UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K
 
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2010
 
or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to __________
 
Commission file number 1-32146 

 
DOCUMENT SECURITY SYSTEMS, INC. 

(Exact name of registrant as specified in its charter)
 
New York
 
16-1229730
(State or other jurisdiction of incorporation or organization)
 
(I.R.S.Employer Identification Number)

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

(585) 325-3610
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
Name of  each exchange on which registered
Common Stock, par value $0.02 per share
NYSE Amex Equities
 
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.
YES o   NO x

 
 

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the
Act.       YES o   NO x

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
YES o   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, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

          Large Accelerated Filer o    Accelerated Filer o    Non-Accelerated Filer (Do not check if a smaller reporting company) o Smaller Reporting Company x
 
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 registrant’s common stock held by non-affiliates of the registrant computed by reference to the closing price of such common stock as reported on the NYSE Amex Equities exchange on  June 30, 2010, was $40,543,056.

The number of shares of the registrant’s common stock outstanding as of March 25, 2011, was 19,498,884.
 
DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement  relating to the registrant’s 2011 Annual Meeting of Stockholders, to be held on June 9, 2011 are incorporated by reference into Part III of this Annual Report on Form 10-K.
 
 
 

 
 
DOCUMENT SECURITY SYSTEMS, INC. & SUBSIDIARIES
Table of Contents
 
 PART I
     
ITEM 1.
BUSINESS
1
ITEM 1A.
RISK FACTORS
7
ITEM 2.
PROPERTIES
14
ITEM 3.
LEGAL PROCEEDINGS
14
 
   
PART II
 
   
ITEM 5.
MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
SECURITIES
16
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
17
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
28
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
29
ITEM 9A.
CONTROLS AND PROCEDURES
29
 
   
PART III
 
   
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
30
ITEM 11.
EXECUTIVE COMPENSATION
30
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS
30
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND
DIRECTOR INDEPENDENCE
30
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
30
     
PART IV
     
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
30
 
SIGNATURES
33
 
 
 

 

ITEM 1 - BUSINESS

Overview

Document Security Systems, Inc. (referred to in this report as “Document Security Systems”, “Document Security,” “DSS,” “we,” “us,” “our” or  “Company”) develops, markets, manufactures and sells paper and plastic 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.  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 protection 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.  The basis of our document security business in our early stages was several patents, research and development and knowledge we acquired from privately held document security technology businesses in 2002 and 2003.  Our business model focused on developing anti-copying technologies for the printing industry.   We now have numerous patents, patent pendings, trademarks and trade secrets that form the basis of our security technology offerings.  Our competitive position in the security printing market is based on our attention to the research and development of technologies, ideas and know-how that combat a widening range of copying, scanning and other duplication devices that exist in today’s market that can be used for counterfeiting and unauthorized duplication of sensitive information and images.   In 2006, we began to expand our strategic focus to become a full service provider of documents securing products to the end-user customer.

  Prior to 2006, the Company’s primary revenue source in its document security division was derived from the licensing of its technology.  The Company had limited production capabilities.   In 2006, the Company began to expand its ability to be a provider of anti-counterfeiting products that utilize the Company’s anti-counterfeiting technologies.  In 2006, we acquired Plastic Printing Professionals, Inc. (“P3”), a privately held plastic cards manufacturer located in the San Francisco, CA area.   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 and by manufacturing for various industry integrators.
 
 
In December 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a privately held commercial printer located in Rochester, NY.  We formed DPI Secuprint (“DPI”) to incorporate this new company which significantly improved our ability to produce our security paper products as well as improving our competitiveness in the market for custom security printing, especially in the areas of vital records, secure coupons, transcripts, and prescription paper along with the ability to offer our customers a wider range of commercial printing offerings.

In February 2010, the Company acquired Premier Packaging Corporation (“Premier Packaging”), a privately held packaging company located in the Rochester NY area.  Premier Packaging  is an ISO 9001:2008 registered manufacturer of custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others.   The Company expects the acquisition will allow it to introduce anti-counterfeiting products to the packaging market that further expands the usage of its technologies.  The Company believes that the ability to deter and prevent counterfeiting of brand packaging will provide major benefits to companies around the globe which are affected by product counterfeiting.

In 2010, we generated revenue of $13.4 million, a 35% increase compared to 2009.  The increase was primarily due to the acquisition of Premier Packaging in the early part of 2010.  The increase in revenue caused by the acquisition of Premier Packaging more than offset decreases in revenue experienced by the Company’s other divisions, Document Security Systems, DPI and P3, and the loss of revenue as a result of the Company’s divestiture of its legal products division in October of 2009.  In October 2010, we distributed our shares of Internet Media Services in the form of a dividend to our shareholders.

 
1

 

Our Core Products, Technology and Services

Our core business is counterfeit prevention, brand protection and validation of authentic print media, including government-issued documents, aerospace industry spare parts documents, packaging, ID Cards, licenses and more.  We believe 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, consumer product companies 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, packaging, or digitally via our AuthentiGuard® DX™ product suite.  We believe that our continued efforts in the field of digital security and technology greatly expands 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 over 30 technologies that provide to our customers a wide spectrum of solutions.

The Company’s primary anti-counterfeiting products and technologies are marketed under the following trade names:

 
·
AuthentiGuard™ DX™
 
·
AuthentiGuard® Laser Moiré™
 
·
AuthentiGuard® Prism™
 
·
AuthentiGuard® Pantograph 4000™
 
·
AuthentiGuard® Phantom™
 
·
AuthentiGuard® VeriGlow™
 
·
AuthentiGuard® Survivor 21®
 
·
AuthentiGuard® Block-Out™
 
·
AuthentiGuard® MicroPerf™

Products and Services

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 – when the paper is faxed, copied or scanned.  The hidden words appear on the duplicate or the computer digital file and essentially prevent documents, including forms, coupons and tickets, from being counterfeited.

Security and non-security printing:  We believe 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, vital records, prescription paper, driver’s licenses, birth certificates, receipts, manuals, identification materials, entertainment tickets, secure coupons, parts tracking forms, as well as product packaging including pharmaceutical and a wide range of consumer goods.  In addition, we provide a full range of digital and large offset commercial printing capabilities to our customers.

In our early stages, we had primarily outsourced the production of our custom security print orders to strategic printing vendors.  In December 2008, we acquired a commercial printer with long run offset and short run digital printing capabilities that will allow us to produce the majority of our security print orders in house.    We produce our plastic printed documents such as ID cards, event badges, and driver licenses at our manufacturing facility in Brisbane, California under the name P3. In late 2007, we moved our P3 manufacturing facility to a 25,000 square foot facility in order to increase our plastic manufacturing capacity, and during 2008, we upgraded their production capabilities by adding equipment that will improve its productivity, along with equipment for high speed data encoding and equipment for production of high-volume precision RFID cards.

Packaging: We produce our secure and non-secure packaging products such as boxes, mailers, and point of sale displays, utilizing a CAD/CAM design system that allows for early stage prototyping at our manufacturing facility in Victor, New York.  Our packaging division offers automated die cutting, high speed folding, gluing, window and paper patching, automated in-line inserting, pick and place and tip-on systems.   We can incorporate our security technologies into printed packaging to help companies prevent or deter brand and product counterfeiting.   In addition, our technologies and services can be integrated into various supply chain anti-diversion programs such as track and trace that deter product diversion throughout the supply chain.

 
2

 
 
Digital Security Solutions:  Using software that we have developed, we can electronically render several of our technologies digitally to extend the use of optical security to the end-user of sensitive information.  With our AuthentiGuard® DX™ we market a networked appliance that allows the author of any Microsoft Office document (Outlook, Word, Excel, or PowerPoint) to secure nearly any of its alphanumeric content when it is printed or digitally stored. AuthentiGuard® DX prints selected content using our patented technology so that it cannot be read by the naked eye.  Reading the hidden content, or authenticating the document is performed with a proprietary viewing device or software.

 The Company has developed an internet delivered technology called AuthentiGuard® – On Demand™ where information is hidden and then verified utilizing an inexpensive viewing glass.  This technology is currently being utilized by a Central American country for travel visas.

The Company has also developed digital versions of its AuthentiGuard® – Prism™  and AuthentiGuard® – Pantograph 4000™  technologies which are produced on HP Indigo Presses, Canon Color Copiers, Ricoh Color Copiers and Konica Desktop Printers.  The Company sells the digital products directly through its internal sales force and it has also entered into a contract to sell its digital solutions through a third party who specializes in hardware software engineering solutions.

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;
 
·
Joint venture or profit sharing arrangements; and
 
·
Pay Per Finished Piece.

Legal Products:  We also owned and operated, through our wholly-owned subsidiary, Legalstore, an Internet company which sold legal supplies and documents, including security paper and products for the users of legal documents and supplies in the legal, medical and educational fields.  On October 8, 2009 we sold the assets and liabilities associated with Legalstore to Internet Media Services, Inc. (“Internet Media Services”) in exchange for 7,500,000 shares of its common stock representing approximately 37% of the outstanding shares of Internet Media Services. In October 2010, we distributed our shares of Internet Media Services in the form of a dividend to our shareholders.

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 research and development to ensure that we are a market leader with the ability to provide our customers effective solutions against a never changing array of counterfeit risks.  Our position in the security print market is based on our technologies and products.  We dedicate 2 staff members to research and development of print technologies, digital graphic files, and printing techniques that allow us to expand our ability to combat a wide variety of counterfeiting and brand protection issues.   In 2010 and 2009, we spent approximately $265,000 and $291,000 respectively, on research and development which is comprised mainly of compensation costs, materials and third-party services.

