Unassociated Document

10-Q 1 v093822_10q.htm Unassociated Document

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2007

1-32146

Commission file number

DOCUMENT SECURITY SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

New York		16-1229730
(State of incorporation)		(IRS Employer Identification Number)

28 Main Street East, Suite 1525

Rochester, NY 14614

(Address of principal executive office)

(585) 325-3610

(Registrant's telephone number)

Indicate by check mark whether the registrant:

(1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports)

And

(2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

Yes o No x

Applicable only to corporate issuers

As of November 12, 2007 (the most recent practicable date), there were 13,676,030 shares of the issuer's Common Stock, $0.02 par value per share, outstanding.

DOCUMENT SECURITY SYSTEMS, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION
Item 1	Financial Statements
	Consolidated Balance Sheets	3
	Consolidated Statements of Operations	4
	Consolidated Statements of Cash Flows	5
	Notes to Financial Statements	6
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3	Quantitative and Qualitative Disclosures about Market Risk	25
Item 4	Controls and Procedures	25

PART II	OTHER INFORMATION
Item 1	Legal Proceedings	26
Item 1a	Risk Factors	27
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	34
Item 3	Defaults upon Senior Securities	34
Item 4	Submission of Matters to a Vote of Security Holders	34
Item 5	Other Information	34
Item 6	Exhibits	34
		35
SIGNATURES

PART I

FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

	September 30,			December 31,
	2007			2006
	(unaudited)			(audited)
ASSETS
Current assets:
Cash and cash equivalents	$	1,376,944		$	5,802,615
Accounts receivable, net of allowance
of $39,000 ($74,000 -2006)		731,492			618,622
Inventory		234,654			239,416
Prepaid expenses and other current assets		857,469			224,782

Total current assets		3,200,559			6,885,435
Restricted cash		177,345			-
Fixed assets, net		887,278			637,732
Other assets		145,351			156,734
Goodwill		1,396,734			1,396,734
Other intangible assets, net		6,573,643			5,389,564


Total Assets	$	12,380,910		$	14,466,199

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,472,350		$	1,283,503
Accrued expenses & other current liabilities		564,126			877,261
Deferred revenue		780,912			564,439
Current portion of capital lease obligations		31,336			34,814

Total current liabilities		2,848,724			2,760,017

Long-term capital lease obligations		26,755			50,417
Long-term deferred revenue		15,938			466,875

Commitments and contingencies (see Note 9)

Stockholders' equity
Common stock, $.02 par value;
200,000,000 shares authorized,
13,676,030 shares issued and outstanding
(13,544,724 in 2006)		273,521			270,894
Additional paid-in capital		31,235,453			28,145,793
Accumulated deficit		(22,019,481	)		(17,227,797	)
Total stockholders' equity		9,489,493			11,188,890
Total Liabilities and Stockholders' Equity	$	12,380,910		$	14,466,199

See accompanying notes

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(unaudited)

	Three Months Ended						Nine Months Ended
	September 30,			September 30,			September 30,			September 30,
	2007			2006			2007			2006

Revenue
Security printing	$	945,941		$	723,916		$	2,764,323		$	2,185,193
Royalties		278,290			246,528			871,243			343,223
Digital solutions		9,469			-			184,240			-
Legal products		175,725			167,518			513,070			483,983
Total Revenue		1,409,425			1,137,962			4,332,876			3,012,399

Costs of revenue
Security printing		635,935			511,343			1,691,473			1,399,820
Digital solutions		3,507			-			40,521			-
Legal products		82,575			86,355			276,342			267,240

Total costs of revenue		722,017			597,698			2,008,336			1,667,060

Gross profit		687,408			540,264			2,324,540			1,345,339

Operating expenses:

Selling, general and administrative		1,979,171			1,363,654			5,587,903			3,674,767
Research and development		110,833			93,693			314,130			262,577
Amortization of intangibles		480,256			275,714			1,258,985			763,989
Operating expenses		2,570,260			1,733,061			7,161,018			4,701,333

Operating loss		(1,882,852	)		(1,192,797	)		(4,836,478	)		(3,355,994	)

Other income (expense):
Interest income		14,829			7,200			89,816			51,338
Loss on foreign currency transactions		(6,378	)		-			(10,669	)		-
Interest expense		(1,362	)		(2,788	)		(3,811	)		(13,632	)
Loss from continuing operations before income taxes		(1,875,763	)		(1,188,385	)		(4,761,142	)		(3,318,288	)

Income taxes		4,738			-			14,214			-
Loss from continuing operations		(1,880,501	)		(1,188,385	)		(4,775,356	)		(3,318,288	)

Loss from discontinued operations (Note 6):
Gain on sale of discontinued assets		42,905			-			42,905			-
Loss from operations of discontinued
operations		(43,807	)		(16,041	)		(59,233	)		(87,237	)
Loss on discontinued operations		(902	)		(16,041	)		(16,328	)		(87,237	)
Net loss	$	(1,881,403	)	$	(1,204,426	)	$	(4,791,684	)	$	(3,405,525	)

Net loss per share -basic and diluted:
Continuing operations	$	(0.14	)	$	(0.09	)	$	(0.35	)	$	(0.26	)
Discontinued operations		0.00			0.00			0.00			0.00
Net Loss	$	(0.14	)	$	(0.09	)	$	(0.35	)	$	(0.26	)
Weighted average common shares outstanding, basic and diluted		13,676,030			12,920,315			13,629,241			12,868,887

See accompanying notes

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30,

		2007			2006
Cash flows from operating activities:		(unaudited)			(unaudited)
Net loss	$	(4,791,684	)	$	(3,405,525	)

Adjustments to reconcile net loss to net cash used by
operating activities:
Depreciation and amortization expense		1,396,262			927,635
Stock based compensation		970,829			591,684
Net gain on disposal of discontinued operations		(42,905	)		-
(Increase) decrease in assets:
Accounts receivable		(112,870	)		(389,229	)
Inventory		4,762			(30,487	)
Prepaid expenses and other assets		(171,526	)		(20,541	)
Increase (decrease) in liabilities:
Accounts payable		445,334			360,080
Accrued expenses		(25,635	)		(125,361	)
Deferred revenue		(234,464	)		595,783
Net cash used by operating activities		(2,561,897	)		(1,495,961	)

Cash flows from investing activities:
Purchase of fixed assets		(423,918	)		(78,204	)
Proceeds from the sale of discontinued operations		80,000			-
Acquisition of business		-			(1,301,670	)
Increase in other intangible assets		(1,150,977	)		(453,542	)
Net cash used by investing activities		(1,494,895	)		(1,833,416	)

Cash flows from financing activities:
Repayment of long-term debt		-			(218,200	)
(Increase) decrease in restricted cash		(177,345	)		240,000
Repayment of capital lease obligations		(27,140	)		(24,704	)
Payment of accrued stock issuance costs		(519,619	)		-
Issuance of common stock		355,225			899,159
Net cash (used) provided by financing activities		(368,879	)		896,255


Net decrease in cash and cash equivalents		(4,425,671	)		(2,433,122	)
Cash and cash equivalents beginning of period		5,802,615			3,953,482
Cash and cash equivalents end of period	$	1,376,944		$	1,520,360

See accompanying notes

DOCUMENT SECURITY SYSTEMS, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2007

(Unaudited)

1. Basis of Presentation and Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and cash flows include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated.

Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc (the “Company”) accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2006.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions.

Revenue Recognition - Sales of security and other printing products, and legal products are recognized when a product or service is delivered, shipped or provided to the customer and all material conditions relating to the sale have been substantially performed.

The Company recognizes revenue from technology licenses over the term of license agreements once all the following criteria for revenue recognition have been met: (1) persuasive evidence of an agreement exists; (2) the right and ability to use the product or technology has been rendered; (3) the fee is fixed and determinable and not subject to refund or adjustment; and (4) collection of the amounts due is reasonably assured.

For digital solutions sales, revenue is recognized in accordance with the American Institute of Certified Public Accountant's Statement of Position (SOP) No. 97-2, "Software Revenue Recognition," as modified by SOP No. 98-9, "Modification of SOP No. 97-2, Software Revenue Recognition with Respect to Certain Transactions" and Staff Accounting Bulletin (SAB) No. 104, "Revenue Recognition." Accordingly, revenue is recognized when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service or product has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable (4) the collection of our fees is reasonably assured.

The Company also enters into arrangements under which hosted software applications are provided. Revenue is recognized for these arrangements based on the provisions of EITF No. 00-3, Application of AICPA SOP 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware (“EITF 00-3”), and the provisions of Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements”, when there is persuasive evidence of an arrangement, collection of the resulting receivable is probable, the fee is fixed or determinable and acceptance has occurred. Revenues related to these arrangements consist of system implementation service fees and software subscription fees. System implementation services represent set-up services that do not qualify as separate units of accounting from the software subscriptions as the customer would not purchase these services without the purchase of the software subscription. As a result, revenue is recognized on system implementation fees ratably over a period of time from when the core system implementation services are completed and accepted by the customer over the remaining customer relationship life, which is the contractual life of the customer’s subscription agreement. Software subscription fees, which typically commence upon completion of the related system implementation, are recognized ratably over the applicable subscription period. Amounts billed and/or collected prior to satisfying our revenue recognition policy are reflected as deferred revenue.

