3com and a major telecommunications equipment provider, and joint
development with Chinese Academy of Sciences for remote data protection
services, will continue to expand this market.

InfiniBand is a new promising protocol used by the High Performance Computing
market. We are in early stages with customers, but potentially leading this
market in tying in the large InfiniBand clusters to traditional Fibre Channel
SANs. Our non-disruptive approach protects our customer's investments, while
delivering speeds over 1GBs. As the Inifiband clusters proliferate, we believe
we will lead in managing the storage with our partners.

We expect the PrimeVault Service Provider Channel to expand in 2007, by bringing
online several large network service providers. Similar to the Chinese Academy
of Sciences, these offerings will be for disaster recovery for large
institutions and primary data protection for small and mid size businesses.

SALES, MARKETING AND CUSTOMER SERVICE

FalconStor plans to continue to sell its products primarily through original
equipment manufacturers (OEMs), value-added resellers (VARs, also sometimes
called "solution providers"), and distributors.

OEM RELATIONSHIPS. OEMs collaborate with FalconStor to integrate FalconStor
technology into their own product offerings or to resell FalconStor technology
under their own label.

VAR AND DISTRIBUTOR RELATIONSHIPS. FalconStor has entered into VAR and
distributor agreements to help sell its product in various geographic areas.
FalconStor's VARs and distributors market various FalconStor products and
receive a discount off of the list price on products sold.

STORAGE APPLIANCES. FalconStor has agreements with strategic partners to adapt
FalconStor products for use in the strategic partners' special-purpose storage
appliances.

DIRECT SALES TO END USERS. In a limited number of circumstances, FalconStor has
entered into software license agreements directly with end users.

FalconStor's marketing efforts focus on building brand recognition among
customers, partners, analysts, and the media, and developing qualified leads for
the sales force.

FalconStor Professional Services personnel are also available to assist
customers and partners throughout the life cycle of FalconStor solution
deployments. The Professional Services team includes experienced Storage
Architects (expert field engineers) who can assist in the assessment,
planning/design, deployment, and testing phases of a deployment project, and a
Technical Support group for post-deployment assistance and ongoing support.

COMPETITION

As the demand for data protection and network-based storage products and
services increases, more competitors will enter this high-growth market segment.
Although there are several companies attempting to offer unified storage
services or data protection, FalconStor believes it is the only software-based
solution provider capable of comprehensive data protection. We believe the
IPStor platform and its integrated services of virtualization, VTL, CDP,
Replication for remote offices and data centers is unique to the industry.

Although some of FalconStor's products provide capabilities that put them in
competition with products from a number of companies with substantially greater
financial resources, FalconStor is not aware of any other software company
providing unified data protection storage services running on a standard Linux-,
Windows- or Solaris-based appliance. FalconStor believes that the principal
competitive factors affecting its marketability include product features such as
scalability, data availability, ease of use, price, reliability,
hardware/platform neutrality, customer service, and support.

Additionally, as more partners offer appliances that integrate FalconStor
products, the Company has experienced competitive pressures from smaller, niche
players in the industry. However, FalconStor believes these competitors
currently do not offer the depth or breadth of storage services delivered by
FalconStor, nor do they possess the experience and technological innovation
needed to develop and deliver reliable, fully integrated, and proven storage
services.

As FalconStor continues its move into the non-enterprise storage market, the
products and services offered by its partners may compete with existing or new
products and services offered by current and new entrants to the market.

FalconStor's future and existing competitors could conceivably introduce
products with superior features, scalability, and functionality at lower prices
than FalconStor's products and could also bundle existing or new products with
other more established products to compete with FalconStor. Increased
competition could result in price reductions and reduced gross margins, which
could harm FalconStor's business. FalconStor's success will depend largely on
its ability to generate market demand and awareness of its products and to
develop additional or enhanced products in a timely manner. FalconStor's success
will also depend on its ability to convince potential partners of the benefits
of licensing its software rather than that of competing technologies.

INTELLECTUAL PROPERTY

FalconStor's success is dependent in part upon its proprietary technology.
Currently, the IPStor software suite forms the core of this proprietary
technology. FalconStor currently has six patents and numerous pending patent
applications; and multiple registered trademarks - including "FalconStor,"
"FalconStor Software" and "IPStor" - and many pending trademark applications
related to FalconStor and its products.

FalconStor seeks to protect its proprietary rights and other intellectual
property through a combination of copyright, trademark and trade secret
protection, as well as through contractual protections such as proprietary
information agreements and nondisclosure agreements. The technological and
creative skills of its personnel, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leadership position.

FalconStor generally enters into confidentiality or license agreements with its
employees, consultants, and corporate partners, and generally controls access to
and distribution of its software, documentation, and other proprietary
information. Despite FalconStor's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use its
products or technology. Monitoring unauthorized use of its products is
difficult, and there can be no assurance that the steps FalconStor has taken
will prevent misappropriation of its technology, particularly in foreign
countries where laws may not protect its proprietary rights as fully as do the
laws of the United States.

MAJOR CUSTOMERS

For the year ended December 31, 2006, FalconStor had one customer that accounted
for 27% of revenues. For the year ended December 31, 2005, FalconStor had two
customers that together accounted for 31% of revenues. For the year ended
December 31, 2004, FalconStor had one customer that accounted for 16% of
revenues. As of December 31, 2006, the Company had two customers with accounts
receivable balances greater than 5% of gross accounts receivable, which in the
aggregate were 30% of the accounts receivable balance. As of December 31, 2005,
the Company had two customers with accounts receivable balances greater than 5%
of gross accounts receivable, which in the aggregate were 28% of the accounts
receivable balance.

EMPLOYEES

As of December 31, 2006, FalconStor had 340 full-time employees, consisting of
167 in research and development, 95 in sales and marketing, 59 in service, and
19 in general administration. FalconStor is not subject to any collective
bargaining agreements and believes its employee relations are good.

INTERNET ADDRESS AND AVAILABILITY OF FILINGS

FalconStor's internet address is WWW.FALCONSTOR.COM. FalconStor makes available
free of charge, on or through its Internet website, FalconStor's Annual Report
on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Sections 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably
practicable after FalconStor electronically files such material with, or
furnishes it to, the SEC. FalconStor complied with this policy for every
Securities Exchange Act of 1934, as amended, report filed during the year ended
December 31, 2006.

ITEM 1A. RISK FACTORS

We are affected by risks specific to us as well as factors that affect all
businesses operating in a global market. The significant factors known to us
that could materially adversely affect our business, financial condition, or
operating results are set forth below, whether or not there has been a material
change in any Risk Factor.

DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET AND OUR RELIANCE ON OUR PARTNERS, WE MAY HAVE DIFFICULTY ACCURATELY
PREDICTING REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.

The rapidly evolving nature of the network storage software market in
which we sell our products, the degrees of effort and success of our partners'
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 of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.

THE MARKET FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE STILL
MATURING, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS WE
EXPECT.

The continued adoption of Storage Area Networks (SAN) and Network Attached
Storage (NAS) solutions is critical to our future success. The markets for SAN
and NAS solutions are still maturing, making it difficult to predict their
potential sizes or future growth rates. If these markets develop more slowly
than we expect, our business, financial condition and results of operations
would be adversely affected.

THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS STILL MATURING, AND OUR BUSINESS
WILL SUFFER IF IT DOES NOT CONTINUE TO DEVELOP AS WE EXPECT.

The continued adoption of disk-based backup solutions, such as our
VirtualTape Library software, is critical to our future success. The market for
disk-based backup solutions is still maturing, making it difficult to predict
its potential size or future growth rate. If this market develops more slowly
than we expect, our business, financial condition and results of operations
would be adversely affected.

THE MARKET FOR IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

The rapid adoption of IP-based Storage Area Networks (SAN) is important to
our future success. The market for IP-based SANs is still unproven, making it
difficult to predict the potential size or future growth rate. We are uncertain
whether a viable market for our products will develop or be sustainable. If this
market fails to develop, or develops more slowly than we expect, our business,
financial condition and results of operations would be adversely affected.

THE MARKET FOR InfiniBand SOLUTIONS IS NEW AND UNCERTAIN, AND OUR BUSINESS WILL
SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

The rapid adoption of InfiniBand solutions is important to our future
success. The market for InfiniBand solutions is still unproven, making it
difficult to predict the potential size or future growth rate. We are uncertain
whether a viable market for our products will develop or be sustainable. If this
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/HOME
OFFICE MARKETS.

We offer products for the small/medium business (SMB) and small
office/home office (SOHO) markets. Our products may not be attractive to the SMB
and the SOHO markets, or to reach agreements with OEMs and resellers with
significant presences in the SMB and SOHO markets. If we are unable to penetrate
the SMB and SOHO markets, we will not be able to recoup the expenses associated
with our efforts in these markets and our ability to grow revenues could suffer.

THE MARKET FOR OUR PRIMEVAULTSM SERVICES IS COMPETITIVE AND IT IS UNCERTAIN
WHETHER WE WILL ATTRACT ENOUGH CUSTOMERS TO PROVIDE AN ADEQUATE RETURN ON
INVESTMENT.

We have continued to make investments in infrastructure and in operating,
sales and marketing personnel for our PrimeVault disaster recovery, data backup,
and VTL replication services. The market for these services is competitive with
a number of vendors offering similar services. Despite what we believe are
competitive advantages offered by our PrimeVault services based on our
proprietary IPStor and VTL families of software, there can be no assurance that
we will be able to attract enough customers, or earn enough revenues, to cover
our investment in PrimeVault services or to provide an adequate return on that
investment.

IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.

The network storage software market continues to evolve and as a result
there is continuing demand for new products. Accordingly, we may need to develop
and manufacture new products that address additional network storage software
market segments and emerging technologies to remain competitive in the data
storage software industry. We are uncertain whether we will successfully qualify
new network storage software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking software products. Any failure to address additional
market segments could harm our business, financial condition and operating
results.

OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.

Our current products are only one part of a storage system. All components
of these systems must comply with the same industry standards in order to
operate together efficiently. We depend on companies that provide other
components of these systems to conform to industry standards. Some industry
standards may not be widely adopted or implemented uniformly, and competing
standards may emerge that may be preferred by OEM customers or end users. If
other providers of components do not support the same industry standards as we
do, or if competing standards emerge, our products may not achieve market
acceptance, which would adversely affect our business.

OUR PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED DEMAND FOR
OUR PRODUCTS OR COSTLY LITIGATION.

Our IPStor platform, including VirtualTape Library, is complex and is
designed to be deployed in large and complex networks. Many of our customers
have unique infrastructures, which may require additional professional services
in order for our software to work within their infrastructures. Because our
products are critical to the networks of our customers, any significant
interruption in their service as a result of defects in our product could result
in damage to our customers. These problems could cause us to incur significant
service and engineering costs, divert engineering personnel from product
development efforts and significantly impair our ability to maintain existing
customer relationships and attract new customers. In addition, a product
liability claim, whether successful or not, would likely be time consuming and
expensive to resolve and would divert management time and attention. Further, if
we are unable to fix the errors or other problems that may be identified in full
deployment, we would likely experience loss of or delay in revenues and loss of
market share and our business and prospects would suffer.

Our other products may also contain errors or defects. If we are unable to
fix the errors or other problems that may be discovered, we would likely
experience loss of or delay in revenues and loss of market share and our
business and prospects would suffer.

FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.

We have entered into agreements with resellers and OEM partners to develop
storage appliances that combine certain aspects of IPStor or VTL functionality
with third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. In addition, in certain instances, we install our
software onto third party hardware for resale to end users. If the storage
appliances are not easy to deploy or do not integrate smoothly with end user
systems, the basic premise behind the appliances will not be met and sales would
suffer.

OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.

Prior to offering our products for sale, our OEM customers typically
require that each of our products undergo an extensive qualification process,
which involves interoperability testing of our product in the OEM's system as
well as rigorous reliability testing. This qualification of a product by an OEM
does not assure any sales of the product to the OEM. Despite this uncertainty,
we devote substantial resources, including engineering, sales, marketing and
management efforts, toward qualifying our products with OEMs in anticipation of
sales to them. If we are unsuccessful or delayed in qualifying any products with
an OEM, such failure or delay would preclude or delay sales of that product to
the OEM, which may impede our ability to grow our business.

WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.

Almost all of our sales come from sales to end users of our products by
our OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage software market and in other markets. The OEM customers and
resellers may choose to focus their sales efforts on other products in the
network storage software market or other markets. The OEM customers might also
choose not to continue to develop or to market products which include our
products. This would likely result in lower revenues to us and would impede our
ability to grow our business.

OUR OEM CUSTOMERS ARE NOT OBLIGATED TO CONTINUE TO SELL OUR PRODUCTS.

We have no control over the shipping dates or volumes of systems
incorporation of our product that our OEM customers ship and they have no
obligation to ship systems incorporating our software applications. Our OEM
customers also have no obligation to recommend or offer our software
applications exclusively or at all, and they have no minimum sales requirements.
These OEMs also could choose to develop their own data protection and network
storage software internally, or to license software from our competitors, and
incorporate those products into their systems instead of our software
applications. The OEMs that we do business with also compete with one another.
If one of our OEMs views our arrangement with another OEM as competing with its
products, it may decide to stop doing business with us. Any material decrease in
the volume of sales generated by OEMs with whom we do business, as a result of
these factors or otherwise, would have a material adverse effect on our revenues
and results of operations in future periods.

THE FAILURE OF OUR RESELLERS TO EFFECTIVELY SELL OUR SOFTWARE APPLICATIONS COULD
HAVE A MATERIAL ADVERSE EFFECT ON OUR REVENUES AND RESULTS OF OPERATIONS.

We rely significantly on our value-added resellers, systems integrators
and corporate resellers, which we collectively refer to as resellers, for the
marketing and distribution of our software applications and services. However,
our agreements with resellers are generally not exclusive, are generally
renewable annually and in many cases may be terminated by either party without
cause. Many of our resellers carry software applications that are competitive
with ours. These resellers may give a higher priority to other software
applications, including those of our competitors, or may not continue to carry
our software applications at all. If a number of resellers were to discontinue
or reduce the sales of our products, or were to promote our competitors'
products in lieu of our applications, it would have a material adverse effect on
our future revenues. Events or occurrences of this nature could seriously harm
our sales and results of operations. In addition, we expect that a significant
portion of our sales growth will depend upon our ability to identify and attract
new reseller partners. The use of resellers is an integral part of our
distribution network. We believe that our competitors also use reseller
arrangements. Our competitors may be more successful in attracting reseller
partners and could enter into exclusive relationships with resellers that make
it difficult to expand our reseller network. Any failure on our part to expand
our network of resellers could impair our ability to grow revenues in the
future.

WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A SIGNIFICANT PORTION OF OUR
RECEIVABLES IS CONCENTRATED WITH TWO CUSTOMERS.

We tend to have one or more customers account for 10% or more of our
revenues during each fiscal quarter. For the year ended December 31, 2006, we
had one customer who accounted for 27% of our revenues. While we believe that we
will continue to receive revenue from this client, our agreements do not have
any minimum sales requirements and we cannot guarantee continued revenue. If our
contract with this customer terminates, or if the volume of sales from this
customer significantly declines, it would have a material adverse effect on our
operating results.

In addition, as of December 31, 2006, two customers accounted for a total
of 30% of our outstanding receivables, 21% and 9%, respectively. While we
currently have no reason to question the collectibility of these receivables, a
business failure or reorganization by either of these customers could harm our
ability to collect these receivables and could damage our cash flow.

THE REPORTING TERMS OF SOME OF OUR OEM AGREEMENTS MAY CAUSE US DIFFICULTY IN
ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS, BUDGETING FOR EXPENSES OR
RESPONDING TO TRENDS.

Certain of our OEM customers do not report license revenue to us until
sixty days or more after the end of the quarter in which the software was
licensed. There is thus a delay before we learn whether licensing revenue from
these OEMs has met, exceeded, or fallen short of expectations. The reporting
schedule from these OEMs also means that our ability to respond to trends in the
market could be harmed as well. For example, if, in a particular quarter, we see
a significant increase or decrease in revenue from our channel sales or from one
of our other OEM partners, there will be a delay in our ability to determine
whether this is an anomaly or a part of a trend. 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 of anticipated revenue. As a
result, we may not be able to decrease our expenses in a timely manner to offset
any shortfall in revenue or to increase our sales, marketing or support
headcounts to take advantage of positive developments.

ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.

As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage
to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.

WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.

Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. Some of our agreements with our OEM customers grant to the
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 or could cause other
potential OEM partners to consider or select software from our competitors for
their storage solutions. In addition, the desire for product differentiation
could cause potential OEM partners to select software from our competitors. We
cannot guarantee that our current strategic partners, or those companies with
whom we may partner in the future, will continue to be our partners for any
period of time. If our software were to be replaced in an OEM solution by
competing software, or if our software is not selected by OEMs for future
solutions, it would likely result in lower revenues to us and would impede our
ability to grow our business.