Based largely on these efforts, we currently hold numerous patents and  have numerous patent applications in process, including provisional and PCT patent applications and applications that have entered the National Phase in various countries including the United States, Canada, Europe, Japan, Brazil, Israel, Mexico, Indonesia and South Africa. These applications cover our technologies, including our AuthentiGuard® On-Demand and ADX, AuthentiGuard® Prism™, AuthentiGuard® Phantom™, AuthentiGuard® ObscuraScan™, AuthentiGuard® Survivor 21™, AuthentiGuard® VeriGlow™ products, and several other anti-counterfeiting and authentication technologies in development.

 
3

 
 
In addition to our current patent activities, we own several patents that we acquired in 2002 when we acquired companies owned by various members of the Wicker Family and The Estate of Ralph Wicker, including US Patents 5,018,767, European Patent 0455750, Canadian Patent 2,045,580, and a 50% ownership of US Patent No 5,735,547 (collectively, the “Wicker Patents”).  However, due to previous contractual agreements associated with the Wicker Patents, we did not obtain certain economic rights to these patents, including certain economic rights to benefits derived from settlements, licenses or other subsequent business arrangements from any person or entity that had been proven to infringe these patents.  Therefore, to consolidate our ownership and economic rights to the Wicker Patents, we entered into the following transactions.

 
·
In 2004, we entered into an agreement with The Estate of Ralph Wicker and its assigns to purchase from them the right to 70% of the future economic benefit derived from settlements, licenses or subsequent business arrangements from any infringer of the Wicker Patents that we choose to pursue, with The Estate of Ralph Wicker receiving the remaining 30% of such economic benefit.

 
·
In February 2005, we further consolidated our ownership of the Wicker Patents by purchasing the economic interests and ownership from 45 persons and entities that had purchased various rights in Wicker Family technologies, including the Wicker Patents.  As a result of this transaction, we increased our ownership of US Patent 5,735,547 to 100%, and increased our right to future economic benefits relating to the Wicker Patents to approximately 86% of all settlements or license royalties derived from, among other things, infringement suits related to the foreign Wicker Patents, including European Patent 0455750.  Pursuant to these transactions, we issued an aggregate of 541,460 shares  of our common stock, valued at approximately $3.9 million to these 45 persons and entities.

In August 2005, the Company commenced a suit against the European Central Bank (“ECB”) alleging patent infringement by the ECB and claimed unspecified damages. We brought the suit in the European Court of First Instance in Luxembourg.  We alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 (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.  Commencing in March 2006, the ECB countersued in eight national courts alleging that the Patent was invalid.  Through August 2008, the Company spent approximately $4.2 million dollars on legal, expert and consulting fees for its case.    In August  2008, the Company decided to reduce its cost burden associated with the case and entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet agreed to pay substantially all of the litigation costs associated with pending validity proceedings and future validity and future patent infringement suits filed against the ECB and certain other alleged infringers of the Patent in exchange for 50% of any future proceeds or settlements associated with the litigation. The Patent has been confirmed to be valid and enforceable in one jurisdiction (Spain) that used the Euro as its national currency allowing the Company or Trebuchet, on the Company’s behalf, to proceed with infringement cases in Spain if we choose to do so.

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.

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.

Major Customers

During 2010, two customers accounted for 25% and 10% of the Company’s total revenue from continuing operations.   As of December 31, 2010, these customers accounted for 37% and 7% of the Company’s trade accounts receivable balance, respectively.   During 2009, two customers accounted for 19% and 12% of the Company’s total revenue from continuing operations.  As of December 31, 2009, two customers’ account receivable balance accounted for 21% and 17% of the Company’s trade accounts receivable balance.  We believe that the risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.

 
4

 
 
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 website www.protectedpaper.com, an e-commerce site that markets and sells our patented security papers hand-held security verifiers and custom security documents to end users worldwide.   We market digital and large offset commercial printing at our subsidiary website:  www.dpirochester.com.   In addition, in February 2010, we acquired Premier Packaging, which maintains the website www.premiercustompkg.com.    In addition to the active websites, the company owns over 40 domain names for future use or for strategic competitive reasons.

Markets and 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 to 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.

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.  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.

 
5

 
 
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 word 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 used or are 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.

The commercial printing industry in the US includes around 35,000 companies with $90 billion of annual revenue.  (Source: http://www.firstresearch.com/industryanalysis/commercialprinting.html).  Several giants like RR Donnelley and Canadian printer Quebecor World have multibillion revenues, but most printers considered "large" have annual revenues under $1 billion. The majority of commercial printers are small or midsized businesses that operate one production plant, employ fewer than 20 people, and have annual revenue under $5 million.  Despite continuing consolidation, the industry is highly fragmented; the largest 50 companies hold only about 30 percent of the market. We compete primarily with locally-based printing companies in the Rochester and Western New York markets.  Most of our competitors in these markets are privately-held, single location operations.

In the packaging industry, we compete with a significant number of national, regional and local companies, many of which are independent and privately-held. The largest competitors in this market are primarily focused on the long-run print order market. They include large integrated paper companies such as Rock-Tenn Company, Caraustar Industries, Inc., Graphic Packaging Holding Company and Mead Westvaco.

In general, changes in prevailing U.S. economic conditions significantly impact the general commercial printing industry.  To the extent weakness in the U.S. economy causes local and national corporations to reduce their spending on advertising and marketing materials, the demand for commercial printing services may be adversely affected.

Employees

As of March 25, 2011, we had a total of 104 employees..  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

In light of the events of September 11, 2001 and the subsequent war on terrorism, governments, private entities and individuals have become more aware of, and concerned with, the problems related with counterfeit documents. Homeland Security remains a high priority in the United States. This new heightened awareness may result in new laws or regulations which could impact our business. We believe, however, that any such laws or regulations would be aimed at requiring or promoting anti-counterfeiting, and therefore would likely have a positive impact on our business plans.

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.

 
6

 

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 effective April 1, 2008.

ITEM 1A – RISK FACTORS

Risks Related to Our Company

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 disclosures.

We have a history of losses.
 
We have a history of losses. In fiscal 2010, 2009, and 2008, we incurred losses of approximately $4.6 million, $4.0 million, and $8.3 million, respectively.  Our results of operations in the future will depend on many factors, but largely on our ability to successfully market our anti-counterfeiting products and services.  Our failure to achieve profitability in the future could adversely affect the trading price of our common stock and our ability to raise additional capital and, accordingly, our ability to continue to grow our business. There can be no assurance that we will succeed in addressing any or all of these risks, and the failure to do so could have a material adverse effect on our business, financial condition and operating results.

We have a significant amount of indebtedness and may be unable to satisfy our obligations to pay interest and principal thereon when due.
 
As of December 31, 2010, we have the following approximate amounts of outstanding indebtedness:
 
 
(i)
 
$575,000 Promissory Note bearing interest at 10% per annum due November 24, 2012, secured by the assets of the Company’s wholly owned subsidiary DPI.  
       
 
(ii)
 
$583,000 due under a Credit Facility to a related party under which the Company can borrow up to $1,000,000 bearing interest at LIBOR plus 2% per annum due January 4, 2012.
       
 
(iii)
 
$1,250,000 due under a Term Loan which matures March 1, 2013 and is payable in 35 monthly payments of $25,000 plus interest commencing March 1, 2010 and a payment of $625,000 on the 36th month.  Interest accrues at 1 Month LIBOR plus 3.75% and is secured by all of the assets of the Company’s subsidiary, Premier Packaging , which the Company acquired on February 12, 2010.  The Company subsequently entered into a interest rate swap agreement to lock into a 5.6% effective interest rate over the life of the Term Loan.  The Term Loan has also been guaranteed by Document Security Systems, and its subsidiaries P3 and DPI.
 
 
(iv)
 
Up to $1,000,000  in a revolving line of credit available for use by Premier Packaging, subject to certain limitations which matures on May 13, 2011(as amended) and is payable in monthly installments of interest only beginning on March 1, 2010. Interest accrues at 1 Month LIBOR plus 3.75%, and is secured by all of the assets of the Company’s subsidiary, Premier Packaging.  As of December 31, 2010, there was approximately $615,000 outstanding on the line.
 
 
(v)
 
 Up to $450,000 under a Standby Term Loan Note available to Premier Packaging for the funding of eligible equipment purchases and is secured by all of the assets of the Company’s subsidiary, Premier Packaging.   The Company has 12 months to draw a line of credit, after which the balance of funds advanced from the line is converted into a 5 year term loan.  Interest accrues at LIBOR plus 3.00%.   As of December 31, 2010, there was approximately $53,000 outstanding on the line.
 
 
 
7

 
 
If we lose our current litigation, we may lose certain of our technology rights, which may affect our ability to sell certain of our products and effectuate our business plan.
 
We are subject to litigation and threatened litigation, including without limitation our litigation with the ECB, in which parties allege, among other things, that certain of our patents are invalid.  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.   Furthermore, we have granted nearly all control over our ECB litigation to a third party, Trebuchet, who may or may not have the resources or capabilities to successfully defend our patent rights or meet its financial obligations.   If Trebuchet is unable to meet its financial obligations, then we may be obligated to pay for certain court mandated legal costs to the ECB or other parties, which may materially affect our financial condition.
 
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 patents 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.
 
 
8

 

The value of our intangible assets may not be equal to their carrying values.
 