Share-Based Payments - The Company’s accounting policy for equity instruments issued to consultants and vendors in exchange for goods and services follows the provisions of EITF 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF 00-18, “Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other Than Employees.” The measurement date for the fair value of the equity instruments issued is determined at the earlier of (i) the date at which a commitment for performance by the consultant or vendor is reached or (ii) the date at which the consultant or vendor’s performance is complete. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement.

Recent Accounting Pronouncements -In July 2006, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109, Accounting for Income Taxes and requires a two-step approach to evaluate tax positions and determine if they should be recognized in the financial statements. The two-step approach involves recognizing any tax positions that are “more likely than not” to occur and then measuring those positions to determine if they are recognizable in the financial statements. The interpretation is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 on January 1, 2007 (See Note 8).

2. Restricted Cash

In July 2007, the Company was required to establish a restricted cash balance of 87,500 pounds, or approximately $177,000, as collateral for a deed of guarantee required by the English Court of Appeals in order for the Company to pursue an appeal in that court. (See Note 9 Legal Matters)

3. Inventory

Inventory consisted of the following:

		September 30,		December 31,
		2007		2006
		(unaudited)		(audited)
Finished Goods	$	139,434	$	145,206
Raw Materials		95,220		94,210
	$	234,654	$	239,416

4. Other Intangible Assets

Other intangible assets are comprised of the following:

	September 30, 2007								December 31, 2006
	Useful		Gross Carrying		Accumulated		Net Carrying		Gross Carrying		Accumulated		Net Carrying
	Life		Amount		Amortizaton		Amount		Amount		Amortizaton		Amount
Royalty rights	5 years	$	90,000	$	67,500	$	22,500	$	90,000	$	54,000	$	36,000
Other intangibles	5 years		1,187,595		277,258		910,337		666,300		149,036		517,264
Patent and contractual rights	Varied (1)		8,134,170		2,493,364		5,640,806		6,212,400		1,376,100		4,836,300
		$	9,411,765	$	2,838,122	$	6,573,643	$	6,968,700	$	1,579,136	$	5,389,564

(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of September 30, 2007 the weighted average remaining useful life of these assets in service was 4.0 years.

5. Shareholders’ Equity

Stock Issued for Patent Defense Costs - On November 14, 2006, the Company entered into an agreement with McDermott Will & Emery LLP (“MWE”), its lead counsel on its European Central Bank (“ECB Litigation”) patent infringement and related cases. The agreement with MWE allows the Company to use its common stock with a value not to exceed $1.2 million to eliminate the Company’s cash requirements for MWE’s legal fees related to the ECB patent validity litigation. During the nine months ended September 30, 2007, 60,866 restricted common shares were issued to MWE to pay for approximately $746,000 of legal fees incurred through September 30, 2007. In total, 107,881 shares valued at $1,203,000 have been issued to MWE.

Stock Issued in Private Placement - On January 22, 2007, the Company sold 6 units at a price of $50,000 per unit consisting of 35,280 unregistered shares of its common stock and five-year warrants to purchase up to an aggregate of 17,640 shares of its common stock at an exercise price of $11.75 per share. The fair market value of these warrants was determined using the Black Scholes option pricing model at $107,000. The Company incurred placement agent fees associated with the offering equal to 9% commissions, or $27,000. In addition, in January 2007, the Company paid $492,000 of private placement fees and legal fees related to an offering that occurred during 2006.

Restricted Stock - On May 3, 2007, the Company granted 25,000 restricted shares of its common stock pursuant to the Company’s 2004 Employee Stock Option Plan that will vest over two years to a member of its senior management team. These shares were valued at the fair value on the grant date at approximately $312,000. Also on May 3, 2007, the Company granted 445,000 restricted shares of common stock pursuant to the Company’s 2004 Employee Stock Option Plan to certain members of senior management. These 445,000 shares vest only upon the occurrence of certain events over the next 5 years, which include, among other things a change of control of the Company 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 lawsuit against the European Central Bank. These 445,000 shares, if vested, would result in the recording of stock based compensation expense of approximately $5,563,000 over the period beginning when any of the contingent vesting events is deemed to be probable over the expected requisite service period. As of September 30, 2007, vesting is not considered probable and no compensation expense has been recognized.

Stock Options - On March 26, 2007, the Company issued options to purchase 150,000 shares of its common stock pursuant to the Company’s 2004 Employee Stock Option Plan with an exercise price of $10.89 per share to a third party consultant that vest over three years, subject to certain vesting acceleration provisions. During the nine months ended September 30, 2007, the Company recognized approximately $98,000 of compensation expense associated with these options. The Company values stock options utilizing the Black Scholes option pricing model. The Company records stock based payment expense related to these options at the then current fair value of at each reporting date as the services are performed in accordance with EITF 96-18. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement in accordance to EITF 00-18.

During 2007 the Company has issued options to purchase 177,5000 of its common shares pursuant to the Company’s 2004 Employee Stock Option Plan and the 2004 Non-Employee Officer Director Stock Option Plan at exercise prices ranging from $11.10 to $12.50 per share to employees and directors that vest between one to two years. During the nine months ended September 30, 2007, the Company recognized approximately $194,000 of compensation expense associated with these options. The Company values stock options utilizing the Black Scholes option pricing model. The Company records stock-based payment expense related to these options based on the grant date fair value in accordance with FASB 123R.

Stock Warrants -During the nine months ended September 30, 2007, the Company received approximately $55,000 in proceeds from the exercise of warrants to purchase 12,125 shares of its common stock.

In June, 2007, the Company entered into an agreement with International Barcode Technologies, also known as BTI, to extend the expiration date of warrants to purchase 500,000 shares of common stock of the Company at a purchase price of $10.00 per share that the Company previously issued to BTI from June 16, 2007 to December 31, 2007. In exchange, BTI has agreed to provide the Company with a license to market and produce BTI’s advanced barcode technologies in the United States for five years The value of the extension of the warrant was determined to be approximately $521,000 using the Black-Scholes option pricing model. This amount was recorded as an other intangible asset and will be amortized over the expected useful life of the license agreement of five years. During the nine months ended September 30, 2007, the Company recognized approximately $223,000 of stock based compensation associated with these warrants, prior to the modification of the warrants.

In August 2007, the Company issued 25,000 fully vested warrants to purchase the Company’s shares with an exercise price of $12.59 per share with a three-year term to a unrelated third party consultant. In September 2007, the Company issued 136,750 warrants to purchase the Company’s shares with an exercise price of $12.63 per share with a five-year term to another unrelated third party consultant of which 50% of the warrants vested upon issuance with the remaining warrants to vest six months from the date of grant, subject to certain vesting acceleration provisions. As a result of these warrant issuances, the Company recognized $46,000 of compensation expense during the three months ended September 30, 2007. In addition, approximately $525,000 was recorded as prepaid services associated with the nonforfeitable, fully vested portion of these warrant grants. The Company values stock warrants utilizing the Black Scholes option pricing model. The Company records stock based payment expense related to these warrants at the then current fair value of at each reporting date as the services are performed in accordance with EITF 96-18. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement in accordance to EITF 00-18. Accordingly, the Company records the fair value of nonforfeitable, fully vested warrants issued for future consulting services as prepaid services in its consolidated balance sheet.

Stock-Based Compensation - 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. During the three and nine months ended September 30, 2007, the Company recognized approximately $338,000 and $971,000, respectively ($311,000 and $592,000- respectively, in 2006) in stock-based compensation.

As of September 30, 2007, there were approximately $9.1 million of total unrecognized compensation costs related to non-vested options and restricted stock granted under the Company’s stock option plans, the cost of which will be recognized if earned over a period of not to exceed five years. The total fair value of options, warrants and restricted shares that vested during the nine-month period ended September 30, 2007 was approximately $1,657,000 ($542,000 - 2006).

6. Discontinued Operations

On September 25, 2007, the Company sold certain assets and the operations of its retail copying and quickprinting 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. The Company recognized a gain on the sale of approximately $43,000. The operating results relating to these assets are segregated and reported as discontinued operations in the accompanying 2007 and 2006 consolidated statement of operations. The results of operations directly attributed to the division’s operations that have been reclassified from continuing operations are as follows:

		Three Months Ended						Nine Months Ended
		September 30,			September 30,			September 30,			September 30,
		2007			2006			2007			2006
Revenues	$	72,791		$	125,347		$	292,282		$	423,426
Cost of sales		48,720			70,027			150,525			265,505
Operating expenses		67,878			71,361			200,990			245,158
Loss from discontinued
operations	$	(43,807	)	$	(16,041	)	$	(59,233	)	$	(87,237	)

7. Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In periods of losses, diluted loss per share is computed on the same basis as basic loss per share as the inclusion of any other potential shares outstanding would be anti-dilutive. If the Company had generated earnings during the nine-month period ended September 30, 2007, 767,887 (875,436- 2006) common equivalent shares would have been added to the weighted average shares outstanding to compute the diluted weighted average shares outstanding.

