FALCONSTOR SOFTWARE INC Management’s Discussion and Analysis of Financial Condition and Results of Operations (Form 10-Q)

26

————————————————– ——————————


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


FalconStor Software, Inc., a Delaware corporation ("we", the "Company" or
"FalconStor") is a trusted data protection software leader modernizing disaster
recovery and backup operations for the hybrid cloud world. The Company enables
enterprise customers and managed service providers to secure, migrate, and
protect their data while reducing data storage and long-term retention costs by
up to 95%. More than 1,000 organizations and managed service providers worldwide
standardize on FalconStor as the foundation for their cloud first data
protection future. Our products are offered through and supported by a worldwide
network of leading managed service providers ("MSPs"), systems integrators,
resellers, and original equipment manufacturers ("OEMs").

Our products address a demand for enterprise data protection driven by the
manner in which consumers and businesses are increasingly interacting in a
digital space through multiple devices, networks and platforms. The onset of the
coronavirus pandemic accelerated this shift, as ongoing remote work and work
from home arrangements introduced novel challenges to maintaining enterprise
data security. The adoption of increased employee mobility and flexible remote
work arrangements, such as a broader incorporation of cloud technology and the
option for employees to use their own devices, has introduced additional
vulnerabilities that businesses must monitor and protect through solutions like
ours in order to maintain enterprise data integrity.

Our products are utilized by enterprises and MSPs to address two key areas of
enterprise data protection: (i) long-term data retention and recovery, and (ii)
data replication to preserve business continuity. Our integration with modern
cloud-based data storage environments, such as IBM PowerVS Cloud, AWS and
Microsoft Azure, enables our enterprise customers to significantly reduce costs
and improve the portability, security and accessibility of their enterprise
data. We believe this accessibility is key in our modern world, where data must
be protected and intelligently leveraged to facilitate learning, improve product
design and drive competitive advantage. Our products can be used regardless of
the underlying hardware, cloud and source-data, which enables our enterprise
customers to leverage their existing hardware and software investments.

Since the beginning of 2020, we have focused our go-to-market efforts on
long-term data retention and recovery data protection segments, building on the
momentum we generated since 2019. In 2021, we increased our go-to-market
investment within our core regions of the Americas, EMEA, Japan, Korea, and
Southeast Asia, and released StorSafeTM, the next generation of our Virtual Tape
Library ("VTL") product family built for MSPs.

During the third quarter of 2022, we continued to deliver innovation and to
enhance each of our products. Our StorSafeTM solution is a vital backup
long-term archive retention tool in enterprise IT departments' data protection
arsenal and for MSPs that provide data protection as a service to enterprise
companies. It enables them to modernize their backup and archive environments,
leverage efficient hybrid- and public-cloud storage environments, such as those
provided by IBM PowerVS Cloud, AWS and Microsoft Azure, save operational costs,
and improve restore performance for rapid remote disaster recovery.

Through StorSafeTM, we are making progress expanding our technology to deliver
an enterprise-class, highly flexible and efficient backup and long-term data
storage optimization solution for the hybrid cloud world.


                                       27
--------------------------------------------------------------------------------

Beyond our long-term retention and reinstatement products, our StorGuardTM
business continuity driven data replication solution gives our customers the
ability to move workloads to the right destination, on-premises or in the cloud,
with advanced insight. This solution is designed for MSPs and enterprise
organizations with complex, heterogeneous IT environments and the full spectrum
of data management use cases, including but not limited to large enterprises,
universities, health care entities and governmental institutions. StorGuardTM is
a modern, comprehensive and easy-to-use software solution that enables IT
professionals to have complete insight into and control over their
organization's data.

To provide for greater ease of use for all our products, we also made
significant enhancements to our central data management console, now called
StorSightTM, to interface with each of our products to provide a holistic view
of an enterprise's entire data protection environment - whether on-premises in
data centers, in the public cloud, or a hybrid - as well as the key analytics,
reports and dashboards our customers need to continuously optimize their
operations.

FalconStor continues to focus on MSPs, enterprise customers, and OEM partners.
These markets offer the most significant opportunity and are best suited to
realize the value of FalconStor products, and provide an efficient and effective
access to broad, worldwide markets. Most of our revenue comes from sales to MSPs
and to enterprise customers through resellers.

Our "Business Partner" program for our MSPs and resellers provides financial
incentives for those partners that are willing to make a commitment to
FalconStor through training, marketing and revenue. As part of our review of all
of our operations to maximize savings without sacrificing sales, and in
connection with our Business Partner program, we continually review our
relationship with each of our partners in all regions. We decided to focus on
only those partners who have the expertise, personnel and networks to identify
potential customers and to service our end users.

Historically, the majority of our software licenses have been sold on a capacity
basis and have included a perpetual right to use the licensed capacity. However,
we have shifted our focus to an annual recurring revenue model through
subscription or term-based licenses, which gives a customer the right to utilize
our solutions over a designated period of time. We expect revenue from
subscription-based licensing to increase over the next several years.