As of December 31, 2010, we had approximately $3.8 million of net intangible assets, including goodwill.  We are required to evaluate the carrying value of such intangibles.  Whenever events or changes in circumstances indicate that the carrying value of an intangible asset, including goodwill, may not be recoverable, we determine whether there has been impairment by comparing the anticipated undiscounted cash flows (discounted cash flows for goodwill) from the operation and eventual disposition of the product line with its carrying value. If any of our intangible assets are deemed to be impaired then it will result in a significant reduction of the operating results in such period.  An impairment of patent acquisition costs of $377,000 was recognized in the fourth quarter of 2010 as a result of adverse decisions in the Company’s patent infringement case against the ECB which caused the Company to reduce the estimated cash flows that supported the Company’s capitalized patent acquisition based intangible asset.
 
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 several 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 2011 and beyond includes plans to incur significant marketing and sales costs for these newer products, particularly the digitally delivered products.  If we are not able to 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.
 
 
9

 
 
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 complementary to our existing operations and expanding our operations to include manufacturing capabilities. We may also seek to acquire other businesses. The success of this acquisition strategy will depend, in part, on our ability to accomplish the following:
 
 
·
identify suitable businesses or assets to buy;
 
·
complete the purchase of those businesses on terms acceptable to us;
 
·
complete the acquisition in the time frame we expect; and
 
·
improve the results of operations of the businesses that we buy and successfully integrate their operations into our own.
 
Although we were able to acquire our P3 subsidiary in February 2006, our DPI subsidiary in December 2008, and Premier Packaging in February 2010, 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.
 
We may not realize the anticipated benefits of our recent acquisition of Premier Packaging.
 
Our expectations regarding the earnings, operating cash flow, capital expenditures and liabilities resulting from our recent acquisition of Premier Packaging in February 2010 are based on information currently available to us and may prove to be incorrect. In particular, 72% of Premier Packaging’s sales for the year ended December 31, 2009 were with two customers comprising 81% of Premier Packaging’s accounts receivable balance as of December 31, 2009.  As of  December 31, 2010 one of the customers, which accounted for 25% of the Company’s consolidated sales for 2010, has a contract with the Company that is currently set to expire in July 2011, and this customer also comprises 37% of the Company’s consolidated accounts receivable as of December 31, 2010.  Our inability to realize any of the anticipated benefits of this acquisition and to successfully integrate the acquired assets into our existing business will have an adverse effect on our financial condition.

 
10

 

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 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.  There can be no assurance that these persons will continue to agree to be employed by us after the expiration dates of their current contracts.
 
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.   If we are unable to hire or retain qualified sales personnel or if newly hired personnel fail to develop the necessary skills to be productive, or if they reach productivity more slowly than anticipated, our ability to increase our revenues and grow could be compromised. The challenge of attracting, training and retaining qualified candidates may make it difficult to meet our sales growth targets. Further, we may not generate sufficient sales to offset the increased expense resulting from expanding our sales force or we may be unable to manage a larger sales force.
 
Future growth in our business could make it difficult to manage our resources.
 
Our anticipated business expansion could place a significant strain on our management, administrative and financial resources. Significant growth in our business may require us to implement additional operating, product development and financial controls, improve coordination among marketing, product development and finance functions, increase capital expenditures and hire additional personnel. There can be no assurance that we will be able to successfully manage any substantial expansion of our business, including attracting and retaining qualified personnel. Any failure to properly manage our future growth could negatively impact our business and operating results.
 
We cannot predict our future capital needs and we may not be able to secure additional financing.

We may need to raise additional funds in the future to fund our working capital needs, to fund more aggressive expansion of our business, to complete development, testing and marketing of our products, or to 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 necessary funds will be available for us to finance our development on acceptable terms, if at all.  Furthermore, such additional financings may involve substantial dilution of our stockholders or may require that we relinquish rights to certain of our technologies or products. In addition, we may experience operational difficulties and delays due to working capital restrictions. If adequate funds are not available from operations or additional sources of financing, we may have to delay or scale back our growth plans.

Risks Related to Our Industry

If we are unable to respond to regulatory or industry standards effectively, our growth and development could be delayed or limited.

Our future success will depend in part on our ability to enhance and improve the functionality and features of our products and services in accordance with regulatory or industry standards. Our ability to compete effectively will depend in part on our ability to influence and respond to emerging industry governmental standards in a timely and cost-effective manner. If we are unable to influence these or other standards or respond to these or other standards effectively, our growth and development of various products and services could be delayed or limited.

Increased emphasis on expanding our marketing efforts to foreign countries subjects us to risks that are in addition to those to which we are exposed in our domestic operations.

We believe that revenue from sales of products and services to commercial, governmental and other customers outside the United States could represent a growing percentage of our total revenue in the future. International sales efforts are subject to a number of risks that can adversely affect our sales of products and services to customers outside the United States, including:
 
 
11

 

 
·
changes in foreign government regulations and security requirements;
 
·
export license requirements, tariffs and taxes;
 
·
trade barriers;
 
·
difficulty in protecting intellectual property;
 
·
difficulty in collecting accounts receivable;
 
·
currency fluctuations;
 
·
longer payment cycles than those customary in the United States; and
 
·
political and economic instability.

We do not maintain operational infrastructure for international business. We depend on international business partners and licensees for support of our international marketing efforts. These factors may result in greater risk of performance problems or of reduced profitability with respect to our international sales efforts. In addition, if foreign customers, particularly foreign governmental authorities, terminate or delay the implementation of our products and services, it may be difficult for us to generate profitable business in these foreign jurisdictions.

Changes in the laws and regulations to which we are subject may increase our costs.

We are subject to numerous laws and regulations, including, but not limited to, environmental and health and welfare benefit regulations, as well as those associated with being a public company. These rules and regulations may be changed by local, state, provincial, national or foreign governments or agencies. Such changes may result in significant increases in our compliance costs. Compliance with changes in rules and regulations could require increases to our workforce, and could result in increased costs for services, compensation and benefits, and  investment in new or upgraded equipment.

Declines in general economic conditions or acts of war and terrorism may adversely impact our business.

Demand for printing services are correlated with general economic conditions. The recent declines in U.S. economic conditions have adversely impacted our business and results of operations, and may continue to do so for the foreseeable future. The overall business climate of our industry may also be impacted by domestic and foreign wars or acts of terrorism, which events may have sudden and unpredictable adverse impacts on demand for our products and services.

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, 2010, there were approximately 180 million authorized but unissued shares of our common stock. Our management continues 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 NYSE Amex, New York law, or other applicable laws.   If our Board of Directors determines to issue additional shares of our common stock from the large pool of 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 such transaction.

 
12

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

As of December 31, 2010, we had outstanding stock options and warrants to purchase an aggregate of  2,767,131 shares of our common stock at exercise prices ranging from $1.86 to $12.65 per share.  This amount includes the warrants issued to Fletcher  on December 31, 2010 (as amended on February18, 2011 and March 14, 2011).  These amounts do not include potentially issuable shares under Fletcher’s Later Investment rights which provide Fletcher the right to acquire up to 756,387 shares of the Company’s common stock at a price per share of $5.38 anytime prior to July 2, 2011. For each share purchased by Fletcher pursuant to the Later Investment, Fletcher would receive a warrant to purchase an additional share of the Company’s commons stock at $5.38 for up to nine years.   If Fletcher exercises all of its Later Investment Rights, then an additional 756,387 warrants would be issued.   (See Item 15 -Notes To The Consolidated Financial Statements).  This amount does includes 45,000 unvested restricted shares of our common stock that are subject to various vesting terms. To the extent that these securities are converted into common stock, 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 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.
 
We have material weaknesses in our internal control over financial reporting structure, which, until remedied, may cause errors in our financial statements that could require restatements of our financial statements and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K.

We have identified two material weaknesses in our internal control over financial reporting in our annual assessment of internal controls over financial reporting that management performed for the year ended December 31, 2010.  Management has concluded that (i) we did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties; and (ii) we lack sufficient resources within the accounting department to have effective controls associated with identifying and accounting for complex and non-routine transactions in accordance with U.S. generally accepted accounting principles, and that the foregoing represented material weaknesses in our internal control over financial reporting. We are uncertain at this time of the costs to remediate all of the above listed material weaknesses, however, we anticipate the cost to be in the range of $200,000 to $400,000 (including the cost of hiring additional qualified accounting personnel to eliminate segregation of duties issues and using the services of accounting consultants for complex and non-routine transactions if and when they arise). We cannot guarantee that the actual costs to remediate these deficiencies will not exceed this amount.  If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements and in our disclosure that could require restatements. Investors may lose confidence in our reported financial information and in our disclosure, which could lead to a decline in our stock price.

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

As a result, we cannot assure you that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also materially adversely affect the results of periodic management evaluations regarding disclosure controls and procedures and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder.
 
 
13

 

We may not meet the continued listing standards of the NYSE AMEX

In December 2008, we received a letter from the NYSE Amex stating that, based on the NYSE Amex’s review of publicly available information, we were considered to be below the NYSE Amex’s continued listing standards.  After submitting a plan of compliance to the NYSE Amex and additional evaluation by the NYSE Amex, we were informed in March 2010 that we had resolved the continued listing deficiencies.  

On January 25, 2011, we received a warning letter from the NYSE Amex in connection with the Company's failure to secure NYSE Amex approval for the additional issuances of our securities as required by Section 301 of the NYSE Amex Company Guide and its continued listing standards.  The listing deficiency involved three stock issuances totaling 1,235,153 shares made in November and December of 2010.   We thereafter filed our applications for the additional share listings with the NYSE Amex. On March 15, 2011, we received notification from NYSE Amex that our additional listing applications have been approved, and that the Company has regained full compliance with NYSE Amex listing requirements.