CONSOLIDATION IN THE NETWORK STORAGE INDUSTRY COULD HURT OUR STRATEGIC
RELATIONSHIPS.

In the past, companies with whom we have OEM relationships have been
acquired by other companies. These acquisitions caused disruptions in the sales
and marketing of our products and have had an impact on our revenues. If
additional OEM customers are acquired, the acquiring entity might choose to stop
offering solutions containing our software. Even if the solutions continued to
be offered, there might be a loss of focus and sales momentum as the companies
are integrated.

THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE
COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.

The network storage software market is intensely competitive even during
periods when demand is stable. Some of our current and potential competitors
have longer operating histories, significantly greater resources, broader name
recognition and a larger installed base of customers than we have. Those
competitors and other potential competitors may be able to establish or to
expand network storage software offerings more quickly, adapt to new
technologies and customer requirements faster, and take advantage of acquisition
and other opportunities more readily.

Our competitors also may:

o consolidate or establish strategic relationships among themselves to lower
their product costs or to otherwise compete more effectively against us;
or

o bundle their products with other products to increase demand for their
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 to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.

OUR ABILITY TO SELL OUR SOFTWARE APPLICATIONS IS HIGHLY DEPENDENT ON THE QUALITY
OF OUR SERVICES OFFERINGS, AND OUR FAILURE TO OFFER HIGH QUALITY SUPPORT AND
PROFESSIONAL SERVICES WOULD HAVE A MATERIAL ADVERSE AFFECT ON OUR SALES OF
SOFTWARE APPLICATIONS AND RESULTS OF OPERATIONS.

Our services include the assessment and design of solutions to meet our
customers' storage management requirements and the efficient installation and
deployment of our software applications based on specified business objectives.
Further, once our software applications are deployed, our customers depend on us
to resolve issues relating to our software applications. A high level of service
is critical for the successful marketing and sale of our software. If we or our
partners do not effectively install or deploy our applications, or succeed in
helping our customers quickly resolve post-deployment issues, it would adversely
affect our ability to sell software products to existing customers and could
harm our reputation with potential customers. As a result, our failure to
maintain high quality support and professional services would have a material
adverse effect on our sales of software applications and results of operations.

FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING
RESULTS.

Achieving our anticipated growth will depend on a number of factors, some
of which include:

o retention of key management, marketing and technical personnel;

o our ability to increase our customer base and to increase the sales of our
products; and

o competitive conditions in the network storage infrastructure software
market.

We cannot assure you that the anticipated growth will be achieved. The failure
to achieve anticipated growth could harm our business, financial condition and
operating results.

OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.

The operating results of our business depend in part on the overall demand
for network storage software. Because the market for our software is primarily
major corporate customers, any softness in demand for network storage software
may result in decreased revenues.

OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.

Our previous results are not necessarily indicative of our future
performance and our future quarterly results may fluctuate significantly.

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

Our future performance will depend on many factors, including:

o the timing of securing software license contracts and the delivery of
software and related revenue recognition;

o the seasonality of information technology, including network storage
products, spending;

o the average unit selling price of our products;

o existing or new competitors introducing better products at competitive
prices before we do;

o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;

o new products or enhancements from us or our competitors;

o import or export restrictions on our proprietary technology; and

o personnel changes.

Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.

OUR STOCK PRICE MAY BE VOLATILE

The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, during the past twelve months ended
December 31, 2006, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $6.06 and $9.78 per share and subsequent
to December 31, 2006 the closing market price had a high of $11.23 per share.
The market price of our common stock may be significantly affected by the
following factors:

o actual or anticipated fluctuations in our operating results;

o failure to meet financial estimates;

o changes in market valuations of other technology companies, particularly
those in the network storage software market;

o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures or
capital commitments;

o loss of one or more key OEM customers; and

o departures of key personnel.

The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.

OUR ABILITY TO FORECAST EARNINGS IS LIMITED BY THE IMPACT OF ACCOUNTING
REQUIREMENTS.

The Financial Accounting Standards Board requires companies to recognize
the fair value of stock options and other share-based payment compensation to
employees as compensation expense in the statement of operations. However, this
expense, which, in accordance with accounting standards, we calculate based on
the "Black-Scholes" model, is subject to factors beyond our control. These
factors include the market price of our stock on a particular day and stock
price "volatility." In addition, we do not know how many options our employees
will exercise in any future period. These unknowns make it difficult for us to
forecast accurately what the stock option and equity-based compensation expense
will be in the future. Because of these factors, our ability to make accurate
forecasts of future earnings is compromised.

THE AMOUNT OF INCOME TAXES WE HAVE TO PAY MAY INCREASE.

We currently have net operating loss carryforwards which reduce the amount
of income taxes that we are required to pay. The availability of these net
operating losses are limited. If we generate taxable income in the future in
excess of our ability to utilize our net operating losses, the amount of income
tax we pay will likely increase significantly.

WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.

Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Further, we have entered into change of
control agreements with certain executives, which may also have the effect of
delaying, deterring or preventing a change in control.

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

As of December 31, 2006, we had an aggregate of 11,810,975 outstanding
options and outstanding restricted shares and warrants to purchase our common
stock. The weighted average exercise price of the outstanding options and
warrants is $5.65 per share. We also have 794,573 shares of our common stock
reserved for issuance under our stock plans with respect to options (or
restricted stock) that have not been granted.

The exercise of all of the outstanding options and warrants and/or the
grant and exercise of additional options or restricted stock would dilute the
then-existing stockholders' percentage ownership of common stock, and any sales
in the public market of the common stock issuable upon such exercise could
adversely affect prevailing market prices for the common stock. Moreover, the
terms upon which we would be able to obtain additional equity capital could be
adversely affected because the holders of such securities can be expected to
exercise or convert them at a time when we would, in all likelihood, be able to
obtain any needed capital on terms more favorable than those provided by such
securities.

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 scale
blackout in the northeastern United States. While our headquarters facilities
contain redundant power supplies and generators, our domestic and foreign
operations, and the operations of our industry partners, remain susceptible to
fire, floods, power loss, power shortages, telecommunications failures,
break-ins and similar events.

Any interruption in power supply or telecommunications would be
particularly disruptive to our PrimeVault backup and disaster recovery
operations. If PrimeVault customers are unable to access their data, confidence
in our ability to provide disaster recovery and backup services will be damaged
which will impair our ability to retain existing customers, to gain new
customers and to expand our operations.

Terrorist actions domestically or abroad could lead to business
disruptions or to cancellations of customer orders or a general decrease in
corporate spending on information technology, or could have direct impact on our
marketing, administrative or financial functions and our financial condition
could suffer.

UNITED STATES GOVERNMENT EXPORT RESTRICTIONS COULD IMPEDE OUR ABILITY TO SELL
OUR SOFTWARE TO CERTAIN END USERS.

Certain of our products include the ability for the end user to encrypt
data. The United States, through the Bureau of Industry Security, places
restrictions on the export of certain encryption technology. These restrictions
may include: the requirement to have a license to export the technology; the
requirement to have software licenses approved before export is allowed; and
outright bans on the licensing of certain encryption technology to particular
end users or to all end users in a particular country. Certain of our products
are subject to various levels of export restrictions. These export restrictions
could negatively impact our business.

THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR
OPERATING RESULTS.

We sell our products worldwide. Accordingly, our operating results could
be materially adversely affected by various factors including regulatory,
political, or economic conditions in a specific country or region, trade
protection measures and other regulatory requirements, and acts of terrorism and
international conflicts.

Our international sales are denominated primarily in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products more expensive and, therefore, potentially less competitive in
foreign markets.

Additional risks inherent in our international business activities
generally include, among others, longer accounts receivable payment cycles,
difficulties in managing international operations, decreased flexibility in
matching workforce to needs as compared with the U.S., and potentially adverse
tax consequences. Such factors could materially adversely affect our future
international sales and, consequently, our operating results.

IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER.

Our success is dependent upon our proprietary technology. Currently, the
IPStor software suite is the core of our proprietary technology. We have six
patents issued, we have received a notice of allowance for one patent, and we
have multiple pending patent applications, numerous trademarks registered and
multiple pending trademark applications related to our products. We cannot
predict whether we will receive patents for our pending or future patent
applications, and any patents that we own or that are issued to us may be
invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.

We also rely on trade secret, copyright and trademark laws, as well as the
confidentiality and other restrictions contained in our respective sales
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 INVOLVED
IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.

In recent years, there has been significant litigation in the United
States involving patents, trademarks and other intellectual property rights.

We were already subject to one action, which alleged that our technology
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 settlement
were expensive and the litigation diverted management's time and attention. Any
additional litigation, regardless of its outcome, would likely be time consuming
and expensive to resolve and would divert management's time and attention and
might subject us to significant liability for damages or invalidate our
intellectual property rights. Any potential intellectual property litigation
against us could force us to take specific actions, including:

o cease selling our products that use the challenged
intellectual property;

o obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology or
trademark, which license may not be available on reasonable
terms, or at all; or

o redesign those products that use infringing intellectual
property or cease to use an infringing product or trademark.

DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR
ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION.

Many of our products are designed to include software or other
intellectual property licensed from third parties, including "Open Source"
software. At least one intellectual property rights holder has alleged that it
holds the rights to software traditionally viewed as Open Source. It may be
necessary in the future to seek or renew licenses relating to various aspects of
these products. There can be no assurance that the necessary licenses would be
available on acceptable terms, if at all. The inability to obtain certain
licenses or other rights or to obtain such licenses or rights on favorable
terms, or the need to engage in litigation regarding these matters, could have a
material adverse effect on our business, operating results, and financial
condition. Moreover, the inclusion in our products of software or other
intellectual property licensed from third parties on a nonexclusive basis could
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. We do not have key person
life insurance on any of our personnel. Worldwide competition for skilled
employees in the network storage software industry is extremely intense. If we
are unable to retain existing employees or to hire and integrate new employees,
our business, financial condition and operating results could suffer. In
addition, companies whose employees accept positions with competitors often
claim that the competitors have engaged in unfair hiring practices. We may be
the subject of such claims in the future as we seek to hire qualified personnel
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 or
their assets. Integration of the acquired products, technologies and businesses,
could divert management's time and resources. Further, we may not be able to
properly integrate the acquired products, technologies or businesses, with our
existing products and operations, train, retain and motivate personnel from the
acquired businesses, or combine potentially different corporate cultures. If we
are unable to fully integrate the acquired products, technologies or businesses,
or train, retain and motivate personnel from the acquired businesses, we may not
receive the intended benefits of the acquisitions, which could harm our
business, operating results and financial condition.

IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND
ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
FUTURE PERIODS COULD BE MATERIALLY AFFECTED.

The preparation of consolidated financial statements and related
disclosure in accordance with generally accepted account principles requires
management to establish policies that contain estimates and assumptions that
affect the amounts reported in the consolidated financial statements and the
accompanying notes. Note 1 to the Consolidated Financial Statements in this
Report on Form 10-K describes the significant accounting policies essential to
preparing our financial statements. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures.
We base our estimates on historical experience and assumptions that we believe
to be reasonable under the circumstances. Actual future results may differ
materially from these estimates. We evaluate, on an ongoing basis, our estimates
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 in
businesses. These investments may involve technology risks as well as
commercialization risks and market risks. As a result, we may be required to
write down some or all of these investments in the future.

UNKNOWN FACTORS

Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None

ITEM 2. PROPERTIES

FalconStor's headquarters are located in an approximately 45,000 square foot
facility located in Melville, New York. Offices are also leased for development,
sales and marketing personnel, which total an aggregate of approximately 44,000
square feet in Le Chesnay, France; Taipei and Taichung, Taiwan; Tokyo, Japan;
Beijing, Shenzhen and Shanghai, China; Munich, Germany; Seoul, Korea; Kuala
Lumpur, Malaysia; and North Sydney, Australia. Initial lease terms range from
one to eight years, with multiple renewal options.

ITEM 3. LEGAL PROCEEDINGS

We are subject to various legal proceedings and claims, asserted or unasserted,
which arise in the ordinary course of business. While the outcome of any such
matters cannot be predicted with certainty, we believe that such matters will
not have a material adverse effect on our financial condition, results of
operations, cash flows or liquidity.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

MARKET INFORMATION

Our Common Stock is listed on The Nasdaq Global Market ("Nasdaq") under
the symbol "FALC". The following table sets forth the range of high and
low closing sales prices of our Common Stock for the periods indicated as
reported by Nasdaq:

2006 2005
-------------- --------------
High Low High Low
----- ----- ----- -----
Fourth Quarter $8.83 $7.25 $8.02 $5.81
Third Quarter $7.95 $6.06 $6.87 $5.66
Second Quarter $9.25 $6.15 $7.43 $5.23
First Quarter $9.78 $7.54 $9.67 $5.78

HOLDERS OF COMMON STOCK

We had approximately 178 holders of record of Common Stock as of February
21, 2007. This does not reflect persons or entities whom hold Common Stock
in nominee or "street" name through various brokerage firms.

DIVIDENDS

We have not paid any cash dividends on our common stock since inception.
We expect to reinvest any future earnings to finance growth, and therefore
do not intend to pay cash dividends in the foreseeable future. Our board
of directors may determine to pay future cash dividends if it determines
that dividends are an appropriate use of Company capital.

EQUITY COMPENSATION PLAN INFORMATION

The Company currently does not have any equity compensation plans not
approved by security holders.

Number of
Securities to be Weighted - Number of Securities
Issued upon Average exercise Remaining Available for
Exercise of Price of Future Issuance Under
Outstanding Outstanding Equity Compensation Plans
Options, Warrans Options, Warrants (Excluding Securities
and Rights (1) and Rights (1) Reflected in Column (a)(1)
Plan Category (a) (b) (c)
------------- ---------------- ----------------- ---------------------------
Equity compensation
plans approved by
security holders 10,835,975 $ 5.62 794,573

(1) As of December 31, 2006

COMMON STOCK PERFORMANCE: The following graph compares, for each of the
periods indicated, the percentage change in the Company's cumulative total
stockholder return on the Company's Common Stock with the cumulative total
return of a) an index consisting of Computer Software and Services
companies, a peer group index, and b) the Russell 3000 Index, a broad
equity market index.

FALCONSTOR SOFTWARE, INC. COMPARATIVE CUMULATIVE TOTAL RETURN

ASSUMES $100 INVESTED ON DEC. 31, 2001
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING DECEMBER 31, 2006

Fiscal Year Ending
------------------
2001 2002 2003 2004 2005 2006
---- ---- ---- ---- ---- ----
FALCONSTOR SOFTWARE, INC. 100.00 42.83 96.74 105.63 81.57 95.47
COREDATA GROUP INDEX 100.00 68.11 88.07 96.72 96.96 112.58
RUSSELL 3000 INDEX 100.00 77.19 99.37 109.39 114.06 129.80

There can be no assurance that the Common Stock's performance will
continue with the same or similar trends depicted in the graph above.

ITEM 6. SELECTED FINANCIAL DATA

The selected financial data appearing below have been derived from our audited
consolidated financial statements, and should be read in conjunction with these
consolidated financial statements and the notes thereto and the information
contained in Item 7, "Management's Discussion and Analysis of Financial
Condition and Results of Operations."

