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 third quarter of 2009 were below our expectations. While revenues grew 10% over the third quarter of 2008, we had expected higher growth. Our revenues for the third quarter of 2008 had been severely impacted by the economic slowdown and a general freeze in orders from larger end users following the bankruptcy of Lehman Brothers. While general economic conditions have made only a modest improvement since last year, we had anticipated higher revenue in the third quarter of 2009.

The shortfall is partially attributable to lower than expected revenue from Sun Microsystems, one of our OEMs. In May, 2009, Sun entered into an agreement to be acquired by Oracle Corporation. Both Oracle and Sun stated that they expected the transaction to close by the fall. Instead, the transaction remains open while Oracle and Sun await approval from the European Union. As reported by Oracle and by Sun, this delay has had a serious negative impact on Sun's business. This negative impact has affected those products sold by Sun for which we receive royalties.

We also had several software license transactions from which we had expected revenue that did not close in the third quarter. We expect that some of these deals will close in the fourth quarter of this year.

We are also disappointed in our net loss for the quarter. We attribute the loss to the fact that most of our expenses are fixed, in the form of salaries, benefits, office leases, and the like. If revenues for a quarter decline, we are not able to decrease these expenses in the same time frame. We also manage our business for the long term, rather than quarter by quarter.

Revenues for the third quarter of 2009 increased 10% to $21.5 million compared with revenues of $19.6 million in the third quarter of 2008. Revenues for the third quarter of 2009 decreased 12% compared with revenues of $24.5 million in the second quarter of 2009.

Total revenues from our OEM customers increased 3% to $8.5 million for the quarter from the third quarter of 2008. EMC Corporation accounted for 17% of our revenues in the quarter, the same as in the third quarter of 2008. While there are no minimums in our agreement with EMC, we continue to anticipate that EMC will account for 10% or more of our revenues for the full year 2009. Our agreement with EMC has been in effect since December of 2003, and, subject to earlier termination in EMC's discretion, runs until 2013.

Sun Microsystems accounted for 12% of our revenues in the quarter, compared with 11% for the third quarter of 2008. We continue to anticipate that Sun will account for 10% or more of our revenues for the full year 2009. However, the delay in the expected merger of Sun into Oracle 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 the continuing delays in closing the transaction, the 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.

Overall, we received 40% of our total revenues for the quarter from our OEM customers and 60% from our non-OEM customers, as compared with the third quarter of 2008 when 42% of our total revenues were derived from OEM customers and 58% from non-OEM.

Net loss decreased on a year-over-year basis. We had a net loss of $2.0 million for the three months ended September 30, 2009, compared with net loss of $1.6 million for the third quarter of 2008. This loss includes $2.2 million of stock-based compensation expense for the quarter. For the third quarter of 2008, stock-based compensation expense totaled $1.6 million.

Deferred revenue at September 30, 2009 decreased 1%, compared with the balance at September 30, 2008, and decreased 5% when compared to the balance at June 30, 2009. We continue to believe that decreases in our deferred revenue are attributable to general economic conditions, rather than to any issues with our products or our customer support. Our end users typically purchase one to three years worth of maintenance and support when they initially license our products or when they renew expiring maintenance and support agreements. During 2009, we have had fewer end users purchasing maintenance and support contracts for periods longer than twelve months. From discussions with our customers, we believe that end users are less willing to make multi-year commitments than they had been when the economic outlook was more robust.

Operating expenses increased by $3 million, or 15%, compared with the third quarter of 2008. Operating expenses include $2.2 million in stock-based compensation expense for the third quarter of 2009, and $1.6 million in stock-based compensation expense for the third 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 on a year over year basis to 80% from 82%, and also decreased from 84% for the second quarter of 2009. Our margins decreased primarily as the result of the increase in hardware costs associated with our increased sales of our bundled solutions

At September 30, 2009, we had 533 employees compared with 506 employees at September 30, 2008. 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 continue to monitor our management structure to determine whether changes or additional resources will help to continue or to accelerate the positive momentum.

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 OEM partners and to expand the FalconStor product lines offered by these OEMs.

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2009 COMPARED WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2008.

