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

Our revenues for the first quarter of 2009 met our expectations and declined only slightly from the first quarter of 2008, even with the difficult economic conditions. Net cash flows from operations remained positive and we continued to invest in our business by increasing both human capital and the equipment necessary for further growth.

Revenues for the first quarter of 2009 decreased 4% to $21.0 million compared with revenues of $21.8 million in the first quarter of 2008.

Revenues from our resellers increased compared with the first quarter of 2008 while revenues from our OEMs declined. For the quarter, 64% of our revenues came from resellers. We have always expected an increase in the percentage of revenue from our channel sales as our business grows and matures. It was intended that our agreements with OEMs would provide us with early market exposure and sales, followed by an increase in the licensing of FalconStor-branded software through our resellers. We anticipate that this trend will continue and that revenues from our resellers will continue to be the majority of our revenues. Revenues from the channel grew compared with the same period in 2008 in both our Asia-Pacific region and our Europe, Middle East and Africa region. Revenues from channel sales declined compared with the same period in 2008 in our Americas region. We believe this decline was a result of an increase in the amount of time taken by businesses in North America to decide whether to invest in additional technology and in which technology investments should be made. This lengthening of the sales cycle seems to be a result of both the difficult economic conditions, which has resulted in a tightening of money available for new technology spending, and more products being available for consideration. We are still seeing healthy pipelines of deals in all three regions.

EMC Corporation accounted for 13% of our revenues in the quarter. We anticipate that EMC will account for 10% or more of our revenues for the full year 2009, but not 20% or more of our revenue as it has in the past. Sun Microsystems accounted for 11% of our revenues in the quarter, despite significant cuts in Sun's sales force and the uncertainty caused by rumors and an official announcement concerning Sun's future. We continue to anticipate that Sun will account for 10% or more of our revenues for the full year 2009. However, Oracle's recent announcement that it will acquire Sun makes it more difficult to predict the revenues we will receive from Sun. Oracle has indicated that it intends to continue the Sun product lines. Nevertheless, we expect that uncertainty regarding the future of Sun's products, and further cuts to Sun's sales force, could have a short-term negative effect on the amount of revenues we receive from Sun. Our second fiscal quarter coincides with Sun's fourth quarter, and is typically a time when our revenues from Sun are high. There can be no assurance that we will see this historical seasonality repeated this year.

We had a loss for the quarter. Our net loss for the quarter was $0.9 million, compared with net income of $1.3 million in the first quarter of 2008. This net loss includes $2.2 million of share-based compensation expense related to SFAS No. 123(R). Our net loss includes a $0.5 million loss from "Interest and Other Income." This loss came primarily from foreign currency losses. Because our sales in foreign currency have increased, in the second quarter of fiscal 2009 we have begun to hedge our currency exposure to minimize any fluctuation in our earnings. Of course, no hedging program can entirely remove all risk related to changes in relative values of the U.S. Dollar and the foreign currency in which some of our revenues are recorded.

Even in the challenging economic environment, cash flows from operations in the first quarter of 2009 continued to be positive. We continue to believe that our ability to fund our own growth internally bodes well for our long-term success.

Deferred revenue at March 31, 2009 increased 10%, compared with the balance at March 31, 2008. We consider the continued growth of our deferred revenue as an important indicator of the success of our products. We believe that support and maintenance renewals, which comprise the majority of our deferred revenue, indicate satisfaction with our products and our support organization from our end users.

Operating expenses increased by $1.8 million, or 9%, compared with the first quarter of 2008. Operating expenses include $2.2 million in share-based compensation expense for the first quarter of 2009, and $2.3 million in share-based compensation expense for the first quarter of 2008. We will continue to monitor expenses carefully, but we do not manage the Company on a quarter to quarter basis and we will continue to invest in the long-term success of the Company.

Our gross margins decreased to 82% for the first quarter of 2009 from 85% for the first quarter of 2008. The major contributors to the decline in gross margins were compensation expense and the decrease in software license revenue.

At March 31, 2009, we had 521 employees, compared with 439 employees at March 31, 2008. While we will be prudent, we plan to continue adding research and development and sales and support personnel, both in the United States and worldwide, as necessary. We also plan to continue investing in infrastructure, including both equipment and property. We believe this continued investment is necessary to keep growing our business.