CONSOLIDATED STATEMENTS OF OPERATIONS DATA:

Year Ended Year Ended Year Ended Year Ended Year Ended
December 31, December 31, December 31, December 31, December 31,
2006 2005 2004 2003 2002
-------------------------------------------------------------------
(In thousands, except per share data)
Revenues:
Software license revenue ................................. $ 38,317 $ 29,544 $ 21,488 $ 12,251 $ 8,667
Maintenance revenue ...................................... 12,475 7,594 4,443 2,473 1,297
Software services and other revenue ...................... 4,274 3,826 2,778 2,220 665
-------- -------- -------- -------- --------
55,066 40,964 28,709 16,944 10,629
-------- -------- -------- -------- --------

Operating expenses:
Amortization of purchased and capitalized software ..... 362 782 1,394 1,394 899
Cost of maintenance, software services and other revenue 9,048 6,114 4,150 2,580 1,309
Software development costs ............................. 20,022 12,039 9,050 7,068 6,281
Selling and marketing .................................. 23,713 16,109 14,277 10,967 9,856
General and administrative ............................. 5,828 4,213 5,109 2,878 2,592
Litigation settlement .................................. 799 -- 1,300 -- --
Lease abandonment charge ............................... -- -- -- 550 --
Impairment of prepaid royalty .......................... -- -- -- -- 483
-------- -------- -------- -------- --------
59,772 39,257 35,280 25,437 21,420
-------- -------- -------- -------- --------
Operating income (loss) .............................. (4,706) 1,707 (6,571) (8,493) (10,791)
-------- -------- -------- -------- --------

Interest and other income ................................ 1,650 705 714 1,122 1,585
Impairment of long-lived assets .......................... -- -- -- 35 (2,300)
-------- -------- -------- -------- --------

Income (loss) before income taxes .................... (3,056) 2,412 (5,857) (7,336) (11,506)

Provision for income taxes ............................... 319 119 32 33 37
-------- -------- -------- -------- --------

Net income (loss) .................................... $ (3,375) $ 2,293 $ (5,889) $ (7,369) $(11,543)
======== ======== ======== ======== ========

Basic net income (loss) per share ........................ $ (0.07) $ 0.05 $ (0.13) $ (0.16) $ (0.26)
======== ======== ======== ======== ========

Diluted net income (loss) per share ...................... $ (0.07) $ 0.05 $ (0.13) $ (0.16) $ (0.26)
======== ======== ======== ======== ========

Basic weighted average common shares outstanding ......... 48,045 47,662 46,967 45,968 45,233
======== ======== ======== ======== ========

Diluted weighted average common shares outstanding ....... 48,045 50,776 46,967 45,968 45,233
======== ======== ======== ======== ========

CONSOLIDATED BALANCE SHEET DATA:

December 31, December 31, December 31, December 31, December 31,
2006 2005 2004 2003 2002
--------------------------------------------------------------------
(In thousands)
Cash and cash
equivalents and
marketable securities $40,960 $36,631 $33,973 $36,685 $51,102

Working capital 46,934 39,730 36,452 39,527 47,746

Total assets 78,231 63,974 56,074 56,493 64,710

Long-term obligations 3,783 2,316 1,290 396 --

Stockholders' equity 55,043 48,658 46,364 50,556 55,901

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

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

OVERVIEW

We were pleased with our continued revenue growth in 2006. Our revenues
for the full year increased to $55.1 million from $41.0 million in 2005. This is
a thirty-four percent year over year increase in revenues. This increase was
driven by sales of our core products. We reached our revenue target for the year
even though revenues from certain areas in which we had anticipated seeing
growth, such as iSCSI and the SMB/SOHO market, were not significant contributors
to our revenue. We believe that our ability to grow our revenues by thirty four
percent even without significant contributions from these areas shows the
strength of our core products. We believe we are on the right track and we
anticipate further revenue growth in 2007.

We had a net loss of $3.4 million in 2006. Due to a change in accounting
rules, it is difficult to compare this result with results in prior years. New
accounting rules that went into effect for us in 2006 required us to include in
our consolidated financial statements an expense for the grant date fair value
of share-based compensation for the first time. This expense -- which relates to
stock options and restricted stock we grant to employees as part of our
incentive compensation plan -- totaled $9.4 million in 2006.

As it has been in the past, our focus will continue to be on managing our
business with a view towards long-term success and growth. In 2006, we continued
to invest in research and development and other areas to build on our momentum,
to design new products, and to enhance our existing products to position the
Company for future growth. We will continue to invest in these areas in 2007 and
we anticipate that our research and development and sales and marketing expenses
will increase in 2007.

To continue to create industry-leading, cutting-edge network storage
solutions, we hired additional software development engineers and quality
assurance engineers. These software engineers design and test the software
products that are or will be sold by our OEM partners and resellers. Continuing
to deliver new and enhanced products to meet the demands of the storage market
is necessary if we are to remain competitive and to continue our growth.

We also increased our sales force and our technical support team. An
increased sales force should expand the market exposure for our products. The
expanded technical support team responds to questions and technical issues from
end users of our products and from our resellers and OEM partners. Providing top
notch technical support to these groups enhances our ability to continue to make
sales. End users who are satisfied with our technical support are more likely to
order additional products from us. Resellers and OEM partners who are happy with
our technical support, and whose end users are satisfied, will be more likely to
recommend our current products and less likely to consider other providers for
future products.

The key factors we look to for our future business prospects continue to
be our sales pipeline, our ability to establish and expand relationships with
key industry OEMs and resellers, sales by our OEM partners, additional orders
from resellers, growth in deferred revenue, re-orders from existing customers,
and the growth of the overall market for storage solutions. Gross margins are
also a key factor in evidencing the scalability of our business.

Our sales "pipeline" consists of inquiries from end users and resellers
for possible purchases of our products. Our overall sales pipeline steadily
increased for each quarter of 2006 compared with the same quarter in 2005.

OEM relationships continue to be important to us for two main reasons:

First, sales by our OEM partners contribute to our revenues. Overall,
product licenses to OEMs accounted for approximately forty two percent of our
revenues in 2006. One OEM customer accounted for twenty seven percent of our
revenues. We anticipate that OEMs will account for over forty percent of our
revenues in 2007. We expect that at least one OEM will account for at least ten
percent of our revenues in 2007. Accordingly, the loss of this customer would
have a material adverse effect on our business.

Second, having our products selected by respected, established industry
leaders signals to customers, resellers and other potential OEM partners that
our products are quality products that add value to their enterprise. Before
licensing software, OEM partners typically undertake broad reviews of many of
the competing software solutions available. The choice of our products by major
industry participants validates both the design and the capabilities of the
products and our product roadmaps.

In 2006, we renewed and extended our OEM agreement with EMC Corporation,
to 2013. EMC also launched a new range of products that incorporate our VTL
technology. In 2006 we also extended our strategic relationship with Sun
Microsystems by entering into a joint development agreement. Sun's next
generation open systems virtual tape solution will incorporate FalconStor's VTL
technology. In 2006, we entered into OEM agreements with other companies,
including companies in Asia and companies focused on the SMB market, as
discussed below. We also renewed or extended agreements with existing OEM
partners. We will continue to seek additional OEM opportunities in the future.

We do everything we can to assure that our products meet the needs of our
OEM partners and their customers. However, we cannot control decisions by our
OEM partners to change their product or marketing mix in ways that impact sales
of products licensed by the OEMs from us. Over our history, we have entered into
OEM agreements with two Tier-1 OEM companies, and with another significant
company in the computer, networking and communications products business, only
to see those OEM partners change their strategies and make significant
reductions in their commitments to the products that incorporate our technology.

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.

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. Sales from our resellers in the United States fell below
our expectations in 2006. Increasing sales from resellers is an area of focus
for us. Steps we have taken to increase sales from resellers include the
addition of sales, marketing and support personnel focused on those accounts. We
also have instituted, and we will be instituting further, support, training and
incentive programs intended to increase sales by our resellers.

In 2006, we signed agreements with new resellers worldwide. We also
terminated relationships with resellers who we believed were not properly
selling our products. We will continue to enter into relationships with
resellers and to discontinue relationships with resellers with whom we are not
satisfied.

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. An increase in deferred revenues thus
indicates growth in our installed base and end user and OEM satisfaction with
our products and our maintenance and support services. Our deferred revenue
increased to $15.1 million as of December 31, 2006, compared with $9.6 million
as of December 31, 2005. We expect deferred revenue to continue to grow in 2007.

The level of re-orders from existing end users of our products is another
measure of customer satisfaction. Information technology professionals will only
order additional products and services for their companies if they determine
that the products have reduced total cost of ownership and have provided a good

return on investment. Re-orders are thus an indication that our products are
delivering as promised and that our support is meeting the end user's needs. In
2006, many end users ordered additional copies of our products, or additional
products or ordered additional options. If re-orders decline, it would indicate
that future sales might also decline. As the percentage of our revenues from
OEMs increases, our ability to gauge re-orders decreases because our OEM
partners typically do not provide us with information identifying the end user
for each order.

Consolidation in the network storage market continued in 2006. The
consolidation did not have a significant impact on our revenue.

The storage solutions market continues to grow. In addition to growth
based on demand for storage server consolidation and replication, there was
growth in backup acceleration. We expect each of these areas to continue growing
in 2007.

In the fourth quarter of 2005, we announced the launch of our PrimeVault
disaster recovery, services. These services are based on our IPStor and
VirtualTape Library (VTL) software and provide a means for us to leverage our
successes with those products to increase our customer base to include end users
who do not have the resources - either technical or financial - to undertake a
full implementation of our products. Initially, we intended to offer these
services directly to end users and through resellers. In 2006, we modified our
approach to PrimeVault so that we would no longer be the primary provider of the
services. Instead, we now license the PrimeVault services to third parties for
resale to end users. Payment to us is based on either a revenue share or a fee
based on the amount of storage managed by the third party. PrimeVault services
did not provide significant revenue in 2006, but we anticipate an increase in
revenue in 2007.

In 2005 and the beginning of 2006, we launched initiatives in the
small/medium business (SMB) and small office/home office (SOHO) markets. In
early 2006, we signed an OEM agreement with a leading computer, networking and
communications products manufacturer to offer an entry-level data storage and
protection appliance, powered by a version of IPStor optimized to run on a
System-on-Chip ("SOC") platform ("IPStor Express"), targeting the SMB/SOHO
market. Shortly after the launch of the product, the OEM partner announce a
major strategic review of its operations and decided to scale back its
commitment to this product line. As a result of this change in strategy,
revenues from our SMB/SOHO product line were lower than expected and were not
significant. We continue to believe that these non-enterprise markets are
another growth area for storage software and in 2006 we signed agreements with
OEM companies, both in the United States and abroad, whose product lines target
these markets. While we expect revenue growth in 2007 from our SMB/SOHO
products, it is too early to estimate whether revenues from these markets will
be significant contributors to our revenues in 2007.

Another area of focus for us in 2006, and one that will remain an area of
focus in 2007, was the China market. In 2006, we signed an agreement with
Hangzhou Huawei-3Com Technology Co. Ltd, a leading global manufacturer of IP
network solutions, to expand our strategic partnership in IP Network Storage to
include joint R&D activities in China and a multi-year, multi-million dollar
commitment. In 2006, we also signed an OEM agreement with a Chinese company that
is a leader in telecommunications networks. In early 2007, we signed a joint
development and research agreement with the Computer Network Information Center,
Chinese Academy of Sciences (CNIC, CAS) to establish a laboratory to develop
data protection and remote disaster recovery solutions for the Chinese
government and enterprises with the goal of providing our PrimeVault data
protection services throughout China.

As we had anticipated, we saw the greatest increase in revenues from our
VirtualTape Library software. We expect this growth to continue, if not
accelerate, in 2007, as our OEM partners introduce new products and as we
introduce additional features and functionality for the product. The continued
decline in prices for disk storage, and the continuing need for rapid back up,
disaster recovery and regulatory compliance, should contribute to this growth.

Another important measure of our business is gross margin. Among other
things, gross margin measures our ability to scale our business. Unlike
manufacturers of hardware, our incremental cost for each additional unit of
software licensed is a small percentage of the software license revenue. Thus,
our gross margins tend to increase as our software license revenue increases. 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 cost of hardware and
software used in development. We also have expenses for software support, sales
and marketing, and general and administrative functions.

Our gross margins for 2006 were 83%. Due to the change in accounting rules
regarding share-based compensation (as discussed above), a direct comparison
with our gross margins in 2005 is not meaningful. The impact of the equity-based
compensation expense on gross margin in 2006 was equivalent to 2%. We believe
that our gross margin in 2006 demonstrates that we were successful in our
ability to scale our business.

We believe the change in accounting rules also makes any comparison of
expenses in 2006 and 2005 not meaningful. Nonetheless, we are pleased with our
ability to contain the increase of expenses in 2006. Excluding share-based
compensation expense, our expenses grew at a lower rate than our revenues. We
will continue to invest in infrastructure and personnel to maintain and enhance
our leading edge designs and to support our customers, but we will continue to
do so in a controlled, cost-effective manner.

One additional factor that we expect to continue to affect our revenues on
a quarterly, but not annual, basis, is the seasonality of the information
technology business. Historically, information technology spending has been
higher in the fourth and second quarters of each calendar year, and somewhat
slower in the other quarters, particularly the first quarter. Our quarterly
results reflected this seasonality in 2006, and we anticipate that our quarterly
results for 2007 will show the effects of seasonality as well.

As discussed above, the new accounting rules relating to share-based
compensation expense had a negative impact on our earnings in 2006. Both before
the rules became effective, and during 2006, we weighed the impact of the
changes on our consolidated financial statements against the impact of
discontinuing the grant of equity-based compensation to our worldwide workforce.
We decided that we will 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. We believe 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. For the management
of our business and the review of our progress, we will continue to look to our
results before 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.

Our critical accounting policies are those related to revenue recognition,
accounts receivable allowances, accounting for share-based compensation and
deferred income taxes. As described in note 1 to our consolidated financial
statements, we recognize revenue in accordance with the provisions of Statement
of Position 97-2, Software Revenue Recognition, as amended. Software license
revenue is recognized only when pervasive evidence of an arrangement exists and
the fee is fixed and determinable, among other criteria. An arrangement is
evidenced by a signed customer contract for nonrefundable royalty advances
received from OEMs or a customer purchase order or a royalty report summarizing
software licenses resold by an OEM, distributor or solution provider to an end
user. The software license fees are fixed and determinable as our standard
payment terms generally range from 30 to 90 days, depending on regional billing
practices. When a customer licenses software together with the purchase of
maintenance, we allocate a portion of the fee to maintenance for its fair value.

We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for
uncollectible accounts and returns, we consider historical return rates,
specific past due accounts, analysis of our accounts receivable aging, customer
payment terms, historical collections, write-offs and returns, changes in
customer demand and relationships, concentrations of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer
relationships, contract provisions and credit assessments. Changes in the
product return rates, credit worthiness of customers, general economic
conditions and other factors may impact the level of future write-offs, revenues
and our general and administrative expenses.

With the adoption of SFAS No. 123(R) on January 1, 2006, the Company is
required to record the fair value of share-based compensation awards as an
expense. In order to determine the fair value of stock options on the date of
grant, the Company applies the Black-Scholes option-pricing model. Inherent in
this model are assumptions related to expected stock-price volatility, option
life, risk-free interest rate and dividend yield. While the risk-free interest
rate and dividend yield are less subjective assumptions, typically based on
factual data derived from public sources, the expected stock-price volatility
and expected term assumptions require a greater level of judgment. We estimate
expected stock-price volatility based primarily on a simple average historical
volatility of the underlying stock over a period equal to the expected term of
the option, but also consider whether other factors are present that indicate
that exclusive reliance on historical volatility may not be a reliable indicator
of expected volatility. With regard to our estimate of expected term, as
adequate information with respect to historical share option exercise experience
is not available, we primarily consider the vesting term and original
contractual term of the options granted.

Consistent with the provisions of Statement of Financial Accounting
Standards No. 109, we regularly estimate our ability to recover deferred income
taxes, and report such assets at the amount that is determined to be
more-likely-than-not recoverable. This evaluation considers several factors,
including an estimate of the likelihood of generating sufficient taxable income
in future periods over which temporary differences reverse, the expected
reversal of deferred tax liabilities, past and projected taxable income, and
available tax planning strategies. As of December 31, 2006, based primarily upon
our cumulative losses, a valuation allowance has been recorded against our
deferred tax assets. In the event that evidence becomes available in the future
to indicate that our deferred taxes will likely be recoverable (e.g., taxable
income generated in and projected for future periods), our estimate of the
recoverability of deferred taxes may change, resulting in a reversal of all or a
portion of such valuation allowance.

RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2006 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2005

Revenues for the year ended December 31, 2006 increased 34% to $55.1
million compared with $41.0 million for the year ended December 31, 2005. Our
operating expenses increased 52% from $39.3 million in 2005 to $59.8 million in
2006. Included in our operating expenses for the year ended December 31, 2006
was $9.4 million of share-based payment compensation expense related to the
implementation of SFAS No. 123(R) beginning January 1, 2006. For the year ended
December 31, 2005, there was insignificant share-based payment compensation
expense. Net loss for the year ended December 31, 2006 was $3.4 million compared
with net income of $2.3 million for the year ended December 31, 2005. The
increase in revenues was mainly due to an increase in (i) demand for our network
storage solution software (ii) maintenance revenue from new and existing
customers and (iii) sales from our resellers and OEM partners. Revenue
contribution from our OEM partners increased in absolute dollars and as a
percentage of our total revenue for the year ended December 31, 2006. Revenue
from resellers and distributors also increased in absolute dollars. Expenses
increased in all aspects of our business to support our growth. For the year
ended December 31, 2006, we increased the number of employees and continued to
invest in our infrastructure by purchasing additional computers and equipment.
We increased the number of employees from 279 as of December 31, 2005 to 340 as
of December 31, 2006. Included in our results for the year ended December 31,
2006 is a litigation settlement charge of $0.8 million relating to a contingent
purchase price dispute associated with an acquisition we made in 2002.