Fluctuation in our revenue is driven by the volume and mix of sales from period
to period. Revenue allocated to perpetual and term software licenses are
recognized at a point in time upon electronic delivery of the download link and
the license keys, as these products have significant standalone functionality.
Product maintenance and support services are satisfied over time as they are
stand-ready obligations throughout the support period. As a result, revenues
associated with maintenance services are deferred and recognized as revenue
ratably over the term of the contract. Revenues associated with professional
services are recognized at a point in time upon customer acceptance.

During the third quarter of 2022, our shift to recurring revenue based revenue
took a material step forward as we continued to expand our strategic reseller
relationship with IBM. Through this strategic reseller relationship, IBM and
FalconStor co-market joint solutions consisting of FalconStor's VTL/StorSafe
software, IBM Cloud Object Storage ("COS"), and IBM Power Virtual Servers
("PowerVS") for efficient application and data migration from on-premises
environments to IBM PowerVS Cloud, and on-going SaaS-based backup and restore
within IBM PowerVS Cloud. While we expect this relationship to provide healthy
recurring revenue growth in the future as our joint solutions will be sold on a
monthly consumption basis (MRR), our accelerated focus in these types of hybrid
cloud relationships, and associated realignment of our sales teams, will
continue to contribute to total GAAP revenue fluctuations in the short-term. In
fact, GAAP total revenue in the third quarter of 2022 declined 6.8%
year-over-year. Given the reduction in GAAP Q3 2022 revenues, we delivered a net
income of $221,372, compared to a net income of $348,640 in the third quarter of
2021, even though we managed operating costs to $2,296,464 in the quarter
compared to $2,391,966 in Q3 2021. Despite our year-over-year GAAP total revenue
decline, we believe GAAP total revenue will continue to increase each quarter
during 2022. In fact, GAAP total revenue increased to $3,059,141 in the third
quarter of 2022 compared to $2,394,335 and $2,049,107 in the second and first
quarters of 2022, respectively, and we expect sequential quarter-over-quarter
GAAP total revenue to continue increasing throughout the balance of 2022.


                                       28
--------------------------------------------------------------------------------

COVID-19[feminine]


We are closely monitoring the impact of the 2019 novel coronavirus, or COVID-19,
on all aspects of our business. In March 2020, the World Health Organization
characterized COVID-19 as a pandemic and the President of the United States
declared the COVID-19 outbreak a national emergency. Since then, the COVID-19
pandemic has rapidly spread across the globe and has already resulted in
significant volatility, uncertainty and economic disruption. The outbreak of
COVID-19 has caused and may continue to cause travel bans or disruptions, and in
some cases, prohibitions of non-essential activities, disruption and shutdown of
businesses and greater uncertainty in global financial markets. The impact of
COVID-19 is fluid and uncertain, but it has caused and may continue to cause
various negative effects, including an inability to meet with actual or
potential customers, our end customers deciding to delay or abandon their
planned purchases or failing to make payments, and delays or disruptions in our
or our partners' supply chains.

OPERATING RESULTS – FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2021.


The following table presents revenue and expense line items reported in our
condensed consolidated statements of operations and their corresponding
percentage of total revenue for the three months ended September 30, 2022 and
2021 and the period-over-period dollar and percentage changes for those line
items. Our results of operations are reported as one business segment,
represented by our single operating segment.

                                        Three Months Ended September 30,                     Change
(amounts in dollars)                     2022                      2021                 Period to Period
Revenue:
Product revenue                 $ 1,568,110         51 %  $ 1,547,013         47 %  $   21,097             1 %
Support and services revenue      1,491,031         49 %    1,736,456      
  53 %    (245,425 )         (14 )%
Total revenue                     3,059,141        100 %    3,283,469        100 %    (224,328 )          (7 )%
Cost of revenue:
Product                              19,711          1 %       41,351          1 %     (21,640 )         (52 )%
Support and service                 360,393         12 %      400,934         12 %     (40,541 )         (10 )%
Total cost of revenue               380,104         12 %      442,285         13 %     (62,181 )         (14 )%
Gross profit                      2,679,037         88 %    2,841,184         87 %    (162,147 )          (6 )%
Operating expenses:
Research and development costs      581,941         19 %      711,273         22 %    (129,332 )         (18 )%
Selling and marketing               887,967         29 %    1,610,635         49 %    (722,668 )         (45 )%
General and administrative          826,556         27 %      633,954         19 %     192,602            30 %
Gain on litigation settlement             -          - %     (632,600 )      (19 )%    632,600          (100 )%
Restructuring costs                       -          - %       68,704          2 %     (68,704 )        (100 )%
Total operating expenses          2,296,464         75 %    2,391,966         73 %     (95,502 )          (4 )%
Operating income (loss)             382,573         13 %      449,218         14 %     (66,645 )         (15 )%
Gain on debt extinguishment               -          - %            -          - %           -             - %

Interest and other charges (111,399 ) (4 )% (84,049 )

