10-K 1 v107049_10k.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K
 
x Annual Report under Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the fiscal year ended December 31, 2007

or

o Transitional Report under Section 13 or 15(d) of the
Securities Exchange Act of 1934
 
1-32146
Commission file number

logo
DOCUMENT SECURITY SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)

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

First Federal Plaza
28 East Main Street, Suite 1525
Rochester, New York 14614
(Address of principal executive office)

(585) 325-3610
(Registrant’s telephone number)

Securities registered under Section 12(b) of the Act: NONE

Securities registered under to Section 12(g) of the Act:
 
Common Stock (Par Value - $0.02)
(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. o

INDICATE BY CHECK MARK WHETHER THE REGISTRANT:

(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this Chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer filer.
 
Large Accelerated Filer o    Accelerated Filer x    Non-Accelerated Filer o
 
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Act).
Yes o No x

The aggregate market value of the stock held by non-affiliates (6,163,619 shares) computed by reference to the closing price of such stock ($13.79), as of June 30, 2007, was $84,996,306.

As of March 10, 2008, there were 13,654,364 shares of Common Stock of Document Security Systems, Inc. outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE

The definitive proxy statement relating to the registrant’s Annual Meeting of Stockholders, to be held on May 1, 2008, is incorporated by reference into Part III of this Form 10-K to the extent described therein.



DOCUMENT SECURITY SYSTEMS, INC. & SUBSIDIARIES
 
Table of Contents

 
PART I
   
       
ITEM 1.
DESCRIPTION OF BUSINESS
 
3
ITEM 1A.
RISK FACTORS
 
9
ITEM 1B.
UNRESOLVED STAFF COMMENTS
 
14
ITEM 2.
PROPERTY
 
14
ITEM 3.
LEGAL PROCEEDINGS
 
15
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
16
       
 
PART II
   
       
ITEM 5.
MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
17
ITEM 6.
SELECTED FINANCIAL DATA
 
19
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
20
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
32
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
32
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
32
ITEM 9A.
CONTROLS AND PROCEDURES
 
33
ITEM 9B.
OTHER INFORMATION
 
34
       
 
PART III
   
       
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
35
ITEM 11.
EXECUTIVE COMPENSATION
 
35
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
35
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
35
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
35
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
35
 
SIGNATURES
 
 
 
2


ITEM 1 - DESCRIPTION OF BUSINESS

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

We were organized as a New York corporation in 1984, and in 2002, chose to strategically focus on becoming a developer and marketer of secure technologies for all forms of print media. To accomplish this, we acquired Lester Levin, Inc., an operator of a small printing company, an Internet-based business called Legalstore.com, and Thomas M. Wicker Enterprises, Inc. and Document Security Consultants, Inc., two privately owned companies engaged in the document security technology business with rights to certain patents developed by certain members of the Wicker Family. As a result of these acquisitions, we compiled the basis of our document security business by combining basic print capabilities necessary for research and development with the knowledge and expertise of our team of printing professionals and a foundation of patented technologies and trade secrets from which to launch our product offerings. Since this early stage, we have focused our efforts on developing and in some cases patenting new technologies and products, building our corporate, operational, marketing and sales staff to accommodate our expected growth, and developing and implementing our patent and intellectual property protection strategy.

In 2006, we acquired San Francisco-based Plastic Printing Professionals, Inc. (“P3”), a privately held security printer specializing in plastic cards containing multiple or singular security technologies. P3’s primary focus is manufacturing long-life composite, laminated and surface printed cards which can include magnetic strips, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, Biometric, RFID and a patent-pending watermark technology. P3’s products are marketed through an extensive broker network that covers much of North America, Europe and South America. P3’s product and client list includes the Grammy Awards, the Country Music Association awards, sporting event media cards, ID cards for major airports and Latin American and African driver’s licenses. Our acquisition of P3 marked the initial execution of our strategy to expand our manufacturing capabilities through acquisitions in order to expand our custom security printing business. In addition, the plastic products of P3 marked the first time that we were able to apply our technologies to a medium other than paper. During 2007, we sold our retail copying and quick-printing business as this operation no longer supported our core industry focus.

We generated revenue from continuing operations of $6.0 million in 2007, which equaled a 39% increase compared to 2006. The increase was primarily due to increases in royalty revenue from the licensing of the Company’s technology, and from increases in sales of security printing and products. Specifically, during 2007, the Company saw increased demand for its safety paper, especially in the latter half of 2007 due in party to new legislation that required hospitals, physicians and pharmacies to use tamperproof paper to fill all Medicaid prescriptions. Initially, the requirement, which was part 7002(b) of the “U.S. Troop Readiness, Veterans’ Care, Katrina Recovery and Iraq Accountability Appropriations Act of 2007” was to become effective on October 1, 2007, but a six-month grace period pushed the deadline to April 1, 2008. The Company, primarily through its customer Boise Cascade, saw an increase in demand to meet the initial October 1, 2007 deadline, which positively impacted the Company’s revenue during the fourth quarter of 2007.

Our increase in royalty revenue primarily reflects a full twelve months of revenue earned in 2007 under a license agreement signed with R.R. Donnelley in August 2006. During 2007, the Company also realized initial sales of its digital solutions products, which the Company officially launched in New York City in September 2007, in conjunction with its premier partner, The Ergonomics Group. The Company’s digital solutions products are an expansion of the Company’s core technologies so that they can be dynamically created in a host of operating environments and formats, including the ability to output security features on widely available, low cost desktop printers.

During 2007, gross profit from continuing operations increased by 57%, a greater pace than the 39% increase in revenue because a large portion of the increased revenue during 2007 was from royalty revenue, the Company’s highest margin product category. In addition, the Company focused its security printing and products business on the highest margin opportunities, which helped increase that group’s margins by 9%. Both of these trends positively impacted the Company’s overall profit margin percentage, which was 52% in 2007, a 13% increase over 46% in 2006.
 
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Operating expenses from continuing operations for 2007 were $10.1 million compared with $6.8 million in 2006, an increase of 50%. Operating increases reflect increases in our organization, including costs associated with the move of our plastic card manufacturing operation into a 25,000 square foot facility, as well as a significant increase in sales and marketing expenditures. Sales and marketing costs reflect the focus by the Company to increase its presence in certain key vertical markets to drive long-term revenue opportunities. In addition, the Company experienced a significant increase in accounting expense associated with it Sarbanes Oxley compliance requirements. The expense increase also reflects increases in non-cash expenses of stock based payments and amortization of intangibles of 35% and 71%, respectively.
 
We recorded a net loss during 2007 of $7.0 million, or $0.51 per basic and diluted share, compared with a net loss of $4.8 million in 2006 or $0.37 per basic and diluted share. Adjusted EBITDA loss during 2007 was $3.8 million, or $0.28 per share, compared with a Adjusted EBITDA loss of $2.6 million, or $0.20 per share. Adjusted EBITDA, defined as earnings before interest, taxes, depreciation, amortization and non-cash stock based compensation expense, is a non-GAAP measurement of financial performance that the Company believes is relevant to the understanding of the Company’s financial results.

Our Core Products, Technology and Services

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 are a leader in the research and development of optical deterrent technologies and have commercialized these technologies with a suite of products that offer our customers an array of document security solutions. We provide document security technology to security printers, corporations and governments worldwide and for currency, identifications, certifications, travel documents, prescription and medical forms, consumer product and pharmaceutical packaging, and school transcripts.

Our products can be delivered on paper, plastic, or digitally via our AuthentiGuard® DX product suite. We believe that our continued efforts in the field of digital security and technology greatly expand the reach and potential market for our AuthentiGuard® DX digital products and enterprise solutions. We believe that our AuthentiGuard® DX solution significantly changes the economics of document security for many customers as it eliminates the requirement to utilize pre-printed forms while allowing customers to leverage existing investments in their information technology infrastructure.

Technologies
 
We have developed or acquired various optical deterrent and related 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™ DX, which includes On-Demand™ and Plugin, AuthentiGuard® Laser Moiré™, AuthentiGuard® Prism™, AuthentiGuard® Pantograph 4000™, AuthentiGuard® Phantom™, AuthentiGuard® VeriGlow™, AuthentiGuard® Survivor 21™ and AuthentiGuard® MicroPerf™.

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Products and Services

Custom Document Security Solutions and Production: Our technology portfolio allows us to create unique custom secure paper, plastic, packaging and Internet-based and software enterprise solutions. We market and sell to end-users that require anti-counterfeiting and authentication features in a wide range of printed materials such as documents, passports, 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.

Currently, we outsource the production of the majority of our custom security print orders to strategic printing vendors, except for secure plastic printed documents such as ID cards, which are manufactured mainly at our P3 manufacturing facility. The acquisition of P3 in February 2006 marked the initial execution of our strategy to expand our manufacturing capabilities through acquisitions, partnerships or strategic alliances in order to fully service our custom security printing business. In late 2007, we moved our P3 manufacturing facility to a 25,000 square foot facility in order to increase our plastic manufacturing capacity. Our P3 division generally charges a per unit fee for its printing projects. Custom projects are generally billed at cost plus mark-up.

Additionally, our custom security solutions include our digital technology that provides custom-hosted or server-based 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. For these projects, we typically charge the client a project fee along with ongoing licenses and maintenance fees. We also anticipate that we will be entering into per usage fee arrangements for certain applications of the digital solution.

Generic Security Paper: Our primary product for the retail end-user market is AuthentiGuard® Security Paper. AuthentiGuard® Security Paper is blank paper that contains our Pantograph 4000TM technology. The paper reveals hidden warning words, logos or images using The Authenticator- our proprietary viewing lens - or when the paper is faxed, copied or scanned. The hidden words appear on the duplicate or the computer digital file and essentially prevents documents, including forms, coupons and tickets, from being counterfeited. We market and sell our AuthentiGuard® Security Paper primarily through two major paper distributors: Boise Cascade and PaperlinX Limited. Since 2005, Boise has marketed our AuthentiGuard® Security Paper under its Boise Beware brand name in North America, primarily through its commercial paper sales group. In late 2005, we entered into an agreement with PaperlinX to market and sell our AuthentiGuard® Security Paper under the name SecurelinX in Europe, Australia and New Zealand. In addition, our licensee PyroTech has the marketing rights to manufacture and sell our Security Paper in the continent of Africa. We retain the rights to sell the same AuthentiGuard® Security Paper directly to end-users anywhere in the world.

Custom Security Paper: We also sell custom-designed security paper containing one or more of our technologies. We typically sell this security paper for high-end security solutions with special non-public authentication systems. One such product is used by a large Aerospace company that utilizes a custom paper for the security of spare parts. The Federal Aviation Administration has given our custom designed form an official part number which is utilized by Aerospace technicians.

In addition we have designed another custom security paper that meets the guidelines as set forth in new Medicaid prescription requirements which goes into effect on April 1, 2008. This paper is being sold by Boise Cascade in a controlled environment to medical professionals throughout the United States.

Currently, our AuthentiGuard® Security Paper is manufactured and stored for us by a third-party printer, which we believe has sufficient manufacturing capacity to meet the foreseeable demand for this product.

Technology Licensing: We license our anti-counterfeiting technology and trade secrets to security printers through licensing arrangements. 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. Licenses can be for a single technology or for a package of technologies.  We offer licensees a variety of pricing models, including:

 
·
Pay us one price per year;

 
·
Pay us a percentage of gross sales price of the product containing the technology during the term; or

 
·
Joint venture or profit sharing arrangement.

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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.

Intellectual Property

Patents

Our ability to compete effectively depends, in part, on our ability to maintain the proprietary nature of our technology, products and manufacturing processes. We principally rely upon patent, trademark, trade secrets and contract law to establish and protect our proprietary rights. During our development, we have expended a significant percentage of our resources on the research and development to ensure that we are a market leader with the ability to provide our customers effective solutions against an ever changing array of counterfeit risks. During 2007, 2006 and 2005, we spent 7% ($420,000), 8% ($353,000) and 24% ($314,000) of our revenue from continuing operations, respectively, for our research and development efforts. As we continue to grow our business, we expect to continue our research and development efforts, although these costs are expected to continue to decrease as a percentage of our revenue.
 