REVENUES

SOFTWARE LICENSE REVENUE

Software license revenue is comprised of software licenses sold through
our OEMs, value-added resellers and distributors to end users and, to a lesser
extent, directly to end users. These revenues are recognized when, among other
requirements, we receive a customer purchase order or a royalty report
summarizing software licenses sold and the software and permanent key codes are
delivered to the customer. We sometimes receive nonrefundable royalty advances
and engineering fees from some of our OEM partners. These arrangements are
evidenced by a signed customer contract, and the revenue is recognized when the
software product master is delivered and accepted, and the engineering services,
if any, have been performed.

Software license revenue increased 30% to $38.3 million in 2006 from $29.5
million in 2005. Increased market acceptance and demand for our product and
increased sales from our resellers and OEM partners were the primary drivers of
the increase in software license revenue. Revenue from our OEM partners
increased as a percentage of total revenue. We expect our software license
revenue to continue to grow and the percentage of future software license
revenue derived from our OEM partners to increase.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenues are comprised of
software maintenance and technical support, professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. Revenue derived from maintenance and technical support
contracts is deferred and recognized ratably over the contractual maintenance
term. Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue

from engineering services is recognized in the period the services are
completed. In 2006 and 2005, we had a limited number of transactions in which we
purchased hardware and bundled this hardware with our software and sold the
bundled solution to our customer. A portion of the contractual fees is
recognized as revenue when the hardware or software is delivered to the customer
based on the relative fair value of the delivered element(s). Maintenance,
software services and other revenue increased 47% to $16.7 million in 2006 from
$11.4 million in 2005.

The major factor behind the increase in maintenance, software services and
other revenue was an increase in the number of maintenance and technical support
contracts we sold. As we are in business longer, and as we license more
software, we expect these revenues will continue to increase. The majority of
our new customers purchase maintenance and support and most customers renew
their maintenance and support after their initial contracts expire. Maintenance
revenue increased from $7.6 million for the year ended December 31, 2005 to
$12.5 million for the year ended December 31, 2006. Software services and other
revenue increased from $3.8 million in 2005 to $4.3 million in 2006. The
increase in software services and other revenue was partially attributable to
our hardware sales which increased from $2.3 million in 2005 to $2.6 million in
2006. This increase was the result of an increase in demand from our customers
for bundled solutions. Growth in our professional services sales, which
increased from $1.5 million in 2005 to $1.7 million in 2006, also contributed to
the increase in software services and other revenues. This increase in
professional services revenue was related to the increase in our software
license customers who elected to purchase professional services. We expect
maintenance, software services and other revenues to continue to increase.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations, we have purchased or licensed various software for resale since
2001. As of December 31, 2006 and 2005, we had $5.2 million and $5.0 million,
respectively, of purchased software licenses that are being amortized over three
years. For the year ended December 31, 2006, we recorded $0.4 million of
amortization related to these purchased software licenses. For the year ended
December 31, 2005, we recorded $0.8 million of amortization related to these
purchased software licenses. We will continue to evaluate third party software
licenses and may make additional purchases, which would result in an increase in
amortization expense.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Cost of maintenance, software services and other revenues consists
primarily of personnel costs, other costs associated with providing software
implementations, technical support under maintenance contracts and training, and
share-based payment compensation expense associated with the implementation of
SFAS No. 123(R). Cost of maintenance, software services and other revenues also
includes the cost of hardware that was resold. Cost of maintenance, software
services and other revenues for the year ended December 31, 2006 increased by
48% to $9.0 million compared with $6.1 million for the year ended December 31,
2005. The increase in cost of maintenance, software services and other revenue
was partially due to $1.3 million of share-based payment compensation expense.
There was no share-based payment compensation expense included in cost of
maintenance, software services and other revenue for the year ended December 31,
2005. Additionally, cost of maintenance, software services and other revenue
increased due to an increase in personnel. As a result of our increased sales of
maintenance and support contracts and professional services, we hired additional
employees to provide technical support and to implement our software.
Additionally, due to an increase in hardware sales, our associated hardware
costs increased from $1.5 million for the year ended December 31, 2005 to $1.8
million for the year ended December 31, 2006. Our cost of maintenance, software
services and other revenue will continue to grow in absolute dollars as our
revenue increases.

Gross profit for the year ended December 31, 2006 was $45.7 million or 83%
of revenues compared with $34.1 million or 83% of revenues for the year ended
December 31, 2005. Gross margin remained consistent despite the inclusion of
share-based payment compensation expense in the cost of maintenance, software
services and other revenue for the year ended December 31, 2006. Share-based
payment compensation expense was equal to 2% of revenue for the year ended
December 31, 2006.

SOFTWARE DEVELOPMENT COSTS

Software development costs consist primarily of personnel costs for
product development personnel, share-based payment compensation expense
associated with the implementation of SFAS No. 123(R), and costs associated with
the development of new products, enhancements to existing products, quality
assurance and testing. Software development costs increased 66% to $20.0 million
in 2006 from $12.0 million in 2005. The major contributing factor to the
increase in software development costs was $4.3 million of share-based payment
compensation expense. There was no share-based payment compensation expense
included in software development costs for the year ended December 31, 2005. The
increase is also due to an increase in employees required to enhance and test
our core network storage software product, as well as to develop new innovative
features and options. In addition, we required additional employees to test and
integrate our software with our OEM partners' products. We intend to continue
recruiting and hiring product development personnel to support our software
development process.

SELLING AND MARKETING

Selling and marketing expenses consist primarily of sales and marketing
personnel costs, share-based payment compensation expense associated with the
implementation of SFAS No. 123(R), travel, public relations expense, marketing
literature and promotions, commissions, trade show expenses, and the costs
associated with our foreign sales offices. Selling and marketing expenses
increased 47% to $23.7 million in 2006 from $16.1 million in 2005. The increase
in selling and marketing expenses was partially due to $2.8 million of
share-based payment compensation expense. There was insignificant share-based
payment compensation expense included in selling and marketing expenses for the
year ended December 31, 2005. In addition, we continued to hire new sales and
sales support personnel and to expand our worldwide presence to accommodate our
revenue growth. As a result of the increase in revenue and interest in our
software, our commission expense and travel expenses also increased. We believe
that to continue to grow sales, our sales and marketing expenses will continue
to increase.

GENERAL AND ADMINISTRATIVE

General and administrative expenses consist primarily of personnel costs
of general and administrative functions, share-based payment compensation
expense associated with the implementation of SFAS No. 123(R), public company
related costs, directors and officers insurance, legal and professional fees and
other general corporate overhead costs. General and administrative expenses
increased 38% to $5.8 million in 2006 from $4.2 million in 2005. The major
contributing factor to the increase in general and administrative expenses was
$0.9 million of share-based payment compensation expense. There was no
share-based payment compensation expense included in general and administrative
expense for the year ended December 31, 2005. Additionally, as our revenue and
number of employees increase, our legal and professional fees and other general
corporate overheard costs have increased and are likely to continue to increase.

LITIGATION SETTLEMENT CHARGE

In January 2007, we resolved claims brought against us by two former
shareholders of IP Metrics, Inc. ("IP Metrics"). When we purchased IP Metrics in
July 2002, part of the contractual consideration was payments to be made in 2003
and 2004 to the former IP Metrics shareholders based on sales of IP Metrics
products and/or payments to be made if certain events occurred. We made payments
to all four former shareholders in 2003 and 2004. Two of the former shareholders
alleged that they were entitled to additional payments based on the alleged
occurrence of certain contingent events and they brought an action against us.
This action was resolved in January, 2007 without any admission of liability, by
the payment of an additional $0.8 million to the two former shareholders. This
amount was recorded as an operating expense as of December 31, 2006. All claims
in the lawsuit have now been dismissed.

INTEREST AND OTHER INCOME

We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
increased to $1.7 million for the year ended December 31, 2006 compared with
$0.7 million for the year ended December 31, 2005. This increase is primarily
due to a higher average cash balance and higher interest rates.

INCOME TAXES

We did not record a tax benefit associated with our pre-tax loss incurred
for the year ended December 31, 2006, as we deemed that it was uncertain that
the related deferred tax assets would be realized based on our cumulative losses
incurred since inception and our limited period of profitability. For the year
ended December 31, 2005, our pre-tax income was substantially offset by
available net operating losses. Our income tax provision for 2006 and 2005
consists of taxes related to alternative minimum taxes, state income taxes, and
taxes from our foreign subsidiaries. In 2007, in the event that we continue to
generate taxable income and our forecasts indicate that it is
more-likely-than-not that we will recover a portion of our deferred tax assets
in the future, we will likely reverse a portion of our deferred tax asset
valuation allowance.

RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2005 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2004

REVENUES

SOFTWARE LICENSE REVENUE

Software license revenue increased 37% to $29.5 million in 2005 from $21.5
million in 2004. Increased market acceptance and demand for our product and
increased sales from our OEM partners were the primary drivers of the increase
in software license revenue. Software license revenue increased from both our
OEM partners and from our resellers. Revenue from our OEM partners increased as
a percentage of total revenue.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenue increased 58% to $11.4
million in 2005 from $7.2 million in 2004. The major factor behind the increase
in maintenance, software services and other revenue was the increase in the
number of maintenance and technical support contracts we sold. As we are in
business longer, and as we license more software, we expect these revenues will
continue to increase. The majority of our new customers purchase maintenance and
support and most customers renew their maintenance and support after their
initial contracts expire. Maintenance revenue increased from $4.4 million for
the year ended December 31, 2004 to $7.6 million for the year ended December 31,
2005. Software services and other revenue increased from $2.8 million in 2004 to
$3.8 million in 2005. The increase in software services and other revenue was
partially attributable to our hardware sales which increased from $1.5 million
in 2004 to $2.3 million in 2005. This increase was the result of an increase in
demand from our customers for bundled solutions. Growth in our professional
services sales, which increased from $1.3 million in 2004 to $1.5 million in
2005, also contributed to the increase in software services and other revenues.
This increase in professional services revenue was related to the increase in
our software license customers who elected to purchase professional services.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

As of December 31, 2005 and 2004, we had $5.0 million and $4.9 million,
respectively, of purchased software licenses that are being amortized over three
years. For the year ended December 31, 2005, we recorded $0.8 million of
amortization related to these purchased software licenses. For the year ended
December 31, 2004 amortization was $1.4 million.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Cost of maintenance, software services and other revenues for the year
ended December 31, 2005 increased by 47% to $6.1 million compared with $4.2
million for the year ended December 31, 2004. The increase in cost of
maintenance, software services and other revenue was principally due to an
increase in personnel. As a result of our increased sales of maintenance and
support contracts and professional services, we hired additional employees to
provide technical support and to implement our software. Additionally, due to an
increase in hardware sales, our associated hardware costs increased from $1.0
million for the year ended December 31, 2004 to $1.5 million for the year ended
December 31, 2005.

Gross profit for the year ended December 31, 2005 was $34.1 million or 83%
of revenues compared with $23.2 million or 81% of revenues for the year ended
December 31, 2004. The increase in gross profit and gross margin was directly
related to the increase in revenues. Additionally, the increased percentage of
revenue from our OEM partners in 2005 contributed to the increase in gross
margins since revenues from our OEM partners typically have higher gross
margins.

SOFTWARE DEVELOPMENT COSTS

Software development costs increased 33% to $12.0 million in 2005 from
$9.1 million in 2004. The increase in software development costs was primarily
due to an increase in employees required to enhance and test our core network
storage software product, as well as to develop new innovative features and
options. In addition, we required additional employees to test and integrate our
software with our OEM partners' products.

SELLING AND MARKETING

Selling and marketing expenses increased 13% to $16.1 million in 2005 from
$14.3 million in 2004. As a result of the increase in revenue and interest in
our software, our commission expense and travel expenses increased. In addition,
we continued to hire new sales and sales support personnel and to expand our
worldwide presence to accommodate our revenue growth.

GENERAL AND ADMINISTRATIVE

General and administrative expenses decreased 18% to $4.2 million in 2005
from $5.1 million in 2004. The overall decrease in general and administrative
expenses was primarily due to a decrease in legal expenses. For the year ended
December 31, 2004 we had $1.0 million in legal expenses attributable to
litigation related to alleged patent infringement.

LITIGATION SETTLEMENT CHARGE

During the third quarter of 2004, we resolved claims relating to alleged
patent infringement brought by Dot Hill and by Crossroads against us in the
United States District Court for the Western District of Texas. Pursuant to the
terms of the Settlement Agreement between Crossroads and us, we, without
admission of infringement, made a one-time payment of $1.3 million and granted
to Crossroads licenses to certain of our technology in exchange for a worldwide,
perpetual license to the technology underlying the Crossroads' patents at issue
in the litigation. All claims against us by both Dot Hill and Crossroads have
now been dismissed.

INTEREST AND OTHER INCOME

Interest and other income remained consistent at $0.7 million. Interest
income increased from $0.7 million to $1.0 million due to a higher average cash
balance and slightly higher interest rates. Additionally, interest and other
income for the year ended December 31, 2005, includes an out-of-period charge of
approximately $0.2 million to recognize investment losses realized in prior
years.

INCOME TAXES

For the year ended December 31, 2005, our pre-tax income was substantially
offset by available net operating losses. For the year ended December 31, 2004,
we did not record a tax benefit associated with the pre-tax loss incurred, as we
deemed that it was uncertain that the related deferred tax assets would be
realized based on our cumulative losses incurred since inception and our limited
period of profitability. Accordingly, we provided a full valuation allowance
against our net deferred tax assets. Our income tax provision for 2005 and 2004
consists of tax expenses related to alternative minimum taxes, state income
taxes, and taxes from our foreign subsidiaries.

LIQUIDITY AND CAPITAL RESOURCES

Our total cash and cash equivalents and marketable securities balance as
of December 31, 2006 increased by $4.3 million compared with December 31, 2005.
Our cash and cash equivalents totaled $15.6 million and marketable securities
totaled $25.4 million at December 31, 2006. As of December 31, 2005, we had
$18.8 million in cash and cash equivalents and $17.8 million in marketable
securities.

In 2006, we made investments in our infrastructure to support our
long-term growth. We increased the total number of employees in 2006 and made
investments in property and equipment to support our growth. As we continue to
grow, we will continue to make investments in property and equipment and will
need to continue to increase our headcount. In the past, we have also used cash
to purchase software licenses and to make acquisitions. We will continue to
evaluate potential software license purchases and acquisitions and if the right
opportunity presents itself we may continue to use our cash for these purposes.
However, as of the date of this filing, we have no agreements, commitments or
understandings with respect to any such acquisitions.

We currently do not have any debt and our only significant commitments are
related to our office leases.

In connection with our acquisition of IP Metrics in July 2002, we were
required to make cash payments to the former shareholders of IP Metrics, which
were contingent on the level of revenues from IP Metrics products for a period
of twenty-four months through June 30, 2004. In 2004, we made payments to the
former shareholders of IP Metrics totaling $214,009. In 2006, we recorded a
litigation settlement expense of $0.8 million relating to a contingent purchase
price dispute with two former shareholders of IP Metrics. This settlement was
paid out in the first quarter of 2007.

In October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding common stock. Since October 2001, 865,200
shares have been repurchased at an aggregate purchase price of $5.8 million
including 315,600 shares repurchased in 2006 at an aggregate purchase price of
$2.1 million.

Net cash provided by operating activities totaled $8.2 million for the
year ended December 31, 2006, compared with net cash provided by operating
activities of $6.5 million for the year ended December 31, 2005 and net cash
used in operating activities of $1.1 million for the year ended December 31,
2004. The increase in net cash provided by operating activities was primarily
due to an increase in non-cash charges of $9.4 million related to share-based
payment compensation expense. There was insiginificant share-based payment
compensation expense for the years ended December 31, 2005 and 2004. Also
contributing to the increase in net cash provided by operating activities was an
increase in our deferred revenues, which increased to $5.5 million compared with
$4.2 million in 2005 and $2.8 million in 2004, as well as, an increase in
accrued expenses and other liabilities which increased to $2.0 million compared
with $1.1 million in 2005 and $0.8 million in 2004. These amounts were partially
offset by increases in our net accounts receivable balances of $8.9 million in
2006, $4.9 million in 2005 and $3.2 million in 2004. The increases in our
accounts receivable balances are due to our continued revenue growth.