   (3 )%    (27,350 )         (33 )%
Income (loss) before income
taxes                               271,174          9 %      365,169         11 %     (93,995 )         (26 )%
Income tax expense (benefit)         49,802          2 %       16,529          1 %      33,273           201 %
Net income (loss)               $   221,372          7 %  $   348,640         11 %  $ (127,268 )         (37 )%
Less: Accrual of Series A
redeemable
  convertible preferred stock
dividends                           391,016         13 %      288,802          9 %     102,214            35 %
Less: Accretion to redemption
value of
  Series A redeemable
convertible preferred
  stock                              40,023          1 %       13,517          0 %      26,506           196 %
Net income (loss) attributable
to
  common stockholders           $  (209,667 )       (7 )% $    46,321          1 %  $ (255,988 )        (553 )%




                                       29
--------------------------------------------------------------------------------

Revenue


Our primary sales focus is on selling software solutions and platforms which
includes stand-alone software applications, software integrated with industry
standard hardware and sold as one complete integrated solution or sold on a
subscription or consumption basis. As a result, our revenue is classified as
either: (i) product revenue, or (ii) support and services revenue. During the
three months ended September 30, 2022, we recognized revenue of $3,059,141,
compared with $3,283,469 in the prior year period.

Product revenue


Product revenue is comprised of sales of both licenses for our software
solutions and sales of the platforms on which the software is installed. This
includes stand-alone software applications and, on occasion, software integrated
with industry standard hardware. We no longer primarily source or sell hardware,
rather we facilitate our customers in buying their own hardware. Our products
are sold through (i) value-added resellers, (ii) distributors, and/or (iii)
directly to end-users. These revenues are recognized when all the applicable
criteria under accounting principles generally accepted in the United States are
met.

For the three months ended September 30, 2022 and 2021, product revenue
represented 51% and 47% of our total revenue, respectively. Product revenue of
$1,568,110 for the three months ended September 30, 2022 increased slightly by
$21,097, or 1%, from $1,547,013 in the prior year period. Product revenue during
the three months ended September 30, 2022 was comparable to product revenue for
the same quarter in the prior year period.

We continue to invest in our product portfolio by refreshing and updating our
existing product lines and developing our next generation of innovative product
offerings to drive our sales volume in support of our long-term outlook.

Support and Services Revenue


Support and services revenue is comprised of revenue from (i) maintenance and
technical support services, (ii) professional services primarily related to the
implementation of our software, and (iii) engineering services. Revenue derived
from maintenance and technical support contracts are deferred and recognized
ratably over the contractual maintenance term. Revenues associated with
professional and engineering services are recognized at a point in time upon
customer acceptance.

Maintenance and technical support services revenue for the three months ended
September 30, 2022 decreased by $152,278 to $1,489,635, compared to $1,641,913
in the prior year period. Our maintenance and technical support service revenue
results primarily from (i) the purchase of maintenance and support contracts by
our customers, and (ii) the renewal of maintenance and support contracts by our
existing and new customers after their initial contracts expire. The decrease in
maintenance and technical support service revenue from the previous year
reflects a decline in new contracts and renewals.

We received $1,396 in professional services revenue for the three months ended
September 30, 2022 as compared to $94,543 in the prior year period. Professional
services revenue will vary depending on the number of solutions for which
customers elect to purchase engineering or professional services to assist with
their implementations or other projects. We expect professional services revenue
to continue to vary from period to period based upon the number of customers who
elect to utilize our professional services upon purchasing any of our solutions.

Cost of revenue, gross profit and gross margin


Total cost of revenue for the three months ended September 30, 2022 decreased
14% to $380,104, compared with $442,285 in the prior year period. Total gross
profit decreased $162,147, or 6%, to $2,679,037 for the three months ended
September 30, 2022, compared with $2,841,184 for the prior year period. Total
gross margin decreased to 88% for the three months ended September 30, 2022,
compared with 87% for the prior year period. The decrease in our total gross
profit, in absolute dollars, was due to decreased revenue.

                                       30
--------------------------------------------------------------------------------

Generally, our total gross profits and total gross margins fluctuate based on
several factors, including (i) revenue growth levels, (ii) changes in personnel
headcount and related costs, and (iii) our product offerings and mix of sales.

Product Revenue Cost, Gross Profit and Gross Margin


Cost of product revenue consists primarily of hardware and warranty expenses.
Cost of product revenue for the three months ended September 30, 2022 decreased
to $19,711, compared with $41,351 in the prior year period. This decrease in
cost of product revenue for the three months ended September 30, 2022 was
primarily due to a continued intentional shift away from hardware sales in the
current period, compared to the prior year period.

Cost of Support and Service Revenue, Gross Profit and Gross Margin


Cost of support and service revenue consists primarily of personnel and other
costs associated with providing software implementations, technical support
under maintenance contracts and training. Cost of support and service revenue
for the three months ended September 30, 2022 decreased 10% to $360,393,
compared with $400,934 in the prior year period. Support and service gross
margin decreased slightly to 76 % for the three months ended September 30, 2022,
compared with 77 % for the prior year period. The decrease in the cost of
support and service revenue was primarily related to decreased contractors and
consulting fees.