We use intellectual property to differentiate our products and technologies, mitigate infringement risk, and develop opportunities for licensing. Licensing of our optical deterrent and related technologies is supported by a patent portfolio covering a wide range of methods, applications, and system architectures.

Most of our patents relate to various methods for embedding optical deterrents and hidden images in printed documents, packaging, labels or plastic printed products such as ID Cards, whether the content is rendered by traditional printing methods or digital formats. Optical deterrent technologies are utilized to prevent or distort a scanners ability to capture true authentic looking images. The technologies are mainly ink that is printed in particular patterns that confuse the scanners imaging capture process. Our technologies prevent desktop scanners, high-end professional scanning systems, digital color copiers and photographic scanners from capturing images that are protected by our intellectual property.

The optical deterrent technologies can also be applied digitally utilizing software files and printing to a digital print output device such as large high-speed digital print engines such as the Hewlett Packard Indigo, Xerox I-Gen or Kodak Nexpress. In addition, the AuthentiGuard® On-DemandTM product is produced on desktop printers as the technology is applied on servers and accessed over the Internet to produce the secure document.

To protect our significant efforts in creating these technologies, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contracts. As a result, our patent portfolios has five U.S. and three foreign issued patents and 15 U.S. and foreign patent applications on file as of December 31, 2007 in the areas of optical deterrents and related technologies. Separately, we own registered trademarks in both the U.S. and other countries and have applied for other trademarks. We continue to develop and broaden our portfolio of patented technologies, including optical deterrents and related applications and systems, and other technologies related to image and document protection. Digital versions of the technologies represent the majority of the new development.

Although we devote significant resources to developing and protecting our technologies, and periodically evaluate potential competitors of our technologies for infringement of our intellectual property rights, these infringements may nonetheless go undetected or may arise in the future. We expect that infringement claims may increase as companies become more concerned with protecting their content from digital copying.
 
By aggressively defending our intellectual property rights, we believe that we may be able to secure a potentially significant amount of additional and ongoing revenue by securing proceeds from lawsuits, settlements, or licensing agreements with those persons, companies or governments that we believe are infringing our patents. We intend to use the appropriate legal means that are economically feasible to protect our ownership of these technologies. We cannot be assured, however, that our efforts to prevent the misappropriation of the intellectual property used in our business will be successful, or that we will be successful in obtaining monetary proceeds from entities that we believe are infringing our patents. Further, we cannot be assured that any patents will be issued for our U.S. or foreign applications or that, if issued, they will provide protection against competitive technologies or will be held valid and enforceable if challenged. We also cannot be assured that competitors would not be able to design around any such proprietary right or obtain rights that we would need to license or design around in order to practice under these patents.
 
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Trademarks

We have registered our “AuthentiGuard” mark, as well as our “Survivor 21” electronic check icon with the U.S. Patent and Trademark Office. A trademark application is pending in Canada for “AuthentiGuard.” AuthentiGuard® is registered in several European countries including the United Kingdom.

Sales and Marketing

We believe that 2006 was a year in which we completed our “early development” stage and entered the growth and commercialization phase of business. In 2006, we began to see the results of our efforts of building our brand, and identifying strategic partners and customers upon which to grow our business. As we entered this new phase of our business, we increased our sales and marketing expenditures in order to facilitate our expected growth. Although we increased revenues from continuing operations from $4.3 million in 2006 to $6.0 million in 2007, this growth did not meet our targets, and we are evaluating the size, structure and compensation of our sales and marketing groups in order to better achieve our goals.

In 2007, we focused on sales activities associated with the commercialization of our products, with both established and new customers and partners, and also defined opportunities to expand our products and our channels to market. We also continued to implement our vertical market strategy to help support these efforts with a focus on five primary verticals were our focused: academic/higher education, financial institutions, government/government agencies, genuine parts/manufacturers, and healthcare/pharmaceutical. We believe that these industries provide the largest revenue potential and opportunities for our technology and product solutions.

We also continued the expansion and reorganization of our sales and marketing staff, which we believe is necessary to continue to grow our business, expand our reach, drive revenue, and create ongoing brand and name recognition. We began to see the positive results of these initiatives throughout 2007, and expect to continue to see these benefits in 2008 as we focus our marketing and sales efforts on sales prospects that provide a high degree of likelihood to purchase our products. Our marketing activities are focused on developing brand awareness of AuthentiGuard®, our technology suite brand, and selling related products.
 
Major Customers

During 2007, one customer accounted for 13% of the Company’s total revenue from continuing operations. As of December 31, 2007, one customer accounted for 16% of the Company’s trade accounts receivable balance.

Websites

We maintain the website, www.documentsecurity.com, which describes our patented document security solutions, our targeted vertical markets, company history, and offers our security consulting services. We also maintain www.plasticprintingprofessionals.com, which describes our ID card and other plastic and vinyl printing services. In addition, we maintain the websites www.safetypaper.com and www.protectedpaper.com, which are e-commerce sites that market and sell our patented blank Security Paper, hand-held security verifiers and custom security documents to end users worldwide, and the website www.legalstore.com, which sells printing services and security products primarily to members of the legal profession. We also utilize www.authenticate-360.com, a website which is hosted and owned by our licensee, The Ergonomic Group; this website is. a source for counterfeiting information and promotion of our On-Demand™ products.

Competition

Currently, the security print market is comprised of a few very large companies and an increasing number of small companies with specific technology niches. The expansion of this market is the result of increasing requirements for national security, as well as the proliferation of brand and identity theft. Counterfeiting has expanded significantly as advancing technologies in digital duplication and scanning combined with increasingly sophisticated design software has enabled easier reproduction of originals.

Our industry is highly fragmented and characterized by rapid technological change and product innovations and evolving standards. We feel a consolidation of the industry may transpire in the near future as larger, well financed companies acquire smaller technology companies to position themselves in the industry and access their intellectual property and access to client lists. Many of our current competitors have longer operating histories, more established products, greater name recognition, larger customer bases, and greater financial, technical and marketing resources. As a result, our competitors 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. There is no assurance 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.
 
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Although our technology is effective primarily on analog and digital copiers and scanners, our competition covers a wide array of document security and anti-counterfeiting solutions. We conduct research and development to improve our technology, including the development of new patents and trade secrets. We will rely primarily upon our patents and trade secrets to attempt to thwart competition, although there can be no assurance that we will be successful. 

Our competitors include Standard Register Company, which specializes in printing security technologies for the check and forms and medical industries; De La Rue Plc, that specializes in printing secure currency, tickets, labels, lottery tickets and vital records for governments and Fortune 500 companies; Xerox, an industry leader in copying and scanning that has made recent entries into the anti-counterfeiting business and has a competing Safety Paper product called “X Void.” Our P3 ID card manufacturing operation competes with Lasercard Corporation which supplies advanced ID technology to the U.S. federal government and other government programs worldwide, with a range of products and solutions that includes secure ID technologies.

In addition, other competing hidden word technologies are being marketed by competitors such as Nocopi Technologies which sells and markets secure paper products, and Graphic Security Systems Corporation, which markets scrambled indicia.

Digital watermarks, RFID and biometric technologies are also being introduced into the marketplace by Digimarc Corporation, IBM and L-1 Identity Solutions. These digital protection systems require software and hardware such as scanners and computers to implement and utilize the technology and, consequently, this technology must be utilized in a controlled environment with the necessary equipment to create the verification process. Therefore, versions of our optical security technologies do not require hardware and software to operate and therefore, provide a power outage fail-safe when combined or layered with RFID, digital watermarks or biometric systems.

Large Office Equipment Manufacturers, called OEMs, such as Sharp, Canon, Ricoh, Hewlett Packard and Eastman Kodak are developing “smart copier” technology that recognizes particular graphical images and produces warning words or distorted copies. Some of the OEMs are also developing user assigned and variable pantograph “hidden word” technologies in which users can assign a particular hidden work in copy, such as “void” that is displayed when copy of such document is made.

Optical Deterrent features such as ours are utilized mainly by the large worldwide security printers for the protection of currency. Many of these features such as micro-printing were developed pre-1980 as they were designed to be effective on the imaging devices of the day which were mainly photography mechanisms. With the advent of modern day scanners, digital copiers, digital cameras and easy to use imaging software such as Adobe Photoshop many of the pre-1980 optical deterrents such as micro-printing are no longer or much less effective in the prevention of counterfeiting.

Unlike some of our competitors, our technologies are developed to defeat today’s modern imaging systems. Almost all of our products and processes are built to thwart scanners and digital copiers and we believe that our products are the most effective in doing so in the market today. In addition, our technologies do not require expensive hardware or software add-ons to authenticate a document, but instead require simple, inexpensive hand-held readers which can be calibrated to particular hidden design features. Our technologies are literally ink on paper that is printed with a particular method to hide selected things from a scanner’s “eye” or distort what a scanner “sees.” These attributes make our anti-scanning technologies very cost effective versus other current offerings on the market since our technologies are imbedded during the normal printing process, thereby significantly reducing the costs to implement the technologies.

There are many types of digital software security providers offering encryption protection in documents, but we feel our digital enterprise solutions are of the few, if not only, ones that provide encryption, authentication and copy /scanning protection. In 2007, we had two clients install our initial products of this new technology offering, HSBC Bank in Mexico and Indra Systemas in Spain, which used the technology to protect Panama Canal Visas. Both of these clients accepted proposals from other software security providers but selected our products for the projects. We feel competition in the software digital solutions will continue to be intense, but we continue to feel our greatest revenue generating opportunities will be in this digital product line. We will be working with our licensee, The Ergonomics Group, a large software and hardware engineering firm based in Long Island, New York to help develop, support and sell our digital offerings. In addition we will look to sell this product through large integrators such as Indra Systemas.

Segment Information
 
We operate through two segments:
 
 
·
Document Security and Production. This segment consists of the 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, we sold the assets of our 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 our core operations. The results of this division are reported as discontinued operations and are not a component of this segment’s results (See Note 9).
 
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·
Legal Supplies. This segment consists of the sale of specialty legal supplies, primarily to lawyers and law firms located throughout the United States, via the Legalstore.com website.
 
Financial information regarding these segments is provided in Note 14 to our consolidated financial statements included in this Annual Report on Form 10-K. Financial information relating to revenues and other operating income, net loss, operating expenses and total assets for the three years ended December 31, 2007, can be found in Item 6 “Selected Financial Data”.

Employees

As of December 31, 2007, we had 59 full and part-time employees, three of whom are executive officers. It is important that we continue to retain and attract qualified management and technical personnel. Our employees are not covered by any collective bargaining agreement, and we believe that our relations with our employees are good. 

Government Regulation


Document Security Systems plays an active role with the Document Security Alliance group, as it sits on various committees and has been involved in design recommendations for important U.S. documents. This group of security industry specialists was formed by the U.S. Secret Service to evaluate and recommend security solutions to the Federal government for the protection of credentials and vital records.

As counterfeiting continues to increase worldwide, various new laws and mandates are occurring to address the growing security problem which we believe will increase our ability to generate revenue. For example, in 2007 Federal legislation was enacted that required hospitals, physicians and pharmacies to use tamperproof paper to fill all Medicaid prescriptions. Initially, the requirement, which was part 7002(b) of the “U.S. Troop Readiness, Veterans’ Care, Katrina Recovery and Iraq Accountability Appropriations Act of 2007”, was scheduled to go into effect on October 1, 2007, but the effective date was delayed to April 1, 2008. Prior to the delay of the effective date, we realized an increase in the sales of our AuthentiGuard® Security Paper in the third quarter of 2007 as customers prepared to satisfy the requirements of this legislation.

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-K, including our financial statements and related notes, competition and intellectual property.

We have a limited operating history with our 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 $24,215,000 at December 31, 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 this new business 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 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.
 