We cannot assure you that we will not receive additional deficiency letters in the future, or that we will continue to satisfy the continued listing standards in order to remain listed on the NYSE Amex Equities exchange.
 
ITEM 2 - PROPERTIES

Our administrative offices are approximately 4,700 square feet and are located in the First Federal Plaza Building, 28 East Main Street, Rochester, New York 14614 which we occupy under a lease that will expire in January 2012.   Our plastic printing division leases approximately 25,000 square feet in Brisbane, California in a lease that will expire in July 2014.  DPI, our commercial printing group, leases an approximately 20,000 square foot facility in Rochester, New York under a lease expiring in December 2013.   We lease approximately 40,000 square feet of production and warehouse space located in Victor, New York, a suburb of Rochester, from Bzdick Properties, LLC, an entity owned by the former owner of Premier Packaging and the Company’s new President and Chief Operating Officer, which will expire on February 12, 2020.  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.

 ITEM 3 - LEGAL PROCEEDINGS

On August 1, 2005, the Company commenced a suit against the ECB alleging patent infringement by the ECB and claimed unspecified damages. We brought the suit in the European Court of First Instance in Luxembourg.  We alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 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 formally requested the Company to pay attorneys and court fees in the amount of Euro 93,752 which, unless the amount is settled will be subject to an assessment procedure that has not been initiated, the Company will accrue as soon as the assessed amount, if any, is reasonably estimable.

 In 2006, the Company received notices that the ECB had filed separate claims in each of the United Kingdom, The Netherlands, Belgium, Italy, France, Spain, Germany, Austria and Luxembourg courts seeking the invalidation of the Patent.  Proceedings were commenced before the national courts seeking revocation and declarations of invalidity of the Patent.  On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England ruled that the Patent was deemed invalid in the United Kingdom, and on March 19, 2008 this decision was upheld on appeal.   As a result of these decisions, the Company was notified of the final assessment of the reimbursable ECB costs for both court cases was ₤356,490, of which all was paid as of December 31, 2010.

On March 27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that the German part of the Patent was valid, having considered the English Court’s decision.  On July 6, 2010, the Company was notified that the German Court has ruled that the Patent, that was awarded to the Company by the European Patent Office and upheld as valid in a previous hearing in the German Court of First Instance, has now been deemed invalid in Germany due to added matter.  On January 9, 2008 the French Court held that the Patent was invalid in France for the same reasons given by the English Court.  The Company filed an appeal against the French decision on May 7, 2008. On March 20, 2010, the Company was informed that the decision was upheld in the French appeal.  On March 12, 2008 the Dutch Court  ruled that the Patent is valid in the Netherlands.  The ECB filed an appeal against the Dutch decision on March 27, 2008.  The Dutch appeal was heard in June 2010, and the Company was notified on December 21, 2010 that the patent was deemed invalid upon appeal.  On November 3, 2009, the Belgium Court held that the Patent was invalid in Belgium for the same reasons given by the English and French courts as were similarly informed by the Austrian court on November 17, 2009.   Cost reimbursement, if any, associated with the Belgium, Austrian, and French validity cases as well as the appeals in Germany and France are covered under the Trebuchet agreement described below.  On March 24, 2010 the Spanish Court ruled that the Patent was valid.  In Italy the validity case is to be heard again by a newly appointed judge expected during 2011 and a hearing in Luxembourg thereafter.

 
14

 
 
On August 20, 2008, the Company entered into an agreement with Trebuchet under which Trebuchet agreed to pay substantially all of the litigation costs associated validity proceedings in eight European countries relating to the Patent.  Trebuchet also agreed to pay substantially all of the litigation costs associated with any future validity challenges filed by the ECB or other parties, provided that Trebuchet elects to assume the defense of any such challenges, in its sole discretion, and patent infringement suits filed against the ECB and certain other alleged infringers of the Patent, all of which suits may be brought at the sole discretion of Trebuchet and may be in the name of the Company, Trebuchet or both. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the agreement under the terms of the Agreement, and in consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest of the Company's rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and distinct interest in and share of the Patent, along with the right to sue and recover in litigation, settlement or otherwise to collect royalties or other payments under or on account of the Patent. In addition, the Company and Trebuchet have agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. Trebuchet is also entitled to recoup any litigation expenses specifically awarded to the Company in such actions.

The Patent has been confirmed to be valid and enforceable in one jurisdiction (Spain) that uses the Euro as its national currency allowing the Company or Trebuchet, on the Company’s behalf, to proceed with infringement cases in Spain if we choose to do so.   On February 18, 2010, Trebuchet, on behalf of the Company, filed an infringement suit in the Netherlands against the ECB and two security printing entities with manufacturing operations in the Netherlands, Joh. Enschede Banknotes B.V and Koninklijke Joh. Enschede B.V.  Upon determination on December 21, 2010, that the patent was invalid in the Netherlands, the infringement case will not be continued.

On January 31, 2003, the Company commenced an action, unrelated to the above ECB litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and Andrew McTaggert (United States District Court, Western District Of New York Case No.03-Cv-6044t(F)) regarding certain intellectual property in which the Company has an interest.  On December 7, 2009, the Company reached an agreement to terminate all litigation in association with this suit.  In conjunction with that agreement, the Company issued to the opposing parties an aggregate of 40,000 shares of common stock valued at approximately $85,000 and 50,000 of common stock warrants for the purchase of common shares at $3.00 per share valued at approximately $30,000 utilizing the Black Scholes pricing model.  The Company recorded an expense related to the estimated grant date fair value of the shares and warrants issued of approximately $115,000.   In addition, both parties agreed not to compete with certain of the other party’s customers for 7 years.  The Company does not believe that the competition agreement will have a material impact on its business.

There are no other material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of its property is subject, other than ordinary routine litigation incidental to the Company’s business.

 
15

 
 
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 NYSE Amex, 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, 2010
  $ 4.41     $ 2.44  
June 30, 2010
    3.94       2.70  
September 30, 2010
    4.01       3.04  
December 31, 2010
    5.51       3.38  
                 
QUARTER ENDING
 
HIGH
   
LOW
 
March 31, 2009
  $ 1.92     $ 1.59  
June 30, 2009
    2.24       1.63  
September 30, 2009
    2.45       1.86  
December 31, 2009
    3.14       1.95  
 
The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.

From January 1, 2011 through March 25, 2011, our common stock had a high closing price of $5.58 and a low closing price of $4.48.

Issued and Outstanding

Our certificate of incorporation authorizes 200,000,000 shares of common stock, par value $0.02. As of March 25, 2011, we had 19,498,884 shares of common stock issued and outstanding.

Equity Compensation Plan Information
 
The following table provides certain information as of December 31, 2010 with respect to our equity compensation plans.

   
Restricted stock
to be issued upon vesting
   
Number of securities to be issued upon exercise of outstanding options, warrants and rights
   
Weighted average exercise price of outstanding options, warrants and rights
   
Number of securities remaining available for future issuance (under equity compensation Plans (excluding securities reflected in
column (a & b))
 
                         
Plan Category
 
(a)
   
(b)
   
(c)
   
(d)
 
                         
                         
Equity compensation plans approved by security holders
                   
      2004 Employee Stock Option Plan
    45,000       673,500     $ 6.09       846,481  
      2004 Non-Executive Director Stock Option Plan
            157,000       5.61       43,000  
                                 
Equity compensation plans not approved by security holders
                         
       Contractual warrant grants for services
    -       376,760       6.65       -  
                                 
Total
    45,000       1,207,260     $ 5.96       889,481  
 
 
16

 

Recent Issuances of Unregistered Securities.

There were no issuances of unregistered securities sold by the Company that have not been previously reported in the Company’s Current Reports on Form 8-K.

Stockholders

As of March 24, 2011, we had approximately 919 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

On September 23, 2010, our Board of Directors declared a non-monetary dividend pursuant to which we distributed to our stockholders of record on October 8, 2010 on a pro-rata basis an aggregate of 7,500,000 shares of common stock of Internet Media Services.  The dividend was recorded at approximately $229,000 which was the book value of the investment as of September 23, 2010. We did not pay dividends during 2009.  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.

Shares Repurchased by the Registrant

We did not purchase or repurchase any of our securities in the fiscal year ended December 31, 2010, 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, 2010, and which is incorporated by reference herein.

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

Forward-Looking Statements

Forward-looking statements in this Annual Report, including without limitation, statements related to the Company’s plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act and 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 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.  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.

 
17

 
 
We have developed or acquired over 30 technologies that provide to our customers a wide spectrum of solutions.  We hold numerous patents, patent pendings, trademarks and trade secrets that form the basis of our security technology offerings.  Our competitive position in the security printing market is based largely on our attention to the research and development of technologies, ideas and know-how that combat a widening range of copying, scanning and other duplication devices that exist in today’s market that can be used for counterfeiting and unauthorized duplication of sensitive information and images.  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.

Prior to 2006, the Company’s primary revenue source in its document security division was derived from the licensing of its technology.  The Company had limited production capabilities.   In 2006, the Company began to expand our ability to be a provider of anti-counterfeiting products that utilize our anti-counterfeiting technologies.  In 2006, we acquired P3, a privately held plastic cards manufacturer located in the San Francisco, CA area.   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 and by manufacturing for various industry integrators.