8. Income Taxes

We adopted the Financial Accounting Standard Board’s Interpretation No. 48, Accounting for Income Tax Uncertainties (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertain income tax positions recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. As of January 1, 2007, there were no unrecognized tax positions. Our policy is to recognize interest and penalties on tax deficiencies in the provision for income taxes in the consolidated statements of operations. As of September 30, 2007, the Company has no accrued interest or penalties related to uncertain tax positions. Tax years beginning in 2003 are subject to examination by taxing authorities, although net operating loss and credit carryforwards from all years are subject to examinations and adjustments for at least three years following the year in which the attributes are used.

9. Commitments and Contingencies

Operating Lease

On May 19, 2007, the Company entered in to a seven-year operating lease for an approximately 25,000 square foot production facility in Brisbane, California. Pursuant to the terms of the lease, the Company will be responsible for minimum lease commitments as follows:

2007	$	109,058
2008	$	241,217
2009	$	248,454
2010	$	255,907
2011	$	263,585
2012	$	271,492
Thereafter	$	433,535
	$	1,823,248

Legal Matters

On August 1, 2005, we commenced a suit against the European Central Bank (the “ECB”) alleging patent infringement by the ECB and have claimed unspecified damages. We brought the suit in European Court of First Instance in Luxembourg. We alleged that all Euro banknotes in circulation infringe our European Patent 455750B1 (the “Patent”), which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. The Court of First Instance ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim, which has opened the door for country-by-country infringement litigation.

On March 24, 2006, we received notice that the ECB has filed a separate claim in the United Kingdom and Luxembourg patent courts (Luxembourg being the seat of the European Court of First Instance) seeking the invalidation of the Patent. Claims to invalidity in each of the Netherlands, Belgium, Italy, France, Spain, Germany and Austria were subsequently served on the Company. On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England (the “English Court”) ruled that the Patent that was awarded to us by the European Patent Office Technical Board of Appeal has been deemed invalid in the United Kingdom. The English Court’s decision does not affect the validity of the Patent in other European countries. On March 30, 2007, the Company was given permission by the English Court to appeal to the Court of Appeal the ruling. This appeal is scheduled for February 4, 2008. As a result of the ruling and according to English Court rules, the Company was also required to pay a portion of the ECB’s legal costs associated with the case. On April 2, 2007, the English Court rewarded the ECB 180,000 pounds ($365,000) for such reimbursement, of which the Company paid 90,000 pounds ($182,000) on April 4, 2007 and the remaining 90,000 pounnds ($182,000) is included in accrued expense at September 30, 2007. On March 27, 2007, the German Federal Patent Court (Bundespatentgericht) in Munich ruled that the Patent was valid in Germany. This ruling validates the legal basis of the Company’s infringement suit against the ECB. The ECB is appealing the German ruling. In addition, as a result of this ruling, the Company expects to be awarded reimbursements for its costs associated with the German validity case, which is Euro 44,692. On June 4, 2007, a trial was held in the Paris High Court in Paris, France regarding a validity of the Patent. A decision in the French trial is expected on January 9, 2008. The Netherlands trial has been set for December 14, 2007 in Amsterdam, and the Spanish trial in early 2008. Additional trials regarding validity are expected to commence in the four other countries during 2008 and 2009.

On January 31, 2003, we commenced an action, unrelated to the above ECB litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and Andrew McTaggert (United States District Court, Western District Of New York Case No.03-Cv-6044t(F)) regarding certain intellectual property in which we have an interest. We commenced this action alleging various causes of action against Adler Technologies, Inc. and Andrew McTaggert for breach of contract, breach of the duty of good faith and fair dealing, various business torts, including unfair competition and declaratory relief. Adler distributes and supplies anti-counterfeit document products and Mr. McTaggert is a principal of Adler. Adler had entered into several purported agreements with Thomas M. Wicker Enterprises and Document Security Consultants, both of which we acquired in 2002. These alleged agreements, generally, would have authorized Adler to manufacture in Canada our “Checkmate®” patented system for verifying the authenticity of currency and documents. Other purported agreements were signed between these parties and Thomas Wicker regarding other technology claimed to have been owned by Wicker and assigned to us. Among other things, we contend that certain of the purported agreements are not binding and/or enforceable. To the extent any of them are binding and enforceable, we claim that Adler has breached these purported agreements, failed to make an appropriate accounting and payments under them , and may have exceeded the scope of its license. Adler has denied the material allegations of the complaint and has counterclaimed against our company, claiming Adler owns or co-owns or has a license to use certain technologies of ours. In May 2005, we filed our first amended and supplemental complaint adding Blanks/USA and Raymond Maxon as additional defendants. In February 2007, we filed our second amended and supplemental complaint adding Judith Wu (McTaggart’s wife) and Arcis Digital Security, Inc. (a company in which Ms. Wu is involved) as additional defendants. Maxon has asserted a counterclaim against us contending that our purported acquisition of a certain patent from Thomas Wicker in 2002 gave rise to an alleged right on the part of Maxon to receive a portion of Thomas Wicker’s proceeds from such acquisition. We have denied the material allegations of all of the counterclaims. If Adler is successful, it may materially affect us, our financial condition, and our ability to market and sell certain of our technology and related products. This case is in discovery phase, and it is too soon to determine how the various issues raised by the lawsuit will be determined.

In addition to the foregoing, we are subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of the legal proceedings to which we are a party, whether discussed herein or otherwise, will have a material adverse effect on our results of operations, cash flows or our financial condition.

Commitments

Pursuant to an agreement made in December 2004, the Company is required to share the economic benefit derived from settlements, licenses or subsequent business arrangements that the Company obtains from any infringer of patents formerly owned by the Wicker Family. For infringement matters involving certain U.S. patents, the Company will be required to disburse 30% of the settlement proceeds. For infringement matters involving certain foreign patents, including the lawsuit against the European Central Bank described in Part II Item 1 - Legal Proceedings, the Company will be required to disburse 14% of the settlement proceeds. These payments do not apply to licenses or royalties to patents that the Company has developed or obtained from persons other than the Wicker Family. As of September 30, 2007, there have been no settlement amounts related to these agreements.

In May 2005, the Company made an agreement with its legal counsel in charge of the Company’s patent infringement litigation in the Court of First Instance with the European Central Bank which capped its fees for all matters associated with that infringement litigation at $540,000 plus expenses, and a $150,000 contingent payment upon a successful ruling or settlement on the Company’s behalf in that litigation. The Company will record the $150,000 in the period in which the Company has determined that a successful ruling or settlement is probable.

10. Supplemental Cash Flow Information

During the nine months ended September 30, 2007, the Company issued 60,866 shares of Common Stock valued at approximately $746,000 in conjunction with the payment of legal expenses which were capitalized as other intangible assets. In addition, the Company issued fully vested, nonforfeitable warrants to consultants of approximately $525,000 that are recorded as a prepaid expense that will be recognized as stock based compensation expense over the term of the consulting agreement. In addition, the Company extended the term of previously issued warrants to a warrant holder in exchange for a license valued at approximately $521,000. During the nine months ended September 30, 2006, the Company issued 18,704 shares of Common Stock valued at $250,000 in conjunction with the acquisition of Plastic Printing Professionals.

11. Segment Information

The Company's businesses are organized, managed and internally reported as four operating segments. Three of these operating segments, Document Security Systems, Plastic Printing Professionals and Patrick Printing, respectively, are engaged in various aspects of developing and applying printing technologies and procedures to produce, or allow others to produce, documents with a wide range of features, including the Company’s patented technologies and trade secrets. For the purposes of providing segment information, these three operating segments have been aggregated into one reportable segment in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 131- “Disclosures about Segments of an Enterprise and Related Information”. A summary of the two segments is as follows:

Document Security and Production

License, manufacture and sale of document security technologies, including digital security print solutions and secure printed products at Document Security Systems and Plastic Printing Professionals divisions. In September 2007, the Company sold the assets of its retail printing and copying division, a former component of the Document Security and Production segment, to an unrelated third party as this operation was not critical to the Company’s core operations. The results of this division are reported as discontinued operations and are not a component of these segment results (See Note 6).

Legal Supplies

Sale of specialty legal supplies, primarily to lawyers and law firms located throughout the United States as Legalstore.com.

