Forward-Looking Statements

This Annual Report 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, including statements that contain the words "believes," "anticipates," "expects," "plans," "intends" and similar words and phrases. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from the results projected in any forward-looking statement. In addition to the factors specifically noted in the forward-looking statements, other important factors, risks and uncertainties that could result in those differences include, but are not limited to, those discussed under Part I, Item 1A "Risk Factors" in this Annual Report. The forward-looking statements are made as of the date of this Annual Report, and we assume no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements. Investors should consult all of the information set forth in this report and the other information set forth from time to time in our reports filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, including our reports on Forms 10-Q and 8-K.

The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in Item 8 of this Annual Report.

Overview

Document Security Systems, Inc., markets and sells products designed to protect valuable information from unauthorized scanning, copying, and digital imaging. We have developed security technologies that are applied during the normal printing process and by all printing methods including traditional offset, gravure, flexo, digital or via the internet on paper, plastic, or packaging. We hold eight patents that protect our technology and have over a dozen patents in process or pending. Our technologies and products are used by federal, state and local governments, law enforcement agencies and are also applied to a broad variety of industries as well, including financial institutions, high technology and consumer goods, entertainment and gaming, healthcare/pharmaceutical, defense and genuine parts industries. Our customers use our technologies where there is a need for enhanced security for protecting and verification of critical financial instruments and vital records, or where there are concerns of counterfeiting, fraud, identity theft, brand protection and liability.

We have developed or acquired over 30 technologies that provide to our customers a wide spectrum of solutions. We sell our products under the AuthentiGuard® name generally in the following ways: (a) as generic products, including safety paper and plastic cards geared for the end user market for printed security products;
(b) as custom printed products; (c) as technology licenses; or (d) as customized digital implementations.

In 2006, we acquired San Francisco-based Plastic Printing Professionals, Inc. ("P3"), a privately held security printer specializing in plastic cards containing state of the art multiple or singular security technologies. P3's primary focus is manufacturing long-life composite, laminated and surface printed cards which can include magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, Biometric, RFID and a patent-pending watermark technology. P3's products are marketed through an extensive broker network that covers much of North America, Europe and South America. P3's product and client list includes the Grammy Awards, the Country Music Association awards, sporting event media cards, ID cards for major airports and Latin American and African driver's licenses. Our acquisition of P3 marked the initial execution of our strategy to expand our manufacturing capabilities through acquisitions in order to expand our custom security printing business. During 2007, we moved P3's operation to a 25,000 square foot facility and upgraded some of its equipment, most notably with a significant investment in a new state of the art laminator. These actions were taken in order to significantly increase the capacity and efficiency of the operation to meet expected future demand requirements. During 2007, we sold the assets of our retail printing and copying division, called Patrick Printing, to an unrelated third party to further improve our focus and efficiency.

On August 20, 2008, we entered into an agreement with Trebuchet Capital Partners, LLC in which Trebuchet agreed to pay substantially all of the litigation costs associated with pending litigation proceedings initiated by the European Central Bank in eight European countries relating to the Company's European Patent 0 455 750B1 that the Company has claimed the ECB infringed in printing of the Euros currency in exchange for a 50% share of any proceeds generated from the litigation. Under the terms of the agreement, and in consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest of the Company's rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have as a separate and exclusive interest including a separate and distinct right to exploit the Patent.

In December 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a million privately held commercial printer with approximately $7.6 million in sales in 2007 located in Rochester, NY. We formed a new subsidiary called DPI Secuprint to house this new company. As a result of this acquisition, we have significantly improved our ability to meet our current and expected future demand of our security paper products as well as improving our competitiveness in the market for custom security printing, especially in the areas of vital records, coupons, transcripts, and prescription paper. In addition, as a result of the acquisition, we believe we can offer our customers a wider range of commercial printing offerings.

During 2008, we placed approximately $600,000 of leased equipment into service at our plastic printing division to significantly increase the production capability and expand its services in the variable data card and RFID markets. These leases were accounted for as operating leases.

RESULTS OF OPERATIONS FOR THE FISCAL YEARS ENDED DECEMBER 31, 2008 AND 2007

The following discussion and analysis provides information that our management believes is relevant to an assessment and understanding of our results of operations and financial condition. All amounts have been adjusted to reflect the Company's results after effect of the discontinued operations. On September 25, 2007, the Company sold its copying and quick-printing business to a private investor. In accordance with FASB 144, the Company accounts for the revenue and expenses of this operation, which is a component of its security and commercial printing segment, as a discontinued operation. In December 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a $7.6 million privately held commercial printer located in Rochester, NY with approximately $7.6 million in sales in 2007. We formed a new subsidiary called DPI Secuprint to house this new company. DPI Secuprint's results for the period from December 19, 2008 to December 31, 2008 are included in 2008 amounts. The discussion should be read in conjunction with the financial statements and footnotes that appear elsewhere in this report.