Net cash used in investing activities was $11.8 million in 2006 compared
with net cash used in investing activities of $2.8 million in 2005 and net cash
provided by investing activities of $6.3 million in 2004. Included in investing
activities for each year are the sales and purchases of our marketable
securities. These represent the sales, maturities and reinvesting of our
marketable securities. The net cash used in investing activities from the net
purchase of securities was $7.5 million in 2006 and the net cash provided by
investing activities from the net sale of securities was $0.6 million for 2005
and $9.5 million in 2004. 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 $3.7 million, $3.2 million and $2.8 million
in 2006, 2005 and 2004, respectively. The cash used to purchase software
licenses was $0.2 million in 2006 and $0.1 million in both 2005 and 2004. We
continually evaluate potential software licenses and we may continue to make
similar investments if we find opportunities that would benefit our business.

Net cash provided by financing activities was $0.4 million in 2006,
$24,385 in 2005, and $1.8 million in 2004. We received proceeds from the
exercise of stock options of $2.5 million in 2006, $1.9 million in 2005 and $2.0
million in 2004. We made payments of $2.1 million in 2006, $1.9 million in 2005
and $0.3 million in 2004 to acquire treasury stock.

The Company's only significant commitments relate to its operating leases.
The Company has an operating lease covering its primary office facility that
expires in February, 2012. The Company also has several operating leases related
to offices in foreign countries. The expiration dates for these leases range
from 2007 through 2012. The following is a schedule of future minimum lease
payments for all operating leases as of December 31, 2006:

Year ending december 31

2007............................................................. $1,875,673
2008............................................................. 1,372,384
2009............................................................. 1,365,163
2010............................................................. 1,331,877
2011............................................................. 1,367,538
Thereafter....................................................... 708,120
----------
$8,020,755
==========

We believe that our current balance of cash, cash equivalents and
marketable securities, and expected cash flows from operations will be
sufficient to meet our cash requirements for at least the next twelve months.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In September 2006, the FASB issued SFAS No. 158, EMPLOYERS' ACCOUNTING FOR
DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS - an amendment of FASB
Statements No. 87, 88, 106 and 132(R) ("SFAS 158"). SFAS 158 requires that
employers recognize the funded status of their defined benefit pension and other
postretirement plans on their consolidated balance sheet and recognize as a
component of other comprehensive income, net of tax, the gains or losses and
prior service costs or credits that arise during the period but are not
recognized as components of net periodic benefit cost. SFAS No. 158 also
requires additional disclosures in the notes to financial statements. The
Company adopted SFAS No. 158, effective December 31, 2006, and recorded an
adjustment to accumulated other comprehensive income.

In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS
("SFAS 157"), which defines fair value, establishes a framework for measuring
fair value and expands the related disclosure requirements. Adoption is required
as of the beginning of the first fiscal year that begins after November 15,
2007. SFAS No. 157 applies under other accounting pronouncements that require or
permit fair value measurements and does not require any new fair value
measurements. Management is evaluating the impact the adoption of this statement
will have on the Company's consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin ("SAB") No.
108, CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING
MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS ("SAB No. 108") to provide
guidance on the consideration of the effects of prior year misstatements in
quantifying current year misstatements for the purpose of a materiality
assessment. Under SAB No. 108, companies should evaluate a misstatement based on
its impact on the current year income statement, as well as the cumulative
effect of correcting such misstatements that existed in prior years existing in
the current year's ending balance sheet. The Company adopted SAB No. 108 for the
year ended December 31, 2006 with no impact to the Company's consolidated
financial statements.

In June 2006, the FASB issued FASB Interpretation No. ("FIN") 48,
ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES - an Interpretation of SFAS No. 109,
which clarifies the accounting for uncertainty in income taxes recognized in the
financial statements in accordance with SFAS No. 109, ACCOUNTING FOR INCOME
TAXES. FIN 48 prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. Any change in the net assets or
liabilities recognized as a result of adopting the provisions of FIN 48 would be
recorded as an adjustment to the opening balance of retained earnings. FIN 48 is
effective for the Company as of January 1, 2007. Management is currently
evaluating the impact, if any, the adoption of FIN 48 will have on the Company's
consolidated financial statements.

ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities which aggregated to $41.0 million as of December 31, 2006,
is subject to interest rate risks. We regularly assess these risks and have
established policies and business practices to manage the market risk of our
marketable securities.

FOREIGN CURRENCY RISK. We have several offices outside the United States.
Accordingly, we are subject to exposure from adverse movements in foreign
currency exchange rates. The effect of foreign currency exchange rate
fluctuations have not been material since our inception. We do not use
derivative financial instruments to limit our foreign currency risk exposure.

We do not believe that our results would be materially affected by a 10% change
in interest or foreign exchange rates.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements

Page

Reports of Independent Registered Public Accounting Firm .................... 37

Consolidated Balance Sheets as of December 31, 2006 and 2005 ................ 39

Consolidated Statements of Operations for the years ended
December 31, 2006, 2005 and 2004 .......................................... 40

Consolidated Statements of Stockholders' Equity and Comprehensive
Income (Loss) for the years Ended December 31, 2006, 2005 and 2004 ........ 41

Consolidated Statements of Cash Flows for the years ended
December 31, 2006, 2005 and 2004 .......................................... 42

Notes to Consolidated Financial Statements................................... 43

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
FalconStor Software, Inc.:

We have audited the accompanying consolidated balance sheets of FalconStor
Software, Inc. and subsidiaries as of December 31, 2006 and 2005, and the
related consolidated statements of operations, stockholders' equity and
comprehensive income (loss), and cash flows for each of the years in the
three-year period ended December 31, 2006. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of FalconStor Software,
Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2006, in conformity with U.S. generally accepted accounting
principles.

As discussed in Notes 1 (k) and 8 to the accompanying consolidated financial
statements, the Company adopted Statement of Financial Accounting Standards No.
123 (Revised 2004), "SHARED-BASED PAYMENT", as of January 1, 2006.

We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of FalconStor
Software, Inc.'s internal control over financial reporting as of December 31,
2006, based on criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO), and our report, dated March 14, 2007, expressed an unqualified opinion
on management's assessment of, and the effective operation of, internal control
over financial reporting.

/s/ KPMG LLP

Melville, New York
March 14, 2007

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
FalconStor Software, Inc.:

We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that
FalconStor Software, Inc. and subsidiaries (the Company) maintained effective
internal control over financial reporting as of December 31, 2006, based on
criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.

In our opinion, management's assessment that the Company maintained effective
internal control over financial reporting as of December 31, 2006, is fairly
stated, in all material respects, based on criteria established in INTERNAL
CONTROL--INTEGRATED FRAMEWORK issued by COSO. Also, in our opinion, the Company
maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2006, based on criteria established in INTERNAL
CONTROL--INTEGRATED FRAMEWORK issued by COSO.

We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of
the Company as of December 31, 2006 and 2005, and the related consolidated
statements of operations, stockholders' equity and comprehensive income (loss),
and cash flows for each of the years in the three-year period ended December 31,
2006, and our report, dated March 14, 2007, expressed an unqualified opinion on
those consolidated financial statements. As discussed in our report, dated March
14, 2007, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 123 (Revised 2004), "SHARED-BASED PAYMENT", as of
January 1, 2006.

/s/ KPMG LLP

Melville, New York
March 14, 2007

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

DECEMBER 31,
2006 2005
------------ ------------
Assets

Current assets:
Cash and cash equivalents .............................................................. $ 15,605,329 $ 18,796,973
Marketable securities .................................................................. 25,354,259 17,833,683
Accounts receivable, net of allowances of $6,016,298 and
$3,846,882, respectively ............................................................. 24,134,257 15,187,408
Prepaid expenses and other current assets .............................................. 1,244,937 911,715
------------ ------------

Total current assets ............................................................... 66,338,782 52,729,779

Property and equipment, net of accumulated depreciation of
$10,221,780 and $7,150,762, respectively ............................................... 5,960,317 5,277,609
Goodwill ................................................................................. 3,512,796 3,512,796
Other intangible assets, net ............................................................. 407,316 216,864
Other assets, net ........................................................................ 2,011,433 2,236,725
------------ ------------

Total assets ......................................................................... $ 78,230,644 $ 63,973,773
============ ============

Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ....................................................................... $ 1,432,510 $ 1,152,228
Accrued expenses ....................................................................... 6,505,536 4,446,559
Deferred revenue ....................................................................... 11,466,552 7,401,018
------------ ------------

Total current liabilities ............................................................ 19,404,598 12,999,805

Other long-term liabilities .............................................................. 137,317 75,653
Deferred revenue ......................................................................... 3,645,482 2,240,208
------------ ------------
Total liabilities .................................................................... 23,187,397 15,315,666
------------ ------------

Commitments and Contingencies

Stockholders' equity:
Preferred stock - $.001 par value, 2,000,000 shares authorized, none issued ............ -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
49,085,539 and 48,441,614 shares issued, respectively and 48,220,339
and 47,892,014 shares outstanding, respectively..................................... 49,086 48,442
Additional paid-in capital ............................................................. 99,282,308 87,342,747
Accumulated deficit .................................................................... (38,033,857) (34,659,329)
Common stock held in treasury, at cost (865,200 and 549,600 shares,
respectively).......................................................................... (5,780,163) (3,632,930)
Accumulated other comprehensive loss, net .............................................. (474,127) (440,823)
------------ ------------

Total stockholders' equity ......................................................... 55,043,247 48,658,107
------------ ------------
Total liabilities and stockholders' equity ......................................... $ 78,230,644 $ 63,973,773
============ ============

See accompanying notes to consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

Years Ended December 31,

2006 2005 2004
---------------------------------------------------------
Revenues:
Software license revenue ..................................... $ 38,317,352 $ 29,544,467 $ 21,487,866
Maintenance revenue .......................................... 12,475,342 7,593,804 4,442,724
Software services and other revenue .......................... 4,273,334 3,825,832 2,778,088
------------ ------------ ------------
55,066,028 40,964,103 28,708,678
------------ ------------ ------------

Operating expenses:
Amortization of purchased and capitalized
software ................................................... 362,159 781,500 1,393,908
Cost of maintenance, software services
and other revenue .......................................... 9,048,354 6,114,112 4,150,309
Software development costs ................................... 20,021,899 12,039,488 9,050,092
Selling and marketing ........................................ 23,712,488 16,109,440 14,277,167
General and administrative ................................... 5,828,150 4,212,769 5,108,516
Litigation settlement ........................................ 799,317 -- 1,300,000
------------ ------------ ------------
59,772,367 39,257,309 35,279,992
------------ ------------ ------------
Operating income (loss) .................................. (4,706,339) 1,706,794 (6,571,314)
------------ ------------ ------------

Interest and other income, net ................................. 1,650,284 705,063 714,412
------------ ------------ ------------

Income (loss) before income taxes ........................ (3,056,055) 2,411,857 (5,856,902)

Provision for income taxes ..................................... 318,473 118,750 31,945
------------ ------------ ------------

Net income (loss) ........................................ $ (3,374,528) $ 2,293,107 $ (5,888,847)
------------ ------------ ------------

Basic net income (loss) per share .............................. $ (0.07) $ 0.05 $ (0.13)
============ ============ ============

Diluted net income (loss) per share ............................ $ (0.07) $ 0.05 $ (0.13)
============ ============ ============

Basic weighted average common shares
outstanding .................................................. 48,044,946 47,662,446 46,967,422
============ ============ ============

Diluted weighted average common shares
outstanding .................................................. 48,044,946 50,776,396 46,967,422
============ ============ ============

See accompanying notes to consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)

Additional Deferred
Common paid-in compen- Accumulated
stock capital sation deficit
------------ ------------ ------------ ------------
Balance, December 31, 2003 $ 46,745 $ 83,277,981 $ (7,969) $(31,063,589)

Issuance of stock options to
non-employees -- 87,023 -- --

Exercise of stock options 1,024 2,035,736 -- --

Amortization of deferred
compensation -- -- 7,969 --

Net loss -- -- -- (5,888,847)

Acquisition of treasury stock -- -- -- --

Change in unrealized losses on
marketable securities, net -- -- -- --

Foreign currency translation
adjustment -- -- -- --
------------ ------------ ------------ ------------

Balance, December 31, 2004 $ 47,769 $ 85,400,740 $ -- $(36,952,436)

Issuance of stock options to
non-employees -- (32,860) -- --

Exercise of stock options, including
tax benefit 673 1,974,867 -- --

Net income -- -- -- 2,293,107

Acquisition of treasury stock -- -- -- --

Change in unrealized losses on
marketable securities, net -- -- -- --

Foreign currency translation
adjustment -- -- -- --
------------ ------------ ------------ ------------

Balance, December 31, 2005 $ 48,442 $ 87,342,747 $ -- $(34,659,329)

Exercise of stock options, including
tax benefit 644 2,546,407 -- --

Issuance of stock options to
non-employees -- 17,914 -- --

Share-based compensation -- 9,375,240 -- --

Net loss -- -- -- (3,374,528)

Acquisition of treasury stock -- -- -- --

Adjustment to initially apply SFAS
No. 158, net of tax (Note 11) -- -- -- --

Change in unrealized losses on
marketable securities, net -- -- -- --

Foreign currency translation
adjustment -- -- -- --
------------ ------------ ------------ ------------

Balance, December 31, 2006 $ 49,086 $ 99,282,308 $ -- $(38,033,857)
------------ ------------ ------------ ------------

Accumulated
other
compre-
hensive Total Compre-
Treasury income stockholders' hensive
stock (loss) equity income (loss)
------------ ------------ ------------ ------------
Balance, December 31, 2003 $ (1,435,130) $ (262,489) $ 50,555,549

Issuance of stock options to
non-employees -- -- 87,023 --

Exercise of stock options -- -- 2,036,760 --

Amortization of deferred
compensation -- -- 7,969 --

Net loss -- -- (5,888,847) (5,888,847)

Acquisition of treasury stock (279,645) -- (279,645) --

Change in unrealized losses on
marketable securities, net -- (148,849) (148,849) (148,849)

Foreign currency translation
adjustment -- (6,010) (6,010) (6,010)
------------ ------------ ------------ ------------

Balance, December 31, 2004 $ (1,714,775) $ (417,348) $ 46,363,950 $ (6,043,706)
============

Issuance of stock options to
non-employees -- -- (32,860) --

Exercise of stock options, including
tax benefit -- -- 1,975,540 --

Net income -- -- 2,293,107 2,293,107

Acquisition of treasury stock (1,918,155) -- (1,918,155) --

Change in unrealized losses on
marketable securities, net -- 218,523 218,523 218,523

Foreign currency translation
adjustment -- (241,998) (241,998) (241,998)
------------ ------------ ------------ ------------

Balance, December 31, 2005 $ (3,632,930) $ (440,823) $ 48,658,107 $ 2,269,632
============

Exercise of stock options, including
tax benefit -- -- 2,547,051 --

Issuance of stock options to
non-employees -- -- 17,914 --

Share-based compensation -- -- 9,375,240

Net loss -- -- (3,374,528) (3,374,528)

Acquisition of treasury stock (2,147,233) -- (2,147,233) --

Adjustment to initially apply SFAS
No. 158, net of tax (Note 11) -- (87,482) (87,482) --

Change in unrealized losses on
marketable securities, net -- 25,800 25,800 25,800

Foreign currency translation
adjustment -- 28,378 28,378 28,378
------------ ------------ ------------ ------------

Balance, December 31, 2006 $ (5,780,163) $ (474,127) $ 55,043,247 $ (3,320,350)
------------ ------------ ------------ ------------

See accompanying notes to consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31,

2006 2005 2004
--------------------------------------------------------
Cash flows from operating activities:
Net income (loss) .............................................. $ (3,374,528) $ 2,293,107 $ (5,888,847)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization .............................. 3,581,451 3,505,562 3,656,212
Share-based payment employee compensation................... 9,375,240 -- 7,969
Non-cash professional services expenses .................... 17,914 (32,860) 87,023
Realized loss on marketable securities ..................... 28,854 270,026 17,795
Realized gain on sale of cost method
investment ............................................... (3,112) -- --
Realized gain on sale of warrants .......................... (38,378) -- --
Tax benefit from stock option exercise ..................... (45,895) 33,000 --
Provision for returns and doubtful accounts ................ 4,765,148 4,340,102 3,296,275
Changes in operating assets and liabilities:
Accounts receivable ........................................ (13,704,152) (9,274,971) (6,456,175)
Prepaid expenses and other current assets .................. (326,695) (291,693) 636,208
Other assets ............................................... 122,098 (50,401) (251,038)
Accounts payable ........................................... 254,211 354,471 259,128
Accrued expenses and other liabilities ..................... 2,018,002 1,104,416 791,498
Deferred revenue ........................................... 5,492,625 4,234,918 2,789,987
------------ ------------ ------------

Net cash provided by (used in) operating
activities ............................................. 8,162,783 6,485,677 (1,053,965)
------------ ------------ ------------

Cash flows from investing activities:
Purchase of marketable securities .............................. (78,776,443) (61,264,424) (33,897,295)
Sale of marketable securities .................................. 71,252,813 61,867,854 43,441,277
Sale of cost method investment ................................. 96,755 -- --
Purchase of cost method investment ............................. (198,117) -- --
Purchase of warrants ........................................... (635,000) -- --
Sale of warrants ............................................... 673,378 -- --
Purchase of property and equipment ............................. (3,693,756) (3,161,383) (2,842,792)
Purchase of software licenses .................................. (173,431) (108,000) (50,000)
Purchase of intangible assets .................................. (373,229) (126,241) (131,392)
Net cash paid for acquisition of IP Metrics .................... -- -- (214,009)
Security deposits .............................................. (2,062) -- (4,500)
------------ ------------ ------------

Net cash (used in) provided by investing
activities ................................................. (11,829,092) (2,792,194) 6,301,289
------------ ------------ ------------

Cash flows from financing activities:
Proceeds from exercise of stock options ........................ 2,501,156 1,942,540 2,036,760
Payments to acquire treasury stock ............................. (2,147,233) (1,918,155) (279,645)
Tax benefit from stock option exercise ......................... 45,895 -- --
------------ ------------ ------------

Net cash provided by financing activities .................... 399,818 24,385 1,757,115
------------ ------------ ------------

Effect of exchange rate changes .................................. 74,847 (405,468) (6,010)
------------ ------------ ------------

Net increase (decrease) in cash and cash equivalents.............. (3,191,644) 3,312,400 6,998,429

Cash and cash equivalents, beginning of year ..................... 18,796,973 15,484,573 8,486,144
------------ ------------ ------------

Cash and cash equivalents, end of year ........................... $ 15,605,329 $ 18,796,973 $ 15,484,573
============ ============ ============

Cash paid for income taxes ....................................... $ 79,501 $ 21,583 $ 24,554
============ ============ ============

The Company did not pay any interest for the three years ended December
31, 2006.