Approximate information concerning the operations by reportable segment for the three and nine months ended September 30, 2007 and 2006 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:

	Legal			Security &
	Supplies			Production			Corporate			Total
3 months ended Septmber 30, 2007:
Revenues from external customers from continuing operations	$	176,000		$	1,233,000		$	-		$	1,409,000
Depreciation and amortization from continuing operations		3,000			511,000			1,000			515,000
Segment profit or (loss) from continuing
operations		(13,000	)		(799,000	)		(1,069,000	)		(1,881,000	)

3 months ended September 30, 2006:
Revenues from external customers from continuing operations	$	$168,000		$	970,000		$	-			1,138,000
Depreciation and amortization from continuing operations		3,000			288,000			16,000			307,000
Segment profit or (loss) from continuing
operations		13,000			(773,000	)		(428,000	)		(1,188,000	)

					Document
		Legal			Security &
		Supplies			Production			Corporate			Total
9 months ended September 30, 2007:
Revenues from external customers from continuing operations	$	513,000		$	3,820,000		$	-		$	4,333,000
Depreciation and amortization from continuing operations		9,000			1,324,000			30,000			1,363,000
Segment profit or (loss) from continuing
operations		(11,000	)		(2,217,000	)		(2,547,000	)		(4,775,000	)

9 months ended September 30, 2006:
Revenues from external customers from continuing operations	$	484,000		$	2,528,000		$	-		$	3,012,000
Depreciation and amortization from continuing operations		9,000			796,000			72,000			877,000
Segment profit or (loss) from continuing
operations		(18,000	)		(1,845,000	)		(1,455,000	)		(3,318,000	)

ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors, including, without limitation, those contained in our Form 10-K for the year ended December 31, 2006 and those described herein that could cause actual results to differ materially from the results anticipated in the forward-looking statements.

Overview

Document Security Systems, Inc. (referred to in this report as “Document Security,” “we,” “us,” “our” or “Company”) markets and sells products designed to protect valuable information from unauthorized scanning, copying, and digital imaging. We develop sophisticated 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 believe we are a leader of customized document protection solutions for companies and governments worldwide. We hold seven 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.

Our core business is counterfeit prevention, brand protection and validation of authentic print media, including government-issued documents, currency, private corporate records, securities and more. We believe we are a world leader in the research and development of optical deterrent technologies and have commercialized these technologies with a broad suite of products that offer our customers a wide array of document security solutions that satisfy their specific anti-counterfeiting requirements. We provide document security technology to security printers, corporations and governments worldwide. Our technology can be used in securing sensitive and critical documents such as currency, automobile titles, spare parts forms for the aerospace industry, gift certificates, permits, checks, licenses, receipts, prescription and medical forms, engineering schematics, ID cards, labels, original music, coupons, homeland security manuals, consumer product and pharmaceutical packaging, tickets, and school transcripts. In addition, we have developed an On-Demand^TM product to implement our technologies in Internet-based environments utilizing standard desktop printers. We believe that our On-Demand technology greatly expands the reach and potential market for our technologies and solutions.

Technologies

We have developed or acquired over 30 technologies that provide to our customers a wide spectrum of solutions. Our primary anti-counterfeiting products and technologies are marketed under the following trade names:

·	AuthentiGuard™ On-Demand

·	AuthentiGuard™Laser Moiré

·	AuthentiGuard™ Prism

·	AuthentiGuard™ Pantograph 4000

·	AuthentiGuard™ Survivor 21

·	AuthentiGuard™ Obscurascan

·	AuthentiGuard™ Block-Out

·	AuthentiGuard™ MicroPerf

·	AuthentiGuard™ Phantom

·	AuthentiGuard™VeriGlow.

Products and Services

Document Security Solutions and Production: Our technology portfolio allows us to create unique custom secure paper, plastic, packaging and Internet-based solutions. We target end-users that require anti-counterfeiting and authentication features in a wide range of printed materials like documents, vital records, driver’s licenses, birth certificates, receipts, manuals, identification materials, entertainment tickets, coupons, parts tracking forms, as well as product packaging including pharmaceutical and a wide range of consumer goods.

Additionally, our custom security solutions include our On-Demand technology that provides custom hosted or server-based digital solutions for our customers. Depending on our customer’s specific requirements, we host a secure server that accepts user inputs and delivers custom, variable secure documents for output at the user location, or offer a bundled server solution that allows for the production of custom, variable secure documents within the user’s network environment. .

Security Paper: Our primary product for the retail end-user market is AuthentiGuard Security Paper. AuthentiGuard Security Paper uses our Pantograph 4000 technology. It is a paper that reveals hidden warning words, logos or images using The Authenticator- our proprietary viewing lens - or when the paper is faxed, copied, scanned or re-imaged in any form. The hidden words appear on the duplicate or the computer digital file and essentially prevents important documents from being counterfeited. We market and sell our Security Paper primarily through two major paper distributors: Boise Cascade and PaperlinX Limited.

Technology Licensing: We license our anti-counterfeiting technology and trade secrets through licensing arrangements with security printers. We seek licensees that have a broad customer base that can benefit from our technologies or have unique and strategic capabilities that expand the capabilities that we can offer our potential customers. Revenue from Licensing can take several forms. Licenses can be for a single technology or for a package of technologies. Licensee's can choose from a variety of payment models, such as:

·	Pay one price per year - Licensee will estimate their annual usage and a single payment is paid and reviewed each year based on actual results.

·	Pay a percentage of sales of the technology - Licensees only pay as they sell product containing the technology. If, for example, they sell $1 million in our security technology printing, they would pay us from 2.5% to 10% of the sales price of their jobs.

·	Pay on a per piece method - Licensees pay royalties based on a price per piece. A pre-determined price schedule is implemented based on job volumes and a per-piece price is utilized. Typically, the higher the volume, the lower the price per piece.

·	Joint venture licensing- profit sharing arrangement with clients where DSS shares the net profit of all products sold containing DSS Technologies.

Legal Products: We also own and operate Legalstore.com, an Internet company which sells legal supplies and documents, including security paper and products for the users of legal documents and supplies in the legal, medical and educational fields. While not a component of our core business strategy, we continuously seek to maximize the revenue and profitability of this operation.

Results of Operations for the Three and Nine Months Ended September 30, 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. The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our annual report on Form 10-K for the year ended December 31, 2006. 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 printing segment, as a discontinued operation.

The following discussion also includes a non-GAAP financial measure which has been reconciled to the most comparable GAAP financial measure of net loss. Our management believes that this performance measure is a relevant indicator of the Company’s financial performance.

Revenue

		Three Months Ended September 30, 2007				Nine Months Ended September 30, 2007
			% change vs. 3 months				% change vs. 9 months
		$	ended September 30, 2006			$	ended September 30, 2006
Revenue
Security printing	$	946,000	31	%	$	2,765,000	27	%
Royalties		278,000	13	%		871,000	154	%
Digital solutions		9,000				184,000
Legal products		176,000	5	%		513,000	6	%
Total Revenue		1,409,000	24	%		4,333,000	44	%

Document Security and Production

For the three-month period ended September 30, 2007, revenue from continuing operations increased 24% from the same period ended September 30, 2006. The increase in revenue resulted primarily from increases sales of security printing and increases in royalty revenue from the licensing of the Company’s patented technology. Sales of security printing, after removing in discontinued operations, increased 31% from the prior year’s quarter which reflected increased demand for the Company’s plastic printing unit driven by shipments on a foreign driver license project along with increases in sales of its security paper products, which were positively impacted by orders of security paper for Medicaid Prescription Pads. The Company, through its agreement with Boise Cascade provides paper that meets the standard Medicaid legislation regarding paper-based anti-copy/anti-scan security features required in Medicaid papers. The Company saw a significant increase in orders for secure prescription paper based on recent U.S. Federal legislation from that requires secure paper to be used in order to receive Medicaid reimbursements for prescriptions. While the initial deadline for compliance was moved from October 1, 2007 to April 1, 2008, the Company experienced a increase in demand for security paper as healthcare providers rushed to meet the new requirements.

For the nine-month period ended September 30, 2007, revenue from continuing operations increased 44% from the same period ended September 30, 2006. The Company has increased revenue in all of its major product categories, including increases in royalty revenue from the licensing of the Company’s patented technology, an increase in sales of security products and documents, including initial shipments on a foreign driver license project and increased demand of the Company’s security paper, and for initial sales of the Company’s On-Demand product which was introduced in early 2007. In addition, the security printing revenue increase reflects the effect of the Company’s acquisition in February 2006 of Plastic Printing Professionals.

Legal Products

Revenue from our legal products business, Legalstore.com, increased 5% during the third quarter of 2007 compared with the third quarter of 2006, and has increased 6% through the first nine months of 2007 compared to 2006. While we view our legal supplies business segment as a non-core part of our company, we continue to seek growth opportunities for the business. The Company is currently redesigning the Legalstore.com’s website and e-commerce platform along with expanding its product offerings.