In December 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a privately held commercial printer located in Rochester, NY.  We formed DPI to incorporate this new company which significantly improved our ability to produce our security paper products as well as improving our competitiveness in the market for custom security printing, especially in the areas of vital records, secure coupons, transcripts, and prescription paper along with the ability to offer our customers a wider range of commercial printing offerings.

In February 2010, the Company acquired Premier Packaging, a privately held packaging company located in the Rochester NY area.  Premier Packaging  is an ISO 9001:2008 registered manufacturer of custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others.   The Company expects the acquisition will allow it to introduce anti-counterfeiting products to the packaging market that further expands the usage of its technologies.  The Company believes that the ability to deter and prevent counterfeiting of brand packaging will provide major benefits to companies around the globe who are affected by product counterfeiting.

In the past few years, we have divested two operations so that we could focus our efforts on security and commercial printing.  During 2007, we sold the assets of our retail printing and copying division, called Patrick Printing.  In October 2009, we sold the assets and liabilities associated with Legalstore in exchange for 7,500,000 shares of common stock of Internet Media Services.  In October 2010, we distributed our shares of Internet Media Services in the form of a dividend to our shareholders.

RESULTS OF OPERATIONS FOR THE FISCAL YEARS ENDED DECEMBER 31, 2010 AND 2009

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.  In October 2009, the Company sold Legalstore.  In accordance with FASB ASC 205-20-45, the Company reported the results of Legalstore as continued operations because the operations and cash flows of the component have not been eliminated given the Company’s continued involvement after the sale as a shareholder in Internet Media Services, the purchaser of Legalstore.  In October 2010, we distributed our shares of Internet Media Services in the form of a dividend to our shareholders.  In February 2010, we acquired Premier Packaging, a $7,000,000 packaging company based in Victor, NY, approximately 17 miles from Rochester, NY, our headquarters.    The discussion should be read in conjunction with the financial statements and footnotes that appear elsewhere in this report.

 
18

 
 
Revenue
 
   
Year Ended
December 31,
2010
   
Year Ended
December 31,
2009
   
% change
 
Revenue
                 
Security and commercial printing
  $ 6,988,000     $ 8,773,000       (20 )%
Packaging
    5,753,000       -       -  
Technology license royalties and digital solutions
    641,000       783,000       (18 )%
Legal products
    -       355,000       (100 )%
Total Revenue
  $ 13,382,000     $ 9,911,000       35 %
 
Revenue - Revenue in 2010 increased 35% from 2009.   Security and commercial print sales decreased 20%, primarily due to decreases in commercial printing orders from the Company’s DPI division.  The Company experienced lower orders from certain customers as a result of the change in the Company’s market focus.  Generally, the Company is seeking to reduce its overall commercial printing business and focus more of its printing on security printing opportunities.  Furthermore, the Company utilized a portion of it press time on printing for its newly acquired packaging company, which resulted in lower external print sales.    Packaging sales were $5.8 million for the ten and one-half-month period from February 12, 2010 to December 31, 2010.   During 2010, the Company focused on streamlining operations between its security printing, commercial printing and packaging division to strengthen its competitive position in the markets it sells to and generate cost savings and synergies.   During 2010, the Company had approximately $936,000 as opposed to $212,000 in 2009 of intercompany sales which were eliminated for consolidated reporting.
 
The Company’s technology license revenue declined 18% as usage by its largest licensee declined.   The Company continues to seek long-term licensing partners, however, we primarily focus our sales and business development efforts on end-user solutions for our customers.   Furthermore, during 2010, the Company did not have any legal product sales as this division was sold in October 2009.
 
Gross profit
 
   
Year Ended
December 31,
2010
   
Year Ended
December 31,
2009
   
% change
 
                   
Costs of revenue
                 
Security and commercial printing
  $ 5,304,000     $ 6,063,000       (13 )%
Packaging
    4,387,000       -       -  
Technology license royalties and digital solutions
    5,000       14,000       (64 )%
Legal products
    -       179,000       (100 )%
Total cost of revenue
    9,696,000       6,256,000       55 %
                         
Gross profit
                       
Security and commercial printing
    1,684,000       2,710,000       (38 )%
Packaging
    1,366,000       -       -  
Technology license royalties and digital solutions
    636,000       769,000       (17 )%
Legal products
    -       176,000       (100 )%
Total gross profit
  $ 3,686,000     $ 3,655,000       1 %
 
 
19

 
 
   
Year Ended
December 31,
2010
   
Year Ended
December 31,
2009
   
% change
 
Gross profit percentage:     28 %     37 %     (24 )%
 
Gross Profit - Gross profit was flat between 2010 and 2009, which was primarily due to the significant decrease in the gross profits generated from the Company’s security and commercial printing as a result of decreases in sales at the Company’s commercial printing division, which more than offset the increase in gross profits as a result of the Company’s packaging division which the Company acquired in February 2010.  In addition, the Company did not have any gross profits from legal product sales as the division was sold in the fourth quarter of 2009.  The Company’s gross profit percentage decrease for 2010 as compared to 2009 reflects the larger weight that packaging sales, which typically carry a lower gross profit margin, have on the Company’s overall revenue areas, along with the weakness in commercial printing sales.   The Company expects that the impact of the Company’s acquisition of it packaging division will be to decrease overall gross profit margins for at least the near future, especially as the number of non-security packaging projects out-number the security packaging projects, which the Company expects will be at higher profit margins.
 
Operating Expenses
 
   
Year Ended December 31, 2010
   
Year Ended December 31, 2009
   
% change
 
                   
Operating Expenses
                 
Sales, general and administrative compensation
  $ 3,431,000     $ 3,638,000       (6 )%
Professional Fees
    603,000       539,000       12 %
Sales and marketing
    238,000       154,000       55 %
Research and development
    265,000       292,000       (9 )%
Rent and utilities
    659,000       477,000       38 %
Other
    642,000       710,000       (10 )%
      5,838,000       5,810,000       0 %
Other Operating Expenses
         
Depreciation and software amortization
    140,000       148,000       (5 )%
Stock based compensation
    423,000       68,000       522 %
Impairment of patents
    377,000       -       -  
   Amoritization of intangibles     803,000       1,342,000       (40 )%
      1,743,000       1,558,000       12 %
                         
Total Operating Expenses
  $ 7,581,000     $ 7,368,000       3 %
 
Sales, general and administrative compensation costs were 6% lower in 2010 as compared to 2009, which reflects the impact of the addition of approximately $634,000 of SG&A compensation expense from the packaging division the Company acquired in February 2010.  Otherwise, SG&A compensation costs would have decreased 23% during 2010 as compared to 2009 as the result of staff reductions made by the Company throughout 2009 and in early 2010 primarily in its commercial printing division.
 
 
20

 
 
Professional fees in 2010 increased 12% in 2010 due to increases in legal fees primarily associated with legal costs associated with the Company’s various business development and contractual activities, along with an increase in consulting costs.   In February of 2011, the Company hired an in-house General Counsel in an effort to reduce its overall legal costs in 2011 and beyond.
 
Sales and marketing costs during 2010 increased 55% from 2009 due to sales and marketing at the Company’s Premier Packaging division as well as an increase in marketing efforts and trade show participation for its security printing and plastic printing divisions in 2010 based on expectations that the sales downturn the Company had experienced during the global recession was reversing.
 
Research and development costs consist primarily of compensation costs for research personnel and direct costs for the use of third-party printers’ facilities to test our technologies on equipment that we do not have access to internally.   Research and development costs decreased due to a reduction in compensation cost.
 
Rent and utilities increased as a result of the acquisition of Premier Packaging in February 2010.
 
Other operating expenses are primarily equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs.  During 2010, these costs decreased 10% which was primarily the result of a one time write off of previously accrued estimated expenses of approximately $139,000 that were never incurred and a write off of previous  accrued expenses that never transpired.   This more than offset increases in other expenses of $171,000 associated with the Company’s packaging division, which the Company acquired in February 2010.
 
Stock based compensation expense in 2010 was $423,000 as compared to $68,000 of stock based compensation expense in 2009 which reflected the effect of reversals of previously recorded stock based compensation expense for stock options and restricted shares issued to the Company’s employees which terminated unvested due to employee terminations that occurred during the first quarter of 2009.   The 2010 stock based compensation expense included options granted to employees at Premier Packaging when the Company acquired it in February 2010, and to certain senior management, along with stock based compensation expense related to warrants issued to third parties for consulting services.
 
Impairment of patent acquisition costs of $377,000 was recognized in the fourth quarter of 2010 as a result of adverse decisions in the Company’s patent infringement case against the ECB which caused the Company to reduce the estimated cash flows that supported the Company’s capitalized patent acquisition based intangible asset.
 
Amortization of intangibles expense decreased in 2010, as compared to the 2009 as a result of the reduction in the Company’s net capitalized patent acquisition and defense costs asset, partially offset by increases in amortization of other intangible expense of new other intangibles acquired during the Company’s acquisition of Premier Packaging in February 2010.
 
Other Income and expenses
 
   
Year Ended
December 31,
2010
   
Year Ended
December 31,
2009
   
% change
 
                   
Other income (expense):
                 
Interest income
  $ -     $ 18,000       (100 )%
Interest expense
    (290,000 )     (259,000 )     12 %
Amortizaton of note discount
    (420,000 )     (250,000 )     68 %
Loss in equity investment
    (121,000 )     -       -  
Gain on deconsolidation of Legalstore.com division
    -       26,000       (100 )%
Gain on foreign currency transactions
    -       15,000       (100 )%
Litigation settlements
    -       (115,000 )     100 %
Registration rights penalties
    -       (109,000 )     100 %
Other income
    143,000       416,000       (66 )%
                         
Other expense, net
  $ (688,000 )   $ (258,000 )     167 %
 
 
21

 
 
Interest expense: During 2010, interest expense increased as a result of the increased debt carried by the Company due to its use of a term note to help fund the Company’s acquisition of Premier Packaging in February 2010 along with the use of a revolving line of credit to fund the working capital needs of Premier Packaging.
 