Revenue

                                                                               Year Ended
                                                         Year Ended           December 31,      % change vs.
                                                      December 31, 2008           2007              2007
Revenue
Security and commercial printing                     $         4,387,000     $    3,913,000                12 %
Technology license royalties                                   1,614,000          1,195,000                35 %
Digital solutions                                                 33,000            201,000               -84 %
Legal products                                                   610,000            682,000               -11 %
Total Revenue                                                  6,644,000          5,991,000                11 %

Revenue - 2008 vs 2007: The increase in total revenue in 2008 compared to 2007 resulted primarily from increases in royalty revenue from the licensing of the Company's technology, and from increases in sales of security and commercial printing. These increases were offset by a decrease in digital solutions revenue as the Company did not have any one significant sale of its digital solutions product line as it had in 2007. Through the first nine months of 2008, revenue had increased 23% compared to the first nine months of 2007 primarily as a the result of the significant impact of royalty revenue recognized in the second quarter of 2008 along with a 24% growth in the company's sales of its security and commercial printing. However, during the fourth quarter of 2008, revenue decreased 21% as compared to 2007 as the Company experienced declines in all of its major revenue categories. The Company believes its fourth quarter results reflected the negative impact of the significant downturn in the overall world economic climate that occurred during the fourth quarter of 2008.

During the second quarter of 2008, the Company recognized approximately $542,000 of previously deferred royalty revenue as the result of a new agreement with the Ergonomic Group in April 2008. Under a previous agreement with the Ergonomic Group, the Company received $1,000,000 in non-refundable license and royalty fees, of which $500,000 was recognized as royalty revenue pro-ratably over a two year license period and the remaining $500,000 was considered a prepaid royalty, to be recognized as revenue when sales of products using the licensed technology were made. This agreement was cancelled and a new agreement with the Ergonomic Group that covers the Company's newest digital technologies was established. As a result, the non refundable license and royalty payment no longer met the criteria for deferral and was recognized in the second quarter of 2008.

Legalstore.com saw an approximately 11% decline in revenue during 2008, which we believe was due to slowing conditions in the general economy along with the effects of an issue with its adwords on one of the major search engine sites that caused it to lose some of its prominent placement for certain keywords during the latter half of 2008 The Company believes that it has addressed this issue with its new website which went live on January 2, 2009.

Gross profit

                                                                               Year Ended
                                                         Year Ended           December 31,      % change vs.
                                                      December 31, 2008           2007              2007

Costs of revenue
Security and commercial printing                     $         2,663,000     $    2,466,000                 8 %
Digital Solutions                                                 14,000             44,000               -68 %
Legal products                                                   352,000            354,000                -1 %
Total cost of revenue                                          3,029,000          2,864,000                 6 %

Gross profit
Security and commercial printing                               1,724,000          1,447,000                19 %
Technology license royalties                                   1,614,000          1,195,000                35 %
Digital solutions                                                 19,000            157,000               -88 %
Legal products                                                   258,000            328,000               -21 %
Total gross profit                                             3,615,000          3,127,000                16 %



                                                        Year Ended
                                   Year Ended          December 31,      % change vs.
                                December 31, 2008          2007              2007
    Gross profit percentage:
    Gross profit percentage:                    54 %              52 %               4 %

Gross Profit - 2008 vs 2007

Gross profit increased 16% to $3,615,000 during 2008 as compared to 2007. The percentage increase in gross profit surpassed the percentage increase in revenue during the same period primarily the result of increase in royalty revenue, which has the highest gross profit margin, along with the ability of the Company to increase its margins through operating efficiencies and material cost savings that the Company was able to generate at its plastics division's new facility. There are no direct costs associated with the Company's license royalty revenue, as any related costs, such as sales commissions, legal fees, and travel fees, are classified in their respective operating expense categories. Legalstore.com experienced a significant decline in margins as that division was impacted by a decline in sales against certain fixed costs of sales, along with a change in sales mix to items that sell at lower markups. The Legalstore division went live with a new e-commerce website that we believe will provide it with improved sales analytic capabilities that the Company expects help it improve its margins in 2009.

