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

While our revenue for the first quarter of 2012 was up only slightly from first quarter of 2011, we view any increase as a positive sign because product revenues from our legacy OEM customers (Oracle, EMC and IBM), declined nearly 99% on a year-over-year basis. We were able to replace these lost product revenues with revenues from sales of our FalconStor-branded products, products from our existing OEM customers, and maintenance fees and professional services.

The investigations by the United States Attorney's Office for the Eastern District of New York and by the Securities and Exchange Commission continue to cause distraction to our efforts to promote, market and sell our goods and services. We cannot predict how long these investigations, or the stockholder lawsuits that have been filed, will last, or what the outcomes will be. The investigations and the lawsuits are more fully described in Part II, Item 1 - Legal Proceedings of this 10-Q filing. In addition, these legal matters have, and could continue to, negatively impact the perception that customers or potential customers have of our Company. This has a negative impact on revenues. We have also incurred, and will continue to incur, significant expenses, and we have made accruals for costs of the investigation. At March 31, 2012, our cash, cash equivalents and marketable securities totaled approximately $37.6 million.

Overall, product revenues decreased 5% from the first quarter of 2011. Our revenues from our OEM partners declined 49% from the first quarter of 2011, with the revenues that we lost from our legacy OEMs being partially replaced by revenues from newer OEM customers. Revenues from our FalconStor-branded products, or non OEM partners, increased 1 % over the first quarter of 2011.

Non-OEMs contributed 93% of our product revenues in the first quarter of 2012 and OEMs contributed 7%. Hitachi Data Systems (HDS), which re-sells our branded solutions, contributed 12% of our total revenues for the first quarter of 2012.

Total revenues for the first quarter of 2012 grew 2% to $19.4 million from $19.0 million in the first quarter of 2011.

Support and services revenue grew 13% on a year-over-year basis. The maintenance fee portion of our support and services revenue, which is more consistent than our professional services revenue, grew 8% to $7.6 million in the first quarter of 2012, from $7.0 million in the first quarter of 2011.

Our net loss for the first quarter of 2012 was $2.4 million, compared with a net loss of $6.0 million for the same period a year ago. Included in the net loss for the first quarter of 2012 was a net reduction of the costs associated with the ongoing government investigations of $1.3 million. The $1.3 million was comprised of a $1.7 million reduction in the accrual for certain costs associated with the possible resolution of the investigations, less $0.4 million in legal fees associated with the investigations in the quarter. During the same period in 2011, we had $2.6 million of costs associated with the ongoing government investigations. The $2.6 million of costs incurred during the first quarter of 2011 was comprised of $1.1 million of legal fees and an accrual of $1.5 million for certain costs associated with the possible resolution of the government investigations.

Operating expenses for the first quarter of 2012 decreased $3.5 million as compared with the first quarter of 2011. However, operating expenses for these periods were affected by accruals and costs related to the government investigations. If these accruals and costs are removed, operating expenses increased $394,000, or 2%, compared with the first quarter of 2011. The increase in operating expenses was primarily attributable to additional sales headcount as we rebuilt our U.S. sales force, and an increase of $206,000 in stock-based compensation expense compared with the same period in 2011.

We had positive cash flows from operations in the first quarter of 2012 of $0.4 million, down from the first quarter of 2011 of $5.6 million. The primary difference in our cash flow from operations year-over-year is reflective of our cash management initiatives that we have implemented surrounding our collection and payment efforts. We believe the more significant metric is that we continue to remain cash flow positive quarter over quarter and year over year.

Deferred revenue at March 31, 2012 increased 3%, compared with the balance at December 31, 2011, and increased 9% compared with the balance at March 31, 2011.

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED MARCH 31, 2012 COMPARED WITH THE THREE MONTHS ENDED MARCH 31, 2011.

Our primary sales focus is on selling turn-key solutions, whereby our software is integrated with industry standard hardware and sold as one complete integrated solution. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. Product revenue consists of both integrated solutions and stand-alone software revenues. Support and services revenues consists of both maintenance revenues and professional services revenues.