Cost of Sales and Gross Profit

		Three Months Ended September 30, 2007				Nine Months Ended September 30, 2007
			% change vs. 3 months				% change vs. 9 months
		$	ended September 30, 2006			$	ended September 30, 2006
Costs of revenue
Security printing & products	$	636,000	24	%	$	1,691,000	21	%
Digital solutions		3,000				41,000
Legal products		83,000	-3	%		276,000	3	%
Total cost of sales		722,000	21	%		2,008,000	20	%

Gross profit
Security printing & products		310,000	46	%		1,073,000	37	%
Royalties		278,000	13	%		871,000	154	%
Digital solutions		6,000				143,000
Legal products		93,000	13	%		237,000	9	%
Total gross profit		687,000	27	%		2,324,000	73	%

	Three Months Ended September 30, 2007				Nine Months Ended September 30, 2007
			% change vs. 3 months				% change vs. 9 months
			ended September 30,				ended September 30,
	%		2006				2006
Gross profit percentage:
Security printing & products	33	%	11	%	39	%	8	%

Royalties	100	%	0	%	100	%	0	%
Digital solutions	67	%			78	%
Legal supplies	53	%	8	%	46	%	3	%
Gross profit percentage:	49	%	2	%	54	%	20	%

Gross Profit

During the third quarter of 2007, gross profit from continuing operations increased 27% to $687,000 as compared to the third quarter of 2006 driven by the increase in sales volume. During the first nine months of 2007, gross profit from continuing operations increased 73% to $2,324,000. Along with increases as the result of license agreements with 100% gross profit percentages and a digital solution implementation with a 78% gross profit percentage, the Company realized significant growth in security printing gross profits during the first quarter of 2007 primarily due to the impact of a large secure driver’s license project which was delivered during the first quarter of 2007. These items resulted in the Company’s gross profit margin increasing 20% during the first nine months of 2007 as compared to the first nine months of 2006.

Operating Expenses

	Three Months Ended September 30, 2007					Nine Months Ended September 30, 2007
			% change vs. 3 months					% change vs. 9 months
			ended September 30,					ended September 30,
	$		2006			$		2006
Selling, general and administrative
General and administrative
compensation	$	514,000		25	%	$	1,310,000		23	%
Stock based payments		338,000		9	%		971,000		64	%
Professional fees		352,000		66	%		1,036,000		10	%
Sales and marketing		466,000		108	%		1,525,000		149	%
Depreciation and amortization		20,000		11	%		61,000		-18	%
Other		289,000		55	%		685,000		74	%
Research and development		111,000		18	%		314,000		19	%
Amortization of intangibles		480,000		74	%		1,259,000		65	%

Total Operating Expenses		2,570,000		48	%		7,161,000		52	%

Selling, General and Administrative

The Company’s selling, general and administrative costs increases generally reflect increases in stock based payments and increases to the size of our organization as the result of the Company’s acquisition of P3 and increases in executive management, sales and operations personnel integral to the Company’s sales growth strategy.

General and administrative compensation costs increases from continuing operations for the three and nine months ended September 30 , 2007 reflect the impact of additions at the Company in senior management and administrative personnel and the impact of increases in medical benefit costs of 11% as compared to the prior year. In addition, the Company incurred annual payrate increases on average of approximately 6% for existing employees as compared to 2006 rates. The Company does not anticipate significant growth in its general and administrative compensation costs as it believes that it is sufficiently staffed for its current and near-term requirements.

Stock-based payments during the three months ended September 30, 2007 were relatively consistent with the three months ended September 30, 2006. The 2007 period reflects expenses due to options and restricted stock grants to new employees and consultants, including an addition to the Company’s senior management team. The Company believes that the grant of equity instruments is an important component of its overall compensation program because it improves the Company’s ability to attract and retain its human resources as well as obtain the services of various third parties without consuming its cash resources significantly. During the third quarter of 2007, the Company issued warrants to two unrelated third party consultants which resulted in approximately $46,000 of stock based expense recorded during the quarter as a result of these warrants. Stock-based compensation during the three months ended September 30, 2006 included approximately $223,000 of expense recognized for the issuance of warrants to International Barcode Corporation (d/b/a Barcode Technology) (“BTI”) in consideration for a cross-marketing relationship. There was no expense associated with these warrants during the third quarter of 2007. The Company values stock warrants utilizing the Black Scholes option pricing model. The Company records stock based payment expense related to these warrants at the then current fair value of at each reporting date as the services are performed in accordance with EITF 96-18. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement in accordance to EITF 00-18. The Company believes that the grant of equity instruments is an important component of its overall compensation program that is needed to attract and retain its human resources as well as obtain the services of various third parties without consuming its cash resources.

In addition, on May 3, 2007, the Company granted a total of 445,000 restricted shares to certain members of senior management. 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. These shares, if vested, would result in the recording of stock based compensation expense of approximately $5,563,000 in the period in which any of the contingent vesting events is deemed to be probable.

Professional fees

		Three Months Ended September 30, 2007				Nine Months Ended September 30, 2007
			% change vs. 3 months				% change vs. 9 months
			ended September 30,				ended September 30,
		$	2006			$	2006
Professional Fees Detail
Accounting and auditing	$	71,000	209	%	$	236,000	70	%
Consulting		95,000	28	%		292,000	36	%
Legal Fees		120,000	126	%		255,000	-4	%
Stock Transfer, SEC and Investor
Relations		66,000	74	%		253,000	7	%
	$	352,000	87	%	$	1,036,000	21	%

Professional fees include legal, accounting, shareholder services, investor relations, and consulting costs. During the first nine months of 2007, accounting and auditing fee increases generally reflect an increase in costs as a result of the growth in the Company as compared to the same period of 2006, along with significant costs associated with the Company’s Sarbanes Oxley compliance requirements. Consulting fees increased during the first nine months of 2007 as compared to 2006 due to addition of an intellectual property consultant, a new agreement with a German consulting firm, and the use of various financial consultants. Legal fees during the first nine months of 2007 have remained relatively flat as compared to 2006 as the Company expends costs on certain of its legal matters. Legal cost increases associated with increased activity in the Company’s Adler Technologies matter have been partially offset by cost savings associated with the hiring of an in-house counsel that had formerly worked for the Company in a retainer arrangement. These legal costs do not include approximately $1,923,000 of legal and related costs incurred during the first nine months of 2007 ($922,000 -2006) associated with the application and defense of our patents which the company capitalizes and amortizes over the expected life of the patent. (See Part I -Financial Information -Note 9 - Legal Matters)

Sales and marketing expenses, including sales and marketing personnel costs, increased in the third quarter and through the first nine months of 2007 as a result of significant expansion in the resources that the Company is investing to grow the size of its sales and marketing team and increase the reach of its products through expansion of its marketing efforts. During the third quarter of 2007, the Company’s costs included costs associated with the September 17, 2007 launch of its AuthentiGuard® On-Demand(TM) product, attendance at several trade shows and international business development efforts, including meetings with prospective customers in Saudi Arabia, Germany, and Mexico. In addition, the Company initiated a direct mailing campaign to targeted vertical markets as a method of increasing the awareness of the Company’s products.

Other expenses from continuing operations are primarily rent and utilities, office supplies, IT support, bad debt expense and insurance costs. Increases in 2007 reflect costs increases associated with a larger organization and increase in rent associated with the move of the Company’s plastic printing division to a 25,000 square foot facility, a five-fold increase in space for that division. In addition, rent increased due to the addition of a Washington, DC sales office in 2007.

Research and Development

We invest in research and development to improve our existing technologies and develop new technologies that will enhance our position in the document security market. Research and development costs consist primarily of compensation costs for our four persons who spend all or at least half of their time on developing new technologies or developing new uses for our existing technology. In addition, we incur costs for the use of third party printers’ facilities to test our technologies on equipment that we do not have access to internally. We seek patent protection for many of our inventions, and we currently have over a dozen formal patents applications pending, including provisional and PCT patent applications and applications that have entered the National Phase in various countries, including the United States, Canada, Europe, Japan, Brazil, Mexico, Indonesia and South Africa. We expect that our research and development costs will continue at current levels for the foreseeable future.

Amortization of intangibles

We amortize the costs associated with the patents that we acquired in 2005 and the legal costs associated with the development and defense of our patents, including the costs associated with our suit against the European Central Bank for patent infringement. In addition, we amortize our acquired intangibles from business combinations. A significant portion of these assets were acquired by the issuance of equity in the company. Our net amortizable patent asset base at September 30, 2007 was approximately $5.6 million and will generate approximately $1.7 million in annual amortization expense during the next 4 years. The Company reviews these assets for impairment annually. If an impairment, such as unfavorable ruling in the Company’s patent infringement lawsuits or an assessment of non-commerciability of certain of its patents, then the Company would write-off a portion of these assets, which could be a significant expense in the period incurred.

In addition, the Company has approximately $932,000 of net other intangible assets as of September 30, 2007 that consist of various royalty rights and marketing and distribution rights as well as acquired intangibles including customer lists and trade names. These assets will generate approximately $250,000 of annual amortization expense during the next 4 years.

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.

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. Prior to the sale, revenue from those operations decreased 42% for the three months and 31% for nine months ended September 30, 2007, respectively, as compared to the 2006 periods. The decline in sales of these operations was primarily contributed to the Company’s shift of resources from these operations to its security research and operations in the middle of 2006.