Revenues for the three months ended September 30, 2009 increased 10% to $21.5 million compared with $19.6 million for the three months ended September 30, 2008. Our operating expenses increased 15% from $21.0 million for the three months ended September 30, 2008 to $24.0 million for the three months ended September 30, 2009. Included in our operating expenses for the three months ended September 30, 2009 and 2008 was $2.2 million and $1.6 million, respectively, of share-based compensation expense. Net loss for the three months ended September 30, 2009 was $2.0 million compared with a net loss of $1.6 million for the three months ended September 30, 2008. Included in our net loss for the three months ended September 30, 2009 was an income tax benefit of $0.2 million compared with an income tax provision of $0.5 million for the three months ended September 30, 2008. The overall growth in revenues was due to increases in all components of our revenue sources. The primary growth in revenues was driven by increases in (i) software licenses for our network storage solution software from our installed customer base and (ii) maintenance revenue from new and existing customers. However, these increases were limited due to the continued difficult economic conditions, which commenced during the third quarter of 2008, as a result of the disruptions in the global financial markets. As a result of the current macroeconomic environment, we continue to experience slowed revenue growth, particularly in software license revenues, due to a downturn in information technology spending, and we expect this trend to continue throughout the remainder of 2009. Revenue contribution from our OEM partners increased in absolute dollars for the three months ended September 30, 2009 as compared with the same period in 2008. Revenue from non-OEM partners increased in both absolute dollars and as a percentage of total revenue for the three months ended September 30, 2009 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 growth, we increased our worldwide headcount to 533 employees as of September 30, 2009, as compared with 506 employees as of September 30, 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 with continued capital expenditures, particularly with purchases of equipment for support of our existing and future product offerings.

Revenues

                                              Three months ended September 30,
                                                  2009                  2008
    Revenues:
      Software license revenue              $      13,615,625       $  12,260,527
      Maintenance revenue                           6,469,942           6,190,467
      Software services and other revenue           1,454,602           1,160,499

    Total Revenues                          $      21,540,169       $  19,611,493

    Year-over-year percentage growth


                 Software license revenue                11 %         0 %
                 Maintenance revenue                      5 %        30 %
                 Software services and other revenue     25 %       -25 %

               Total percentage growth                   10 %         6 %

Software license revenue

Software license revenue is comprised of software licenses sold through our OEMs, and through (i) value-added resellers, and (ii) distributors, and/or (iii) directly to end-users (collectively "non-OEMs"). 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.

Software license revenue increased 11% from $12.3 million for the three months ended September 30, 2008 to $13.6 million for the three months ended September 30, 2009. Software license revenue represented 63% of our total revenues for both the three months ended September 30, 2009 and three months ended September 30, 2008. During the three months ended September 30, 2009, we experienced an increase in software license revenues which was primarily driven by an increase in the number of software solutions purchased, particularly in the U.S. when compared to the same period in 2008. During the third quarter of 2008, the economic crisis in the U.S. quickly accelerated and negatively impacted our software license revenues from the U.S.

Over the past several years, we have experienced a broader market acceptance of our software applications, and 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, our overall software license revenues continued to be negatively impacted by the downturn in information technology spending as a result of the current macroeconomic environment, which commenced during the second half of 2008, and continues into 2009. Overall, during the three months ended September 30, 2009, gross software license revenue from our OEM partners increased 9%, while gross software license revenues from our non-OEM partners increased 12% compared with the same period in 2008.

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 5% from $6.2 million for the three months ended September 30, 2008 to $6.5 million for the three months ended September 30, 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 increased 25% from $1.2 million for the three months ended September 30, 2008 to $1.5 million for the three months ended September 30, 2009.

The increase in software services and other revenue was primarily due to increases in both (i) computer hardware sales, which increased from $0.6 million for the three months ended September 30, 2008 to $0.8 million for the same period in 2009, and (ii) our professional services revenue, which increased from $0.6 million for the three months ended September 30, 2008 to $0.7 million for the same period in 2009. The professional services revenue varies from period to period 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 continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing our software licenses. We expect the hardware revenue will continue to 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 September 30,
                                                    2009                  2008
   Total Revenues:                            $      21,540,169       $  19,611,493

     Cost of maintenance, software services
     and other revenue                        $       4,273,444       $   3,459,307
   Gross Profit                               $      17,266,725       $  16,152,186

   Gross Margin                                              80 %                82 %

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. 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 September 30, 2009 increased $0.8 million, or 24% to $4.3 million compared with $3.5 million for the same period in 2008. The increase in cost of maintenance, software services and other revenue for the three months ended September 30, 2009 as compared with the same period in 2008 was primarily due to (i) the increase in personnel and related costs, and (ii) the increased hardware costs associated with the transactions in which we bundled purchased hardware with our software and sold the bundled solution. 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 increased $1.1 million, or 7% from $16.2 million for the three months ended September 30, 2008 to $17.3 million for the three months ended September 30, 2009. Gross margins decreased to 80% for the three months ended September 30, 2009 from 82% for the same period in 2008. The increase in our gross profit for the three months ended September 30, 2009, compared with the same period in 2008, was primarily due to the 10% increase in our revenues, which was primarily offset by our continued investments in the future through increasing our headcount as well as the increased hardware costs associated with our bundles solutions. 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 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 September 30, 2009 and September 30, 2008, respectively. Share-based compensation expense was equal to 2% of revenue for both the three months ended September 30, 2009 and September 30, 2008, respectively.