Operating Expenses

Our operating expenses for the three months ended September 30, 2022 decreased by $95,502 at $2,296,464 of $2,391,966for the period of the previous year.

Research and development costs


Research and development costs consist primarily of personnel costs for product
development, and other related costs associated with the development of new
products, enhancements to existing products, quality assurance and testing.
Research and development costs decreased by $129,332, or 18%, to $581,941 for
the three months ended September 30, 2022, from $711,273 in the prior year
period. The decrease in research and development costs was primarily related to
a decrease in personnel costs.

Sales and marketing

Sales and marketing expenses mainly include sales and marketing personnel and related expenses, travel, public relations expenses, marketing materials and promotions, commissions, trade show expenses and related costs to our overseas sales offices. Sales and marketing expenses decreased $722,668i.e. 45%, at $887,967 for the three months ended September 30, 2022 of $1,610,635 in the period of the previous year. The decrease in sales and marketing expenses is mainly related to the reduction in personnel costs, commissions, promotion costs, consulting costs, subcontractors and professional fees.

General and administrative


General and administrative expenses consist primarily of personnel costs of
general and administrative functions, public company related costs, directors'
and officers' insurance, legal and professional fees, and other general
corporate overhead costs. General and administrative expenses increased slightly
by $192,602 to $826,556 for the three months ended September 30, 2022, compared
to $0.6 million for the prior year period. The increase in general and
administrative expenses was due primarily to an increase in professional fees
and contractors which were partially offset by a reduction in personnel costs.


                                       31
--------------------------------------------------------------------------------

Gain on litigation settlement


During the three months ended September 30, 2021, we recorded a gain of $632,600
million for a legal settlement of a contractual dispute with a marketing/sales
firm.

Restructuring

In June 2017, the Board of Directors of the Company (the "Board") approved a
comprehensive plan to increase operating performance ("the 2017 Plan"). The 2017
Plan resulted in a realignment and reduction in workforce. The 2017 Plan was
substantially completed by the end of our fiscal year ended December 31, 2017
and when combined with previous workforce reductions in the second quarter of
Fiscal 2017 reduced our workforce to approximately 81 employees at December 31,
2017. As part of this consolidation effort, the Company vacated a portion of its
former Melville, NY office space during the three months ended June 30, 2018. As
the lease has terminated in April 2021, there are no further restructuring costs
associated with this lease.

There were no restructuring charges during the three months ended September 30, 2022a decrease of $68,704 of the previous year.

Interest and other (loss) income, net


Interest and other expense, net, increased $27,350 to a loss of $111,399 for the
three months ended September 30, 2022, compared with a loss of $84,049 in the
prior year period. The increase in interest and other expense primarily relates
to an increase in currency translation loss. The fluctuation in interest and
other expense from quarter to quarter also relates to interest expense, foreign
currency gains and losses, interest income, sublease income and the change in
fair value of our embedded derivatives. For more information on our derivative
instruments, see Note (10) Fair Value Measurements to our unaudited condensed
consolidated financial statements.

Income taxes


Our provision for income taxes consists of state and local, and foreign taxes.
For the three months ended September 30, 2022 and 2021, the Company recorded
income tax provision of $49,802 and provision of $16,529, respectively,
consisting primarily of state and local, and foreign taxes.

From September 30, 2022our conclusion regarding the realizability of our US deferred tax assets has not changed and we have recorded a full valuation allowance against them.

                                       32
--------------------------------------------------------------------------------

OPERATING RESULTS – FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2022 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2021.


The following table presents revenue and expense line items reported in our
condensed consolidated statements of operations and their corresponding
percentage of total revenue for the nine months ended September 30, 2022 and
2021 and the period-over-period dollar and percentage changes for those line
items. Our results of operations are reported as one business segment,
represented by our single operating segment.