Net loss and loss per share

	Three Months Ended September 30, 2007				Nine Months Ended September 30, 2007
			% change vs. 3 months				% change vs. 9 months
			ended September 30,				ended September 30,
	$		2006		$		2006
Net loss	(1,881,000	)	56	%	(4,792,000	)	41	%

Net loss per share, basic and diluted	(0.14	)	57	%	(0.35	)	35	%


Weighted average common
shares outstanding, basic and diluted	13,676,030		6	%	13,629,241		6	%

During the third quarter and first nine months of 2007, the Company experienced a net loss of $1.9 million and $4.8 million, respectively. While we experienced growth in our sales and gross profits during these periods, these increases did not offset significant increases in our operating expenses, especially significant increases in amortization expense, stock based compensation, compensation and sales and marketing expenses. As discussed below, our net income is significantly impacted by amortization of intangibles and stock-based compensation expense, which accounted for 43% and 47%, of the Company’s net losses for the third quarter and first nine months of 2007, respectively.

During the third quarter and first nine months of 2007, our basic and diluted loss per share increased due to the increased dollar value of our loss partially offset by an increase in the weighted average common shares outstanding during each of these periods as compared to 2006. Our outstanding shares have increased primarily due common shares issued by the Company in a private placement in December 2006 and January 2007, and for the payment of patent defense costs.

Non-GAAP Financial Performance Measure

The following adjusted Earnings before interest, taxes, depreciation, amortization and non-cash stock compensation expense (“Adjusted EBITDA”) is presented because the Company’s management believes it to be a relevant measure of the performance of the Company. The Adjusted EBITDA is used by the Company’s management to measure its core operating performance without certain non-cash expenditures. The reconciliation of Adjusted EBITDA to net loss, the most comparable GAAP measure is presented below.

Adjusted EBITDA

		Three Months Ended September 30, 2007					Nine Months Ended September 30, 2007
				% change vs. 3 months					% change vs. 9 months
				ended September 30,					ended September 30,
		$		2006			$		2006
Net Loss	$	(1,881,000	)	56	%	$	(4,792,000	)	41	%
Add back:
Depreciation		45,000		0	%		137,000		-16	%
Amortization of Intangibles		480,000		74	%		1,259,000		65	%
Stock based payments		338,000		9	%		971,000		64	%
Interest Income		(15,000	)	114	%		(90,000	)	76	%
Interest Expense		1,000		-67	%		4,000		-71	%
Income Taxes		5,000					14,000
		854,000		36	%		2,295,000		55	%

Adjusted EBITDA loss		(1,027,000	)	78	%		(2,497,000	)	30	%

As described above, Adjusted EBITDA is a non-GAAP measurement of financial performance that the Company believes is relevant to the understanding of the Company’s financial results. During the three months ended September 30, 2007, the Company experienced an increase in its Adjusted EBITDA loss as increases in its revenue and gross profit did not offset greater increases in its core operating expenses (core operating expenses are general and administrative compensation, professional fees, sales and marketing, other and research and development costs). The Company’s core operating expenses from continuing operations increased 57% and 51% during the third quarter and first nine months of 2007, respectively, as compared to the 2006 periods. Along with expense increases associated with a increase in the size of the Company and an increase in its production facilities and capabilities, the Company has significantly increased spending for marketing and sales efforts. It is the Company’s belief that the amounts it is incurring during the current periods for sales and marketing are investments that will drive future revenue to Adjusted EBITDA break-even levels. However, the Company cannot be certain that it will be able to successfully obtain these break-even levels which would require the Company to significantly reduce its costs structure.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s cash flows and other key indicators of liquidity are summarized as follows:

		Nine Months Ended
		September 30,			September 30,		%
		2007			2006		Change
		(unaudited)			(unaudited)
Cash flows (used) provided by:
Operating activities	$	(2,562,000	)	$	(1,496,000	)	-71	%
Investing activities		(1,495,000	)		(1,833,000	)	18	%
Financing activities		(369,000	)		896,000		-141	%
Working capital		352,000			456,000		-23	%
Current ratio		1.12	x		1.21	x	-7	%

As of September 30, 2007, we had cash and cash equivalents of $1.4 million, a 76% decrease from December 31, 2006. As discussed below, the decrease in the Company’s cash position is primarily due to the payment of legal fees associated with its patent applications and defense costs, as well as cash used for operations.

Operating Cash Flow -During the first nine months of 2007, the Company used approximately $2.6 million of cash for operations, which is consistent with the Adjusted EBITDA loss of $2.5 million during the same period. As discussed above, the 44% increase in revenue during 2007, has been offset by increases in the Company’s expenditures, primarily on sales and marketing, production facility expansion and Sarbanes Oxley compliance costs. As of September 30, 2007, the Company believes that it will need to reach an annual revenue level of approximately $9.0 million based on its projected mix of revenue in order to maintain positive operating cash flow.

Investing Cash Flow -During the first nine months of 2007, the Company used approximately $1.5 million of cash for fixed asset additions and to invest in its patent portfolio. During the third quarter of 2007, the Company initiated a move into new production facility for its San Francisco area plastic printing division. Along with increasing the space of the division five-fold, the Company purchased new equipment, including a state of the art laminator and a digital plate system that significantly will increase the output capacity and efficiency of its operations. The Company began to move into the new facility in November, 2007. In addition, the Company made payments for legal costs associated with patent applications and the defense of its patents, which includes payments to cover third party experts fees associated with the Company’s litigation against the ECB. During this period, the Company used its equity to pay for approximately $746,000 of patent related costs as a result of its agreement with its lead counsel in its ECB litigation

Financing Cash Flows -During the first quarter of 2007, the Company received approximately $340,000 from the private placement of stock and the exercise of warrants which was offset by the payment of approximately $520,000 in fees associated with the private placements concluded in the fourth quarter of 2006 and the first quarter of 2007. As of November 9, 2007, the Company has approximately 239,000 warrants outstanding and exercisable at exercise prices below the closing market price of our Common stock as of November 9, 2007 of $7.30 that, if exercised, would produce approximately $1.3 million in cash proceeds to the Company.

Cash Flows From Discontinued Operations -During the nine months ended September 30, 2007, the company’s retail printing and copying division used approximately $31,000 of cash for operations. In addition, during this period, the division did not have any investing or financing cash flow activities. Cash flows from discontinued operations are included in the consolidated statement s of cash flows for the nine months ended September 30, 2007 and 2006.

Future Capital Needs - As a result of the foregoing, there can be no assurance that cash on hand and cash flow generated internally by the Company will be adequate to fund the operation of its businesses over the next twelve months. We have recently engaged certain financial advisors to assist the Company in entering into business relationships or partnerships with certain strategic investors. There can be no assurance that we will be able to raise any capital, or that any such capital would be raised on terms favorable to the Company, or that any financing could be obtained without significantly diluting the ownership interest of existing shareholders. Accordingly, we may be required to make significant changes to our current business plans, including the implementation of company-wide cost reductions.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our market risk exposures are related to our cash, cash equivalents and investments. We invest our excess cash in certificates of deposits with maturities of 90 days or less. Changes in interest rates affect the investment income we earn and therefore impact our cash flows and results of operations.

We mitigate our foreign currency risks principally by contracting primarily in U.S. dollars. To date, all of our billings were denominated in the U.S. dollar. However, certain of our legal fees are payable in foreign currencies, for which a gain or loss is recognized on foreign currency transactions is recognized when payments are made. To date and for the foreseeable future, gains and losses on such transactions have been minimal.

ITEM 4 - CONTROLS AND PROCEDURES

The Company maintains disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) that are designed to assure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Acting Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide reasonable assurance only of achieving the desired control objectives, and management necessarily is required to apply its judgment in weighting the costs and benefits of possible new or different controls and procedures. Limitations are inherent in all control systems, so no evaluation of controls can provide absolute assurance that all control issues and any fraud within the company have been detected.

As required by Exchange Act Rule 13a-15(b), as of the end of the period covered by this report, management, under the supervision and with the participation of its Chief Executive Officer and the Acting Chief Financial Officer, evaluated the effectiveness of the Company's disclosure controls and procedures. Based on this evaluation, management concluded that the Company's disclosure controls and procedures were effective as of that date.

Commencing in the second fiscal quarter, the Company initiated reviews and analysis of internal control procedures and designs in the context of Section 404 of the Sarbanes Oxley Act of 2002. The Company has begun and expects to continue to modify and change its internal control procedures to meet the compliance standards of the Sarbanes Oxley Act for its fiscal year ended December 31, 2007.

PART II

OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS

Information concerning pending legal proceedings is incorporated herein by reference to Note 8 to the Condensed Consolidated Financial Statements (Unaudited) in Part I of this Form 10-Q.