Total revenues for the three months ended March 31, 2012 increased 2% to $19.4 million, compared with $19.0 million for the three months ended March 31, 2011. Our cost of revenues increased 7% to $5.2 million for the three months ended March 31, 2012, compared with $4.8 million for the three months ended March 31, 2011. Included in our cost of revenues for each of the three months ended March 31, 2012 and 2011 was $0.1 million of share-based compensation expense. Our operating expenses decreased 18% from $19.8 million for the three months ended March 31, 2011 to $16.3 million for the three months ended March 31, 2012. Included in the operating results for the three months ended March 31, 2012 was a net reduction of $1.3 million of costs associated with the ongoing government investigations that commenced during the second half of 2010. The net reduction of $1.3 million was comprised of a $1.7 million reduction in the accrual for certain costs associated with the possible resolution of the investigations, less $0.4 million in legal fees associated with the investigations. In addition, included in our operating expenses for the three months ended March 31, 2012 and 2011 was $1.4 million and $1.2 million, respectively, of share-based compensation expense. Net loss for the three months ended March 31, 2012 was $2.4 million, compared with a net loss of $6.0 million for the three months ended March 31, 2011. Included in our net loss for the three months ended March 31, 2012 was an income tax provision of $0.2 million, compared with an income tax provision of $0.6 million for the three months ended March 31, 2011. The income tax provision of $0.2 million was primarily attributable to the impact of our estimated 2012 full year effective tax rate on our pre-tax losses for the three months ended March 31, 2012. The income tax provision of $0.6 million was primarily attributable to the impact of our estimated 2011 full year effective tax rate on our pre-tax losses for the three months ended March 31, 2011.

Overall, the increase in total revenues was primarily due to an increase in support and service revenues for the three months ended March 31, 2012, compared with the same period in 2011. In total, our product revenues decreased 5%. Product revenues from our non-OEM partners increased 1%, while product revenues from our OEM partners decreased 49% for the three months ended March 31, 2012, compared with the same period in 2011. The overall increase in our non-OEM product revenues was primarily attributable to the continued focus and emphasis on our FalconStor-branded business. However, due to the ongoing government investigations and uncertainties surrounding the potential outcome of these investigations, the Company continues to experience challenges and disruptions throughout its business. These disruptions have contributed to the difficulties we continue to experience primarily surrounding our overall product revenue growth within the non-OEM business. In addition, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009, and more recently, end-of-life programs implemented by some of our historical OEM partners, which we have previously reported. We do not anticipate that any of our historical OEM partners will contribute over 10% of our annual revenues for the foreseeable future. However, because of our well-established installed customer base, our support revenues derived from maintenance agreements continued to grow and were e not as significantly impacted by the disruptions in our OEM business.

Overall, our total operating expenses decreased $3.5 million, or 18% to $16.3 million for the three months ended March 31, 2011, as compared with $19.8 million for the same period in 2011. This decrease was primarily due to a net reduction of $1.3 million of costs associated with the ongoing government investigations, as detailed above. We have been successful in reducing costs within certain sectors of our business, while continuing to invest in other sectors of our business with the continued focus on improving and increasing overall operational efficiencies. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook. Our worldwide headcount was 454 employees as of March 31, 2012, compared with 508 employees as of March 31, 2011.

Revenues

                                     Three months ended March 31,
                                        2012                2011
Revenues:
  Product revenue                  $    10,662,953      $ 11,259,015
  Support and services revenue           8,705,119         7,700,247

Total Revenues                     $    19,368,072      $ 18,959,262

Year-over-year percentage growth
  Product revenue                               -5 %              15 %
  Support and services revenue                  13 %               5 %

Total percentage growth                          2 %              11 %

Product revenue

Product revenue is comprised of sales of licenses for our software integrated on industry standard hardware creating a turn-key solution or integrated solution, and our stand-alone software applications. The products are sold through our OEMs, and through (i) value-added resellers, (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 stand-alone software applications sold, integrated solutions sold and/or permanent key codes are delivered to the customer.