See accompanying notes to consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2006

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(A) THE COMPANY AND NATURE OF OPERATIONS

FalconStor Software, Inc., a Delaware Corporation (the "Company"),
develops, manufactures and sells network storage software solutions and provides
the related maintenance, implementation and engineering services.

(B) PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company's significant estimates include those related to
revenue recognition, accounts receivable allowances, share-based payment
compensation and deferred income taxes. Actual results could differ from those
estimates.

(D) CASH EQUIVALENTS AND MARKETABLE SECURITIES

The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$11.0 million and $12.4 million at December 31, 2006 and 2005, respectively.
Marketable securities at December 31, 2006 and 2005 amounted to $25.4 million
and $17.8 million, respectively, and consisted of corporate bonds, government
securities and certificate of deposits, which are classified as available for
sale, and accordingly, unrealized gains and losses on marketable securities are
reflected as a component of accumulated other comprehensive loss in
stockholders' equity.

(E) REVENUE RECOGNITION

The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable, the software is delivered
and collection of the resulting receivable is deemed probable. Software
delivered to a customer on a trial basis is not recognized as revenue until a
permanent key is delivered to the customer. Reseller customers typically send
the Company a purchase order only when they have an end user identified. When a
customer licenses software together with the purchase of maintenance, the
Company allocates a portion of the fee to maintenance for its fair value.
Software maintenance fees are deferred and recognized as revenue ratably over
the term of the contract. The long-term portion of deferred revenue relates to
maintenance contracts with terms in excess of one year. The cost of providing
technical support is included in cost of revenues. The Company provides an
allowance for software product returns as a reduction of revenue, based upon
historical experience and known or expected trends.

Revenues associated with software implementation and software engineering
services are recognized as the services are performed. Costs of providing these
services are included in cost of revenues.

The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided to the reseller a non-exclusive software license to install the
Company's software on certain hardware or to resell the Company's software in
exchange for payments based on the products distributed by the OEM or
distributor. Nonrefundable advances and engineering fees received by the Company
from an OEM are recorded as deferred revenue and recognized as revenue when
related software engineering services, if any, are complete and the software
product master is delivered and accepted.

For the years ended December 31, 2006 and 2005, the Company had a limited
number of transactions in which it purchased hardware and bundled this hardware
with the Company's software and sold the bundled solution to its customer. Since
the software is not essential for the functionality of the equipment included in
the Company's bundled solutions, and both the hardware and software have stand
alone value to the customer, a portion of the contractual fees is recognized as
revenue when the software or hardware is delivered based on the relative fair
value of the delivered element(s).

(F) PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years). Leasehold improvements are amortized on a straight-line basis over
the term of the respective leases or over their estimated useful lives,
whichever is shorter.

(G) GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill represents the excess of the purchase price over the estimated
fair value of net tangible and identifiable intangible assets acquired in
business combinations. Consistent with Statement of Financial Accounting
Standards ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company does
not amortize goodwill, but has instead tested the balance for impairment
annually on December 31st of each year, and more frequently if events or changes
in circumstances indicate that goodwill may be impaired. Identifiable intangible
assets are amortized over a three-year period using the straight-line method.
Amortization expense was $182,777, $216,997 and $220,712 for 2006, 2005 and
2004, respectively. The gross carrying amount and accumulated amortization of
other intangible assets as of December 31, 2006 and December 31, 2005 are as
follows:

December 31, December 31,
2006 2005
----------- -----------

Customer relationships and purchased technology:

Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (216,850) (216,850)
----------- -----------
Net carrying amount $ -- $ --
=========== ===========
Patents:
Gross carrying amount $ 1,023,093 $ 649,864
Accumulated amortization (615,777) (433,000)
----------- -----------
Net carrying amount $ 407,316 $ 216,864
=========== ===========

(H) SOFTWARE DEVELOPMENT COSTS AND PURCHASED SOFTWARE TECHNOLOGY

Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
the end of March 2001. The Company previously capitalized $94,570 of software
development costs which were fully amortized as of the first quarter of 2004.

Amortization of software development costs is recorded at the greater of
straight line over three years or the ratio of current revenue of the related
products to total current and anticipated future revenue of these products.

Purchased software technology of $183,578 and $372,306, net of accumulated
amortization of $5,008,853 and $4,646,694, is included in other assets in the
balance sheets as of December 31, 2006 and December 31, 2005, respectively.
Amortization expense was $362,159, $781,500 and $1,386,027 for the years ended
December 31, 2006, 2005 and 2004, respectively. Amortization of purchased
software technology is recorded at the greater of the straight line basis over
the products estimated remaining life or the ratio of current period revenue of
the related products to total current and anticipated future revenue of these
products.

As of December 31, 2006, amortization expense on existing identifiable
intangible assets and purchased software technology will be $295,433, $223,482,
and $71,979 for the years ended December 31, 2007, 2008 and 2009, respectively.
Such assets will be fully amortized at December 31, 2009.

(I) INCOME TAXES

Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. The Company provides a full valuation
allowance against its deferred tax assets.

(J) LONG-LIVED ASSETS

The Company reviews its long-lived assets for impairment whenever events
or changes in circumstances indicate that the carrying amount of the asset may
not be recoverable. If the sum of the expected future cash flows, undiscounted
and without interest is less than the carrying amount of the asset, an
impairment loss is recognized as the amount by which the carrying amount of the
asset exceeds its fair value.

(K) SHARE-BASED PAYMENTS

Effective January 1, 2006, the Company adopted the provisions of Statement
of Financial Accounting Standards No. 123 (R) (Revised 2004), "SHARE-BASED
PAYMENT" (SFAS No. 123(R)), which establishes the accounting for transactions in
which an entity exchanges its equity instruments for goods or services. Under
the provisions of SFAS No. 123(R), share-based payment compensation is measured
at the grant date, based on the fair value of the award, and is recognized as an
expense over the requisite employee service period (generally the vesting
period). The Company adopted SFAS No. 123(R) using the modified prospective
method and, as a result, periods prior to January 1, 2006 have not been
restated. The adoption of this pronouncement resulted in increased compensation
expense of $9.4 million, which caused net income to decrease by the same amount
or $0.20 per share for the year ended December 31, 2006, as well as cash flows
from financing activities increasing by $45,895 while cash flows from operating
activities decreased by the same amount for the year ended December 31, 2006.
Prior to the adoption of SFAS No. 123 (R), the Company accounted for stock-based
compensation using the intrinsic-value based method under Accounting Principles
Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and
related interpretations, and provided applicable pro-forma disclosures required
by Statement of Financial Accounting Standards No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION. Accordingly, prior to 2006, the Company recorded
employee stock-based compensation expense only if, on the date of grant, the
market price of the underlying stock on the date of grant exceeded the exercise
price.

(L) FINANCIAL INSTRUMENTS

As of December 31, 2006 and 2005, the fair value of the Company's
financial instruments including cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, approximates book value due to the short
maturity of these instruments.

(M) FOREIGN CURRENCY

Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations
within interest and other income, net. Such amounts have historically not been
material.

(N) EARNINGS PER SHARE (EPS)

Basic EPS is computed based on the weighted average number of shares of
common stock outstanding. Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to net losses for the years ended December 31, 2006 and 2004,
all common stock equivalents for these periods were excluded from diluted net
loss per share. As of December 31, 2006, 2005 and 2004, potentially dilutive
common stock equivalents included 11,060,975, 10,200,908 and 8,973,358 stock
options and shares of restricted stock outstanding, respectively. As of December
31, 2006, 2005 and 2004, potentially dilutive common stock equivalents also
included 750,000 warrants outstanding.

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

Year Ended December 31, 2006 Year Ended December 31, 2005
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
------------ ---------- ----------- ----------- ---------- -----------
Basic EPS $(3,374,528) 48,044,946 $ (0.07) $ 2,293,107 47,662,446 $ 0.05
=========== ===========
Effect of dilutive securities:
Stock Options and Restricted Stock -- 3,113,950
----------- ----------- ----------- ----------- ----------- -----------
Diluted EPS $(3,374,528) 48,044,946 $ (0.07) $ 2,293,107 50,776,396 $ 0.05
=========== =========== =========== =========== =========== ===========

Year Ended December 31, 2004
Net Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ---------- -----------
Basic EPS $(5,888,847) 46,967,422 $ (0.13)
===========
Effect of dilutive securities:
Stock Options and Restricted Stock --
----------- ----------- -----------
Diluted EPS $(5,888,847) 46,967,422 $ (0.13)
=========== =========== ===========

(O) COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) includes the Company's net income (loss),
foreign currency translation adjustments and unrealized losses on marketable
securities, net of tax. Components of accumulated other comprehensive income
(loss) were comprised of foreign currency translation adjustment losses of
$363,163 and $391,540 as of December 31, 2006 and 2005, respectively, unrealized
losses on marketable securities of $23,482 and $49,283, net of tax as of
December 31, 2006 and 2005, respectively and unrecognized pension adjustments of
$87,482, net of tax as of December 31, 2006.

(P) NEW ACCOUNTING PRONOUNCEMENTS

(Q) RECLASSIFICATIONS

Certain reclassifications have been made to prior years' consolidated
financial statement presentations to conform to the current year's presentation.

(2) ACQUISITION

On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned
subsidiary of the Company, acquired all of the common stock of IP Metrics
Software, Inc. ("IP Metrics"), a provider of intelligent trunking software for
mission-critical networks, for $2,432,419 in cash plus payments contingent on
the level of revenues from IP Metrics' products and services for a period of
twenty-four months. The acquisition was accounted for under the purchase method
and the results of IP Metrics are included with those of the Company from the
date of acquisition. As of December 31, 2004, the Company made aggregate
contingent acquisition payments totaling $501,139 related to the sale of IP
Metrics' products and services. In 2006, the Company recorded a litigation
settlement expense of $0.8 million relating to a contingent purchase price
dispute with two former shareholders of IP Metrics.

(3) PROPERTY AND EQUIPMENT

Property and equipment consist of the following:

December 31, December 31,
2006 2005
--------------------------------
Computer hardware and software $ 14,845,319 $ 11,410,607

Furniture and equipment 511,184 501,861

Leasehold improvements 812,586 502,895

Automobile 13,008 13,008
------------ ------------
16,182,097 12,428,371

Less accumulated depreciation (10,221,780) (7,150,762)
------------ ------------
$ 5,960,317 $ 5,277,609
============ ============

Depreciation expense was $3,071,018, $2,452,737, and $2,041,592 in 2006,
2005, and 2004, respectively.

(4) MARKETABLE SECURITIES

The Company's investments consist of available-for-sale securities, which
are carried at fair value, with unrealized gains and losses reported as a
separate component of stockholders' equity. Unrealized gains and losses are
computed on the specific identification method. Realized gains, realized losses
and declines in value judged to be other-than-temporary, are included in
interest and other income, net. The cost of available-for-sale securities sold
are based on the specific identification method and interest earned is included
in interest and other income.

The cost and fair values of the Company's available-for-sale marketable
securities as of December 31, 2006, are as follows:

Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
----------- ----------- ----------- -----------
Auction rate securities $10,900,000 $10,900,000 $ -- $ --

Government securities 12,956,804 12,978,952 -- 22,148

Corporate bonds 997,455 998,789 -- 1,334

Certificate of deposit 500,000 500,000 -- --
----------- ----------- ----------- -----------
$25,354,259 $25,377,741 $ -- $ 23,482
=========== =========== =========== ===========

As of December 31, 2006 there are two corporate bonds and twelve
government securities that are in an unrealized loss position. Based on the
credit ratings of these securities and the timing of their respective
maturities, there is no reason to believe the Company will be unable to collect
all amounts due according to the contractual terms of these securities.
Unrealized losses on the Company's available-for-sales securities have not been
determined to be other-than-temporary due principally to the Company's intent
and ability to hold these securities for a period of time sufficient to recover
the value of the investments.

The cost and fair values of the Company's available-for-sale marketable
securities as of December 31, 2005, are as follows:

Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
----------- ----------- ----------- -----------
Auction rate securities $10,098,031 $10,098,031 $ -- $ --

Government securities 6,394,262 6,431,432 -- 37,170

Corporate bonds 1,341,390 1,353,503 -- 12,113
----------- ----------- ----------- -----------
$17,833,683 $17,882,966 $ -- $ 49,283
=========== =========== =========== ===========

The cost basis and fair value of available-for-sale securities by
contractual maturity as of December 31, 2006, were as follows:

Fair
Cost Value
----------- -----------
Due within one year $23,328,950 $23,308,021
Due between one and two years 2,048,791 2,046,238
----------- -----------
$25,377,741 $25,354,259
=========== ===========

(5) ACCRUED EXPENSES

Accrued expenses are comprised of the following:

December 31, December 31,

2006 2005
----------------------------
Accrued compensation $ 2,267,222 $ 1,517,115

Accrued consulting and professional fees 606,702 598,674

Accrued marketing and promotion 220,419 229,675

Other accrued expenses 1,052,536 1,245,873

Accrued income taxes 247,376 24,000

Accrued other taxes 256,989 295,119

Accrued litigation settlement fee 1,100,000 --

Accrued hardware purchases 314,101 38,946

Accrued and deferred rent 440,191 497,157
------------ ------------
$ 6,505,536 $ 4,446,559
============ ============

6) INCOME TAXES

The provision for income taxes for the years ended December 31, 2006 and
2005 is comprised of Federal Alternative Minimum Tax, state income taxes and
foreign income taxes. The tax effects of temporary differences that give rise to
the Company's deferred tax assets (liabilities) as of December 31, 2006 and 2005
are as follows:

2006 2005
------------ ------------
U.S. Federal net operating loss carryforwards (FalconStor) $ 7,420,767 $ 11,123,022
U.S. Federal net operating loss carryforwards (NPI) 31,711,302 31,711,302
Foreign net operating loss carryforwards 1,484,416 941,369
State net operating loss carryforwards 722,234 1,065,636
Start-up costs not currently deductible for taxes -- 90,100
Depreciation (37,943) (358,207)
Compensation 375,922 348,562
Tax credit carryforwards 2,421,810 1,866,248
Alternative minimum tax carryforward 222,684 23,007
Deferred revenue 1,056,016 650,555
Capital loss carryforward 850,134 847,901
Lease abandonment charge 34,369 77,327
Allowance for receivables 2,258,062 1,440,036
Patent 189,889 99,194
Other 8,065 11,636
Share-based payment compensation 1,529,144 --
------------ ------------
50,246,871 49,937,688
Valuation allowance (50,246,871) (49,937,688)
------------ ------------
$ -- $ --
============ ============

The difference between the provision for income taxes computed at the
Federal statutory rate and the reported amount of tax expense attributable to
income (loss) before income taxes for the years ended December 31, 2006, 2005
and 2004, are as follows:

2006 2005 2004
----------- ----------- -----------
Tax at Federal statutory rate $(1,066,688) $ 820,031 $(1,991,300)
Increase (reduction) in income taxes resulting from:
State and local taxes, net of Federal income tax benefit 62,711 885,733 809,345
Non-deductible expenses 355,144 302,207 47,600
Compensation -- -- 2,700
Share-based payment compensation 1,170,364 -- --
Foreign tax credit -- -- (6,100)
Net effect of foreign operations 36,279 128,150 164,800
Research and development credit (568,520) (433,013) (360,100)
AMT tax 199,677 23,007 --
Change in valuation allowance 129,506 (1,607,365) 1,365,000
----------- ----------- -----------
$ 318,473 $ 118,750 $ 31,945
=========== =========== ===========

2006 2005 2004
-------- -------- --------
Federal $239,411 $ 55,887 $ --
State and local 22,862 1,113 --
Foreign 56,200 61,750 31,945
-------- -------- --------
$318,473 $118,750 $ 31,945
======== ======== ========

Income (loss) before provision for income taxes for the years ended
December 31, 2006, 2005 and 2004 are as follows:

2006 2005 2004
----------- ----------- -----------
Domestic income (loss) $(1,599,446) $ 4,390,212 $(5,465,902)
Foreign loss (1,456,609) (1,978,355) (391,000)
----------- ----------- -----------
$(3,056,055) $ 2,411,857 $(5,856,902)
=========== =========== ===========

As of December 31, 2006, the Company had U.S. Federal net operating loss
carryforwards of approximately $21,825,800 which expire from 2020 through 2025.
In August 2001, the Company was a party to a reverse merger with Network
Peripherals, Inc. ("NPI"). As of the date of the merger, NPI had U.S. Federal
net operating loss carryforwards of $93,268,500 that start to expire in
December, 2012. As of December 31, 2006, the Company had state net operating
loss carryforwards of approximately $13,657,200 which expire from 2007 through
2025. As of December 31, 2006, the Company had foreign net operating loss
carryforwards of approximately $4,719,700. At December 31, 2006 and 2005, the
Company established a valuation allowance to reduce its deferred tax assets to
an amount that is more-likely-than-not realizable due to the Company's prior
history of pre-tax losses and uncertainty about the timing of and ability to
generate taxable income in the future. Due to the Company's various equity
transactions, which resulted in a change of control, the utilization of certain
tax loss carryforwards is subject to annual limitations imposed by Internal
Revenue Code Section 382. NPI experienced such an ownership change as a result
of the merger. As such, the Company's ability to use its NOL carryforwards to
offset taxable income in the future may be significantly limited.