Amortization of note discount: During 2009, the Company entered into two convertible notes that had conversion features at below fair value and therefore, a beneficial conversion feature.  Accordingly, the Company determined that a total of approximately $423,000 of note discount had been created as a result of the beneficial conversion features and a warrant issued with the debt.  The Company was amortizing this expense over the expected life of the convertible notes.    On November 29, 2010, the holder exercised the conversion feature of the $350,000 Convertible Note for 218,750 shares of common stock, par value $0.02 which retired the debt in full.  In conjunction with the conversion, the Company recognized approximately $63,000 of note discount expense.  On December 24, 2010, the holder of the note exercised the conversion feature of the $450,000 Convertible Note for 260,116 shares of common stock, par value $0.02 which retired the debt in full.  In conjunction with the conversion, the Company recognized approximately $200,000 of note discount expense.
 
During 2009, the Company also recognized the amortization of note discount expense of approximately $247,000 for warrants that were issued in conjunction with the secured promissory note which had a fair value of approximately $256,000.
 
Gain on deconsolidation of Legalstore division: In October 2009, the Company sold Legalstore  for a non-controlling interest (37% ownership interest) in Internet Media Services.   The Company recognized a gain on the transaction of approximately $26,000 as the estimated fair value of consideration received in exchange for the assets and liabilities sold exceeded the Company’s book value of the assets and liabilities.
 
The Company accounted for the deconsolidation of the business by recognizing a gain in net income, measured as the difference between: the fair value of the consideration received, which in the Company’s case was a 37% equity interest in Internet Media Services over the book value of the assets and liabilities transferred.  The Company determined that the consideration received was not readily measurable because there was no activity in Internet Media Services shares prior to the transaction.  Therefore, the Company determined that the value of the “business transferred” was more readily measurable by determining the fair value utilizing a discounted cash flow model.
 
Loss in equity investment: The Company recognized gains or losses on its investment in Internet Media Services, the entity that purchased Legalstore from the Company in October 2009 under the equity method of accounting for investments.   During 2010, the Company recorded a cumulative loss in its investment of $121,000.   On September 23, 2010, the Company’s Board of Directors declared a dividend pursuant to which the Company distributed to its stockholders of record on October 8, 2010 on a pro-rata basis an aggregate of 7,500,000 shares of common stock of Internet Media Services.  As a result, the Company has recorded a dividend of approximately $229,000 which was the book value of the investment as of September 23, 2010.
 
Litigation settlements: On December 7, 2009, the Company reached an agreement to issue 40,000 shares of common stock valued at approximately $86,000 and 50,000 of common stock warrants valued at approximately $30,000 utilizing the Black Scholes option pricing model, for the purchase of common shares at $3.00 per share in connection with the settlement of certain litigation between the Company and the recipients.  The shares and common stock warrants were recorded at the aggregate estimated fair value of $115,000.
 
Registration Rights Penalties:  During 2009, the Company recorded expense of approximately $109,000 for the fair value of warrants to purchase 40,000 shares of common stock at $2.00 issuable to Printer’s LLC as a result of the Company’s failure to file a registration statement under the terms of the $450,000 Convertible Note issued by the Company in December 2009.

Other Income: The Company received $143,000 during 2010 and $416,000 during 2009 for New York State Qualified Emerging Technology Company (“QETC”) refundable tax credits for the tax years ended 2008, 2007, 2006, and 2005.
 
 
22

 

Net loss and loss per share
 
   
Year Ended
December 31,
2010
   
Year Ended
December 31,
2009
   
% change
 
Net loss
  $ (4,604,000 )   $ (3,990,000 )     15 %
                         
Net loss per share, basic and diluted
  $ (0.26)     $ (0.27 )     (4 )%
                         
Weighted average common shares outstanding, basic and diluted
    17,755,141       14,700,453       21 %
 
Net loss and loss per share -
 
During 2010, the Company experienced a net loss of $4.6 million, a 15% increase from the net loss of 2009.  The increase reflects the impact of certain non-recurring items such as the impairment asset charge of $377,000 the Company recorded in the fourth quarter of 2010, $263,000 of accelerated note discount expense recorded by the Company as a result of the conversion of certain debt instruments, and a significant increase in stock based compensation as compared to 2009.  In addition, in 2009, the Company had significant non-recurring income associated with the receipt of tax credits.  Furthermore, in 2010, the Company acquired Premier Packaging, which increased the non-cash depreciation expense and amortization expense, as the result of the recognition of the fair value of equipment and intangible assets acquired, by approximately $299,000.
 
Liquidity and Capital Resources
 
The Company’s cash flows and other key indicators of liquidity are summarized as follows:
 
   
Year Ended
December 31,
2010
     
Year Ended
December 31,
2009
     
% change vs.
2009
 
                               
Cash flows from:
                             
                               
Operating activities
  $ (1,759,000 )         $ (1,595,000 )           (10 )%
Investing activities
    (2,427,000 )           (108,000 )           (2,147 )%
Financing activities
    7,824,000             2,064,000             279 %
Working capital
    3,003,000             (818,000 )           467 %
Current ratio
    1.72     x       0.70     x       147 %
                                         
Cash and cash equivalents
  $ 4,087,000             $ 449,000               810 %
Funds Available from Open Credit Facilities
  $   802,000             $  417,000               92 %
Debt (excluding unamortized debt discount) and Capitalized Leases
  $  3,263,000             $ 2,218,000               47 %
 
We have historically met our liquidity and capital requirements primarily through the private placement of equity securities and debt financings.  As of December 31, 2010, we had cash and cash equivalents of $4,087,000 representing an 810% increase over our December 31, 2009 cash position of $449,000.  The increase in the Company’s cash position was due to the $4,000,000 sale of equity to Fletcher  that the Company made on December 31, 2010.
 
 
23

 
 
Operating Cash Flow – During 2010, the Company used approximately $1.8 million of cash for operations, a 10% increase from our use of cash for operations in 2009, which generally reflected the Company’s paydown of accounts payables and accrued expenses and timing of cash flows from its Packaging division, which received approximately $300,000 in cash payments from customers in early January 2011 that otherwise would have reflected an improvement in operating cash flows in 2010 as compared to 2009.
 
Investing Cash Flow - During 2010, the Company used approximately $2.0 million for the acquisition of Premier Packaging.  The Company made the acquisition of Premier Packaging as part of the implementation of its long-term strategy to increase its ability to offer end-user customers of secure documents and related product, with brand protection packaging specifically targeted with the Premier Packaging acquisition.  In addition, the Company spent approximately $427,000 on equipment additions and patent related costs.   As the Company becomes more of a manufacturer of security products, it expects to continue to see an increase in its capital expenditures for plant and equipment.  In addition, as the Company continues to focus on the research and development of anti-counterfeiting technologies, techniques and products, it anticipates continuing to spend capital on patents.
 
Financing Cash Flows - During 2010, the Company raised net proceeds through the sale of equity of approximately $6.3 million, of which approximately $3.8 million was raised on December 31, 2010.   Proceeds from these equity sales were used to provide some of the funding for an acquisition, make investments in fixed assets and in the Company’s  patent portfolio, and to fund working capital.   In addition, the Company borrowed $1,500,000 on a five year term note to fund its acquisition of Premier Packaging in February 2010.   As of December 31, 2010, the Company had approximately $4,087,000 in cash, primarily the result of its equity funding.

Future Capital Needs - As of December 31, 2010, the Company has approximately $4,087,000 in cash and $417,000 available to it under one credit facility, along with up to $385,000 available under a credit line at its Premier Packaging subsidiary.   While the Company’s working capital position has significantly improved since December 31, 2009, the Company continued to incur operating losses during 2010, and therefore the Company will likely use its cash on hand to fund its operations until it can consistently generate positive cash flow from its operations.  In addition, the Company has approximately $3.3 million of debt, of which approximately $1 million is current, which may require the use of its cash on hand in order to pay.   While the Company believes that its cash on hand will provide it sufficient resources in order to fund its operations and meet its obligations for at least the next twelve months, if the Company cannot generate sufficient cash from its operations in the future, the Company may need to raise additional funds in order to fund its working capital needs and pursue its growth strategy. 

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 2010 or 2009 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, 2010 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, stock based compensation valuations, the valuation of intangible assets, and allocation of assets in business combinations. 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.

Long Lived Assets

The Company reviews long-lived assets and certain identifiable intangibles 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 generated 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.

 
24

 
 
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.

Goodwill

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.  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. The Company has three reporting units with goodwill 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.