While other companies may be cutting headcount and foregoing investments in this economy, we continue to build for the long term, rather than merely responding to short-term conditions. We continue to operate the business with the goal of long-term growth. We believe that our ability to continue to refine our existing products and features and to introduce new products and features will be the primary driver of additional growth among existing resellers, OEMs and end users, and will drive our strategy to attempt to engage additional reseller and OEM partners and to expand the FalconStor product lines offered by these partners.

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED MARCH 31, 2009 COMPARED WITH THE THREE MONTHS ENDED MARCH 31, 2008.

Revenues for the three months ended March 31, 2009 decreased 4% to $21.0 million compared with $21.8 million for the three months ended March 31, 2008. Our operating expenses increased 9% from $20.1 million for the three months ended March 31, 2008 to $21.8 million for the three months ended March 31, 2009. Included in our operating expenses for the three months ended March 31, 2009 and 2008 was $2.2 million and $2.3 million, respectively, of share-based compensation expense in accordance with SFAS No. 123(R). Net loss for the three months ended March 31, 2009 was $0.9 million compared with net income of $1.3 million for the three months ended March 31, 2008. Included in our net (loss) income for the three months ended March 31, 2009 and 2008, was an income tax benefit of $0.4 million compared with an income tax provision of $1.0 million, respectively. Our 4% decline in revenue for the three months ended March 31, 2009, as compared with the same period in 2008, was primarily due to the current macroeconomic environment. Beginning in the second half of 2008, our revenue growth slowed, particularly software license revenues, as a result of the difficult economic conditions encountered due to disruptions in the global financial markets, specifically in North America, which we continued to experience during the first three months of 2009. The declines in software license revenues were offset by modest increases in our maintenance revenues. Due to our well-established installed customer base, our revenue from maintenance agreements were not significantly impacted as compared with our software license revenues as a result of the downturn in information technology spending experienced beginning in the second half of 2008 and continuing through the first three months of 2009. Revenue contribution from our OEM partners decreased in both absolute dollars and as a percentage of total revenues for the three months ended March 31, 2009 as compared with the same period in 2008. Revenue from resellers, distributors and direct end-users increased in both absolute dollars and as a percentage of total revenue for the three months ended March 31, 2009 as compared with the same period in 2008. Expenses increased in all aspects of our business as we continue to invest in our future by increasing headcount both domestically and internationally. To support our anticipated future growth, we increased our worldwide headcount to 521 employees as of March 31, 2009, as compared with 439 employees as of March 31, 2008. Although our continued investments in the future through additional headcounts may impact our operating profits and margins, we believe these investments are in line with our long-term outlook. Finally, we continue to invest in our infrastructure by increasing our capital expenditures, particularly with purchases of equipment for support of our existing and future product offerings.

Revenues

                                                Three months ended March 31,
                                                   2009                2008
      Revenues:
        Software license revenue              $    13,650,062      $ 15,318,919
        Maintenance revenue                         6,088,784         5,114,247
        Software services and other revenue         1,282,239         1,373,494

      Total Revenues                          $    21,021,085      $ 21,806,660

      Year-over-year Percentage Growth


                Software license revenue                -11%        47%
                Maintenance revenue                      19%        18%
                Software services and other revenue      -7%       -12%

              Total percentage growth                    -4%        33%

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 decreased 11% from $15.3 million for the three months ended March 31, 2008 to $13.7 million for the three months ended March 31, 2009. Software license revenue represented 65% of our total revenues for the three months ended March 31, 2009 and 70% of our total revenues for the same period in 2008. Over the past several years, as we have experienced a broader market acceptance of our software applications, the number of new product offerings and increased demand for our products were the major contributors for our increase in both our customer base as well as the number of software solutions our installed customer base purchased. However, beginning in the second half of 2008, our software license revenues slowed, as a result of the difficult macroeconomic environment and downturn in information technology spending which we continued to experience during the first three months of 2009. Overall, during the three months ended March 31, 2009, gross software license revenue from our OEM partners decreased 28%, while gross software license revenues from our direct end-users and resellers decreased 10% when compared to the same period in 2008. We expect our software license revenue to grow in future periods.

Maintenance revenue

Maintenance revenue is comprised of software maintenance and technical support services. Revenues derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Maintenance revenues increased 19% from $5.1 million for the three months ended March 31, 2008 to $6.1 million for the three months ended March 31, 2009.

The major factor behind the increase in maintenance 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 to new customers and grow our installed customer base, we expect the amount of maintenance and technical support contracts we have to grow as well. We expect our maintenance revenue to continue to increase primarily because (i) the majority of our new customers purchase maintenance and support contracts, and (ii) the majority of our growing existing customer base renewed their maintenance and support contracts after their initial contracts expired.