9


We have secured credit facilities that have large principal payments due in January 2010, and if we are unable to repay them with cash we may be forced to repay, in whole or in part, with each credit facility’s applicable collateral, which would have a material adverse effect on our financial position.

On January 4, 2008, we entered into two credit facilities with an aggregate borrowing capacity of $3.6 million that is repayable in full in January 4, 2010. One of these credit facilities has a borrowing limit of $3.0 million and is secured by our stock in our Plastic Printing Professionals, Inc. subsidiary, and the other credit facility has a borrowing limit of $600,000 and is secured by our accounts receivable. If we cannot generate sufficient cash from operations or raise cash from other sources, including without limitation, fundraising through sales of equity, and if we cannot refinance the credit facilities, we may have to repay, in whole or in part, one or both of the credit facilities with each credit facilities applicable collateral, which would have a material adverse effect on our financial position.
 
Due to our low cash balance and negative cash flow, we may have to further reduce our costs by curtailing future operations.

We have incurred significant net losses in previous years. Our ability to fund our capital requirements out of our available cash and cash generated from our operations depends on a number of factors. Some of these factors include our ability to (i) increase paper and plastic card sales and (ii) increase sales of our digital products. If we cannot generate positive cash flow from operations, we will have to continue to reduce our costs and raise working capital from other sources. These measures could include selling or consolidating certain operations or assets, and delaying, canceling or scaling back product development and marketing programs. These measures could materially and adversely affect our ability to operate profitably.

Our ability to effect a financing transaction to fund our operations could adversely affect the value of your stock.

If we seek additional financing through raising additional capital through public or private equity offerings or debt financing, such additional capital financing may not be available to us on favorable terms and our stockholders will likely experience substantial dilution. Material shortage of capital will require us to take steps such as reducing our level of operations, disposing of selected assets, effecting financings on less than favorable terms or seeking protection under federal bankruptcy laws.

Our limited cash resources may not be sufficient to fund continuing losses from operations and the expenses of the current patent validity and patent infringement litigations.

The cost to defend current and future litigation may be significant. We cannot assure you that the ultimate cost of current known or future unknown litigation and claims will not exceed our current expectations and/or our ability to pay such costs and it is possible that such litigation costs could have a material adverse effect on our business, financial condition and operating results. In addition, litigation is time consuming and could divert management attention and resources away from our business, which could adversely affect our business, financial condition and operating results.

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 Item 3- 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 of our products based on any patent that is invalidated.
 
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 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 adverse rulings 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, with our current estimates of between $1,000,000 to $2,000,000. The payment of these amounts could have a material adverse impact on our operations, cash available and liquidity.
 
10

 
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.
 
11


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.

Certain of our recently developed products are not yet commercially accepted and there can be no assurance that those products will be accepted, which would adversely affect our financial results.

Over the past one to two years, we have spent significant funds and time to create new products by applying our technologies onto media other than paper, including plastic and cardboard packaging, and delivered our technologies digitally. We have had limited success in selling our products that are on cardboard packaging and those that are delivered digitally. Our business plan for 2008 and beyond includes significant marketing and sales of these newer products, particularly the digitally delivered products. If we are not able to successfully sell these new products, our financial results will be adversely affected.

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.

12

 
Although we were able to successfully acquire our Plastic Printing Professionals, Inc. 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; Peter Ettinger, our President; Thomas Wicker, our Chief Technology Officer; 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 expire in June 2008. 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 more aggressive expansion of 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. 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.
 
13


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 December 31, 2007, there are approximately 185 million shares 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. We currently have no specific plans to issue shares of our common stock for any purpose. However, 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 December 31, 2007, there were outstanding stock options and warrants to purchase an aggregate of 1,287,343 shares of our Common Stock at exercise prices ranging from $2.00 to $12.65 per share, most of which are currently exercisable. To the extent that these securities are exercised, dilution to our stockholders will occur. In addition, as of December 31, 2007, there were 513,323 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 1B - UNRESOLVED STAFF COMMENTS

None.

ITEM 2 - PROPERTY

Our administrative offices are located in the First Federal Plaza Building, 28 East Main Street, Rochester, New York 14614. We currently sublease approximately 4,700 square feet of office space under a master lease, which expired in January 2007. Commencing February 1, 2007, we entered into a five-year lease for the same location. In addition, our Security Products and Printing group occupies several locations, including approximately 5,000 square feet at our P3 division in Daly City, California under a month-to-month lease which the Company will exit in April 2008 due to its move completed in January 2008, to an approximately 25,000 square foot facility in Brisbane, California. The new lease, which commenced in July 2007, is for seven years with options to extend up to an additional six years. The Company is currently seeking to sublease approximately 9,800 of this space. Our Legal Supplies group rents approximately 5,000 square feet under a leases expiring in 2010. We believe that our facilities are adequate for our current operations. The Company also believes that it can negotiate renewals or similar lease arrangements on acceptable terms when our current leases expire.
 
14


ITEM 3 - LEGAL PROCEEDINGS

On August 1, 2005, we commenced a suit against the European Central Bank alleging patent infringement by the European Central Bank 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, and also ruled that we will be required to pay attorneys and court fees of the ECB. The ECB have claimed attorneys and court fees in the amount of Euro 93,752, which will be subject to an assessment procedure that will not likely be concluded until no earlier than the middle of 2008.

On March 24, 2006, we received notice that the ECB has filed separate claims in the United Kingdom and Luxembourg courts 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, and such appeal was heard on February 5, 2008. As a result of the English Court’s ruling, the Company was required to pay a portion of the ECB’s legal costs associated with the case. On March 30, 2007, the English Court awarded the ECB 30% of their costs for such reimbursement, of which the Company paid 90,000 pounds (USD $182,000) on April 19, 2007 and the estimated remaining payment is 90,000 pounds ($182,000), which is included in accrued expenses at December 31, 2007. The Company appealed the English Court decision in April 2007. In July 2007, the Company established a restricted cash balance of 87,500 British 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 the appeal in that court. The Company is currently awaiting the decision of the appeal. On March 27, 2007, the German Federal Patent Court (Bundespatentgericht) in Munich, Germany ruled that the Patent was valid in Germany. 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. The ECB has appealed this ruling. On January 9, 2008, the Tribunal de Grande Instance de Paris, 3rd Chamber - 3rd Section of the High Court of Paris in Paris, France ruled that the Patent was invalid in France. The court ruled that no fees were owed by the Company to the ECB for the French litigation. We are evaluating whether to appeal this decision. On March 12, 2008, District Court of the Hague in the Netherlands ruled that the Patent was valid in the Netherlands. We expect the ECB to appeal this decision. Additional decisions and trials regarding validity are expected in the five 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 McTaggart (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 McTaggart 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. McTaggart 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 us, 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. Maxon later sought and received permission from the Court to join Thomas M. Wicker, Thomas Wicker Enterprises, Inc. and the Estate of Ralph Wicker (Thomas Wicker's deceased father's estate) as additional defendants on his counterclaims. We have denied the material allegations of all of the counterclaims. If Adler or Maxon 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.
 
15


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.


There were no matters submitted to a vote of security holders in the fourth quarter of 2007.
 
16


PART II

ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our Common Stock is listed on the American Stock Exchange, where it trades under the symbol “DMC.”

The following table sets forth the high and low closing prices for the shares of our Common Stock, for the periods indicated.

QUARTER ENDING
 
HIGH
 
LOW
 
March 31, 2007
 
$
11.95
 
$
8.60
 
June 30, 2007
   
13.79
   
10.85
 
September 30, 2007
   
14.65
   
10.34
 
December 31, 2007
   
11.20
   
5.32
 
 
QUARTER ENDING
   
HIGH
 
 
LOW
 
March 31, 2006
 
$
15.02
 
$
11.35
 
June 30, 2006
   
13.42
   
8.01
 
September 30, 2006
   
10.47
   
8.74
 
December 31, 2006
   
11.34
   
9.18
 
 
On March 10, 2008 our Common Stock had a high of $4.35 and a low of $4.15 and a closing price of $4.25.

Issued and Outstanding

Our certificate of incorporation authorizes 200,000,000 shares of Common Stock, par value $0.02. As of March 10, 2008, we had 13,654,364 shares of Common Stock, issued and outstanding.

Recent Issuances of Unregistered Securities

Stock Issued for Services - 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 2007, 60,866 restricted common shares were issued to MWE to pay for approximately $746,000 of legal fees incurred the through December 31, 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.
 
17


Comparative Stock Performance Graph
 
        The following graph is intended to allow review of stockholder returns, expressed in terms of the appreciation of the Company’s common stock relative to two broad-based stock performance indices. The information is for historical comparative purposed only and should not be considered indicative of future stock performance. The graph compares the yearly percentage change in the cumulative total stockholder return on the Company’s common stock with the cumulative total return on The American Stock Exchange Composite Index and The American Stock Exchange Technology Index from December 31, 2002 through December 31, 2007.
 
graph

Stockholders

As of March 10, 2008, we had approximately 1,407 record holders of our Common Stock.  This number does not include the number of persons whose shares are in nominee or in “street name” accounts through brokers.

Dividends

We did not pay dividends during 2007 or 2006. We presently intend to retain our cash for use in the operation and expansion of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future.

Stock Transfer Agent and Warrant Agent

Our stock transfer agent is American Stock Transfer & Trust Co., 6201 15th Avenue, Brooklyn, NY 11219. We act as our own warrant agent for our outstanding warrants.

Share Repurchased by the Registrant

We did not purchase or repurchase any of our securities in the fiscal year ended December 31, 2007, including the fourth quarter.

The information required by Item 201(d) of Regulation S-K will be contained in our Proxy Statement for our Annual Stockholders Meeting, which we will file with the Securities and Exchange Commission within 120 days after December 31, 2007, and which is incorporated by reference herein.

18


ITEM 6 - SELECTED FINANCIAL DATA

The selected financial data set forth below should be read in conjunction with consolidated financial statements and the notes to the consolidated financial statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this report. This consolidated statement of operations and balance sheet data as of and for each of the five years in the period ended December 31, 2007 are derived from our audited financial statements.

   
 Year Ended December 31:
 
Consolidated Statements of Income Data
 
2007
 
 
2006
 
 
2005
 
 
2004
 
 
2003
 
                               
Total Revenue
   
5,991,000
(5)
   
4,308,000
(1)
   
1,266,000
     
904,000
     
758,000
 
Total cost of revenue
   
2,864,000
     
2,322,000
     
643,000
     
560,000
     
373,000
 
Total gross profit
   
3,127,000
     
1,987,000
     
623,000
     
344,000
     
385,000
 
     
52
%
   
46
%
   
49
%
   
38
%
   
51
%
                                         
Operating Expenses
   
7,039,000
     
4,726,000
(7)
   
2,651,000
     
1,832,000
     
896,000
 
Stock based payments
   
1,355,000
     
1,002,000
     
119,000
     
59,000
     
790,000
 
Amortization of intangibles
   
1,754,000
     
1,026,000
     
538,000
     
18,000
     
38,000
 
Other income (expense), net (6)
   
34,000
     
(65,000
)
   
(158,000
)
   
(139,000
)
   
(113,000
)
Net loss
   
(6,987,000
)
   
(4,832,000
)
   
(2,843,000
)
   
(1,704,000
)
   
(1,452,000
)
Net loss per share, basic and diluted
   
(0.51
)
   
(0.37
)
   
(0.24
)
   
(0.16
)
   
(0.16
)

   
   As of December 31,
 
Consolidated Balance Sheet Information
 
 2007
 
 
 2006
 
 
 2005
 
 
 2004
 
 
2003
 
                                  
Cash and cash equivalents
 
$
742,000
   
$
5,803,000
(2)
 
$
3,953,000
   
$
2,658,000
   
$
5,116,000
(4)
Total current assets
    2,228,000      
6,885,000
     
4,492,000
     
3,166,000
     
5,391,000
 
Other Intangible assets, net
    6,150,000      
5,390,000
     
4,209,000
(3)
   
344,000
     
-
 
Total Assets
   
11,594,000
     
14,466,000
     
10,333,000
     
4,617,000
     
5,900,000
 
Total current liabilities
    3,426,000      
2,760,000
     
844,000
     
540,000
     
516,000
 
Long-term obligations
    811,000      
517,000
     
252,000
     
336,000
     
190,000
 
Total stockholders' equity
    7,357,000      
11,189,000
     
9,237,000
     
3,741,000
     
5,195,000
 
 
(1)
In February 2006, the Company acquired substantially all of the assets and assumed certain liabilities of Plastic Printing Professionals (“P3”). During 2007 and 2006, P3 accounted for approximately 47% and 53% of our revenue from continuing operations, respectively.
   