If the entire deferred tax asset were realized, $4,631,900 would be
allocated to paid-in-capital with the remainder reducing income tax expense. Of
the amount allocable to paid-in-capital, $2,340,600 relates to the tax effect of
the deductions for payments of liabilities of discontinued operations in
connection with the reverse merger and the remainder of $2,291,300 relates to
the tax effects of excess compensation deductions from exercises of employee and
consultant stock options. In determining the period in which related tax
benefits are realized for book purposes, excess share-based payment deductions
and deduction from discontinued operations included in net operating losses are
realized after regular net operating losses are exhausted.

(7) STOCKHOLDERS' EQUITY

In September, 2003 the Company entered into a worldwide OEM agreement with
a major technology company (the "OEM"), and granted the OEM warrants to purchase
750,000 shares of the Company's common stock with an exercise price of $6.18 per
share. A portion of the warrants may vest annually subject to the OEM's
achievement of pre-defined and mutually agreed upon sales objectives over a

three-year period beginning June 1, 2004. If the OEM generates cumulative
revenues to the Company in the mid-eight figure dollar range from reselling the
Company's products then all the warrants granted will vest. Any warrants that do
not vest by the end of the three-year period will expire. If and when it is
probable that all or a portion of the warrants will vest, the then fair value of
the warrants earned will be recorded as a reduction of revenue. Subsequently,
each quarter the Company will apply variable accounting to adjust such amount to
reflect the fair value of the warrants until they vest. Through December 31,
2006, the Company had not generated any revenues from this OEM and accordingly
no warrants had vested.

(8) SHARE-BASED PAYMENT ARRANGEMENTS

As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000
Stock Option Plan (the "2000 Plan"). The 2000 Plan is administered by the
Compensation Committee of the Board of Directors and, as amended, provides for
the grant of options to purchase up to 14,162,296 shares of Company common stock
to employees, consultants and non-employee directors. Options may be incentive
("ISO") or non-qualified. ISOs granted must have exercise prices at least equal
to the fair value of the common stock on the date of grant, and have terms not
greater than ten years, except those to an employee who owns stock with greater
than 10% of the voting power of all classes of stock of the Company, in which
case they must have an option price at least 110% of the fair value of the
stock, and expire no later than five years from the date of grant. Non-qualified
options granted must have exercise prices not less than eighty percent of the
fair value of the common stock on the date of grant, and have terms not greater
than ten years. All options granted under the 2000 Plan must be granted before
May 1, 2010.

The Company granted options to purchase an aggregate of 50,000 shares of
common stock to certain non-employee consultants in exchange for professional
services during 2002. The aggregate fair value of these options as determined
using the fair value method is expensed over the periods the services are
provided. The related expense amounted to $32,860 and $87,023 in 2005 and 2004,
respectively. These services were completed as of December 31, 2005.

On May 14, 2004, the Company adopted the FalconStor Software, Inc. 2004
Outside Directors Stock Option Plan (the "2004 Plan"). The 2004 Plan is
administered by the Compensation Committee of the Board of Directors and
provides for the granting of options to non-employee directors of the Company to
purchase up to 300,000 shares of Company common stock. Exercise prices of the
options must be equal to the fair market value of the common stock on the date
of grant. Options granted have terms of ten years. All options granted under the
2004 Plan must be granted within three years of the adoption of the 2004 Plan.

On May 17, 2006, the Company adopted the FalconStor Software, Inc. 2006
Incentive Stock Plan (the "2006 Plan"). The 2006 Plan is administered by the
Compensation Committee of the Board of Directors and provides for the grant of
incentive and nonqualified stock options, and restricted stock, to employees,
officers, consultants and advisors of the Company. A maximum of 1,500,000 of the
authorized but unissued or treasury shares of the common stock of the Company
may be issued upon the grant of restricted stock or upon the exercise of options
granted under the 2006 Plan. Exercise prices of the options must be equal to the
fair market value of the common stock on the date of grant. Options granted have
terms of not greater than ten years. All options and shares of restricted stock
granted under the 2006 Plan must be granted within ten years of the adoption of
the 2006 Plan.

A summary of the Company's stock option activity for 2006 is as follows:

Weighted
Weighted Average
Average Remaining Aggregate
Number of Exercise Contractual Intrinsic
Options Price Life (Years) Value
------------ ------------ ------------ ------------
Options Outstanding at December 31, 2005 10,062,745 $ 5.29
============ ============
Granted 2,086,150 $ 7.26
Exercised (643,925) $ 3.88
Canceled (668,995) $ 7.45
------------ ------------

Options Outstanding at December 31, 2006 10,835,975 $ 5.62 6.55 $ 33,360,990
============ ============ ============ ============

Options Exercisable at December 31, 2006 7,530,233 $ 4.89 5.62 $ 28,695,438
============ ============ ============ ============

Options Expected to Vest at December 31, 2006 3,001,271 $ 7.25 8.72 $ 4,199,665
------------ ------------ ------------ ------------

Stock option exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the years ended December 31,
2006, 2005 and 2004 was $2,501,156, $1,942,540 and $2,031,903, respectively. The
total intrinsic value of stock options exercised during the year ended December
31, 2006, was $2,697,850.

The Company realized share-based payment compensation for awards issued
under the Company's stock option plans in the following line items in the
consolidated statement of operations:

Year Ended
December 31,
2006
----------
Cost of maintenance software services and other revenue $1,342,970
Software development costs 4,331,902
Selling and marketing 2,803,585
General and administrative 914,697
----------
$9,393,154
==========

The Company recognized $45,895 of tax benefits related to share-based
payment compensation during the year ended December 31, 2006.

In 2006, the Company granted options to purchase an aggregate of 25,000
shares of common stock to certain non-employee consultants in exchange for
professional services. The aggregate fair value of these options as determined
using the Black-Scholes method, $161,230 as of December 31, 2006, is being
expensed over the periods the services are provided. The related expense
amounted to $17,914 during the year ended December 31, 2006.

In 2006, the Company granted 225,000 shares of restricted stock at an
average fair value per share at date of grant of $7.06 per share. There were no
restricted shares issued or outstanding as of December 31, 2005. As of December
31, 2006 no restricted shares have been vested or forfeited.

For periods prior to January 1, 2006, the Company recorded compensation
expense for employee stock options based upon their intrinsic value on the date
of grant pursuant to Accounting Principles Board ("APB") Opinion No. 25,
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. Since the exercise price for such
options was equal to the fair market value of the Company's stock at the date of
grant, the stock options had no intrinsic value upon grant and, therefore, no
expense was recorded in the consolidated statements of operations.

Had the compensation cost of the Company's share-based payments been
determined in accordance with SFAS No. 123, the Company's pro forma net income
and net income per share for the years ended December 31, 2005 and 2004 would
have been:

Year Ended Year Ended
December 30, December 31,
2005 2004
------------ ------------
Net Income (loss) as reported $ 2,293,107 $ (5,888,847)
Add share-based payment compensation expense
included in reported net income (loss), net of tax $ -- $ 7,969

Deduct total share-based payment compensation
expense determined under fair-value-based method,
net of tax $ (8,565,701) $ (8,268,471)
------------ ------------

Net loss - pro forma $ (6,272,594) $(14,149,349)
============ ============
Basic and diluted net income (loss) per common
share-as reported
$ 0.05 $ (0.13)

Basic and diluted net loss per common share-pro forma $ (0.13) $ (0.30)

Under the modified prospective method, SFAS No. 123(R) applies to new
awards and to awards outstanding on the effective date that are subsequently
modified or cancelled. Compensation expense for outstanding awards for which the
requisite service had not been rendered as of December 31, 2005 is recognized
over the remaining service period using the compensation cost calculated for pro
forma disclosure purposes under SFAS No. 123. Prior to the adoption of SFAS No.
123(R), the Company valued graded vesting awards based on the entire award for
purposes of pro forma disclosure. The Company has elected to continue valuing
awards with graded vesting, based on the value of the entire award. The Company
allocates the fair value of all awards on a straight-line basis over the vesting
period. Cumulative compensation expense recognized at any date will at least
equal the grant date fair value of the vested portion of the award at that time.

The Company estimates the fair value of share-based payments using the
Black-Scholes option pricing model. The Company believes that this valuation
technique and the approach utilized to develop the underlying assumptions are
appropriate in estimating the fair value of the Company's share-based payments
granted during the year ended December 31, 2006. Estimates of fair value are not
intended to predict actual future events or the value ultimately realized by the
employees who receive equity awards.

The per share weighted average fair value of share-based payments granted
during the years ended December 31, 2006, 2005 and 2004 was $4.32, $4.52 and
$6.55, respectively. In addition to the exercise and grant date prices of the
awards, certain weighted average assumptions that were used to estimate the fair
value of share-based payment grants in the respective periods are listed in the
table below:

Year ended December 31,
2006 2005 2004
---- ---- ----
Expected dividend yield 0% 0% 0%
Expected volatility 57 - 60% 61 - 65% 166 - 176%
Risk-free interest rate 4.4 - 5.1% 3.7 - 4.6% 3.5%
Expected term (years) 6 6 5
Discount for post-vesting N/A N/A N/A
restrictions

Options granted during fiscal 2006 have exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
a vesting period of three years and an estimated forfeiture rate of 23%. All
options granted through December 31, 2005 had exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
generally a vesting period of three years and an estimated forfeiture rate of
23%.

The Company estimates expected volatility based primarily on historical
daily volatility of the Company's stock and other factors, if applicable. The
risk-free interest rate is based on the United States treasury yield curve in
effect at the time of grant. The expected option term is the number of years
that the Company estimates that options will be outstanding prior to exercise.
The expected term of the awards issued after December 31, 2005 was determined
using the "simplified method" prescribed in SEC Staff Accounting Bulletin
("SAB") No. 107.

As of December 31, 2006, there was approximately $11,433,934 of total
unrecognized compensation cost related to the Company's unvested options and
restricted shares granted under the Company's stock plans. The unrecognized
compensation cost is expected to be recognized over a weighted-average period of
2.23 years.

As of December 31, 2006, the Company has 12,605,548 shares of common stock
reserved for issuance upon the exercise of options, restricted shares and
warrants.

(9) LITIGATION SETTLEMENT CHARGES

In January 2007, we resolved claims brought against us by two former
shareholders of IP Metrics, Inc. ("IP Metrics"). When we purchased IP Metrics in
July 2002, part of the contractual consideration was payments to be made in 2003
and 2004 to the former IP Metrics shareholders based on sales of IP Metrics
products, and/or payments to be made if certain events occurred. We made
payments to all four former shareholders in 2003 and 2004. Two of the former
shareholders alleged that they were entitled to additional payments based on the
alleged occurrence of certain contingent events and they brought an action
against us. This action was resolved in January, 2007 without any admission of
liability, by the payment of an additional $0.8 million to the two former
shareholders. This amount was recorded as an operating expense as of December
31, 2006. All claims in the lawsuit have now been dismissed.

During the third quarter of 2004, the Company resolved claims relating to
alleged patent infringement brought by Dot Hill Systems Corporation ("Dot Hill")
and by Crossroad Systems (Texas), Inc. ("Crossroads") against the Company.
Pursuant to the terms of the Settlement Agreement between the Company and
Crossroads, the Company, without admission of infringement, made a one-time
payment of $1.3 million and granted to Crossroads licenses to certain Company
technology in exchange for a worldwide, perpetual license to the technology
underlying the Crossroads patents at issue in the litigation. All claims against
the Company by both Dot Hill and Crossroads were dismissed.

(10) COMMITMENTS AND CONTINGENCIES

The Company has an operating lease covering its primary office facility
that expires in February, 2012. The Company also has several operating leases
related to offices in foreign countries. The expiration dates for these leases
range from 2007 through 2012. The following is a schedule of future minimum
lease payments for all operating leases as of December 31, 2006:

Year Ending December 31,

2007.............................................................. $1,875,673
2008.............................................................. 1,372,384
2009.............................................................. 1,365,163
2010.............................................................. 1,331,877
2011.............................................................. 1,367,538
Thereafter........................................................ 708,120
----------
$8,020,755
==========

These leases require the Company to pay its proportionate share of real
estate taxes and other common charges. Total rent expense for operating leases
was $1,945,991, $1,461,051, and $1,103,008 for the years ended December 31,
2006, 2005 and 2004, respectively.

The Company typically provides its customers a warranty on its software
products for a period of no more than 90 days. Such warranties are accounted for
in accordance with SFAS No. 5, ACCOUNTING FOR CONTINGENCIES. To date, the
Company has not incurred any costs related to warranty obligations.

Under the terms of substantially all of its software license agreements,
the Company has agreed to indemnify its customers for all costs and damages
arising from claims against such customers based on, among other things,
allegations that the Company's software infringes the intellectual property
rights of a third party. In most cases, in the event of an infringement claim,
the Company retains the right to (i) procure for the customer the right to
continue using the software; (ii) replace or modify the software to eliminate
the infringement while providing substantially equivalent functionality; or
(iii) if neither (i) nor (ii) can be reasonably achieved, the Company may
terminate the license agreement and refund to the customer a pro-rata portion of
the license fee paid to the Company. Such indemnification provisions are
accounted for in accordance with SFAS No. 5. Except for the alleged patent
infringement claim discussed in note 9, through December 31, 2006, there have
not been any claims under such indemnification provisions.

The Company is subject to various legal proceedings and claims, asserted
or unasserted, which arise in the ordinary course of business. While the outcome
of any such matters cannot be predicted with certainty, the Company believes
that such matters will not have a material adverse effect on its financial
condition or liquidity. The Company expenses legal costs related to
contingencies when incurred.

In November, 2005, the Company entered into a second Amended and Restated
Employment Agreement ("Employment Agreement") with ReiJane Huai. Pursuant to the
Employment Agreement, the Company agreed to employ Mr. Huai as President and
Chief Executive Officer of the Company until December 31, 2007, at an annual
salary of $275,000. The Employment Agreement also provides for the payment of
annual bonuses to Mr. Huai based on the Company's operating income (as defined)
and for certain other contingent benefits set forth in the Employment Agreement.

On December 1, 2005, the Company adopted the 2005 FalconStor Software,
Inc., Key Executive Severance Protection Plan ("Severance Plan"). Pursuant to
the Severance Plan, the Company's Chief Financial Officer and certain other key
executives are entitled to receive certain contingent benefits, as set forth in
the Severance Plan, including lump sum payments and acceleration of stock option
vesting, each in certain circumstances.