Other Intangible Assets and Patent Defense Costs
 
Other intangible assets consists of costs associated with the application, acquisition and defense of the Company’s patents, contractual rights to patents and trade secrets associated with the Company’s technologies, a non-exclusive licensing agreement, and customer lists obtained as a result of acquisitions. The Company’s patents and trade secrets are for document anti-counterfeiting and anti-scanning technologies and processes that form the basis of the Company’s document security business.  Patent application costs are capitalized and amortized over the estimated useful life of the patent, which generally approximates its legal life.  External legal costs incurred to defend the Company’s patents are capitalized to the extent of an evident increase in the value of the patents and an expected successful outcome. Patent defense costs are expensed at the point when it is determined that the outcome is expected to be unsuccessful.   The Company capitalizes the cost of an appeal until it is determined that the appeal will be unsuccessful.     The Company’s capitalized patent defense costs expenses are analyzed for impairment based on the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent in excess of the costs.    Legal actions related to the same patent defense case are unified into one asset group for the purposes on the impairment analysis.   The Company amortizes its other intangible assets over their estimated useful lives.  Patents are amortized over the remaining legal life, up to 20 years.  Intangible asset amortization expense is generally classified as an operating expense.  The Company believes that the decision to incur patent costs is discretionary as the associated products or services can be sold prior to or during the application process.   The Company accounts for other intangible amortization as an operating expense, unless the underlying asset is directly associated with the production or delivery of a product.  To date, the amount of related amortization expense for other intangible assets directly attributable to revenue recognized is not material.  Impairment of patent acquisition costs of $377,000 was recognized in the fourth quarter of 2010 as a result of adverse decisions in the Company’s patent infringement case against the ECB which caused the Company to reduce the estimated cash flows that supported the Company’s capitalized patent acquisition based intangible asset.
 
Conventional Convertible Debt
 
When the convertible feature of the conventional convertible debt provides for a rate of conversion that is below market value, this feature is characterized as a beneficial conversion feature (BCF").   Prior to the determination of the BCF, the proceeds from the debt instrument were first allocated between the convertible debt and any embedded or detachable free standing instruments that are included, such as common stock warrants.  We record a BCF as a debt discount pursuant to FASB ASC Topic 470-20.  In those circumstances, the convertible debt will be recorded net of the discount related to the BCF. We amortize the discount to interest expense over the life of the debt using the effective interest method.
 
 
25

 

Revenue Recognition

Sales of security and commercial printing products, packaging 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 FASB ASC 985-605. Accordingly, revenue is recognized when all of the following conditions are satisfied:   (1) there is persuasive evidence of an arrangement; (2) the service or product has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable (4) the collection of our fees is reasonably assured.
 
The Company recognizes 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.

Business Combinations

The Company adopted the new FASB guidance on business combinations and non-controlling interests. The new guidance on business combinations retains the underlying concepts of the previously issued standard in that the acquirer of a business is required to account for the business combination at fair value. As under previous guidance, the assets and liabilities of the acquired business are recorded at their fair values at the date of acquisition. The excess of the purchase price over the estimated fair values is recorded as goodwill. The new pronouncement results in some changes to the method of applying the acquisition method of accounting for business combinations in a number of significant aspects. Under the new guidance, all acquisition costs are expensed as incurred and in-process research and development costs are recorded at fair value as an indefinite-lived intangible asset. The application of business combination and impairment accounting requires the use of significant estimates and assumptions.

Share-Based Payments

We measure compensation cost for stock awards at fair value and recognize compensation expense over the service period for which awards are expected to vest. The Company uses the Black-Scholes option pricing model for determining the estimated fair value for stock-based awards. The Black-Scholes model requires the use of subjective assumptions which determine the fair value of stock-based awards, including the option’s expected term and the price volatility of the underlying stock.  For equity instruments issued to consultants and vendors in exchange for goods and services the Company determines the measurement date for the fair value of the equity instruments issued 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

The fair value of each option award is estimated on the date of grant utilizing the Black Scholes Option Pricing Model that uses the assumptions noted in the following table.

 
2010
2009
     
Volatility
           54.3
 %
            54.7
 %
Expected option term
3.8
 years
3.9
 years
Risk-free interest rate
2.5
 %
2.3
 %
Expected forfeiture rate
0.0
 %
0.0
 %
Expected dividend yield
0.0
 %
0.0
 %
 
 
26

 
 
Income Taxes

Deferred tax assets and liabilities are determined based on temporary differences between income and expenses reported for financial reporting and tax reporting.  FASB ASC 740 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 a 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, 2010 and 2009, 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.

Investment Valuation and Deconsolidation

On October 8, 2009, the Company entered into an Asset Purchase Agreement with Internet Media Services whereby the Company sold the assets and liabilities of Legalstore, a division of the Company, in exchange for 7,500,000 shares of common stock of Internet Media Services.  The Company recorded its investment in Internet Media Services as an equity method investment at the fair market value of the business sold.   Management determined that the transaction did not qualify as a non-monetary exchange due to the exception noted in FASB ASC 845-10 ( [ A transfer of assets to an entity in exchange for an equity interest in that entity).  Management determined that the transaction qualified as a derecoginition of a subsidiary under FASB ASC 810-10-40.  Therefore, the Company accounted for the deconsolidation of a subsidiary (“the business”) by recording the consideration received at fair market value and recognizing a gain in net income measured as the difference between: the fair value of the consideration received (7,500,000 shares of common stock of Internet Media Services or a 37% interest) and the carrying value of the assets and liabilities sold.  Given that the consideration received is not readily measurable because of the lack of activity in Internet Media Services shares prior to the transaction, the Company determined that the value of the “business transferred” is more readily measurable by determining the fair market value of the business transferred based on a discounted cash flow model.    The Company is recording the equity method investment at fair value.  Under the equity method investment the Company is required to account for the difference between the cost of an investment and the amount of the underlying equity in net assets of an investee as if the investee were a consolidated subsidiary.  If the investor is unable to relate the difference to specific accounts of the investee (e.g., property and equipment), the difference should be considered to be the same as goodwill.  Investors should not amortize goodwill associated with equity method investments after the date FASB ASC 350 is initially applied by the entity in its entirety.  The Company has determined that given the lack of activity in Internet Media Services shares prior to the transaction, the difference between the cost of the investment (fair market value) and the underlying equity interest is attributable to goodwill.  The Company is continuing to report the activity in operating loss and not breaking out and reporting it as discontinued operations because the operations and cash flows of the component have not been eliminated from the ongoing operations of the entity as a result of the equity method investment and because the Company has significant continuing involvement in the operations of Internet Media Services after the disposal transaction because of its ownership percentage and board representation. 

On September 23, 2010, the Company’s Board of Directors declared a dividend which provided for the distribution by the Company to its stockholders of record on October 8, 2010,on a pro-rata basis, of its 7,500,000 shares of stock in Internet Media Services.  The dividend was recorded at approximately $229,000 which was the book value of the investment as of September 23, 2010.

Fair Value of Financial Instruments

Effective January 1, 2008, the Company adopted the new accounting guidance relating to fair value measurements as required by the Fair Value Measurement Topic of the ASC for financial instruments measured at fair value on a recurring basis and effective January 1, 2009 on a non-recurring basis. The new accounting guidance defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP and expands disclosures about fair value measurements.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Fair Value Measurement Topic of the ASC establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include:
 
 
27

 

·
Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets;

·
Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and

·
Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

Derivative instruments are recorded as assets and liabilities at estimated fair value based on available market information. One of the Company's derivative instruments is an interest rate swap that changes a variable rate into a fixed rate on the term loan and qualifies as a cash flow hedge and is included in accrued expenses on the accompanying Consolidated Balance Sheet as of December 31, 2010.   Gains and losses on these instruments are recorded in other comprehensive income (loss) until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income (loss) (AOCI) to the Consolidated Statement of Operations on the same line item as the underlying transaction.   The cumulative net loss attributable to this cash flow hedge recorded in AOCl at December 31, 2010, was approximately $26,000.

The Company accounts for warrants and other rights to acquire capital stock with exercise price reset features, or “down-round” provisions, as derivative liabilities. Similarly, anti-dilution provisions for issuances of common stock are also accounted for as derivative liabilities. These derivative liabilities are measured at fair value with the changes in fair value at the end of each period reflected in current period income or loss. The fair value of derivative liabilities is estimated using a binomial model or Monte Carlo simulation to model the financial characteristics, depending on the complexity of the derivative being measured.  A Monte Carlo simulation provides a more accurate valuation than standard option valuation methodologies such as the Black-Scholes or binomial option models when derivatives include changing exercise prices or different alternatives depending on average future price targets. In computing the fair value of the derivatives, the Company uses significant judgments, which, if incorrect, could have a significant negative impact to the Company’s consolidated financial statements.  The input values for determining the fair value of the derivatives include observable market indices such as interest rates, and equity indices as well as unobservable model-specific input values such as certain volatility parameters.
 


ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Our audited financial statements for the fiscal years ended December 31, 2010 and 2009 follow Item 15, beginning at page F-1.
 
 
 
28

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

None

ITEM 9A - CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of December 31, 2010. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, based on the material weaknesses discussed below, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act were recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Act Commission’s rules and forms and that our disclosure controls are not effectively designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
 
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.

Management’s Annual Report on Internal Control over Financial Reporting

The Company’s management, including the Company’s Chief Executive Officer and Principal Financial Officer assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. In making this assessment, our management used the framework established in “Internal Control—Integrated Framework” promulgated by the Committee of Sponsoring Organizations of the Treadway Commission, commonly referred to as the “COSO” criteria. Under COSO criteria, a material weakness exists if there 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, 2010:

We did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties. During 2010 we had one person on staff that performs nearly all aspects of our external 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 external 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 Securities and Exchange Commission (“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, 2010 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.

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

As a result of the material weaknesses described above, our management concluded that as of December 31, 2010, we did not maintain effective internal control over financial reporting based on the criteria established in Internal Control—Integrated Framework issued by the COSO.

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act that permits us to provide only management’s report in this annual report.
 
Plan for Remediation of Material Weaknesses
 
In response to the identified material weaknesses, management, with oversight from the Company’s audit committee, plans to review our control environment and to evaluate whether cost effective solutions are available to remedy the identified material weaknesses by expanding the resources available to the financial reporting process.