(2)
In December 2006, the Company received $4.2 million in net proceeds from a private placement of its common stock.
   
(3)
In February 2005, the Company acquired various interests to patent related assets through the issuance of its common stock valued at $3.9 million.
   
(4)
In December 2003, the Company received $5.0 million in net proceeds from a private placement of its common stock.
   
(5)
In September 2007, the Company sold it retail printing and copying operation whose operations in 2007 are recorded as discontinued operations. As a result, all consolidated statement of income amounts have been restated to take into account the discontinued operations.
   
(6)
Includes results form discontinued operations per (5) above.
   
(7)
In 2006, the Company adopted SFAS 123R for employee equity based compensation.

19


ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This Annual Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements that contain the words “believes,” “anticipates,” “expects,” “plans,” “intends” and similar words and phrases. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from the results projected in any forward-looking statement. In addition to the factors specifically noted in the forward-looking statements, other important factors, risks and uncertainties that could result in those differences include, but are not limited to, those discussed under Part I, Item 1A “Risk Factors” in this Annual Report. The forward-looking statements are made as of the date of this Annual Report, and we assume no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements. Investors should consult all of the information set forth in this report and the other information set forth from time to time in our reports filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, including our reports on Forms 10-Q and 8-K.
 
The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in Item 8 of this Annual Report.

Overview

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

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

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

In 2007, we focused on sales activities associated with the commercialization of our products, with both established and new customers and partners, and also defined opportunities to expand our products and our channels to market. We also continued to implement our vertical market strategy to help support these efforts with a focus on five primary verticals were our focused: academic/higher education, financial institutions, government/government agencies, genuine parts/manufacturers, and healthcare/pharmaceutical. We believe that these industries provide the largest revenue potential and opportunities for our technology and product solutions.

We also continued the expansion and reorganization of our sales and marketing staff, which we believe is necessary to continue to grow our business, expand our reach, drive revenue, and create ongoing brand and name recognition. We began to see the positive results of these initiatives throughout 2007, and expect to continue to see these benefits in 2008 as we focus our marketing and sales efforts on sales prospects that provide a high degree of likelihood to purchase our products. Our marketing activities are focused on developing brand awareness of AuthentiGuard®, our technology suite brand, and selling related products.
 
20

 
RESULTS OF OPERATIONS FOR THE FISCAL YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
 
The following discussion and analysis provides information that our management believes is relevant to an assessment and understanding of our results of operations and financial condition. All amounts have been adjusted to reflect the Company’s results after effect of the discontinued operations. On September 25, 2007, the Company sold its copying and quick-printing business to a private investor. In accordance with FASB 144, the Company accounts for the revenue and expenses of this operation, which is a component of its security printing segment, as a discontinued operation. The discussion should be read in conjunction with the financial statements and footnotes that appear elsewhere in this report.
 
Summary

   
Year Ended December 31:
 
Year Ended
 
% change
 
   
2007
 
2006
 
% change vs. 2006
 
December 31, 2005
 
2006 vs. 2005
 
Revenue, net
   
5,991,000
   
4,308,000
   
39
%
 
1,266,000
   
240
%
                                 
Costs of revenue
   
2,864,000
   
2,322,000
   
23
%
 
644,000
   
261
%
                                 
Gross profit
   
3,127,000
   
1,986,000
   
57
%
 
622,000
   
219
%
                                 
        Total Operating Expenses
   
10,148,000
   
6,753,000
   
50
%
 
3,307,000
   
104
%
                                 
Operating loss
   
(7,021,000
)
 
(4,767,000
)
 
47
%
 
(2,685,000
)
 
78
%
                                 
Other income (expense), net
   
64,000
   
42,000
   
52
%
 
82,000
   
-49
%
                                 
Loss from continuing operations before income taxes
   
(6,957,000
)
 
(4,725,000
)
 
47
%
 
(2,603,000
)
 
82
%
                                 
Income taxes
   
(19,000
)
 
-
         
-
       
Loss on discontinued operations
   
(11,000
)
 
(107,000
)
 
-90
%
 
(240,000
)
 
-55
%
                                 
Net loss
   
(6,987,000
)
 
(4,832,000
)
 
45
%
 
(2,843,000
)
 
70
%
 
Revenue

   
Year Ended December 31, 2007
 
Year Ended December 31, 2006
 
% change vs. 2006
 
Year Ended December 31, 2005
 
% change 2006 vs. 2005
 
Revenue, net
                     
Security printing & products
 
$
3,913,000
 
$
2,995,000
   
31
%
$
660,000
   
354
%
Royalties
   
1,195,000
   
682,000
   
75
%
 
81,000
   
742
%
Digital solutions
   
201,000
   
-
         
-
       
Legal products
   
682,000
   
631,000
   
8
%
 
525,000
   
20
%
Total Revenue
   
5,991,000
   
4,308,000
   
39
%
 
1,266,000
   
240
%
 
Revenue - 2007 vs 2006: The increase in total revenue in 2007 compared to 2006 resulted primarily from increases in royalty revenue from the licensing of the Company’s technology, and from increases in sales of security printing and products. Specifically, during 2007, the Company saw increased demand for its safety paper, especially due to the increase in demand experienced in the latter half of 2007 for safety paper which was significantly impacted by new legislation that required hospitals, physicians and pharmacies to use tamperproof paper to fill all Medicaid prescriptions. Initially, the requirement, which was part 7002(b) of the “U.S. Troop Readiness, Veterans’ Care, Katrina Recovery and Iraq Accountability Appropriations Act of 2007” was in effect as of October 1, 2007. Subsequently, a six-month grace period for compliance was passed by Congress, which pushed the deadline to April 1, 2008. The Company, primarily through its customer Boise Cascade, saw a rapid increase in demand to meet the initial October 1, 2007 deadline, which positively impacted the Company’s revenue during the fourth quarter of 2007.
 
The increase in royalty revenue primarily reflects a full twelve months of revenue earned in 2007 under the license agreement that the Company signed with R.R. Donnelley in August 2006. During 2007, the Company also realized initial sales of its digital solutions products, which the Company officially launched in New York City in September 2007, in conjunction with its premier partner, the Ergonomics Group. The Company’s digital solutions products are an expansion of the Company’s core technologies so that they can be dynamically created in a host of operating environments and formats, including the ability to output security features on generally available, low cost desktop printers.
 
21

 
Revenue from the Legalstore.com division continued a trend of steady growth as it increased the breadth of its product offerings and the size of its customer base. In addition, during 2007, the Company divested the assets that comprised it retail printing and copying operation to allow the Company to focus its resources on its higher margin business opportunities.
 
The following summarizes significant new contracts and business development agreements entered into by the Company during 2007:
 
·
Partnered with The Ergonomic Group results in development and launch of AuthentiGuard® On-Demand™ - a system that allows the production of Pantograph 4000 and Prism from a desktop computer and printer;
 
·
Implemented and installed in over 400 locations the first AuthentiGuard® On-Demand system for the Panamanian Canal Authorities together with Indra Sistemas, S.A.;
 
·
Partnered with Boise Cascade to provide doctors with enhanced document security for Medicaid prescription pads in advance of Legislative deadline;
 
·
Announced an initial project under our agreement with Barcode Technology (BTI) to market and produce DSS technologies both independently and in combination with BTI’s technology in China;
 
·
Opened a sales office in Stuttgart, Germany to continue commercialization efforts in Europe;
 
·
Received orders, through our P3 subsidiary, from Major League Baseball for playoff and World Series credentials, from New York Islanders for secure credentials, and from the U.S. Poker Tour for gaming credentials;
 
·
Signed licensing agreement with a top Federal government printer - NPC, Inc.;
 
·
Expanded our Premier Partnership with P.T. Sekur Grafika to include Malaysia, Singapore, and Indonesia; and
 
·
Signed new Premier Partner, Cultura Interactiva S.A. de C.V., for Mexico.
 
Revenue - 2006 vs 2005: The increase in total revenue in 2006 compared to 2005 resulted primarily from increases in royalty revenue from the licensing of the Company’s technology, and from increases in sales of security printing and products primarily derived from the Company’s acquisition during the first quarter of 2006 of Plastic Printing Professionals (“P3”), a manufacturer of secure plastic cards and documents. During 2006, P3 accounted for $2,304,000 or 53% of consolidated revenue from continuing operations. In addition, revenue from the Legalstore.com division continued a trend of steady growth as it increased the breadth of its product offerings and the size of its customer base.
 
In addition, during 2006, the Company generated approximately $1,031,000 in deferred license and royalty revenue, which was deferred over the terms of the license or service and therefore, not reflected in the 2006 results.
 
Gross profit

   
 Year Ended December 31, 2007
 
Year Ended December 31, 2006
 
% change vs. 2006
 
Year Ended December 31, 2005
 
% change 2006 vs. 2005
 
Costs of revenue
                      
Security printing & products
 
$
2,466,000
 
$
1,972,000
   
25
%
$
371,000
   
431.5
%
Digital solutions
   
44,000
   
-
   
0
%
 
-
       
Legal products
   
354,000
   
350,000
   
1
%
 
273,000
   
28
%
Total cost of revenue
   
2,864,000
   
2,322,000
   
23
%
 
644,000
   
261
%
                                 
Gross profit
                               
Security printing & products
   
1,447,000
   
1,024,000
   
41
%
 
289,000
   
254
%
Royalties
   
1,195,000
   
682,000
   
75
%
 
81,000
   
742
%
Digital solutions
   
157,000
   
-
         
-
       
Legal products
   
328,000
   
281,000
   
17
%
 
252,000
   
12
%
Total gross profit
   
3,127,000
   
1,987,000
   
57
%
 
622,000
   
219
%
 
22

 
   
 Year Ended December 31, 2007
 
Year Ended December 31, 2006
 
% change vs. 2006
 
Year Ended December 31, 2005
 
% change 2006 vs. 2005
 
Gross profit percentage:
                      
Security printing & products
   
37
%
 
34
%
 
8
%
 
44
%
 
-22
%
Royalties
   
100
%
 
100
%
 
0
%
 
100
%
 
0
%
Digital solutions
   
78
%
                       
Legal supplies
   
48
%
 
45
%
 
8
%
 
48
%
 
-7
%
Gross profit percentage:
   
52
%
 
46
%
 
13
%
 
49
%
 
-6
%
                                 
Gross Profit - 2007 vs 2006
 
During 2007, gross profit increased by 57%, a greater pace than revenue as a large portion of the revenue increase during 2007 was from royalty revenue, the Company’s highest margin product category. In addition, the Company focused its security printing and products business on the highest margin opportunities, which helped increase that group’s margins by 8%. Both of these trends positively impacted the Company’s overall profit margin percentage, which was 52% in 2007, a 13% increase over 46% in 2006.
 
Gross Profit - 2006 vs 2005
 
During 2006, gross profit increases as compared to 2005 were primarily the result of increases in both security printing & products profits and royalties profits. The increase in the gross profits of the document security printing & products category during 2006 included $851,000 in gross profit derived from the Company’s P3 division, which was acquired in February of 2006. In addition, 2005 results are shown after effect of discontinued operations for the Company’s retail copying and printing operations. During 2005, sales of security printing was in its nascent stages and were only slightly greater than the direct costs, including certain fixed production costs such as equipment depreciation and lease costs.
 