Software services and other revenue

Software services and other revenues are comprised of professional services primarily related to the implementation of our software, engineering services, and sales of computer hardware. 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 in which the services are completed. We have transactions in which we purchase hardware and bundled this hardware with our software and sell this bundled solution to our customer base. Our software is not essential to the functionality of the bundled hardware. The amount of revenue allocated to the software and hardware bundle is recognized as revenue in the period delivered provided all other revenue recognition criteria have been met. We further separate the software sales revenue from the hardware revenue for purposes of classification in the unaudited condensed consolidated statements of operations in a systematic and rational manner based on their deemed relative fair values Software services and other revenue decreased 7% from $1.4 million for the three months ended March 31, 2008 to $1.3 million for the three months ended March 31, 2009.

The decrease in software services and other revenue was primarily due to a decrease in computer hardware sales, which declined from $1.0 million for the three months ended March 31, 2008 to $0.4 million for the same period in 2009. Our professional services revenue increased to $0.8 million for the three months ended March 31, 2009 from $0.4 million in the same period in 2008. The professional services revenue will vary from year to year based upon (i) the number of software license contracts sold during the year, (ii) the number of our software license customers who elected to purchase professional services, and/or (iii) the number of professional services contracts that were completed during the year. We expect professional services revenues to vary from year to year based upon the number of customers who elect to utilize our professional services upon purchasing our software licenses. The hardware revenue will vary from period to period based upon the number of customers who wish to have us bundle hardware with our software for one complete solution.

Cost of Revenues

                                                  Three months ended March 31,
                                                     2009                2008
     Total Revenues:                            $    21,021,085      $ 21,806,660

       Cost of maintenance, software services
       and other revenue                        $     3,806,043      $  3,314,488
     Gross Profit                               $    17,215,042      $ 18,492,172

     Gross Margin                                            82 %              85 %

Cost of maintenance, software services and other revenue

Cost of maintenance, software services and other revenues consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, amortization of purchased and capitalized software and share-based compensation expense associated with SFAS No. 123(R). Cost of maintenance, software services and other revenues also includes the cost of hardware purchased that was resold. Cost of maintenance, software services and other revenues for the three months ended March 31, 2009 increased by 15% to $3.8 million compared with $3.3 million for the same period in 2008. The increase in cost of maintenance, software services and other revenue was primarily due to (i) the increase in personnel and related costs, and (ii) the increase in amortization related to purchased and capitalized software, specifically related to the acquisition of World Venture Limited on July 1, 2008 (see Note (8) Acquisitions to our unaudited condensed consolidated financial statements for additional information) for the three months ended March 31, 2009 as compared with the same period in 2008. As a result of our increased sales from maintenance and support contracts, we continued to hire additional employees to provide technical support services. Our cost of maintenance, software services and other revenue will continue to grow in absolute dollars as our revenues from these services also increase.

Gross profit decreased $1.3 million from $18.5 million for the three months ended March 31, 2008 to $17.2 million for the three months ended March 31, 2009. Gross margins decreased from 85% for the three months ended March 31, 2008 to 82% for the three months ended March 31, 2009. The decreases in both our gross profit and gross margins for the three months ended March 31, 2009, as compared with the same period in 2008, were primarily due to the 4% decrease in our revenues and our continued investments in the future through increasing our headcounts which adversely impacted our operating profits and margins. Generally, our gross margins may fluctuate based on several factors, including
(i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and service mix of sales. Share-based compensation expense included in the cost of maintenance, software services and other revenue increased in absolute dollars to $0.4 million from $0.3 million for the three months ended March 31, 2009 and March 31, 2008, respectively. Share-based compensation expense was equal to 2% and 1% of revenue for the three months ended March 31, 2009 and March 31, 2008, respectively.