Product revenue decreased 5% from $11.3 million for the three months ended March 31, 2011 to $10.7 million for the three months ended March 31, 2012. These amounts are net of a benefit of $0.6 million recognized during the three months ended March 31, 2012, compared with a benefit of $0.9 million in the same period in 2011, resulting from the impact of our collections of previously reserved accounts receivable. Product revenue represented 55% and 59% of our total revenues for the three months ended March 31, 2012 and 2011, respectively. Product revenues from our non-OEM partners increased 1%, while product revenues from our OEM partners decreased 49% for the three months ended March 31, 2012, compared with the same period in 2011. The overall increase in our non-OEM product revenues was primarily attributable to the continued focus and emphasis on our FalconStor-branded business. However, due to the ongoing government investigations and uncertainties surrounding the potential outcome of these investigations, the Company continues to experience challenges and disruptions throughout its business. These disruptions have contributed to the difficulties we continue to experience primarily surrounding our overall product revenue growth within the non-OEM business. In addition, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009, and more recently, end-of-life programs implemented by some of our historical OEM partners, which we have previously reported. We do not anticipate that any of our historical OEM partners will contribute over 10% of our annual revenues for the foreseeable future. Product revenue from our non-OEM partners represented 93% and 87% of our total product revenue for the three months ended March 31, 2012 and 2011, respectively. Product revenue from our OEM partners represented 7% and 13% of our total product revenue for the three months ended March 31, 2012 and 2011, respectively.

We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook. We anticipate that our investments in the FalconStor-branded business will result in our non-OEM generated product revenue growing at a greater rate in future years when compared to our OEM generated product revenue.

Support and services revenue

Support and services revenue is comprised of (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenues derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Support and services revenue increased 13% from $7.7 million for the three months ended March 31, 2011 to $8.7 million for the three months ended March 31, 2012. The increase in support and services revenue was attributable to increases in both
(i) maintenance and technical support services and (ii) professional services.

Maintenance and technical support services increased from $7.0 million for the three months ended March 31, 2011 to $7.6 million for the same period in 2012. As we are in business longer, and as we license more integrated solutions and stand-alone software applications 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. The anticipated growth in our maintenance and technical support service revenue is expected to result 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.

Professional services revenues increased from $0.7 million for the three months ended March 31, 2011 to $1.1 million for the same period in 2012. The professional services revenue varies from period to period based upon (i) the number of integrated solutions sold during the existing and previous periods,
(ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that were completed during the period. 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 any of our integrated solutions.

Cost of Revenues

                           Three months ended March 31,
                              2012                2011
Cost of revenues:
  Product                $     2,020,486      $  1,723,006
  Support and service          3,161,356         3,119,219
Total cost of revenues   $     5,181,842      $  4,842,225

Total Gross Profit       $    14,186,230      $ 14,117,037

Gross Margin:
  Product                             81 %              85 %
  Support and service                 64 %              59 %
Total gross margin                    73 %              74 %

Cost of revenues, gross profit and gross margin

Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of purchased and capitalized software, shipping and logistics costs, and share-based compensation expense. Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense. Cost of product revenue for the three months ended March 31, 2012 increased $0.3 million, or 17%, to $2.0 million compared with $1.7 million for the same period in 2011. The increase in cost of product revenue was primarily attributable to increased hardware costs. Hardware costs will vary from period to period based upon the mix of deals whereby our software is integrated on industry standard hardware creating a turn-key solution or integrated solution. Our cost of support and service revenues for the three months ended March 31, 2012 increased less than $0.1 million, or 1% to $3.2 million compared with $3.1 million for the same period in 2011. The increase in cost of support and service revenue is primarily related to personnel costs, primarily the mix of our headcount within support and services as compared with the same period in 2011.

Total gross profit increased $0.1 million, or 1%, to $14.2 million for the three months ended March 31, 2012 from $14.1 million for the same period in 2011. Total gross margin decreased to 73% for the three months ended March 31, 2012 from 74% for the same period in 2011. Generally, our total gross profits and total 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 mix of sales.

Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for both the three months ended March 31, 2012 and March 31, 2011. Share-based compensation expense included in the cost of support and service revenue remained consistent at $0.1 million for each of three months ended March 31, 2012 and March 31, 2011. Share-based compensation expense related to cost of support and service revenue was equal to less than 1% and 1% of total revenue for the three months ended March 31, 2012 and 2011, respectively.

Operating Expenses

Research and Development Costs

Research and development costs consist primarily of personnel costs for product development, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $1.4 million, or 23%, to $4.7 million for the three months ended March 31, 2012 from $6.1 million in the same period in 2011. The decrease in research and development costs was primarily the result of (i) a decline in salary and personnel costs, including share-based compensation expenses, as a result of lower research and development headcount, and (ii) an increase of approximately $0.3 million related to the capitalization of costs associated with software development. We believe we continue to provide adequate levels of resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options. Share-based compensation expense included in research and development costs decreased to $0.3 million from $0.5 million for the three months ended March 31, 2012 and March 31, 2011, respectively. Share-based compensation expense included in research and development costs was equal to 2% and 3% of total revenue for the three months ended March 31, 2012 and 2011, respectively.