                                                                                            Change
                                       Nine Months Ended September 30,                 Period to Period
(amounts in dollars)                   2022                       2021
Revenue:
Product revenue               $  3,125,936         42 %  $  5,288,747         51 %  $ (2,162,811 )      (41 )%
Support and services revenue     4,376,647         58 %     5,081,795         49 %      (705,148 )      (14 )%
Total revenue                    7,502,583        100 %    10,370,542        100 %    (2,867,959 )      (28 )%
Cost of revenue:
Product                             65,018          1 %       298,966          3 %      (233,948 )      (78 )%
Support and service              1,128,764         15 %     1,233,067         12 %      (104,303 )       (8 )%
Total cost of revenue            1,193,782         16 %     1,532,033         15 %      (338,251 )      (22 )%
Gross profit                     6,308,801         84 %     8,838,509         85 %    (2,529,708 )      (29 )%
Operating expenses:
Research and development
costs                            1,943,446         26 %     2,032,360         20 %       (88,914 )       (4 )%
Selling and marketing            3,202,311         43 %     4,267,010         41 %    (1,064,699 )      (25 )%
General and administrative       2,400,561         32 %     2,129,921         21 %       270,640         13 %
Gain on litigation settlement            -          - %      (632,600 )       (6 )%      632,600       (100 )%
Restructuring costs                    744          0 %       792,754          8 %      (792,010 )     (100 )%
Total operating expenses         7,547,062        101 %     8,589,445         83 %    (1,042,383 )      (12 )%
Operating income (loss)         (1,238,261 )      (17 )%      249,064          2 %    (1,487,325 )     (597 )%
Gain on debt extinguishment              -          - %       754,000          7 %      (754,000 )     (100 )%
Interest and other expense        (430,630 )       (6 )%     (544,625 )       (5 )%      113,995         21 %
Income (loss) before income
taxes                           (1,668,891 )      (22 )%      458,439          4 %    (2,127,330 )     (464 )%
Income tax expense (benefit)       150,369          2 %        63,804          1 %        86,565        136 %
Net income (loss)             $ (1,819,260 )      (24 )% $    394,635          4 %  $ (2,213,895 )     (561 )%
Less: Accrual of Series A
redeemable
  convertible preferred stock
dividends                        1,030,365         14 %       848,898          8 %       181,467         21 %
Less: Accretion to redemption
value of Series
  A redeemable convertible
preferred stock                     90,420          1 %       285,814          3 %      (195,394 )      (68 )%
Net income (loss)
attributable to common
  stockholders                $ (2,940,045 )      (39 )% $   (740,077 )       (7 )% $ (2,199,968 )     (297 )%



Revenue

Our primary sales focus is on selling software solutions and platforms which
includes stand-alone software applications, software integrated with industry
standard hardware and sold as one complete integrated solution or sold on a
subscription or consumption basis. As a result, our revenue is classified as
either: (i) product revenue, or (ii) support and services revenue. During the
nine months ended September 30, 2022, we recognized revenue of $7.5 million,
compared with $10.4 million in the prior year period.

Product revenue


Product revenue is comprised of sales of both licenses for our software
solutions and sales of the platforms on which the software is installed. This
includes stand-alone software applications and, on occasion, software integrated
with industry standard hardware. We no longer primarily source or sell hardware,
rather we facilitate our customers in buying their own hardware. Our products
are sold through (i) value-added resellers, (ii) distributors, and/or (iii)
directly to end-users. These revenues are recognized when all the applicable
criteria under accounting principles generally accepted in the United States are
met.


                                       33
--------------------------------------------------------------------------------

For the nine months ended September 30, 2022 and 2021, product revenue
represented 42% and 51% of our total revenue, respectively. Product revenue of
$3,125,936 for the nine months ended September 30, 2022 decreased $2,162,811, or
41%, from $5,288,747 in the prior year period. The decrease in product revenue
is due to order delays as well as entering into several large multi-year
contracts in the first nine months of 2021 that did not repeat in the first half
of 2022.

We continue to invest in our product portfolio by refreshing and updating our
existing product lines and developing our next generation of innovative product
offerings to drive our sales volume in support of our long-term outlook.

Support and Services Revenue


Support and services revenue is comprised of revenue from (i) maintenance and
technical support services, (ii) professional services primarily related to the
implementation of our software, and (iii) engineering services. Revenue derived
from maintenance and technical support contracts are deferred and recognized
ratably over the contractual maintenance term. Revenues associated with
professional and engineering services are recognized at a point in time upon
customer acceptance.

Maintenance and technical support services revenue for the nine months ended
September 30, 2022 decreased $456,857 to $4,369,416, compared to $4,826,273 in
the prior year period. Our maintenance and technical support service revenue
results primarily from (i) the purchase of maintenance and support contracts by
our customers, and (ii) the renewal of maintenance and support contracts by our
existing and new customers after their initial contracts expire. The decrease in
maintenance and technical support service revenue from the previous year
reflects a decline in new contracts and renewals.

Professional services revenue for the nine months ended September 30, 2022
decreased to $7,231, compared to $255,522 in the prior year period. Professional
services revenue will vary depending on the number of solutions for which
customers elect to purchase engineering or professional services to assist with
their implementations or other projects. We expect professional services revenue
to continue to vary from period to period based upon the number of customers who
elect to utilize our professional services upon purchasing any of our solutions.

Cost of revenue, gross profit and gross margin


Total cost of revenue for the nine months ended September 30, 2022 decreased 22%
to $1,193,782, compared with $1,532,033 in the prior year period. Total gross
profit decreased $2.5 million, or 28.6%, to $6.3 million for the nine months
ended September 30, 2022, compared with $8.8 million for the prior year period.
Total gross margin decreased slightly to 84% for the nine months ended September
30, 2022, compared with 85% for the prior year period. The decrease in our total
gross profit was due to decreased revenue. Generally, our total gross profits
and total gross margins fluctuate based on several factors, including (i)
revenue growth levels, (ii) changes in personnel headcount and related costs,
and (iii) our product offerings and mix of sales.