Operating Expenses

   
 Year Ended December 31, 2007
 
Year Ended December 31, 2006
 
% change vs. 2006
 
Year Ended December 31, 2005
 
% change 2006 vs. 2005
 
Selling, general and administrative
                      
General and administrative compensation
 
$
2,023,000
   
1,521,000
   
33
%
 
475,000
   
220
%
Stock based payments
   
1,355,000
   
1,002,000
   
35
%
 
119,000
   
742
%
Professional Fees
   
1,404,000
   
1,120,000
   
25
%
 
759,000
   
48
%
Sales and marketing
   
1,974,000
   
1,049,000
   
88
%
 
750,000
   
40
%
Depreciation and amortization
   
89,000
   
92,000
   
-3
%
 
86,000
   
7
%
Other
   
1,129,000
   
590,000
   
91
%
 
266,000
   
122
%
Research and development
   
420,000
   
353,000
   
19
%
 
314,000
   
12
%
Amortization of intangibles
   
1,754,000
   
1,026,000
   
71
%
 
538,000
   
91
%
        Total Operating Expenses
   
10,148,000
   
6,753,000
   
50
%
 
3,307,000
   
104
%
 
Selling, General and Administrative - 2007 vs 2006
 
General and administrative compensation cost increases from continuing operations for the year ended December 31, 2007 reflect the impact of additions at the Company in senior management, including the hiring of legal counsel and the first full year of salary of the Company’s President who was hired in June 2006. In addition, the increase in 2007 reflect the impact of increases in medical benefit costs of approximately 11% as compared to the prior year and 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 reflects expenses due to options and restricted stock grants to 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. Accordingly, approximately $867,000 of stock based compensation was recognized during 2007 for employee and director based incentive grants as compared to $289,000 in 2006. During 2007, the company issued warrants to three unrelated third party consultants which resulted in approximately $266,000 of stock based expense recorded during the year. In addition, the company issued stock options to certain employees and outside directors during 2007 that resulting in approximately $388,000 of stock based expense during the year. 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.
 
23

 
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

   
 Year Ended December 31, 2007
 
Year Ended December 31, 2006
 
% change vs. 2006
 
Year Ended December 31, 2005
 
% change 2006 vs. 2005
 
Professional Fees Detail
                      
Accounting and auditing
 
$
326,000
 
$
169,000
   
93
%
$
140,000
   
21
%
Consulting
   
447,000
   
349,000
   
28
%
 
233,000
   
50
%
Legal Fees
   
347,000
   
365,000
   
-5
%
 
275,000
   
33
%
Stock Transfer, SEC and Investor Relations
   
284,000
   
237,000
   
20
%
 
111,000
   
114
%
   
$
1,404,000
 
$
1,120,000
   
25
%
$
759,000
   
48
%
 
Professional fees include legal, accounting, stockholder services, investor relations, and consulting costs. Accounting and auditing fee increases during 2007 reflect significant costs associated with the Company’s Sarbanes Oxley compliance requirements. 
 
Consulting fees averaged $37,000 per month, and increased during 2007 as compared to 2006 due to the addition of an intellectual property consultant, an agreement with a consulting firm to enter the German and European markets, the addition of two sales consulting firms focused on developing opportunities with large government and government integrator users and the use of various financial consultants.
 
Legal fees during 2007 decreased from 2006 as the Company experienced a decrease in activity on costs for certain of its legal matters. In addition, the Company experience savings in third party legal costs as the result of hiring of an in-house counsel that had formerly worked for the Company in a retainer arrangement. These legal costs do not include approximately $2,033,000 of legal and related costs incurred during 2007 ($1,578,000 -2006) associated with the application and defense of our patents, which the Company capitalizes and amortizes over the expected life of the patent. (Part I Item 3 -Legal Proceedings)
 
Sales and marketing expense consists of sales and marketing compensation costs, including sales commissions, travel and entertainment costs and marketing material and support costs. Increases of sales and marketing costs in 2007 have been the result of a significant expansion in the resources that the Company invested to grow its sales and marketing team and increase the reach of its products through expansion of its marketing efforts. During 2007, the Company’s costs included costs associated with the September 2007 launch of its AuthentiGuard® On-Demand 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. During 2008, the Company will focus its sales and marketing efforts on direct selling objectives to optimize the results of its sales and marketing costs.
 
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.
 
Selling, General and Administrative - 2006 vs 2005
 
The Company’s selling, general and administrative costs increases in 2006 generally reflect 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.
 
24

 
 
General and administrative compensation costs increases that the Company experienced in 2006 were primarily due to the addition of management and operations support personnel, as well as the addition of personnel at P3. Of the $1,046,000 increase in compensation expense in 2006, $517,000 or 49%, stem from P3, which was acquired in February of 2006.
 
Stock based payments during 2006 include approximately $668,000 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 that enables the Company to expedite its entry into the Chinese market for secure documents, and $334,000 associated with restricted shares and option based compensation expenses for share based payments to employees and board members.
 
Professional fees include legal, accounting, stockholder services, investor relations, and consulting costs. Consulting fees, are primarily directed towards efforts to help the Company develop market opportunities with government and large multinational corporations, and intellectual property management. Legal and accounting fees are generally associated with the Company’s corporate governance, and public company reporting requirements, negotiating contracts and other corporate matters. In addition, legal fees include costs associated with certain litigation matters regarding Adlertech and F. Laloggia, respectively- (See Item 3 -Legal Proceedings). These legal costs do not include costs associated with the application and defense of our patents, which the company capitalizes and amortizes over the expected life of the patent. (See Item 3 -Financial Information -Note 4) Stock Transfer, SEC and Investor Relation fees include the general costs of maintaining the public status of the Company’s shares on the American Stock Exchange as well as the costs associated with an investor relation firm which the Company hired in January of 2006. The Company expects that these costs have generally stabilized and do not expect these costs to increase in proportion to revenue increases that are expected in 2007 and beyond.
 
Sales and marketing expense consist of sales and marketing compensation costs, including sales commissions, travel and entertainment costs and marketing material and support costs. Increases of sales and marketing costs in 2006 have been the result of investments in resources to expand its sales and marketing efforts in order to increase customer awareness and understanding of the Company technologies and solutions. The Company expects to continue to increase its sales and marketing efforts in correlation with expected revenue growth.
 
Other expenses are primarily rent and utilities, office supplies, IT support, and insurance costs. Increases in 2006 reflect costs associated with a larger organization including higher rent and utility costs associated with the addition of P3 in February 2006.
 
Research and Development - 2007 vs 2006
 
Research and development costs consist primarily of compensation costs associated with personnel who are involved in the research, development and testing of our various technologies. The Company operates a small print shop that is available for the research group to do its testing. In addition, the Company utilizes certain third party printers, generally in the Rochester, NY area, that allow the research group to test it technologies on printing presses and other equipment that the Company does not have internally. We continue to invest in research and development to improve our existing technologies and develop new technologies that we believe will enhance our position in the document security market. We expect that our research and development costs will continue at current levels for the foreseeable future.
 
Research and Development - 2006 vs 2005
 
We continue to invest in research and development to improve our existing technologies and develop new technologies that we believe 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 expect that our research and development costs will continue at current levels for the foreseeable future.
 
Amortization of intangibles
 
Commencing in the second quarter of 2005, we began to 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 lawsuit against the European Central Bank for patent infringement and the related patent invalidity lawsuits. In addition, we amortize our acquired intangibles from business combinations. We acquired a significant portion of these assets by the issuance of equity in the Company. Our amortizable asset base for patent and contractual rights at December 31, 2007 was approximately $9.5 million and will generate approximately $1,700,000 in annual amortization expense during the next 3 years. In addition, the Company has approximately $1,278,000 of other intangible assets as of December 31, 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.
 
25

 
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. During 2007 and 2006, the Company did not determine that an impairment exists on these assets.
 
Goodwill
 
As of December 31, 2007 and 2006, the Company had $1,397,000 in goodwill derived from acquisitions. Goodwill is not amortized, but could become a component of expense if an impairment is determined. During 2007 and 2006, the Company did not determine that impairment exists on any of its components of goodwill.
 
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

   
Year Ended December 31:
 
Year Ended
 
% change
 
   
2007
 
2006
 
% change vs. 2006
 
December 31, 2005
 
2006 vs. 2005
 
Net loss
   
(6,987,000
)
 
(4,832,000
)
 
45
%
 
(2,843,000
)
 
70
%
                                 
Net loss per share, basic and diluted
   
(0.51
)
 
(0.37
)
 
40
%
 
(0.24
)
 
54
%
                                 
Weighted average common shares outstanding, basic and diluted
   
13,629,877
   
12,891,505
   
6
%
 
12,010,464
   
7
%
 
Net loss and loss per share - 2007 vs 2006
 
During 2007, the Company continued to experience net losses as it has since it refocused its business on the document security business in 2002. While the Company generated growth in its sales and gross profits, these increases did not offset increases in operating expenses. As discussed below, our net income is significantly impacted by amortization of intangibles and stock-based compensation expense, which accounted for 44% and 42%, of the Company’s net losses for the years ended December 31, 2007 and 2006, respectively.
 
Our basic and diluted loss per share has increased due to the increased dollar value of our loss partially offset by an increase in the weighted average common shares outstanding in 2007 compared to 2006. Our shares have increased as we have issued our common shares for warrants exercised, to pay for legal fees and pursuant to a private placement of common stock that occurred between December 2006 and January 2007.
 
Net loss and loss per share -2006 vs 2005
 
During 2006, the Company continued to experience net losses as it had since the Company chose to strategically focus on security printing markets in 2002. While the Company generated growth in its sales and gross profits, these increases did not offset increases in operating expenses. Our basic and diluted loss per share has increased due to the increased dollar value of our loss partially offset by an increase in the weighted average common shares outstanding in 2006 compared to 2005. Our shares have increased as we have issued our common shares for warrants exercised, for the acquisition of P3, to pay for legal fees and pursuant to a private placement of common stock.
 
26

 
Non-GAAP Financial Performance Measure
 
The following adjusted Earnings before interest, taxes, depreciation, amortization and non-cash stock based 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

Non-GAAP Financial Performance Measure
 
 
Year Ended December 31:
 
Year Ended
 
% change
 
   
2007
 
2006
 
% change vs. 2006
 
December 31, 2005
 
2006 vs. 2005
 
Adjusted EBITDA
                     
Net Loss
 
$
(6,987,000
)
$
(4,832,000
)
 
45
%
$
(2,843,000
)
 
70
%
Add back:
                               
Depreciation
   
191,000
   
207,000
   
-8
%
 
183,000
   
13
%
Amortization of Intangibles
   
1,754,000
   
1,026,000
   
71
%
 
538,000
   
91
%
Stock based payments
   
1,355,000
   
1,002,000
   
35
%
 
119,000
   
742
%
Interest Income
   
(93,000
)
 
(60,000
)
 
55
%
 
(86,000
)
 
-30
%
Interest Expense
   
5,000
   
15,000
   
-67
%
 
26,000
   
-42
%
Income Taxes
   
19,000
   
-
         
-
       
Adjusted EBITDA
   
(3,756,000
)
 
(2,642,000
)
 
42
%
 
(2,063,000
)
 
28
%
 
Adjusted EBITDA -2007 vs 2006
 
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 year ended December 31, 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 50% from 2006. During 2007, the Company saw expenses increases due to an increase in its production facilities and capabilities, significant expenses associated with the Company’s Sarbanes-Oxley compliance requirements, and a significant increase in 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.
 
Adjusted EBITDA -2006 vs 2005
 
While net loss increased 70% in 2006 as compared to 2005, Adjusted EBITDA deficit increased only 28% between the same periods. These results reflect that the increases in revenue and resulting gross profits during the year ended December 31, 2006 significantly outpaced increases in the Company’s core operating expenses (core operating expenses are compensation, professional fees, sales and marketing, other and research and development costs), which increased 81% during the same periods.
 