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 $1.3 million, or 15%, to $9.8 million for the three months ended March 31, 2012 from $8.5 million for the same period in 2011. The increase in selling and marketing expenses was primarily attributable to the full impact of personnel costs, primarily salaries and commissions, related to the hiring of additional sales and support personnel specifically within the sales organizations during the first half of 2011. Share-based compensation expense included in selling and marketing increased to $0.5 million from $0.4 million for the three months ended March 31, 2012 and 2011, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 3% and 2% of total revenue for the three months ended March 31, 2012 and 2011, respectively.

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 $0.5 million, or 20%, to $3.1 million for the three months ended March 31, 2012 from $2.6 million for the same period in 2011. The overall increase within general and administrative expenses related to increases in (i) personnel related costs, and (ii) various administrative costs. Share-based compensation expense included in general and administrative expenses increased to $0.6 million from $0.3 million for the three months ended March 31, 2012 and 2011, respectively. Share-based compensation expense included in general and administrative expenses was equal to 3% and 1% of total revenue for the three months ended March 31, 2012 and 2011, respectively.

Investigation costs

As we have previously disclosed, we have been cooperating fully with investigations conducted by both the U.S. Attorney's Office for the Eastern District of New York and the Securities and Exchange Commission regarding our disclosure in September 2010 that certain improper payments were made in connection with our licensing of software to one of our customers. We continue to cooperate fully with these ongoing investigations.

During the three months ended March 31, 2012, we reduced our accrual relating to certain costs associated with the possible resolution of the government investigations to $5.8 million, or $1.7 million, from $7.5 million as of December 31, 2011, based upon the most probable resolutions as of the date of this filing. As of March 31, 2012, our total investigation costs resulted in a net reduction of $1.3 million, which was comprised of (i) $0.4 million of legal fees, and (ii) the $1.7 million accrual reduction as previously described. Investigation costs for the three months ended March 31, 2011, totaled $2.6 million, which consisted of $1.1 million of legal and professional fees, and an accrual of $1.5 million for certain costs associated with the possible resolution of the government investigations. See Part II, Item 1 - Legal Proceedings of this quarterly report on Form 10-Q, for a more detailed description of the investigations.

We expect that our operating expenses will continue to be adversely impacted during 2012 due to professional and service provider fees and other costs, resulting from the ongoing external investigations and stockholder lawsuits.

Interest and Other (Loss) Income

We invest our cash primarily in money market funds, government securities, and corporate bonds. As of March 31, 2012, our cash, cash equivalents, and marketable securities totaled $37.6 million, compared with $42.4 million as of March 31, 2011. Interest and other (loss) income decreased $0.4 million to ($0.1) million for the three months ended March 31, 2012 compared with $0.3 million for the same period in 2011. The decrease in interest and other (loss) income was primarily due to a foreign currency loss of ($0.2) million incurred during the three months ended March 31, 2012 as compared with a foreign currency gain of $0.2 million for the same period in 2011.

Income Taxes

Our provision for income taxes consists of state, local, and foreign taxes. For the three months ended March 31, 2012, we recorded an income tax provision of $0.2 million on our pre-tax loss of $2.2 million, consisting of primarily state and local and foreign taxes. For the three months ended March 31, 2011, we recorded an income tax provision of $0.6 million. During 2010, we concluded that our domestic deferred tax assets were no longer realizable on a more-likely-than-not basis. During the three months ended March 31, 2012, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our expected net domestic deferred tax assets for the full year 2012 estimated annual effective tax rate. As of March 31, 2012, the valuation allowance totaled approximately $32.4 million.

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 payments, goodwill and other intangible assets, software development costs, and fair value measurements.

Revenue Recognition. We recognize revenue in accordance with the authoritative guidance issued by the FASB on revenue recognition. Product 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, a customer purchase order, and/or a royalty report summarizing software licenses sold for each software license resold by an OEM, distributor or solution provider to an end user. Product fees are fixed and determinable as our standard payment terms range from 30 to 90 days, depending on regional billing practices, and we have not provided any of our customers with extended payment terms during the three months ended March 31, 2012. When a customer purchases our integrated solutions and/or licenses software together with the purchase of maintenance, we allocate a portion of the fee to . . .