Product Revenue Cost, Gross Profit and Gross Margin


Cost of product revenue consists primarily of hardware and warranty expenses.
Cost of product revenue for the nine months ended September 30, 2022 decreased
to $65,018, compared with $298,966 in the prior year period. Product gross
margin for the nine months ended September 30, 2022 increased, year over year,
to 98 % from 94 % for the same period in 2021. This decrease in cost of product
revenue for the nine months ended September 30, 2022 was primarily due to a
continued intentional shift away from hardware sales in the current period,
compared to the prior year period.

Cost of Support and Service Revenue, Gross Profit and Gross Margin


Cost of support and service revenue consists primarily of personnel and other
costs associated with providing software implementations, technical support
under maintenance contracts and training. Cost of support and service revenue
for the nine months ended September 30, 2022 decreased 8% to $1,128,764,
compared with $1,233,067 in the prior year period. Support and service gross

                                       34
--------------------------------------------------------------------------------

margin decreased slightly to 74% for the nine months ended September 30, 2022,
compared with 76% for the prior year period. The decrease in the cost of support
and service revenue, in absolute dollars, was primarily related to decreased
personnel cost and employee bonuses.

Functionnary costs

Our operating expenses for the nine months ended September 30, 2022 decreased by
$1.0 million at $7.5 million of $8.6 millionfor the period of the previous year.

Research and development costs


Research and development costs consist primarily of personnel costs for product
development, and other related costs associated with the development of new
products, enhancements to existing products, quality assurance and testing.
Research and development costs decreased $88,914, or 4%, to $1,943,446 for the
nine months ended September 30, 2022, from $2,032,360 in the prior year period.
The decrease in research and development costs was primarily related to a
decrease in personnel costs and bonuses.

Sales and marketing

Sales and marketing expenses mainly include sales and marketing personnel and related expenses, travel, public relations expenses, marketing materials and promotions, commissions, trade show expenses and related costs to our overseas sales offices. Sales and marketing expenses decreased $1.1 millioni.e. 25%, at $3.2 million for the nine months ended
September 30, 2022 of $4.3 million in the period of the previous year. The decrease in sales and marketing expenses is mainly related to the reduction in commissions, personnel expenses, employee bonuses and promotional expenses.

General and administrative


General and administrative expenses consist primarily of personnel costs of
general and administrative functions, public company related costs, directors'
and officers' insurance, legal and professional fees, and other general
corporate overhead costs. General and administrative expenses increased by
$270,640 to $2,400,561 for the nine months ended September 30, 2022, compared to
$2,129,921 for the prior year period. The increase in general and administrative
expenses was due primarily to an increase in professional fees and contractors
which were partially offset by a reduction in personnel costs.

Gain on litigation settlement


During the nine months ended September 30, 2021, we recorded a gain of $632,600
million for a legal settlement of a contractual dispute with a marketing/sales
firm.

Restructuring

In June 2017, the Board of Directors of the Company (the "Board") approved a
comprehensive plan to increase operating performance ("the 2017 Plan"). The 2017
Plan resulted in a realignment and reduction in workforce. The 2017 Plan was
substantially completed by the end of our fiscal year ended December 31, 2017
and when combined with previous workforce reductions in the second quarter of
Fiscal 2017 reduced our workforce to approximately 81 employees at December 31,
2017. As part of this consolidation effort, the Company vacated a portion of its
former Melville, NY office space during the three months ended June 30, 2018. As
the lease has terminated in April 2021, there are no further restructuring costs
associated with this lease.

Restructuring expense decreased $792,010 for the nine months ended September 30,
2022 to $744, compared to a restructuring expense of $792,754 in the prior year
period.


                                       35
--------------------------------------------------------------------------------

Gain on extinguishment of debt


Gain on debt extinguishment decreased $754,000 for the nine months ended
September 30, 2022, from $754,000 for the nine months ended September 30, 2021.
The debt extinguishment during such nine months ended September 30, 2021
reflected the forgiveness of the Company's PPP Paycheck Protection Program loan,
which was issued by Peapack Gladstone Bank in an aggregate principal amount of
$754,000, and forgiven in full on March 30, 2021.

Interest and other (loss) income, net


Interest and other expense, net, decreased $113,995 to a loss of $430,630 for
the nine months ended September 30, 2022, compared with a loss of $544,625 in
the prior year period. The decreased interest and other expense primarily
relates to a decrease interest expense as a result of payments made on
outstanding debt, which has been partially offset by an increase in currency
translation loss. The fluctuation in interest and other expense from quarter to
quarter also relates to interest expense, foreign currency gains and losses,
interest income, sublease income and the change in fair value of our embedded
derivatives. For more information on our derivative instruments, see Note (10)
Fair Value Measurements to our unaudited condensed consolidated financial
statements.

Income taxes


Our provision for income taxes consists of state and local, and foreign taxes.
For the nine months ended September 30, 2022 and 2021, the Company recorded
income tax provision of $150,369 and $63,804, respectively, consisting primarily
of state and local, and foreign taxes.