Liquidity and Capital Resources
 
The Company’s cash flows and other key indicators of liquidity are summarized as follows:

   
Year Ended December 31:
 
% change vs.
 
Year Ended
December 31,
 
% change
 
 
 
2007
 
2006
 
2006
 
 2005
 
2006 vs. 2005
 
Cash and cash equivalents
 
$
742,000
 
$
5,803,000
   
-87
%
$
3,953,000
   
47
%
                                 
Cash flows from:
                               
                                 
Operating activities
 
$
(3,038,000
)
$
(1,412,000
)
 
-115
%
 
(1,690,000
)
 
16
%
Investing activities
   
(1,941,000
)
 
(2,274,000
)
 
15
%
 
(293,000
)
 
-676
%
Financing activities
   
(81,000
)
 
5,535,000
   
-101
%
 
3,278,000
   
69
%
Working capital (a)
   
(1,198,000
)
 
4,125,000
   
-129
%
 
3,648,000
   
13
%
Current ratio (a)
   
0.65
x  
2.49
x  
-74
%
 
5.32
x  
-53
%
 
27

 
As of December 31, 2007, we had cash and cash equivalents of $742,000, representing an 87% decrease over our December 31, 2006 cash position. As discussed below, the decrease in the Company’s cash position was primarily due to the use of cash from operations and the use of cash for the expansion of its operations and the defense of its patent portfolio.
 
Operating Cash Flow - During 2007, the Company used approximately $3.2 million of cash for operations. As discussed above, the 39% increase in revenue that the Company achieved during 2007 was offset by increases in the Company’s core expenditures, primarily sales and marketing, production facility expansion and Sarbanes Oxley compliance costs. As of December 31, 2007, the Company believes that it will need to reach an annual revenue level of approximately $9.0 million based on its current expense levels and its projected mix of revenue in order to maintain positive operating cash flow.
 
During 2006, the Company’s used $1.4 million of cash for operations during the year despite reporting a $4.8 million net loss. This differential primarily reflects the significance of non-cash expenditures and deferred revenue on its operating results. Specifically, the Company recorded $1.2 million in depreciation and amortization expense and $1.0 million in stock based compensation expense during the 2006, which combined totaled 46% of the reported net loss but do not represent cash expenses to the Company in 2006. Furthermore, the Company received approximately $1.0 million in pre-payments from customers for licenses and services for which revenue recognition is deferred over the license period or service period. The receipt of this cash significantly reduced the use of cash for operations for the Company during 2006, especially during the latter half of the year. As a result, the Company’s cash flow from operations improved 16% in 2006 as compared to 2005 despite an increase in net loss of 70% between the same periods.
 
Investing Cash Flow - During 2007, the Company used approximately $1.9 million of cash for fixed asset additions and to invest in its patent portfolio. During the second quarter of 2007, the Company initiated a move into new production facility for its San Francisco area plastic printing division. The Company began to move into the new facility in November 2007. During 2007, the Company incurred approximately $480,000 in leasehold improvements associated with the new facility and purchased approximately $433,000 in new equipment, of which $325,000 was financed by capital leases. Along with increasing the space of the division five-fold, the Company’s new equipment, including a state of the art laminator and a digital plate system, are expected to significantly increase the output capacity of its operations.
 
In addition, during 2007, 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 $1,083,000 of patent related costs as a result of its agreement with its lead counsel in its ECB litigation.
 
During 2006, the Company used significant amount of its cash for the acquisition of P3 and to invest in its patent portfolio, including the payment of legal costs associated with patent applications and the defense of our patents, which includes payments to cover third party experts fees and other fees associated with the Company’s litigation against the European Central Bank. The Company expects that these strategic uses of cash will result in future positive cash flows resulting from its ability to maintain and grow its manufacturing capabilities at its P3 facility, and from potential legal settlements of other arrangements resulting from its investments in its patent portfolio and the defense of its patents. Furthermore, as displayed below, the Company has been able to use its equity to offset its use of cash for the investments that it deems important for the continued long-term growth potential of the Company.

   
 2007
 
 2006
 
2005
 
Cash paid for interest
 
$
5,000
   
15,000
   
26,000
 
                     
Non-cash investing and financing activities:
                   
Equity issued for patent defense costs
 
$
746,000
   
457,000
   
500,000
 
Modificaton of equity awards for license agreement
 
$
521,000
   
-
   
-
 
Equity issued for acquisition
 
$
-
   
250,000
   
518,000
 
Equity issued for prepaid services
 
$
561,000
   
-
   
-
 
Equity issued for other intangible assets
 
$
-
   
-
   
3,906,000
 
Equipment purchased via capital lease
 
$
325,000
   
-
   
-
 
Deferred tax liability offsetting additional paid in capital
 
$
181,000
   
-
   
-
 
 
28

 
Financing Cash Flows - During the first quarter of 2007, the Company received approximately $300,000 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. In addition, the Company received approximately $325,000 in capital lease financing during 2007 used to expand its P3 operations and the Company borrowed $300,000 from its CEO, under the terms of a Credit Facility Agreement as discussed below.
 
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 statements of cash flows for the years ended December 31, 2007, 2006 and 2005.
 
Future Capital Needs - The Company expects to use its working capital to support its growth efforts in order to achieve consistent positive cash flow from operations. At its current revenue levels, the Company expects to continue to use cash for operations during 2008 at the pace experienced in 2007. The Company estimates that it requires a revenue level of approximately $9.0 million, or 50% greater than the revenue achieved in 2007, to achieve consistent positive operating cash flows. The Company believes that it will achieve this revenue level by the end of 2008. Based on this expectation, the Company has committed to focus its expenditures during 2008 on areas of research and development, and sales and marketing that support near-term revenue opportunities. In addition, the Company regularly reviews business conditions to gauge whether changes to its expense levels are warranted.
 
The Company’s near term cash requirements also include legal costs and fees associated with the defense of its patents that are incurred by law firms, experts and consultants that are not covered under the share payment arrangement that the Company entered into with its lead counsel on the suit. These costs will be incurred as the Company contends against patent validity suits in nine countries’ patent courts as part of the European Central Bank’s countersuit strategy in the patent infringement case. (See Item 3- Legal Proceedings). The cumulative cash requirements for these cases, which are in various stages, could be as much as $1,000,000 in 2008. If the Company is successful in the defense of its patents or in its litigation against the ECB, the Company believes that it will be able to recover a portion of these litigation costs along with legal fees paid to its lead counsel in common stock. If the Company is not successful in its litigation against the ECB, the Company will likely be required to pay a significant portion of the ECB’s legal costs as well. The Company estimates that these costs could be substantial and the payment of these amounts could adversely affect the Company’s financial position.
 
To address these cash requirements, the Company secured credit financing that if feels will meet its cash requirements for at least the next 12 months. On January 4, 2008, the Company entered into a Credit Facility Agreement with Fagenson and Co., Inc., as agent, a related party to Robert B. Fagenson, the Chairman of the Company's Board of Directors. Under the Fagenson Credit Agreement, the Company can borrow up to a maximum of $3,000,000 from time to time up to and until January 4, 2010. The advances are generally limited to $400,000 unless otherwise mutually agreed upon by both parties per fiscal quarter, with the exception of $600,000 that can be advanced at any time for patent litigation related bills. Any amount borrowed by the Company pursuant to the Fagenson Credit Agreement will have an annual interest rate of 2% above LIBOR and will be secured by the Common Stock of Plastic Printing Professionals, Inc., the Company's wholly owned subsidiary. Interest is payable quarterly in arrears and the principal is payable in full at the end of the term under the Fagenson Credit Agreement. In addition, on January 4, 2008, the Company also entered into a Credit Facility Agreement with Patrick White, the Company's Chief Executive Officer. Under the White Credit Agreement, the Company can borrow up to $600,000 from time to time up to and until January 4, 2010. Any amount borrowed by the Company pursuant to the White Credit Agreement will have an annual interest rate of 2% above LIBOR and will be secured by the accounts receivable of the Company, excluding the accounts receivable of P3. Interest is payable quarterly in arrears and the principal is payable in full at the End of the Term under the White Credit Agreement. Mr. White can accept common stock as payment upon default. Under the terms of the agreements, the Company is required to comply with various covenants. During the year ended December 31, 2007, Patrick White advanced the Company $300,000 while the terms of the credit facility agreement were being finalized.
 
29

 
Future commitments for lease and debt agreements as of December 31, 2007 is as follows:

   
 Payment Due by Period      
 
   
 Total
 
 Less than 1 year
 
 1-3 years
 
 3-5 years
 
Revolving notes
 
$
300,000
 
$
-
 
$
300,000
 
$
-
 
Capital leases
   
487,728
   
125,962
   
286,158
 
$
75,608
 
Operating leases
   
2,283,689
   
389,291
   
1,189,371
   
705,027
 
                           
   
$
3,071,417
 
$
515,253
 
$
1,775,529
 
$
780,635
 
 
Key Indicators of Future Results

We believe that cash flow from operations is a significant key indicator for the Company. Our ability to reduce our use of cash will depend on our ability to grow revenue to a level sufficient to meet our operating expense requirements. To grow revenue, we may merge with or acquire manufacturing or related companies. Our ability to successfully complete these transactions on favorable terms will be a significant key indicator of our future results. These acquisitions may require additional funds that the Company does not currently have. To obtain additional investments in the future may require us to issue shares of our Common Stock. Our ability to sell our Common Stock on favorable terms will also be a significant key indicator of our future results. In addition, we believe that our ability to successfully enforce our patent rights, including our current litigation against the European Central Bank, is a significant key indicator for the Company.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, an effect on our financial condition, financial statements, revenues or expenses.

Inflation

Although our operations are influenced by general economic conditions, we do not believe that inflation had a material effect on our results of operations during 2007 or 2006 as we are generally able to pass the increase in our material and labor costs to our customers, or absorb them as we improve the efficiency of our operations.

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. The consolidated financial statements for the fiscal year ended December 31, 2007 describe the significant accounting policies and methods used in the preparation of the consolidated financial statements. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts and sales returns, goodwill impairments, inventory allowances, revenue recognition, and the valuation of intangible assets. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of our consolidated financial statements:

Goodwill Impairments

Goodwill is the excess of cost of an acquired entity over the fair value of amounts assigned to assets acquired and liabilities assumed in a business combination. With the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized, rather it is tested for impairment annually, and will be tested for impairment between annual tests if an event occurs or circumstances change that would indicate the carrying amount may be impaired. Impairment testing for goodwill is done at a reporting unit level. Reporting units are one level below the business segment level, but are combined when reporting units within the same segment have similar economic characteristics. Under the criteria set forth by SFAS No. 142, the Company has three reporting units based on the current structure. An impairment loss generally would be recognized when the carrying amount of the reporting unit’s net assets exceeds the estimated fair value of the reporting unit. The Company completed its assessment of any potential impairment upon adoption of this standard and performs annual assessments. In making its assessment, management must make estimates of its future cash flows from operations and those estimates could deviate both favorably and unfavorably from actual results. In addition, in arriving at the reporting units fair market value, management must makes estimates of discount rates to apply to the future cash flows based on rates of return associated with the underlying risk with those cash flows. These estimates may be different for what could be achieved in the market place.
 
30


Long Lived Assets and Intangible Assets

The Company accounts for long-lived assets in accordance with the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generate by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on discounted cash flows or appraised values, depending on the nature of the assets. In making its assessment, management must make estimates of its future cash flows from operations and those estimates could deviate both favorably and unfavorably from actual results. 