Software Development Costs

Software development costs consist primarily of personnel costs for product development personnel, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Software development costs increased 11% to $6.9 million for the three months ended September 30, 2009 from $6.2 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 increased in absolute dollars to $0.8 million from $0.6 million for the three months ended September 30, 2009 and September 30, 2008, respectively. Share-based compensation expense included in software development costs was equal to 4% and 3% of revenue for the three months ended September 30, 2009 and September 30, 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, 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 13% to $10.4 million for the three months ended September 30, 2009 from $9.2 million for the same period in 2008. The increase in selling and marketing expenses was primarily due to (i) higher commissions paid as a result of our 10% increase in revenue, (ii) higher salary and personnel related costs as a result of increased sales and marketing headcount, and (iii) higher advertising and marketing related expenses to our ongoing product branding and related advertising and marketing of such initiatives. Share-based compensation expense included in selling and marketing increased in absolute dollars to $0.7 million from $0.6 million for the three months ended September 30, 2009 and September 30, 2008, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 3% of revenue for both the three months ended September 30, 2009 and September 30, 2008, respectively. Additionally, we continue 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, public company related costs, directors and officers insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased 14% to $2.4 million for the three months ended September 30, 2009 from $2.1 million for the same period in 2008. The overall increase within general and administrative expenses related to increases in various administrative costs including (i) personnel related costs and (ii) various professional fees. Share-based compensation expense included in general and administrative increased in absolute dollars to $0.3 million from $0.1 million for the three months ended September 30, 2009 and September 30, 2008, respectively. Share-based compensation expense included in general and administrative expenses was equal to 1% of revenue for the three months ended September 30, 2009 and September 30, 2008, respectively. Additionally, as we continue to increase our headcount as part of our investment in the Company's future infrastructure, as a result of this investment, our overall general corporate overhead costs have generally increased and are likely to continue to increase.

Interest and Other Income

We invest our cash primarily in money market funds, commercial paper, government securities, and corporate bonds. As of September 30, 2009, our cash, cash equivalents, and marketable securities totaled $46.9 million, compared with $48.0 million as of September 30, 2008. Interest and other income decreased less than $0.1 million to $0.2 million for the three months ended September 30, 2009, compared with $0.3 million for the same period in 2008. The decrease in interest and other income was due to a decrease in our interest income. The decrease in interest income for the three months ended September 30, 2009 compared with the same period in 2008 was primarily related to the continued suppressed interest rates on average cash balances invested during the three months ended September 30, 2009, as a result of the U.S. banking liquidity crisis and difficult macroeconomic environment, which began to materially impact the financial markets during the second half of 2008. These decreases in interest income were offset by the increase in other income primarily related to foreign currency gains of $0.1 million for the three months ended September 30, 2009 as compared with a foreign currency loss of $50,000 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 September 30, 2009, we recorded an income tax benefit of $0.2 million as compared with an income tax provision of $0.5 million for the same period in 2008. The decline in the provision for income taxes was primarily attributable to the overall decrease in the forecasted full year pre-tax income and the tax impact from certain non-deductible share-based compensation expenses for income tax purposes expected to be incurred. Our estimated full year effective tax rate decreased to 12% as of September 30, 2009 as compared with 78% as of September 30, 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 years' exercises of stock options. In 2008, we utilized all of our net loss carryforwards, the benefits of which were credited to additional-paid-in-capital. As of September 30, 2009 and December 31, 2008, our deferred tax assets, net of a deferred tax liabilities and valuation allowance, were $11.6 million and $10.0 million, respectively.

RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2009 COMPARED WITH THE NINE MONTHS ENDED SEPTEMBER 30, 2008.

Revenues for the nine months ended September 30, 2009 increased 5% to $67.0 million compared with $63.6 million for the nine months ended September 30, 2008. Our operating expenses increased 12% from $62.5 million for the nine months ended September 30, 2008 to $70.1 million for the nine months ended September 30, 2009. Included in our operating expenses for the nine months ended September 30, 2009 and 2008 was $6.7 million and $6.6 million, respectively, of share-based compensation expense. Net loss for the nine months ended September 30, 2009 was $1.6 million compared with net income of $0.6 million for the nine months ended September 30, 2008. Included in our net loss for the nine months ended September 30, 2009 was an income tax benefit of $1.4 million compared with an income tax provision of $1.8 million for the nine months ended September 30, 2008. The $1.4 million income tax benefit was primarily attributable to (i) a . . .