From September 30, 2022our conclusion regarding the realizability of our US deferred tax assets has not changed and we have recorded a full valuation allowance against them.

CASH AND CAPITAL RESOURCES

Main sources of liquidity and obligations of the company


Our principal sources of liquidity are our cash and cash equivalents balances
generated from operating, investing and financing activities. Our cash and cash
equivalents balance as of September 30, 2022 and December 31, 2021 totaled $1.7
million and $3.2 million, respectively.

We are currently a party to the Amended and Restated Term Loan Credit Agreement,
dated as of February 23, 2018, as amended December 27, 2019, by and between the
Company and HCP-FVA, LLC ("HCP-FVA"), (the "Amended and Restated Loan
Agreement"). In connection with the then-proposed public offering of the Company
as described in the Company's Registration Statement on Form S-1, as amended,
originally filed on June 3, 2021, we entered into the Loan Extension Letter
Agreement, which provided for an extension of the maturity date on the portion
of the outstanding indebtedness owed to Hale Capital Partners, LP ("Hale
Capital") under the Amended and Restated Loan Agreement to June 30, 2023. The
remaining principal amount outstanding, which was owed to other lenders, was
repaid in full. On July 19, 2022, we entered into a letter agreement with Hale
Capital (the "Second Loan Extension Letter Agreement"), that provided for a
subsequent extension of the maturity date on the outstanding indebtedness owed
under the Amended and Restated Loan Agreement from June 30, 2023 to December 31,
2023. See Note (9) Notes Payable to our unaudited condensed consolidated
financial statements for more information. Also, as described further in Note
(12) Series A Redeemable Convertible Preferred Stock to our unaudited condensed
consolidated financial statements, the effective date of the mandatory
redemption right of the Company's Series A Redeemable Convertible Preferred
Stock (the "Series A Preferred Stock") held by HCP-FVA and Hale Capital was
extended from July 30, 2021 to July 30, 2023 pursuant to that certain Amendment
No. 1 to the Company's Amended and Restated Certificate of Designations,
Preferences and Rights of the Series A Preferred Stock, dated as of June 24,
2021 (as amended, the "Certificate of Designations"). On July 19, 2022, the
Company and Hale Capital entered into a letter agreement pursuant to which Hale
Capital agreed not to exercise or to permit the exercise of the mandatory
redemption right of the Series A Preferred Stock on or prior to December 31,
2023 unless the redemption is in accordance with Section 8(e)(z) of the
Certificate of Designations or in accordance with

                                       36
--------------------------------------------------------------------------------

a Breach Event (as defined in the Certificate of Designations). If such Series A
Preferred Stock was redeemed at September 30, 2022, the Company would have been
required to pay the holders of the Series A Preferred Stock $15.5 million.

The Amended and Restated Loan Agreement has customary representations,
warranties and affirmative and negative covenants. The negative covenants
include financial covenants relating to in-force annual contract value. The
Amended and Restated Loan Agreement also contains customary events of default,
including but not limited to payment defaults, cross defaults with certain other
indebtedness, breaches of covenants, bankruptcy events and a change of control.
In the case of an event of default, as administrative agent under the Amended
and Restated Loan Agreement, HCP-FVA, an affiliate of Hale Capital may (and upon
the written request of lenders holding in excess of 50% of the term loans, which
must include HCP-FVA, is required to) accelerate payment of all obligations
under the Amended and Restated Loan Agreement, and seek other available
remedies.

As discussed in Note (17) Restructuring Costs to our unaudited condensed
consolidated financial statements, the Melville, NY lease which ended on April
30, 2021 with a gross annualized rental cost of $1.5 million, will not be
replaced. FalconStor is primarily a virtual company and expects to redeploy this
savings to more productive uses.

Liquidity


As of September 30, 2022, we had a working capital deficiency of $0.2 million,
which is inclusive of current deferred revenue of $3.5 million, and a
stockholders' deficit of $15.7 million. During the nine months ended September
30, 2022, the Company had a net loss of $1.8 million and negative cash flow from
operations of $1.4 million. The Company's total cash balance at September 30,
2022 was $1.7 million, a decrease of $1.5 million compared to December 31, 2021.
On June 30, 2021, the Company repaid in full $1.3 million of the $3.5 million
principal amount that was outstanding as of June 2, 2021 under the Amended and
Restated Loan Agreement.

Although there can be no assurance, based on its projected cash flows from
operations, recently completed financing activities, cost cutting measures in
place and existing cash on hand, the Company is projecting to have sufficient
liquidity and to be cash flow positive through the next 12 months.

Cash flow analysis

The cash flow information is as follows:

                                                           Nine Months Ended September 30,
                                                              2022                  2021
Cash provided by (used in):
Operating activities                                    $      (1,417,959 )     $    (707,889 )
Investing activities                                              (38,078 )          (108,928 )
Financing activities                                                    -           2,371,707
Effect of exchange rate changes                                   (59,118 )              (762 )

Net increase (decrease) in cash and cash equivalents ($1,515,155)

$1,554,128




Net cash used in operating activities totaled $1.4 million for the nine months
ended September 30, 2022, compared with $0.7 million of net cash used in
operating activities in the prior year period. The change in net cash used in
operating activities for the nine months ended September 30, 2022 versus the
prior year was primarily due to our net loss, a larger decrease in deferred
revenue, partially offset with a gain on debt extinguishment and a larger
decrease in accounts receivable.