Software Development Costs

Software development costs consist primarily of personnel costs for product development personnel, share-based compensation expense associated with SFAS No.
123(R), and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Software development costs increased 7% to $6.3 million for the three months ended March 31, 2009 from $5.9 million in the same period in 2008. The major contributing factors to the increase in software development costs were higher salary and personnel related costs as a result of increased headcount to enhance and to test our core network storage software product and the development of new innovative products, features and options. Share-based compensation expense included in software development costs decreased in absolute dollars to $0.7 million from $0.8 million for the three months ended March 31, 2009 and March 31, 2008, respectively. Share-based compensation expense included in software development costs was equal to 3% and 4% of revenue for the three months ended March 31, 2009 and March 31, 2008, respectively. 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 and related costs, share-based compensation expense associated with 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 6% to $9.5 million for the three months ended March 31, 2009 from $9.0 million for the same period in 2008. The increase in selling and marketing expenses was primarily due to (i) higher salary and personnel related costs as a result of increased sales and marketing headcount and (ii) higher advertising and marketing related expenses as a result of our new product offerings/enhancements, ongoing product branding and related advertising and marketing of such initiatives. Share-based compensation expense included in selling and marketing decreased in absolute dollars to $0.9 million from $1.0 million for the three months ended March 31, 2009 and March 31, 2008, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 4% and 5% of revenue for the three months ended March 31, 2009 and March 31, 2008, respectively. In addition, we continued to hire new sales and sales support personnel and to expand our worldwide presence to accommodate our anticipated future revenue growth. We anticipate that as we continue to grow sales, our sales and marketing expenses will continue to increase in support of such sales growth.

General and Administrative

General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense associated with 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 17% to $2.2 million for the three months ended March 31, 2009 from $1.9 million for the same period in 2008. Increased compensation and personnel related costs as a result of increased headcount to support our general and administrative needs was partially offset by decreases in professional fees and various administrative expenses during the three months ended March 31, 2009 as compared with the same period in 2008. Share-based compensation expense included in general and administrative remained consistent in absolute dollars at $0.2 million for the three months ended March 31, 2009 and March 31, 2008. Share-based compensation expense included in general and administrative expenses was equal to 1% of revenue for the three months ended March 31, 2009 and March 31, 2008, respectively. Additionally, as we continue to increase our headcount as part of our investment in the Company's future infrastructure, our overall general corporate overhead costs have generally increased and are likely to continue to increase.

Interest and Other (Loss) Income

We invest our cash primarily in money market funds, commercial paper, government securities, and corporate bonds. As of March 31, 2009, our cash, cash equivalents, and marketable securities totaled $41.8 million, compared with $56.8 million as of March 31, 2008. Interest and other (loss) income decreased $1.0 million to ($0.5) million for the three month ended March 31, 2009, compared with $0.6 million for the same period in 2008. The decrease in interest and other (loss) income was due to a decrease in both our interest income as well as other (loss) income. The decrease in interest income for the three months ended March 31, 2009 compared with the same period in 2008 was primarily related to (i) a decrease in our cash, cash equivalents and marketable securities balances as a result of our repurchase of 6.2 million shares of our common stock at a total cost of $35.4 million since January 1, 2008, and (ii) lower interest rates on average cash balances invested during the three months ended March 31, 2009, as a result of the U.S. banking liquidity crisis and difficult macroeconomic environment, as compared with the same period in 2008. The decreases in other (loss) income was primarily related to other non-operating expenses, particularly, (i) realized losses of $40,000 on auction rate securities (see Note (7) Fair Value Measurements to our unaudited condensed consolidated financial statements for additional information) and (ii) foreign currency losses of $0.6 million for the three months ended March 31, 2009 as compared with a foreign currency gain of $7,000 for the same period in 2008.

Income Taxes

Our provision for income taxes consists of U.S., state and local and foreign taxes in amounts necessary to align our year-to-date tax provision with the effective rate that we expect to achieve for the full year. For the three months ended March 31, 2009, we recorded an income tax benefit of $427,649 as compared with an income tax provision of $978,919 for the same period in 2008. The decline in the provision for income taxes was primarily attributable to our pre-tax loss of $1.3 million for the three months ended March 31, 2009 as compared with pre-tax income of $2.3 million for the same period in 2008. In addition, our effective tax rate decreased to 33% for the three months ended March 31, 2009 as compared with 42% in the same period in 2008.

As of January 1, 2008, we had approximately $5.1 million of federal net operating loss carryforwards available to offset future taxable income. These net operating loss carryforwards related to excess compensation deductions from previous year's exercises of stock options and during 2008, we utilized all of our net loss carryforwards, the benefits of which were credited to additional-paid-in-capital. As of March 31, 2009 and December 31, 2008, our deferred tax assets, net of a deferred tax liabilities and valuation allowance, were $10.6 million and $10.0 million, respectively.

Critical Accounting Policies and Estimates

Our critical accounting policies and estimates are those related to revenue recognition, accounts receivable allowances, deferred income taxes, accounting for share-based compensation expense, acquisitions, goodwill and other intangible assets, and fair value measurements.

Revenue Recognition. 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 . . .