Fixed assets are carried at cost. Depreciation is computed over the estimated useful life of five to seven years using the straight-line depreciation method. Leasehold improvements are amortized over the shorter of their useful life or the lease term. Intangible assets consist primarily of royalty rights, contractual rights, customer list, and patent acquisition, application and defense costs. Amortization is computed over the estimated useful life of five to twenty years using the straight-line depreciation method. For patent related assets, the remaining legal life of the patent is used as the estimate useful life unless circumstances determine that the useful life will be less than the legal life. Long-lived assets to be held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We periodically evaluate the recoverability of our long-lived assets based on estimated future cash flows from and the estimated fair value of such long-lived assets, and provide for impairment if such undiscounted cash flows are insufficient to recover the carrying amount of the long-lived asset. 

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.
 
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.
 
We also enter 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.

We recognize revenue from technology licenses 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.

Share-Based Payments

Prior to January 1, 2006, the Company accounted for stock option awards granted under the Company’s Stock Incentive Plans in accordance with the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, (“APB 25”) and related Interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”, (“SFAS 123”). Share-based employee compensation expense was not recognized in the Company’s consolidated statements of operations prior to January 1, 2006, as all stock option awards granted had an exercise price equal to or greater than the market value of the common stock on the date of the grant, except for modifications of stock option awards, which triggered compensation expense in accordance with provisions of FASB FIN 44 -”Accounting for Certain Transactions Involving Stock Compensation”. As permitted by SFAS 123, the Company reported pro-forma disclosures presenting results and earnings per share as if the Company had used the fair value recognition provisions of SFAS 123 in the Notes to Consolidated Financial Statements. Stock-based compensation related to non-employees was accounted for based on the fair value of the related stock or options in accordance with SFAS 123 and its interpretations.
 
31


Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment”, (“SFAS 123(R)”) using the modified prospective transition method. See Note 7 for further detail on the impact of SFAS 123(R) to the Company’s consolidated financial statements.

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.

Income Taxes

Deferred tax assets and liabilities are determined based on temporary differences between income and expenses reported for financial reporting and tax reporting. Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes” (“SFAS 109”) requires that a valuation allowance be established when management determines that it is more likely than not that all or a portion of a deferred tax asset will not be realized. The Company evaluates the realizability of its net deferred tax assets on an annual basis an valuation allowances are provided or released, as necessary. Since the Company has had cumulative losses in recent years, the accounting guidance suggest that we should not look to future earnings to support the realizability of the net deferred tax asset. As a result, as of the years ended December 31, 2007 and 2006, the Company has elected to record a valuation allowance to reduce net deferred tax assets to zero.

The Company believes that the accounting estimates related to deferred tax valuation allowances are “critical accounting estimates” because: (1) the need for valuation allowance is highly susceptible to change from period to period due to changes in deferred tax asset and deferred tax liability balances, (2) the need for valuation allowance is susceptible to actual operating results and (3) changes in the tax valuation allowance can have a material impact on the tax provisions/benefit in the consolidated statements of operations and on deferred income taxes in the consolidated balance sheets.

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As of December 31, 2007, we held $742,000 in cash. Declines of interest rates over time would reduce our interest income from our highly liquid short-term investments. Based upon our balance of cash and cash equivalents, a decrease in interest rates of 100 basis points would cause a corresponding decrease in our annual interest income of approximately $7,000 for these investments. Due to the nature of our highly liquid cash equivalents, a change in interest rates would not materially change the fair market value of our cash and cash equivalents.
 

Our audited financial statements for the fiscal years ended December 31, 2007, 2006 and 2005 follow Item 14, beginning at page F-1.

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None
 
32

 
ITEM 9A - CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
 
Management is responsible for establishing and maintaining effective disclosure controls and procedures. As of December 31, 2007, our Chief Executive Officer and Chief Financial Officer participated with our management in evaluating the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the Securities and Exchange Commission (“SEC”) reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time period specified by the SEC’s rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. In light of the discussion of material weaknesses set forth below, these officers have concluded that our disclosure controls and procedures were not effective. To address the material weaknesses described below, we performed additional analyses and other post-closing procedures to ensure our consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). Accordingly, management believes that the financial statements included in this Annual Report on Form 10-K fairly present, in all material respects, our financial condition, result of operations and cash flows for the periods presented.
 
Management’s Annual Report on Internal Control Over Financial Reporting
 
A company’s internal control over financial reporting is a process designed by, or under the supervision of, a public company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles (“GAAP”) including those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company, (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures are being made only in accordance with authorizations of management and directors of the company, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
 
Management is responsible for establishing and maintaining adequate internal control over financial reporting. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, our management used the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
 
A material weakness is a control deficiency, or combination of control deficiencies, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. In connection with management’s assessment of our internal control over financial reporting described above, management has identified the following material weaknesses in the Company’s internal control over financial reporting as of December 31, 2007:

We did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties were ineffective. Due to unanticipated turnover, we currently have one person on staff that performs nearly all aspects of our financial reporting process, including but not limited to access to the underlying accounting records and systems, the ability to post and record journal entries and responsibility for the preparation of the financial statements. This creates certain incompatible duties and a lack of review over the financial reporting process that would likely fail to detect errors in spreadsheets, calculations, or assumptions used to compile the financial statements and related disclosures as filed with the SEC. Specifically, we determined that our controls over the preparation, review and monitoring of the financial statements were ineffective to provide reasonable assurance that financial disclosures agreed to appropriate supporting detail, calculations or other documentation. In addition, during the preparation of our annual consolidated financial statements, we determined that certain key assumptions and calculations used in the future cash flow analysis supporting our asset impairment tests required editing after submission to our auditors. These edits did not result in audit adjustments to our December 31, 2007 consolidated financial statements. These control deficiencies could result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.
 
33


Controls associated with identifying and accounting for complex and non-routine transactions in accordance with U.S. generally accepted accounting principles were ineffective.  Specifically, during the course of the quarterly interim reviews and the annual audit, audit adjustments were made to adjust the recorded amounts for certain equity based transactions, including the resulting impact on our income tax provision and disclosures based on the misapplication of GAAP by the Company that would have resulted in a material misstatement of our financial statements.

Controls associated with internal communication were ineffective. Specifically, during the year we identified instances related to equity based transactions which were not effectively communicated to all internal process owners who needed to be involved to account for and report the transactions in a timely manner. This resulted in material adjustments during the quarterly reviews and annual audit, respectively, that otherwise would have been avoided if effective internal communication had been maintained.

As a result of the material weaknesses described above, our management concluded that as of December 31, 2007, we did not maintain effective internal control over financial reporting based on the criteria established in Internal Control—Integrated Framework issued by the COSO.

The effectiveness of our internal control over financial reporting as of December 31, 2007, has been audited by Freed Maxick & Battaglia, CPAs PC, our independent registered public accounting firm, as stated in their report which is included herein.
 
Plan for Remediation of Material Weaknesses
 
In response to the identified material weaknesses, management, with oversight from the Company’s audit committee, plans to improve our control environment and to remedy the identified material weaknesses by expanding the resources available to the financial reporting process. These ongoing efforts are focused on (i) using an external consultant to review spreadsheets, calculations, and assumptions used to compile financial reports on at least a quarterly basis, (ii) consulting with third party accounting firms with the appropriate level of expertise to determine the proper application of GAAP for complex and non-routine transactions and, iii) utilizing an internal disclosure checklist to gather and review matters requiring potential accounting or disclosure.

Notwithstanding the material weaknesses discussed above, management believes that the financial statements included in this report present fairly, in all material respects, our financial position, results of operations, and cash flows for the periods presented in accordance with U.S. generally accepted accounting principles.

Changes in Internal Control over Financial Reporting

     There have been a number of changes made to our internal control over financial reporting (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) during the three months ended December 31, 2007. Specifically, the Company made changes to system access rights in its accounting system to improve the segregation of duties over routine transactions; reallocated certain account reconciliation responsibilities to improve the segregation of duties; began using the services of a third party consultant to improve the Company’s monitoring and review process over financial reporting, and reorganized certain organizational roles that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


None
 
34

 
PART III

ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS, CORPORATE GOVERNANCE

The information required by this Item will be contained in the Company’s Proxy Statement for its Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2007, and which is incorporated by reference herein.
 
We make available free of charge through the investor relations page of our Web site (www.documentsecurity.com) our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports, and all beneficial ownership reports on Forms 3, 4 and 5 filed by directors, officers and beneficial owners of more than 10% of our equity, as soon as reasonably practicable after such reports are electronically filed with the Securities and Exchange Commission. We have adopted codes of business conduct and ethics for all of our employees, including our principal executive officer, principal financial officer and principal accounting officer. Copies of the codes of business conduct and ethics are available on our Web site.
 
Our Web sites and the information contained therein or incorporated therein are not intended to be incorporated into this Annual Report on Form 10-K or our other filings with the SEC.

ITEM 11 - EXECUTIVE COMPENSATION

The information required by this Item will be contained in the Company’s Proxy Statement for its Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2007, and which is incorporated by reference herein.

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this Item will be contained in the Company’s Proxy Statement for its Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2007, and which is incorporated by reference herein.

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this Item will be contained in the Company’s Proxy Statement for its Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2007, and which is incorporated by reference herein.

ITEM 14 - PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required by this Item will be contained in the Company’s Proxy Statement for its Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2007, and which is incorporated by reference herein.

ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) 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.

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).*
     
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).*
     
10.1
 
Agreement dated November 7, 1996 with Charles M. LaLoggia (incorporated by reference from Company’s Form 10-Q for March 31, 1997).*
     
10.2
 
Agreement dated July 2, 1996 with Frank LaLoggia (incorporated by reference from Company’s Form 10-Q for June 30, 1996).*
     
10.3
 
Agreement dated July 31, 2002 between New Sky Communications, Inc. and Patrick White (incorporated by reference from Company’s Form 8-K filed on August 8, 2002).*
 
35

 
10.4
 
Agreement dated July 31, 2002 between New Sky Communications, Inc. and Thomas M. Wicker (incorporated by reference from Company’s Form 8-K filed on August 8, 2002).*
     
10.5
 
Agreement dated November 1, 2002 between New Sky Communications, Inc. and David Thomas M. Wicker, Christine Wicker, Kenneth Wicker and Michael Caton (incorporated by reference to the Registrant’s Form 10-KSB for the fiscal year ended December 31, 2002). *
     
10.6
 
Employment Agreement dated November 1, 2002 between New Sky Communications, Inc. and David Wicker (incorporated by reference to the Registrant’s Form 10-KSB for the fiscal year ended December 31, 2002). *
     
10.7
 
Form of Warrant Agreement between the Registrant and Fordham Financial Management, Inc.(incorporated by reference on Company’s registration statement on Form S-3 filed on January 20, 2004).*
     
10.8
 
Form of Warrant Agreement between the Registrant and W.A.B. Capital (incorporated by reference on Company’s registration statement on Form S-3 filed on January 20, 2004).*
     
10.9
 
Form of Warrant Agreement between the Registrant and Howard Safir (incorporated by reference on Company’s registration statement on Form S-3 filed on January 20, 2004).*
     
10.10
 
Form of Series A Warrant Agreement issued by the Registrant to participants in its private placement offering completed on December 29, 2003. (incorporated by reference on Company’s registration statement on Form S-3 filed on January 20, 2004).*
     
10.11
 
Form of Registration Rights Agreement issued by the Registrant to participants in its private placement offering completed on December 29, 2003. (incorporated by reference on Company’s registration statement on Form S-3 filed on January 20, 2004)*
     
10.12
 
Form of Warrant issued to IDT Venture Capital Corporation dated October 31, 2003.(incorporated by reference on Schedule 13D filed by IDT Venture Capital Corporation dated December 2, 2003)*
     
10.13
 
Form of Securities Purchase Agreement between Registrant and IDT Venture Capital Corporation dated as of October 31, 2003. (incorporated by reference on Schedule 13D filed by IDT Venture Capital Corporation dated December 2, 2003).*
     
10.14 (1)
 
Form of Licensing and Marketing Agreement between Registrant and Boise White Paper LLC dated January 19, 2005. (redacted version)
     
10.15
 
Form of Surrender and Assignment Agreement dated as of February 25, 2005 between Registrant and the Net Interest Holders. (filed as Exhibit 10.1 to form 8-K dated February 25, 2005)* 
     