On March 24, 2006, we received notice that the ECB has filed a separate claim in the United Kingdom and Luxembourg patent courts (Luxembourg being the seat of the European Court of First Instance) seeking the invalidation of the Patent. Claims to invalidity in each of the Netherlands, Belgium, Italy, France, Spain, Germany and Austria were subsequently served on the Company. On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England (the “English Court”) ruled that the Patent that was awarded to us by the European Patent Office Technical Board of Appeal has been deemed invalid in the United Kingdom. The English Court’s decision does not affect the validity of the Patent in other European countries. On March 30, 2007, the Company was given permission by the English Court to appeal to the Court of Appeal the ruling. This appeal is scheduled for February 4, 2008. As a result of the ruling and according to English Court rules, the Company was also required to pay a portion of the ECB’s legal costs associated with the case. On April 2, 2007, the English Court rewarded the ECB 180,000 pounds ($365,000) for such reimbursement, of which the Company paid 90,000 pounds ($182,000) on April 4, 2007. On March 27, 2007, the German Federal Patent Court (Bundespatentgericht) in Munich ruled that the Patent was valid in Germany. This ruling validates the legal basis of the Company’s infringement suit against the ECB. The EBC is appealing the German ruling. In addition, as a result of this ruling, the Company expects to be awarded reimbursements for its costs associated with the German validity case, which is Euro 44,692. On June 4, 2007, a trial was held in the Paris High Court in Paris, France regarding a validity of the Patent. A decision in the French trial is expected on January 9, 2008. The Netherlands trial has been set for December 14, 2007 in Amsterdam, and the Spanish trial in early 2008. Additional trials regarding validity are expected to commence in the four other countries during 2008 and 2009.

ITEM 1A - RISK FACTORS

An investment in our securities is subject to numerous risks, including the Risk Factors described below. Our business, operating results or financial condition could be materially adversely affected by any of the following risks. The risks described below are not the only ones we face. Additional risks we are not presently aware of or that we currently believe are immaterial may also materially affect our business. The trading price of our Common Stock could decline due to any of these risks. In assessing these risks, you should also refer to the other information contained or incorporated by reference in this Form 10-Q, including our financial statements and related notes and information contained in our Form 10-K for the year ended December 31, 2006

We have a limited operating history with our new business model, which limits the information available to you to evaluate our business.

Since our inception in 1984, we have accumulated deficits from historical operations of approximately $22,019,000 at September 30, 2007. In 2002, we changed our business model and chose to strategically focus on becoming a developer and marketer of secure technologies for all forms of print media. We have continued to incur losses since we began our new business model. Also, we have limited operating and financial information relating to our new business model regarding our On-Demand^TM suite of products to evaluate our performance and future prospects. Due to the change in our business model, we do not view our historical financials as being a good indication of our future. We face the risks and difficulties of a company going into a new business model including the uncertainties of market acceptance, competition, cost increases and delays in achieving business objectives. There can be no assurance that we will succeed in addressing any or all of these risks, and the failure to do so could have a material adverse effect on our business, financial condition and operating results.

We have a history of operating losses and we expect to continue to incur losses.

Since we changed our business model in 2002, we have not yet achieved profitability and we expect to continue incurring net losses until we recognize sufficient revenues. We had net losses of approximately $4,832,000 and $2,843,000 for the years ended December 31, 2006 and 2005, respectively, and approximately $4,792,000 for the first nine months of 2007. The principal causes of our losses are likely to continue to be costs resulting from the operation of our businesses, including costs associated with being a public company, costs relating to defending our patent rights, and failure to generate sufficient revenue.

If we lose our current litigation, we may lose certain of our technology rights which may affect our business plan.

We are subject to litigation and alleged litigation, including our litigation with the European Central Bank, in which parties allege, among other things, that certain of our patents are invalid. For more information regarding this litigation, see Part II -Item I- Legal Proceedings. If the ECB or other parties are successful in invalidating any or all of our patents, it may materially affect us, our financial condition, and our ability to market and sell certain technology.

If we lose our current infringement litigation we may be liable for significant legal costs of our counterparts.

We have been able to mitigate the cash outlays that we have been required to make for legal costs of our current infringement litigation and related invalidity cases against the European Central Bank by, among other things, negotiating legal fee caps and using shares of our common stock for payments. However, if we receive an adverse ruling in any of our infringement or related invalidity cases against the European Central Bank, we will likely be responsible for a large portion of the legal costs that were expended by the European Central Bank in such case, which would likely be significant. The payment of these amounts could adversely affect the Company’s financial position.

If we are unable to adequately protect our intellectual property, our competitive advantage may disappear.

Our success will be determined in part by our ability to obtain United States and foreign patent protection for our technology and to preserve our trade secrets. Because of the substantial length of time and expense associated with developing new document security technology, we place considerable importance on patent and trade secret protection. We intend to continue to rely primarily on a combination of patent protection, trade secrets, technical measures, copyright protection and nondisclosure agreements with our employees and customers to establish and protect the ideas, concepts and documentation of software and trade secrets developed by us. Our ability to compete and the ability of our business to grow could suffer if these intellectual property rights are not adequately protected. There can be no assurance that our patent applications will result in patents being issued or that current or additional patents will afford protection against competitors. We rely on a combination of patents, copyrights, trademarks and trade secret protection and contractual rights to establish and protect our intellectual property. Failure of our patents, copyrights, trademarks and trade secret protection, non-disclosure agreements and other measures to provide protection of our technology and our intellectual property rights could enable our competitors to more effectively compete with us and have an adverse effect on our business, financial condition and results of operations. In addition, our trade secrets and proprietary know-how may otherwise become known or be independently discovered by others. No guarantee can be given that others will not independently develop substantially equivalent proprietary information or techniques, or otherwise gain access to our proprietary technology.

In addition, we may be required to litigate in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Any such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, financial condition or results of operations, and there can be no assurances of the success of any such litigation.

We may face intellectual property infringement or other claims against us, our customers or our intellectual property that could be costly to defend and result in our loss of significant rights.

Although we have received U.S. Patents and a European Patent with respect to certain technologies of ours, there can be no assurance that these patents will afford us any meaningful protection. Although we believe that our use of the technology and products we developed and other trade secrets used in our operations do not infringe upon the rights of others, our use of the technology and trade secrets we developed may infringe upon the patents or intellectual property rights of others. In the event of infringement, we could, under certain circumstances, be required to obtain a license or modify aspects of the technology and trade secrets we developed or refrain from using same. We may not have the necessary financial resources to defend an infringement claim made against us or be able to successfully terminate any infringement in a timely manner, upon acceptable terms and conditions or at all. Failure to do any of the foregoing could have a material adverse effect on us and our financial condition. Moreover, if the patents, technology or trade secrets we developed or use in our business are deemed to infringe upon the rights of others, we could, under certain circumstances, become liable for damages, which could have a material adverse effect on us and our financial condition. As we continue to market our products, we could encounter patent barriers that are not known today. A patent search will not disclose applications that are currently pending in the United States Patent Office, and there may be one or more such pending applications that would take precedence over any or all of our applications.

Furthermore, third parties may assert that our intellectual property rights are invalid, which could result in significant expenditures by us to refute such assertions. If we become involved in litigation, we could lose our proprietary rights, be subject to damages and incur substantial unexpected operating expenses. Intellectual property litigation is expensive and time-consuming, even if the claims are subsequently proven unfounded, and could divert management’s attention from our business. If there is a successful claim of infringement, we may not be able to develop non-infringing technology or enter into royalty or license agreements on acceptable terms, if at all. If we are unsuccessful in defending claims that our intellectual property rights are invalid, we may not be able to enter into royalty or license agreements on acceptable terms, if at all. This could prohibit us from providing our products and services to customers, which could have a material adverse effect on us and our financial condition.

If our products and services do not achieve market acceptance, we may not achieve our revenue and net income goals in the time prescribed or at all.

We are at the early stage of introducing our document security technology and products to the market. If we are unable to operate our business as contemplated by our business model or if the assumptions underlying our business model prove to be unfounded, we could fail to achieve our revenue and net income goals within the time we have projected, or at all, which could have a material adverse effect on our business. As a result, the value of your investment could be significantly reduced or completely lost.

We cannot assure you that a sufficient number of such companies will demand our products or services or other document security products. In addition, we cannot predict the rate of market’s acceptance of our document security solutions. Failure to maintain a significant customer base may have a material adverse effect on our business.

The results of our research and development efforts are uncertain and there can be no assurance of the commercial success of our products.

We believe that we will need to continue to incur research and development expenditures to remain competitive. The products we currently are developing or may develop in the future may not be technologically successful. In addition, the length of our product development cycle may be greater than we originally expect and we may experience delays in future product development. If our resulting products are not technologically successful, they may not achieve market acceptance or compete effectively with our competitors’ products.

Changes in document security technology and standards could render our applications and services obsolete.

The market for document security products, applications, and services is fast moving and evolving. Identification and authentication technology is constantly changing as we and our competitors introduce new products, applications, and services, and retire old ones as customer requirements quickly develop and change. In addition, the standards for document security are continuing to evolve. If any segments of our market adopt technologies or standards that are inconsistent with our applications and technology, sales to those market segments could decline, which could have a material adverse effect on us and our financial condition.

The market in which we operate is highly competitive, and we may not be able to compete effectively, especially against established industry competitors with greater market presence and financial resources.