Operating Expenses

                                                                              Year Ended
                                                         Year Ended          December 31,      % change vs.
                                                      December 31, 2008          2007              2007

Selling, general and administrative
General and administrative compensation              $         2,196,000     $   2,023,000                 9 %
Professional Fees                                                896,000         1,404,000               -36 %
Sales and marketing                                            1,089,000         1,974,000               -45 %
Research and development                                         432,000           420,000                 3 %
Other                                                          1,337,000         1,129,000                18 %
                                                               5,950,000         6,950,000               -14 %
Other Operating Expenses
Depreciation and amortization                                    167,000            89,000                88 %
Stock based payments                                           1,747,000         1,355,000                29 %
Impairment of patent defense costs and other
intangible assets                                                797,000                 -
Amortization of intangibles                                    1,972,000         1,754,000                12 %
                                                               4,683,000         3,198,000                46 %

Total Operating Expenses                                      10,633,000        10,148,000                 5 %

Selling, General and Administrative - 2008 vs 2007

General and administrative compensation costs were 9% higher in 2008 as compared
to 2007 which primarily reflects an increase in the cash compensation of the
non-employee members of the Company's board of directors, a full year of the
Company's legal counsel, who was hired during 2007, increases in health
insurance costs, and the impact of the addition of general administrative
personnel from the Company's acquisition which occurred on December 18, 2008.

Professional Fees

                                                                               Year Ended
                                                         Year Ended           December 31,      % change vs.
                                                      December 31, 2008           2007              2007

Professional Fees Detail
Accounting and auditing                              $           259,000     $      326,000               -21 %
Consulting                                                       384,000            447,000               -14 %
Legal                                                             94,000            347,000               -73 %
Stock Transfer, SEC and Investor Relations                       159,000            284,000               -44 %
                                                     $           896,000     $    1,404,000               -36 %

The decrease in professional fees during 2008 reflect significant decreases in non-patent related legal fees, accounting fees, and the impact of the fact that the Company utilized in-house counsel, who's salary is classified as administrative compensation, for all of 2008, as compared to partially in 2007. In addition, stock transfer and investor relations fees reduced as the Company reduced its annual report and meeting fees during 2008. Accounting fee reductions reflect reduced SEC compliance costs. Legal costs do not include approximately $700,000 of legal and related costs incurred during 2008 ($2,033,000 -2007) associated with the application and defense of our patents, which the Company capitalizes and amortizes over the expected life of the patent.

Sales and marketing expenses, including sales and marketing personnel costs, decreased during 2008 as the Company reduced sales and marketing headcount by four, reduced public relations and marketing costs and significantly reduced the amount spent on travel and entertainment. The Company reduced these costs as it realigned its sales process in order to maximize the results of its sales and marketing efforts with the goal of focusing of near term revenue opportunities.

Other expenses are primarily rent and utilities, office supplies, IT support, bad debt expense and insurance costs. Increases in 2008 reflect costs increases associated with an increase in rent costs and one time costs associated with the move of the Company's plastic printing division to a larger facility, higher utility costs, an increase in insurance costs, and the addition of rent, insurance and office costs from the Company's acquisition which occurred on December 18, 2008.

Stock Based Payments

Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. Stock-based compensation increases in year ended December 31, 2008 reflect equity-based payments made to employees, directors, and third-party consultants, including approximately $194,000 of expense as the result of the acceleration of vesting of restricted shares and $18,000 due to the modification of options to the Company's former President as the result of his separation from the Company in May 2008. In addition, on August 13, 2008, the Company cancelled 330,500 employee stock options with exercise prices ranging from $6.24 to $12.50, and replaced the cancelled options with 330,500 employee stock options with an exercise price of $6.00. No other terms of the options were modified. On the date of grant, the fair market value of the Company's Common Stock was $5.15. The repricing was treated as a modification under FAS123R, and resulted additional aggregate fair value expense determined using the Black-Scholes option pricing model of approximately $225,000, of which approximately $170,000 was expensed as of the grant date for fully vested options. The remaining fair value of the modified options will be expense proratably during the expected vesting period of the options thru 2010.

In addition, on May 3, 2007, the Company granted a total of 445,000 restricted shares to certain members of senior management, of which 250,000 were retired unvested in 2008. These shares only vest upon the occurrence of certain events over the next 5 years, which include a change of control or other merger or acquisition of the Company, the achievement of certain financial goals, including among other things, a successful result of the Company's patent infringement suit against the European Central Bank. Of the remaining 195,000 restricted shares remaining under this grants, these shares, if vested, would result in the recording of stock based compensation expense of approximately $2,438,000 in the period in which any of the contingent vesting events is deemed to be probable. As of December 31, 2008 and 2007, vesting was not considered probable and no compensation expense has been recognized for these grants.