10.16
 
Form of Surrender and Assignment Agreement dated as of February 25, 2005 between Registrant and the Gross Interest Holders (filed as Exhibit 10.2 to Form 8-K dated February 25, 2005)*
     
10.17
 
Agreement of Sublease dated May 2004 for the Premises Located at 28 E. Main Street, Rochester, New York (filed as Exhibit 10.1 to Form 10-QSB for the Quarter ended June 30, 2004)*
     
10.18
 
Form of Employment Agreement dated as of June 10, 2004 between Registrant and Patrick White (filed as Exhibit 10.2 to Form 10-QSB for the Quarter ended June 30, 2005)*
     
10.19
 
Form of Employment Agreement dated as of June 11, 2004 between Registrant and Thomas Wicker (filed as Exhibit 10.26 of 10-KSB for the fiscal year ended December 31, 2004)*
     
10.20
 
Form of 2004 Employee Stock Option Plan (filed as Appendix D to Proxy Statement for the Meeting of Stockholders held on December 17, 2004)*
     
10.21
 
Form of Non Executive Director Stock Option Plan (filed as Appendix E to Proxy Statement for the Meeting of Stockholders held on December 17, 2004)*
     
10.22
 
Asset Purchase Agreement, dated February 7, 2006 by and between the Registrant and Plastic Printing Professionals, Inc. . (filed as exhibit 10.30 to Form 10-KSB for the fiscal year ended December 31, 2005)*
     
10.23
 
Stock Option Agreement pursuant to the Registrant’s 2004 Employee Stock Option Plan (filed as exhibit 10.31 to Form S-8 filed May 12, 2006)*
     
10.24
 
Warrant and Amendment to Warrant dated June 16, 2006, granted to International Barcode Corporation (filed as exhibit 10.33 and 10.34 respectively to Form 10-Q for the quarter ended June 30, 2007)*
     
10.25
 
License and Distribution Agreement dated November 8, 2006 by and between the Registrant and PT Sekur Grafika (filed as exhibit 10.30 to Form 10-Q for the quarter ended June 30, 2007)*
     
10.26
 
Form of Subscription Agreement by and between the Registrant and investors in a Private Placement (filed as Exhibit 10.1 to Form 8-K/A dated December 27, 2006)*
     
10.27
 
Registration Rights Agreement dated December 12, 2006 between the Registrant and Perrin, Holden &Davenport Capital Corp. as agent for those investing in a Private Placement (filed as Exhibit 10.2 to Form 8-K/A dated December 27, 2006)*
     
10.28
 
Form of Common Stock Purchase Warrant granted pursuant to a Private Placement (filed as Exhibit 4.1 to Form 8-K/A dated December 27, 2006)*
     
10.29
 
Limited Exclusive Patent License Agreement dated December 29, 2006 between the Registrant and Ergonomic Group, Inc. (filed as exhibit 10.31 to Form 10-Q for the quarter ended June 30, 2007)*
     
10.30
 
Letter Agreement dated June 11, 2007 between the Registrant and International Barcode Corporation (BTI) (filed as exhibit 10.35 to Form 10-Q for the quarter ended June 30, 2007)*
     
10.31
 
License and Distribution Agreement dated June 27, 2007 by and between the Registrant and Cultura Interactiva S.A. de C.V. (filed as exhibit 10.32 to Form 10-Q for the quarter ended June 30, 2007)*
 
36

 
10.32
 
Credit Facility Agreement, dated January 4, 2008, between the Registrant and Fagenson & Co., Inc., as Agent
     
10.33
 
Security Agreement, dated January 4, 2008, between the Registrant and Fagenson & Co., Inc., as Agent
     
10.34
 
Form of Secured Promissory Note between the Registrant and Fagenson & Co., Inc., as Agent
     
10.35
 
Credit Facility Agreement, dated January 4, 2008, between the Registrant and Patrick White
     
10.36
 
Security Agreement, dated January 4, 2008, between the Registrant and Patrick White
     
10.37
 
Form of Secured Promissory Note between the Registrant and Patrick White
     
21
 
Subsidiaries of Registrant
     
23.1
 
Consent of Freed Maxick & Battaglia, CPAs, PC
     
31.1
 
Certification of Chief Executive Officer Pursuant to 18 USC 1350 Section 302
     
31.2
 
Certification Principal Accounting Officer Pursuant to 18 USC 1350 Section 302
     
32.1
 
Certification of Chief Executive Officer Pursuant to 18 USC 1350 Section 906
     
32.2
 
Certification Principal Accounting Officer Pursuant to 18 USC 1350 Section 906

(1) This exhibit contains a redacted copy of the agreement. We have filed a confidentiality request with the Commission with respect to certain portions of the agreement.

37

 
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

CONTENTS
 
 
 
Page
 
Reports of Independent Registered Public Accounting Firm
   
F-1 - F-2
 
 
     
Consolidated Financial Statements:
     
 
     
Balance Sheets
   
F-3
 
 
     
Statements of Operations
   
F-4
 
 
     
Statements of Cash Flows
   
F-5
 
 
     
Statements of Changes in Stockholders’ Equity
   
F-6
 
 
     
Notes to the Consolidated Financial Statements
   
F-7 - F-28
 

38

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders
Document Security Systems, Inc. and Subsidiaries

We have audited the accompanying consolidated balance sheets of Document Security Systems, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Document Security Systems, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Document Security Systems, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our report dated March 17, 2008 expressed an opinion that Document Security Systems, Inc. and Subsidiaries had not maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
 
/s/ FREED MAXICK & BATTAGLIA, CPAs, PC

Buffalo, New York
March 17, 2008
 
F-1


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders
Document Security Systems, Inc. and Subsidiaries

We have audited Document Security Systems, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Document Security Systems, Inc. and Subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses have been identified and included in management's assessment:

The Company did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties were ineffective. The Company currently has one person on staff that performs nearly all aspects of the financial reporting process, including but not limited to access to the underlying accounting records and systems, the ability to post and record journal entries and responsibility for the preparation of the financial statements. This creates certain incompatible duties and a lack of review over the financial reporting process that would likely fail to detect errors in spreadsheets, calculations, or assumptions used to compile the financial statements and related disclosures filed with the SEC. Specifically, the Company’s controls over the preparation, review and monitoring of the financial statements were ineffective to provide reasonable assurance that financial disclosures agreed to appropriate supporting detail, calculations or other documentation. In addition, during the preparation of the annual consolidated financial statements, certain key assumptions and calculations used in the future cash flow analysis supporting the asset impairment tests required editing after submission to us in connection with our audit. These control deficiencies could result in a material misstatement to the interim or annual consolidated financial statements that would not be prevented or detected.

Controls associated with identifying and accounting for complex and non-routine transactions in accordance with U.S. generally accepted accounting principles were ineffective.  Specifically, during the course of the quarterly interim reviews and the annual audit, audit adjustments were made to adjust the recorded amounts for certain equity based transactions, including the resulting impact on the income tax provision and disclosures based on the misapplication of GAAP by the Company that would have resulted in a material misstatement of the financial statements.

Controls associated with internal communication were ineffective. Specifically, during the year we and the Company identified instances related to equity based transactions which were not effectively communicated to all internal process owners who needed to be involved to account for and report the transactions in a timely manner. This resulted in material adjustments during the quarterly reviews and annual audit, that otherwise would have been avoided if effective internal communication had been maintained.

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 financial statements, and this report does not affect our report dated March 17, 2008 on those financial statements.

In our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Document Security Systems, Inc. and Subsidiaries has not maintained effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)".

/s/ FREED MAXICK & BATTAGLIA, CPAs, PC

Buffalo, New York
March 17, 2008
 
F-2

 
DOCUMENT SECURITY SYSTEMS, INC.  AND SUBSIDIARIES
Consolidated Balance Sheets
 As of December 31,
 
   
2007
 
2006
 
ASSETS
         
Current assets:
         
Cash and cash equivalents
 
$
742,468
 
$
5,802,615
 
Accounts receivable, net of allowance
             
of $82,000 ($74,000 -2006)
   
617,320
   
618,622
 
Inventory
   
259,442
   
239,416
 
Loans to employees
   
120,732
   
51,895
 
Prepaid expenses and other current assets (including a prepaid balance with a related party of $91,000 in 2006)
   
487,715
   
172,887
 
      Total current assets
   
2,227,677
   
6,885,435
 
               
Restricted cash
   
177,345
   
-
 
Fixed assets, net
   
1,494,540
   
637,732
 
Other assets
   
147,958
   
156,734
 
Goodwill
   
1,396,734
   
1,396,734
 
Other intangible assets, net
   
6,149,530
   
5,389,564
 
               
Total assets
 
$
11,593,784
 
$
14,466,199
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
               
Current liabilities:
             
Accounts payable
 
$
1,795,085
 
$
1,283,503
 
Accrued expenses & other current liabilities (including a related party balance of $230,000 in 2006)
   
818,606
   
877,261
 
Deferred revenue
   
732,355
   
564,439
 
Current portion of capital lease obligations
   
79,948
   
34,814
 
               
      Total current liabilities
   
3,425,994
   
2,760,017
 
               
Revolving note from related party
   
300,000
   
-
 
Long-term capital lease obligations
   
294,821
   
50,417
 
Long-term deferred revenue
   
15,938
   
466,875
 
Deferred tax liability
   
200,000
   
-
 
Commitments and contingencies (see Note 12)
             
               
Stockholders' equity
             
Common stock, $.02 par value; 200,000,000 shares authorized, 13,654,364 shares issued and outstanding (13,544,724 in 2006)
   
273,087
   
270,894
 
    Additional paid-in capital
   
31,298,571
   
28,145,793
 
    Accumulated deficit
   
(24,214,627
)
 
(17,227,797
)
               
      Total stockholders' equity
   
7,357,031
   
11,188,890
 
               
Total liabilities and stockholders' equity
 
$
11,593,784
 
$
14,466,199
 
 
See accompanying notes.
 
F-3

 
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
For The Years Ended December 31,
 
   
 2007
 
 2006
 
 2005
 
Revenue
                
Security printing and products
 
$
3,912,789
 
$
2,994,899
 
$
660,018
 
Royalties
   
1,195,146
   
682,073
   
80,949
 
Digital solutions
   
201,210
   
-
   
-
 
Legal products
   
682,051
   
631,454
   
525,420
 
                     
Total Revenue
   
5,991,196
   
4,308,426
   
1,266,387
 
                     
Costs of revenue
                   
Security printing and products
   
2,465,898
   
1,972,172
   
370,637
 
Digital solutions
   
44,028
   
-
   
-
 
Legal products
   
353,914
   
349,655
   
272,542
 
                     
Total costs of revenue
   
2,863,840
   
2,321,827
   
643,179
 
                     
Gross profit
   
3,127,356
   
1,986,599
   
623,208
 
                     
Operating expenses:
                   
Selling, general and administrative
   
7,974,312
   
5,375,331
   
2,455,778
 
Research and development
   
420,063
   
352,796
   
313,657
 
Amortization of intangibles
   
1,754,017
   
1,025,528
   
538,110
 
                 
 
 
        Operating expenses
   
10,148,392
   
6,753,655
   
3,307,545
 
                     
Operating loss
   
(7,021,036
)
 
(4,767,056
)
 
(2,684,337
)
                     
Other income (expense):
                   
Interest income
   
93,397
   
59,976
   
85,602
 
Loss on foreign currency transactions
   
(23,519
)
 
(3,526
)
 
-
 
Interest expense
   
(5,108
)
 
(14,943
)
 
(4,330
)
                     
Loss from continuing operations before income taxes
   
(6,956,266
)
 
(4,725,549
)
 
(2,603,065
)
                     
Income taxes
   
19,003
   
-
   
-
 
                     
Loss from continuing operations
   
(6,975,269
)
 
(4,725,549
)
 
(2,603,065
)
                     
Loss from discontinued operations: (Note 9)