Our market is highly competitive and characterized by rapid technological change and product innovations. Our competitors may have advantages over us because of their longer operating histories, more established products, greater name recognition, larger customer bases, and greater financial, technical and marketing resources. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements, and devote greater resources to the promotion and sale of their products. Competition may also force us to decrease the price of our products and services. We cannot assure you that we will be successful in developing and introducing new technology on a timely basis, new products with enhanced features, or that these products, if introduced, will enable us to establish selling prices and gross margins at profitable levels.

Our growth strategy depends, in part, on our acquiring complementary businesses and assets and expanding our existing operations to include manufacturing capabilities, which we may be unable to do.

Our growth strategy is based, in part, on our ability to acquire businesses and assets that are complimentary to our existing operations and expanding our operations to include manufacturing capabilities. We may also seek to acquire other businesses. The success of this acquisition strategy will depend, in part, on our ability to accomplish the following:

·	identify suitable businesses or assets to buy;

·	complete the purchase of those businesses on terms acceptable to us;

·	complete the acquisition in the time frame we expect; and

·	improve the results of operations of the businesses that we buy and successfully integrate their operations into our own.

Although we were able to successfully acquire our P3 subsidiary in February 2006, there can be no assurance that we will be successful in pursuing any or all of these steps on future transactions. Our failure to implement our acquisition strategy could have an adverse effect on other aspects of our business strategy and our business in general. We may not be able to find appropriate acquisition candidates, acquire those candidates that we find or integrate acquired businesses effectively or profitably.

Our acquisition program and strategy may lead us to contemplate acquisitions of companies in bankruptcy, which entail additional risks and uncertainties. Such risks and uncertainties include, without limitation, that, before assets may be acquired, customers may leave in search of more stable providers and vendors may terminate key relationships. Also, assets are generally acquired on an “as is” basis, with no recourse to the seller if the assets are not as valuable as may be represented. Finally, while bankrupt companies may be acquired for comparatively little money, the cost of continuing the operations may significantly exceed expectations.

We have in the past used, and may continue to use, our Common Stock as payment for all or a portion of the purchase price for acquisitions. If we issue significant amounts of our Common Stock for such acquisitions, this could result in substantial dilution of the equity interests of our stockholders.

If we fail to retain our key personnel and attract and retain additional qualified personnel, we might not be able to pursue our growth strategy.

Our future success depends upon the continued service of our executive officers and other key sales and research personnel who possess longstanding industry relationships and technical knowledge of our products and operations. The loss of any of our key employees, in particular, Patrick White, our Chief Executive Officer and Chief Financial Officer; Peter Ettinger, our President; Thomas Wicker, our Vice-President of Research and Development; and David Wicker, our Vice-President of Operations, could negatively impact our ability to pursue our growth strategy and conduct operations. Although we believe that our relationship with these individuals is positive, there can be no assurance that the services of these individuals will continue to be available to us in the future. We have extended our employment agreements with Patrick White to June 2009. Our employment agreements with Thomas Wicker and David Wicker expired in June 2007. Our employment agreement with Peter Ettinger expires in June 2009.There can be no assurance that these persons will continue to agree to be employed by us after such dates.

If we do not successfully expand our sales force, we may be unable to increase our revenues.

We must expand the size of our marketing activities and sales force to increase revenues. We continue to evaluate various methods of expanding our marketing activities, including the use of outside marketing consultants and representatives and expanding our in-house marketing capabilities. Going forward, we anticipate an increasing percentage of our revenues to come from the licensing of our newer technologies, where profit margins are significantly higher than those provided by Security Paper. If we are unable to hire or retain qualified sales personnel, if newly hired personnel fail to develop the necessary skills to be productive, or if they reach productivity more slowly than anticipated, our ability to increase our revenues and grow could be compromised. The challenge of attracting, training and retaining qualified candidates may make it difficult to meet our sales growth targets. Further, we may not generate sufficient sales to offset the increased expense resulting from expanding our sales force or we may be unable to manage a larger sales force.

Future growth in our business could make it difficult to manage our resources.

Our anticipated business expansion could place a significant strain on our management, administrative and financial resources. Significant growth in our business may require us to implement additional operating, product development and financial controls, improve coordination among marketing, product development and finance functions, increase capital expenditures and hire additional personnel. There can be no assurance that we will be able to successfully manage any substantial expansion of our business, including attracting and retaining qualified personnel. Any failure to properly manage our future growth could negatively impact our business and operating results.

We cannot predict our future capital needs and we may not be able to secure additional financing.

We may need to raise additional funds in the future to fund our business, complete the development, testing and marketing of our products, or make strategic acquisitions or investments. We may require additional equity or debt financings, collaborative arrangements with corporate partners or funds from other sources for these purposes. We have recently engaged certain financial advisors to assist the Company in entering into business relationships and partnerships with certain strategic investors. No assurance can be given that these funds will be available for us to finance our development on acceptable terms, if at all. Such additional financings may involve substantial dilution of our stockholders or may require that we relinquish rights to certain of our technologies or products. In addition, we may experience operational difficulties and delays due to working capital restrictions. If adequate funds are not available from operations or additional sources of financing, we may have to delay or scale back our growth plans.

Risks Related to Our Stock

Provisions of our certificate of incorporation and agreements could delay or prevent a change in control of our company.

Certain provisions of our certificate of incorporation may discourage, delay, or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

·	the authority of the Board of Directors to issue preferred stock; and

·	a prohibition on cumulative voting in the election of directors.

We have a large number of authorized but unissued shares of common stock, which our management may issue without further stockholder approval, thereby causing dilution of your holdings of our common stock.

As of September 30, 2007, there were approximately 185,000,000 of authorized but unissued shares of our common stock. Our management will continue to have broad discretion to issue shares of our common stock in a range of transactions, including capital-raising transactions, mergers, acquisitions, for anti-takeover purposes, and in other transactions, without obtaining stockholder approval, unless stockholder approval is required for a particular transaction under the rules of the American Stock Exchange, New York law, or other applicable laws. If our management determines to issue shares of our common stock from the large pool of such authorized but unissued shares for any purpose in the future without obtaining stockholder approval, your ownership position would be diluted without your further ability to vote on that transaction.

The exercise of our outstanding options and warrants and vesting of restricted stock awards may depress our stock price.

As of September 30, 2007, there were outstanding stock options and warrants to purchase an aggregate of 1,768,343 shares of our Common Stock at exercise prices ranging from $2.00 to $12.65 per share, of which 1,410,862 are currently exercisable. To the extent that these securities are exercised, dilution to our stockholders will occur. In addition, as of September 30, 2007, there were 595,000 restricted shares of our common stock that are subject to various vesting terms. To the extent that these securities vest, dilution to our stockholders will occur. Moreover, the terms upon which we will be able to obtain additional equity capital may be adversely affected, since the holders of these securities can be expected to exercise or convert them at a time when we would, in all likelihood, be able to obtain any needed capital on terms more favorable to us than the exercise and conversion terms provided by those securities.

Sales of these shares in the public market, or the perception that future sales of these shares could occur, could have the effect of lowering the market price of our common stock below current levels and make it more difficult for us and our stockholders to sell our equity securities in the future.

Sale or the availability for sale of shares of common stock by stockholders could cause the market price of our common stock to decline and could impair our ability to raise capital through an offering of additional equity securities.

We do not intend to pay cash dividends.

We do not intend to declare or pay cash dividends on our common stock in the foreseeable future. We anticipate that we will retain any earnings and other cash resources for investment in our business. The payment of dividends on our common stock is subject to the discretion of our Board of Directors and will depend on our operations, financial position, financial requirements, general business conditions, restrictions imposed by financing arrangements, if any, legal restrictions on the payment of dividends and other factors that our Board of Directors deems relevant.

ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 5 - OTHER INFORMATION

None

ITEM 6 - EXHIBITS

The Exhibits listed below designated by an * are incorporated by reference to the filings by Document Security Systems, Inc. under the Securities Act of 1933 or the Securities and Exchange Act of 1934, as indicated. All other exhibits are filed herewith.

(a) Exhibits

Item 3.1 Articles of Organization, as amended (incorporated by reference to exhibit 3.1 to the Company's Registration Statements No. 2-98684-NY on Form S-18).*

Item 3.2 By-laws, as amended (incorporation by reference to exhibit 3.2 to the Company's Registration Statement No. 2-98684-NY on Form S-18).*

Item 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act

Item 31.2 Certifications of Acting Chief Financial Officer Pursuant to Section 302 of the Sarbanes Oxley Act

Item 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes Oxley Act

Item 32.2 Certification of Acting Chief Financial Officer Pursuant to Section 906 of the Sarbanes Oxley Act

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.


	DOCUMENT SECURITY SYSTEMS, INC.

November 14, 2007	By:	/s/ Patrick White
		Patrick White Chief Executive Officer



November 14, 2007	By:	/s/ Philip Jones
		Philip Jones Acting Chief Financial Officer (Vice President of Finance)