(11) EMPLOYEE BENEFIT PLANS

DEFINED CONTRIBUTION PLAN

Effective July 2002, the Company established a voluntary savings and
defined contribution plan (the "Plan") under Section 401(k) of the Internal
Revenue Code. This Plan covers all U.S. employees meeting certain eligibility
requirements and allows participants to contribute a portion of their annual
compensation. Employees are 100% vested in their own contributions. For the
years ended December 31, 2006, 2005 and 2004, the Company did not make any
contributions to the Plan.

DEFINED BENEFIT PLAN

The Company has a defined benefit plan covering employees in Taiwan. On
December 31, 2006, the Company adopted the provisions of FASB statement No. 158,
EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT
PLANS, AN AMENDMENT OF FASB STATEMENTS NO. 87, 88, 106, AND 132(R) ("SFAS No.
158"), which required the Company to recognize the funded status of its defined
benefit plan in the accompanying consolidated balance sheet at December 31,
2006, with the corresponding adjustment to accumulated other comprehensive
income, net of tax. Therefore, as a result of adopting the provisions of SFAS
No. 158, the Company increased other non-current liabilities and accumulated
other comprehensive income by $87,482 as of December 31, 2006. The adjustment to
accumulated other comprehensive income upon adoption represents the net
unrecognized actuarial losses, which were previously netted against the funded

status in the Company's consolidated balance sheet in accordance with the
provision of SFAS No. 87. These amounts will be recognized subsequently as net
periodic pension cost. Actuarial gains and losses that arise in subsequent
periods and are not recognized as net periodic pension cost in the same periods
will be recognized as a component of other comprehensive income and will be
recognized subsequently as a component of net periodic pension cost on the same
basis as the amounts recognized in accumulated other comprehensive income upon
adoption of SFAS No. 158.

Included in accumulated other comprehensive loss at December 31, 2006 are
the following amounts, net of tax, that have not yet been recognized in net
periodic pension cost: unrecognized transition obligation of $63,120, and
unrecognized actuarial losses of $24,362. The transition obligation and
actuarial loss included in accumulated other comprehensive loss and expected to
be recognized in net periodic pension cost for the year ended December 31, 2007,
is $5,260 and $740, respectively.

Pension information for the year ended December 31, 2006 is as follows:

Accumulated benefit obligation $108,418
========

Changes in projected benefit obligation:
Projected benefit obligation at beginning of year 120,457
Interest cost 4,216
Actuarial (gain)/loss 31,320
Benefits paid --
Service cost 1,129
--------
Projected benefit obligation at end of year $157,122
========

Changes in plan assets:
Fair value of plan assets at beginning of year 5,780
Actual return on plan assets 28
Benefits paid --
Employer contributions 13,763
--------
Fair value of plan assets at end of year $ 19,571
========

Funded status $137,551
========

Components of net periodic pension cost:
Interest cost $ 4,253
Expected return on plan assets 204
Amortization of net loss 5,306
Service cost 1,139
--------
Net periodic pension cost $ 10,902
========

The company makes contributions to the plan so that minimum contribution
requirements, as determined by government regulations, are met. The Company does
not anticipate a contribution to this plan in 2007. Benefit payments of
approximately $58,000 are expected to be paid in 2012 through 2016.

(12) STOCK REPURCHASE PROGRAM

On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases may be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. During the year ended December 31, 2006,
the Company purchased 315,600 shares of its common stock in open market
purchases for a total cost of $2,147,233. As of December 31, 2006, the Company
had repurchased a total of 865,200 shares for $5,780,163.

(13) SEGMENT REPORTING AND CONCENTRATIONS

The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the years ended
December 31, 2006, 2005 and 2004, and the location of long-lived assets as of
December 31, 2006, 2005 and 2004, are summarized as follows:

2006 2005 2004
-----------------------------------------
Revenues:

United States $37,461,247 $28,300,822 $18,140,465

Asia 8,352,382 6,535,128 5,821,902

Other international 9,252,399 6,128,153 4,746,311
----------- ----------- -----------
Total Revenues $55,066,028 $40,964,103 $28,708,678
=========== =========== ===========

Long-lived assets (includes all non-current assets):

United States $10,113,633 $ 9,716,031 $ 9,929,214

Asia 1,498,534 1,320,865 950,387

Other international 279,695 207,098 322,544
----------- ----------- -----------
Total long-lived assets $11,891,862 $11,243,994 $11,202,145
=========== =========== ===========

For the year ended December 31, 2006, the Company had one customer that
accounted for a total of 27% of revenues. For the year ended December 31, 2005,
the Company had two customers that together accounted for a total of 31% of
revenues. For the year ended December 31, 2004, the Company had one customer
that accounted for 16% of revenues. As of December 31, 2006, the Company had two
customers with accounts receivable balances greater than 5% of gross accounts
receivable, which in the aggregate were 30% of the accounts receivable balance.
As of December 31, 2005, the Company had two customers with accounts receivable
balances greater than 5% of gross accounts receivable, which in the aggregate
were 28% of the accounts receivable balance.

(14) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR RETURNS AND DOUBTFUL
ACCOUNTS

Balance at Balance at
Beginning of Additions charged End of
Period ended Period To Expense Deductions Period
----------------- ---------- ---------- ---------- ----------
December 31, 2006 $3,846,882 $4,765,148 $2,595,732 $6,016,298
December 31, 2005 $2,551,616 $4,340,102 $3,044,836 $3,846,882
December 31, 2004 $1,837,934 $3,296,275 $2,582,593 $2,551,616

(15) QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of selected quarterly financial data for the
years ended December 31, 2006 and 2005:

Fiscal Quarter

First Second Third Fourth
------------------------ ------------ ------------ ------------ ------------
2006

Revenue $ 9,208,320 $ 12,668,227 $ 12,966,111 $ 20,223,370
============ ============ ============ ============
Net income (loss) $ (3,636,886) $ (1,304,795) $ (1,258,371) $ 2,825,524
============ ============ ============ ============
Basic net income
(loss) per share $ (0.08) $ (0.03) $ (0.03) $ 0.06
============ ============ ============ ============
Diluted net income
(loss) per share $ (0.08) $ (0.03) $ (0.03) $ 0.06
============ ============ ============ ============
Basic weighted average
common shares
outstanding 48,006,309 48,047,291 47,990,558 48,134,809
============ ============ ============ ============
Diluted weighted average
common shares
outstanding 48,006,309 48,047,291 47,990,558 50,370,514
============ ============ ============ ============
2005

Revenue $ 8,392,036 $ 9,495,587 $ 10,056,665 $ 13,019,815
============ ============ ============ ============
Net income (loss) (a) $ (133,829) $ 288,105 $ 482,879 $ 1,655,952
============ ============ ============ ============
Basic net income
(loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03
============ ============ ============ ============
Diluted net income
(loss) per share $ (0.00) $ 0.01 $ 0.01 $ 0.03
============ ============ ============ ============
Basic weighted average
common shares
outstanding 47,528,874 47,594,072 47,720,496 47,802,694
============ ============ ============ ============
Diluted weighted average
common shares
outstanding 47,528,874 50,623,983 50,531,012 50,958,553
============ ============ ============ ============

(a) Net income for the year ended December 31, 2005, includes an out-of-period
charge of approximately $0.2 million to recognize investment losses realized in
prior years. Such charge was not considered material to any period.

The sum of the quarterly net loss per share amounts do not always equal
the annual amount reported, as per share amounts are computed independently for
each quarter and the annual period based on the weighted average common shares
outstanding in each such period.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

DISCLOSURE CONTROLS AND PROCEDURES

The Company maintains "disclosure controls and procedures," as such
term is defined in Rules 13a-15e and 15d-15e of the Securities and
Exchange Act of 1934, as amended (the "Exchange Act"), that are
designed to ensure that information required to be disclosed in its
reports, pursuant to the Exchange Act, is recorded, processed,
summarized and reported within the time periods specified in the SEC's
rules and forms, and that such information is accumulated and
communicated to its management, including its Chief Executive Officer
and Chief Financial Officer, as appropriate, to allow timely decisions
regarding the required disclosures. In designing and evaluating the
disclosure controls and procedures, management has recognized that any
controls and procedures, no matter how well designed and operated, can
provide only reasonable assurances of achieving the desired control
objectives, and management necessarily is required to apply its
judgment in evaluating the cost benefit relationship of possible
controls and procedures.

The Company's Chief Executive Officer (its principal executive
officer) and Chief Financial Officer (its principal finance officer
and principal accounting officer) have evaluated the effectiveness of
its "disclosure controls and procedures" as of the end of the period
covered by this Annual Report on Form 10-K. Based on their evaluation,
the principal executive officer and principal financial officer
concluded that its disclosure controls and procedures are effective.

INTERNAL CONTROL OVER FINANCIAL REPORTING

MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Company's management is responsible for establishing and
maintaining adequate internal control over financial reporting for the
Company. To evaluate the effectiveness of the Company's internal
control over financial reporting, the Company's management uses the
Integrated Framework adopted by the Committee of Sponsoring
Organizations of the Treadway Commission ("COSO").

The Company's management has assessed the effectiveness of the
Company's internal control over financial reporting as of December 31,
2006, using the COSO framework. The Company's management has
determined that the Company's internal control over financial
reporting is effective as of that date.

KPMG LLP, the registered public accounting firm that has audited the
Company's consolidated financial statements included in this report,
has issued their attestation report on management's assessment of the
Company's internal control over financial reporting, which is included
herein.

ITEM 9B. OTHER INFORMATION

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information called for by Part III, Item 10, regarding the
Registrant's directors will be included in our Proxy Statement
relating to our annual meeting of stockholders scheduled to be held in
May 2007, and is incorporated herein by reference. The information
appears in the Proxy Statement under the captions "Election of
Directors", "Management", "Executive Compensation", "Section 16 (a)
Beneficial Ownership Reporting Compliance", and "Committees of the
Board of Directors." The Proxy Statement will be filed within 120 days
of December 31, 2006, our year-end.

ITEM 11. EXECUTIVE COMPENSATION

Information called for by Part III, Item 11, will be included in our
Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2007, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
captions "Executive Compensation", "Director Compensation",
"Compensation Committee Interlocks and Insider Participation",
Compensation Committee Report" and "Committees of the Board of
Directors." The Proxy Statement will be filed within 120 days of
December 31, 2006, our year-end.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Information regarding Securities Authorized for Issuance Under Equity
Compensation Plans is included in Item 5 and is incorporated herein by
reference. All other information called for by Part III, Item 12, will
be included in our Proxy Statement relating to our annual meeting of
stockholders scheduled to be held in May 2007, and is incorporated
herein by reference. The information appears in the Proxy Statement
under the caption "Beneficial Ownership of Shares." The Proxy
Statement will be filed within 120 days of December 31, 2006, our
year-end.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information regarding our relationships and related transactions will
be included in our Proxy Statement relating to our annual meeting of
stockholders scheduled to be held in May 2007, and is incorporated by
reference. The information appears in the Proxy Statement under the
caption "Certain Relationships and Related Transactions." The Proxy
Statement will be filed within 120 days of December 31, 2006, our
year-end.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information called for by Part III, Item 14, will be included in our
Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2007, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
caption "Principal Accountant Fees and Services." The Proxy Statement
will be filed within 120 days of December 31, 2006, our year-end.

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

The information required by subsections (a)(1) and (a)(2) of this item
are included in the response to Item 8 of Part II of this annual
report on Form 10-K.

(b) Exhibits

2.1 Agreement and Plan of Merger and Reorganization, dated as of
May 4, 2001, among FalconStor, Inc., Network Peripherals Inc.,
and Empire Acquisition Corp, incorporated herein by reference
to Annex A to the Registrant's joint proxy/prospectus on Form
S-4, filed May 11, 2001.

3.1 Restated Certificate of Incorporation, incorporated herein by
reference to Exhibit 3.1 to the Registrant's registration
statement on Form S-1 (File no. 33-79350), filed on April 28,
1994.

3.2 Bylaws, incorporated herein by reference to Exhibit 3.2 to the
Registrant's quarterly report on form 10-Q for the period
ended March 31, 2000, filed on May 10, 2000.

3.3 Certificate of Amendment to the Certificate of Incorporation,
incorporated herein by reference to Exhibit 3.3 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 1998, filed on March 22, 1999.

3.4 Certificate of Amendment to the Certificate of Incorporation,
incorporated herein by reference to Exhibit 3.4 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 2001, filed on March 27, 2002.

4.1 2000 Stock Option Plan, incorporated herein by reference to
Exhibit 4.1 of the Registrant's registration statement on Form
S-8, filed on September 21, 2001.

4.2 2000 Stock Option Plan, as amended May 15, 2003, incorporated
herein by reference to Exhibit 99 to the Registrant's
quarterly report on Form 10-Q for the period ended June 30,
2003, filed on August 14, 2003.

4.3 2000 Stock Option Plan, as amended May 14, 2004, incorporated
herein by reference to Exhibit 4.3 to the Registrant's Annual
Report on Form 10-K for the year ended December 31, 2004,
filed on March 16, 2005.

4.4 1994 Outside Directors Stock Plan, as amended May 17, 2002
incorporated herein by reference to Exhibit 4.2 to the
Registrant's annual report on Form 10-K for the year ended
December 31, 2002, filed on March 17, 2003.

4.5 2004 Outside Directors Stock Option Plan, incorporated herein
by reference to Exhibit 4.5 to the Registrant's Annual Report
on Form 10-K for the year ended December 31, 2004, filed on
March 16, 2005.

4.6 2006 Incentive Stock Plan incorporated herein by reference to
Exhibit 99.1 to the Company's quarterly report on Form 10-Q
for the quarter ended June 30, 2006, filed on August 8, 2006.

10.1 Agreement of lease between Huntington Quadrangle 2, LLC, and
FalconStor Software, Inc., dated August, 2003, incorporated
herein by reference to Exhibit 99.1 to the Registrant's
quarterly report on Form 10-Q for the period ended September
30, 2003, filed on November 14, 2003.

10.2 Second Amended and Restated Employment Agreement, dated
November 7, 2005 between Registrant and ReiJane Huai,
incorporated herein by reference to Exhibit 10.1 to the
Registrant's quarterly report on Form 10-Q for the period
ended September 30, 2005, filed on November 8, 2005.

10.3 Amended and Restated FalconStor Software, Inc., 2005 Key
Executive Severance Protection Plan, incorporated herein by
reference to Exhibit 10.3 to Registrant's annual report on
Form 10-K for the year ended December 31, 2005, filed on March
15, 2006.

21.1 Subsidiaries of Registrant - FalconStor, Inc., FalconStor AC,
Inc., FalconStor Software (Korea), Inc.

23.1 *Consent of KPMG LLP

31.1 *Certification of the Chief Executive Officer

31.2 *Certification of the Chief Financial Officer

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

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

*- filed herewith.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has signed this report by the undersigned,
thereunto duly authorized in Melville, State of New York on March 15, 2006.

FALCONSTOR SOFTWARE, INC.

By: /S/ REIJANE HUAI Date: March 14, 2007
---------------------------------------------
ReiJane Huai, President, Chief Executive
Officer of FalconStor Software, Inc.

POWER OF ATTORNEY

FalconStor Software, Inc. and each of the undersigned do hereby appoint
ReiJane Huai and James Weber, and each of them severally, its or his true and
lawful attorney to execute on behalf of FalconStor Software, Inc. and the
undersigned any and all amendments to this Annual Report on Form 10-K and to
file the same with all exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission; each of such attorneys
shall have the power to act hereunder with or without the other.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.

By: /S/ Reijane Huai March 14, 2007
--------------------------------------------- -------------------------
Reijane Huai, President, Chief Executive Date
Officer and Chairman of the Board
(Principal Executive Officer)

By: /S/ James Weber March 14, 2007
------------------------------------------- -------------------------
James Weber, Chief Financial Officer, Date
Vice President and Treasurer
(Principal Financial Officer and
Principal Accounting Officer)

By: /S/ Steven L. Bock March 14, 2007
------------------------------------------- -------------------------
Steven L. Bock, Director Date

By: /S/ Patrick B. Carney March 14, 2007
------------------------------------------- -------------------------
Patrick B. Carney, Director Date

By: /S/ Lawrence S. Dolin March 14, 2007
------------------------------------------- -------------------------
Lawrence S. Dolin, Director Date

By: /S/ Steven R. Fischer March 14, 2007
------------------------------------------- -------------------------
Steven R. Fischer, Director Date

By: /S/ Alan W. Kaufman March 14, 2007
------------------------------------------- -------------------------
Alan W. Kaufman, Director Date