Net cash used in investing activities totaled $38,078 for the nine months ended
September 30, 2022, compared with $108,928 of net cash used in investing
activities in the prior year period. The change in net cash used in investing
activities versus the prior year was primarily due to a decrease in security
deposits refunds.


                                       37
--------------------------------------------------------------------------------

There was no cash used in or provided by financing activities for the nine
months ended September 30, 2022, compared with net cash provided by financing
activities of $2,371,707 in the prior year period. The net cash provided by
financing activities in the prior year period included net proceeds from a
public offering of our common stock, less offering costs, and payments on our
long-term debt.

Total cash and cash equivalents decreased $1.5 million at $1.7 million at
September 30, 2022 compared to December 31, 2021.

Contractual obligations


As of September 30, 2022, our significant commitments are related to (i) the
Amended and Restated Loan Agreement, (ii) our operating leases for our office
facilities, (iii) dividends (including accrued dividends) on our Series A
Preferred Stock, and (iv) the potential redemption of the Series A Preferred
Stock as discussed above.

The following is a table summarizing our principal obligations to make future payments under contractual obligations as of September 30, 2022:

                                                                                                Series A          Dividends on
                                                             Interest        Long-Term       Preferred Stock        Series A
                           Operating       Note Payable      Payments        Income Tax         Mandatory        Preferred Stock
                             Leases            (a)              (a)         Payable (b)      Redemption (c)            (d)
2022                      $     19,249     $          -     $    21,766     $          -     $             -     $             -
2023                            38,498        2,176,621          87,065                -                   -                   -
Other                                -                -               -          113,788           9,000,000           8,852,447
Total contractual
obligations               $     57,747     $  2,176,621     $   108,831     $    113,788     $     9,000,000     $     8,852,447



(a) See Note (9) Notes Payable to our unaudited condensed consolidated financial
statements for further information and for a detailed description of the Amended
and Restated Term Loan Credit Agreement.

(b) Represents our liability for uncertain tax positions. We are unable to make
a reasonably reliable estimate of the timing of payments due to uncertainties in
the timing of tax audit outcomes.

(c) Represents our potential liability if the holders of our Series A Preferred
Stock redeem their shares for cash. The earliest date in which a redemption
could occur as of September 30, 2022 was July 30, 2023. However, on July 19,
2022, the Company and Hale Capital entered into a letter agreement pursuant to
which Hale Capital agreed not to exercise or to permit the exercise of the
mandatory redemption right of the Series A Preferred Stock on or prior to
December 31, 2023 unless the redemption is in accordance with Section 8(e)(z) of
the Certificate of Designations or in accordance with a Breach Event (as defined
in the Certificate of Designations). For further information, see Note (12)
Series A Redeemable Convertible Preferred Stock to our unaudited condensed
consolidated financial statements.

(d) Our agreements with the holders of the Series A Preferred Stock provide that
such holders will receive quarterly dividends on the Series A Preferred Stock at
prime rate plus 5%, subject to a maximum dividend rate of 10%. We also have the
ability to accrue and roll over dividends. Due to the lack of sufficient surplus
to pay dividends as required by the Delaware General Corporation Law, the
Company was not permitted to pay the fourth quarter 2016 dividend in cash or
common stock and has been accruing its quarterly dividends since then. This
amount represents our potential liability to pay preferred stock dividends in
cash on July 30, 2023, which was the earliest date in which the holders of our
Series A Preferred Stock could redeem their shares for cash as of September 30,
2022. However, on July 19, 2022, the Company and Hale Capital entered into a
letter agreement pursuant to which Hale Capital agreed not to exercise or to
permit the exercise of the mandatory redemption right of the Series A Preferred
Stock on or prior to December 31, 2023 unless the redemption is in accordance
with Section 8(e)(z) of the Certificate of Designations or in accordance with a
Breach Event (as defined in the Certificate of Designations). For further
information, see Note (12) Series A Redeemable Convertible Preferred Stock to
our unaudited condensed consolidated financial statements.

                                       38
--------------------------------------------------------------------------------

Significant Accounting Policies and Estimates


We describe our significant accounting policies in Note (1) Summary of
Significant Accounting Policies of our 2021 Form 10-K. We discuss our critical
accounting estimates in Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" of our 2021 Form 10-K. There have
been no significant changes in our significant accounting policies or critical
accounting estimates since December 31, 2021.

Impact of recently issued accounting pronouncements

See note (1) Basis of presentation of our unaudited condensed consolidated financial statements.

Off-balance sheet arrangements

From September 30, 2022 and December 31, 2021we had no off-balance sheet arrangements.

© Edgar Online, source Previews

Comments are closed.