Amortization of intangibles

Amortization of intangibles expense increased 12% in 2008 as compared to 2007 due to the increase in the patent defense costs capitalized by the Company during the latter half of 2007 and the first half of 2008. We amortize the costs associated with patent rights that we acquired in 2005 and legal costs associated with the registration and defense of our patents, including the costs associated with our lawsuit against the ECB for patent infringement and the related ECB countersuits for patent validity. The Company considers patent related amortization expense as an operating expense. The company believes that the decision to incur patent costs is discretionary as the associated products or services can be sold prior to or during the application process. A significant portion of these assets were acquired by the issuance of equity-based instruments. On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC, which agreed to pay substantially all of the litigation costs associated with its ECB litigation. Under the terms of the Agreement, and in consideration for Trebuchet's funding agreement, the Company assigned and transferred a 49% interest of all the Company's right, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and exclusive interest including a separate and distinct right to exploit the Patent. In addition, the two parties agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. The Company considered this a triggering event and reviewed its remaining capitalized patent costs related to the Patent for impairment as of September 30, 2008. The Company also reviewed its capitalized patent costs for impairment at December 31, 2008 at which time, the Company determined that the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent was still in excess of the current carrying amount.

In addition, the Company has approximately $261,000 of net other intangible assets as of December 31, 2008 that consist of a royalty right and well as acquired intangibles including customer lists and a trade name. These assets will generate approximately $130,000 of annual amortization expense during the next 2 years. We account for this amortization as an operating expense, unless the underlying asset is directly associated with the production or delivery of a product. To date, the amount of related amortization expense for other intangible assets directly attributable to revenue recognized is not material. In addition, the Company has approximately $1,397,000 in goodwill derived from acquisitions. Goodwill is not amortized, but could become a component of expense if an impairment is determined.

Impairment of Patent Defense Costs and Other Intangible Assets

On March 19, 2008, the Company received notification that its appeal of the invalidation of its European Patent 455750B1 in the UK was not successful. As result of the adverse court decision, the Company recognized an impairment loss of $292,000 associated with costs directly related to the U.K appeal as of March 31, 2008. The impairment loss includes a judgment for reimbursement of estimated counterpart legal fees. In January, 2009, the Company received a formal request for fee reimbursement from the ECB for a total of $420,000 in additon to amounts already paid by the Company. The Company hired an independent firm to assist the Company in reducing or eliminating the ECB's fees request, however, the Company recorded $145,000 as additional accrued expenses and an impairment loss as of December 31, 2008. The Company expect that the UK fee issue will be resolved in second half of 2009. In addition, the Company recorded an impairment of $361,000 for a license agreement the Company had acquired in 2006 for RSS Barcodes for which the Company assessed that the probable future cash flows derived from the license did not support the net carrying value of the license as of December 31, 2008.

Other Income and expense

On May 31, 2008, the Company was awarded a judgment of approximately $126,000 pursuant to a counterclaim by the Company in the matter "Frank LaLoggia v. Document Security Systems, Inc", which the Company won in June 2006. The Company expects to collect the full amount of the judgment.

On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC Pursuant to the Agreement, Trebuchet has agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the European Central Bank in eight European countries relating to the Company's European Patent 0 455 750B1 that the Company has claimed the ECB infringed in printing of the Euros currency. Under the terms of the Agreement, and in consideration for Trebuchet's funding agreement, the Company assigned and transferred a 49% interest of all the Company's right, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and exclusive interest including a separate and distinct right to exploit the Patent. Pursuant to this transaction, the Company recognized a loss on the sale of patent assets for its assignment and transfer of 49% of its ownership rights in the patent, which had a net book value of approximately $1,670,000, for $500,000. As a result, the Company recognized a loss on sale of patent assets of $1,170,000.

During 2008, the Company had significant increase in interest expense as a result of the Company's borrowings it made during 2008 against its various credit facilities, along with interest associated with several capital leases the Company entered into in late 2007. As of December 31, 2008, the Company had $3.2 million of total debt at interest rates ranging from prime plus 2% to 15%.

Discontinued operations

On September 25, 2007, the Company sold certain assets and the operations of its retail copying and quick-printing operations to an unrelated third party for $80,000 and the assumption of ongoing operating leases. The sale included fixed assets with a net book value of approximately $37,000. The Company recognized a gain on the sale of approximately $43,000. In accordance with SFAS 144, the disposal of assets constitutes a component of the entity and has been accounted for as discontinued operations.

Net loss and loss per share

                                                                Years Ended December 31,
                                                                                       % change vs.
                                                         2008             2007             2007
. . .