Changes in Internal Control over Financial Reporting

 There were no changes in our internal controls over the financial reporting during our fourth fiscal quarter that have materially affected, or are reasonably likely to materially effect, our internal control over financial reporting.

 
29

 
 
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 2011 Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2010, and which is incorporated by reference herein.
 
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 at www.documentsecurity.com.
 
Our Web site 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 2011 Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2010, 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 2011 Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2010, 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 2011 Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2010, 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 2011 Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2010, and which is incorporated by reference herein.


PART IV

ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) Exhibits
3.1
Certificate of Incorporation of Document Security Systems, Inc., as amended*
3.2
Amended and Restated By-laws of Document Security Systems, Inc. dated March 18, 2010.*
10.1
Form of Registration Rights Agreement dated as of May 29, 2009 between Document Security Systems, Inc. and the holders listed therein (incorporated by reference to  exhibit 10.2 to Form 8-K dated May 29, 2009).
10.2
Form of Warrant to Purchase Common Stock of Document Security Systems, Inc. dated May 29, 2009
 
10.3
(incorporated by reference to exhibit 4.1 to Form 8-K dated May 29, 2009).
Form of Subscription Agreement dated as of May 29, 2009 between Document Security Systems, Inc. and the Subscribers (incorporated by reference to exhibit 10.1 to Form 8-K dated May 29, 2009).
10.4
Asset Purchase Agreement between Lester Levin Inc. and Internet Media Services, Inc. dated October 8, 2009 (incorporated by reference to exhibit 2.1 to Form 8-K dated October 8, 2009).
10.5
Stock Pledge and Escrow Agreement between Lester Levin Inc., Document Security Systems, Inc., Internet Media Services, Inc., Michael Buechler and Manufacturers and Traders Trust Company dated October 8, 2009 (incorporated by reference to exhibit 10.3 to Form 8-K dated October 8, 2009).
10.6
Stock Pledge and Escrow Agreement between Lester Levin Inc., Document Security Systems, Inc., Internet Media Services, Inc., Raymond Meyers and Manufacturers and Traders Trust Company dated October 8, 2009 (incorporated by reference to exhibit 10.2 to Form 8-K dated October 8, 2009).
 
 
30

 
 
10.7
Voting Agreement between Document Security Systems, Inc., Internet Media Services, Inc., Raymond Meyers and Michael Buechler dated October 8, 2009 (incorporated by reference to exhibit 10.4 to Form 8-K dated October 8, 2009).
10.8
$350,000 Convertible Promissory Note dated November 24, 2009 (incorporated by reference to exhibit 10.1 to Form 8-K dated December 15, 2009).
10.9
$575,000 Promissory Note dated November 24, 2009 (incorporated by reference to exhibit 10.2 to Form 8-K dated December 15, 2009).
10.10
Form of Letter Agreement dated December 11, 2009 (incorporated by reference to exhibit 10.3 to Form 8-K dated December 15, 2009).
10.11
Form of $450,000 Convertible Promissory Note (incorporated by reference to exhibit 10.1 to Form 8-K dated December 30, 2009).
10.12
Form of Warrant to Purchase Common Stock of Document Security Systems, Inc. dated January 28, 2010 (incorporated by reference to exhibit 4.1 to Form 8-K dated February 17, 2010).
10.13
Stock Purchase Agreement dated as of February 12, 2010 by and among Robert B. Bzdick and Joan T. Bzdick and Document Security Systems, Inc. (incorporated by reference to exhibit 10.2 to Form 8-K dated February 17, 2010).
10.14
Employment Agreement dated February 12, 2010 between Document Security Systems, Inc. and Robert Bzdick (incorporated by reference to exhibit 10.3 to Form 8-K dated February 17, 2010).
10.15
$1,500,000 Acquisition Term Loan Note dated February 12, 2010 made by Premier Packaging Corporation in favor of RBS Citizens, N.A. (incorporated by reference to exhibit 10.4 to Form 8-K dated February 17, 2010).
10.16
Revolving Line Note dated February 12, 2010 made by Premier Packaging Corporation in favor of RBS Citizens, N.A. (incorporated by reference to exhibit 10.5 to Form 8-K dated February 17, 2010).
10.17
Credit Facility Agreement dated February 12, 2010 by and between Premier Packaging Corporation and RBS Citizens, N.A. (incorporated by reference to exhibit 10.6 to Form 8-K dated February 17, 2010).
10.18
Security Agreement dated February 12, 2010 by and between RBS Citizens, N.A. and Document Security Systems, Inc, Plastic Printing Professionals, Inc. and Secuprint, Inc. (incorporated by reference to exhibit 10.7 to Form 8-K dated February 17, 2010).
10.19
Guaranty and Indemnity Agreement dated February 12, 2010 by and between RBS Citizens, N.A. and Document Security Systems, Inc., Plastic Printing Professionals, Inc. and Secuprint, Inc. (incorporated by reference to exhibit 10.8 to Form 8-K dated February 17, 2010).
10.20
Form of Subscription Agreement dated as of January 28, 2010 between Document Security Systems, Inc. and Subscribers (incorporated by reference to exhibit 10.9 to Form 8-K dated February 17, 2010).
10.21
Form of Subscription Agreement (incorporated by reference to exhibit 10.1 to Form 8-K/A dated July 21, 2010).
10.22
Form of Common Stock Purchase Warrant (incorporated by reference to exhibit 10.2 to form 8-K dated July 21, 2010).
10.23
Agreement between Document Security Systems, Inc. and Fletcher International, Ltd. dated December 31, 2010 (incorporated by reference to exhibit 99.1 to Form 8-K dated December 31, 2010).
10.24
Warrant Certificate No. 1 dated December 31, 2010 (incorporated by reference to exhibit 99.2 to Form 8-K dated December 31, 2010).
10.25
Warrant Certificate No. 2 dated December 31, 2010 (incorporated by reference to exhibit 99.3 to Form 8-K dated December 31, 2010).
10.26
Amended and Restated Agreement dated February 18, 2011 (incorporated by reference to exhibit 10.1 to Form 8-K dated February 24, 2011).
10.27
Warrant Certificate No. 3 dated February 18, 2011 (incorporated by reference to exhibit 4.1 to Form 8-K dated February 24, 2011).
10.28
Warrant Certificate No. 4 dated February 18, 2011 (incorporated by reference to exhibit 4.2 to Form 8-K dated February 24, 2011).
10.29
Amendment dated March 14, 2011 (incorporated by reference to exhibit 10.1 to Form 8-K dated March 17, 2011).
10.30
Warrant Certificate No. 5 dated March 14, 2011 (incorporated by reference to exhibit 4.1 to Form 8-K dated March 17, 2011).
10.31
Warrant Certificate No. 6 dated March 14, 2011 (incorporated by reference to exhibit 4.2 to Form 8-K dated March 17, 2011).
10.32
2004 Employee Stock Option Plan (incorporated by reference to Appendix D to the definitive proxy statement filed with the SEC on November 17, 2004).
 
 
31

 
 
10.33
Non-Executive Director Stock Option Plan (incorporated by reference to Appendix E to the definitive proxy statement filed with the SEC on November 17, 2004).
10.34
Standby Term Loan Note dated October 8, 2010 between Premier Packaging Corporation and RBS Citizens, N.A. (incorporated by reference to exhibit 10.1 to Form 8-K dated October 12, 2010).
10.35
Amended and Restated Credit Facility Agreement dated October 8, 2010 between Premier Packaging Corporation and RBS Citizens, N.A. (incorporated by reference to exhibit 10.2 to Form 8-K dated October 12, 2010).
10.36
Amended and Restated Security Agreement dated October 8, 2010 between RBS Citizens, N.A. and Document Security Systems, Inc., Plastic Printing Professionals, Inc. and Secuprint, Inc. (incorporated by reference to exhibit 10.3 to Form 8-K dated October 12, 2010).
10.37
Amended and Restated Guaranty and Indemnity Agreement dated October 8, 2010 between RBS Citizens, N.A. and Document Security Systems, Inc., Plastic Printing Professionals, Inc. and Secuprint, Inc. (incorporated by reference to exhibit 10.4 to Form 8-K dated October 12, 2010).
10.38
Interest Rate Swap Transaction Agreement between Premier Packaging Corporation and RBS Citizens, N.A., dated February 25, 2010*
10.39
Amended and Restated 2004 Employee Stock Option Plan (incorporated by reference to Appendix A to the definitive proxy statement filed with the SEC on December 8, 2005).
10.40
Amended and Restated 2004 Non-Executive Stock Option Plan (incorporated by reference to Appendix B to the definitive proxy statement filed with the SEC on December 8, 2005).
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*

filed herewith

 
32

 
 
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

TABLE OF CONTENTS
 
     
          Page
       
Report of Independent Registered Public Accounting Firm
 
F-1
       
       
Consolidated Financial Statements:
   
       
 
Balance Sheets
 
F-2
       
 
Statements of Operations
 
F-3
       
 
Statements of Cash Flows
 
F-4
       
 
Statements of Changes in Stockholders’ Equity
 
F-5
       
       
Notes to the Consolidated Financial Statements
 
F6 - F29
 
 
 
 

 
 
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, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended.  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.  The Company is not required to have, nor have we been engaged to perform, an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly we express no such opinion.  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, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.



/s/ FREED MAXICK & BATTAGLIA, CPAs, PC

Buffalo, New York
March 31, 2011

 
F-1

 

DOCUMENT SECURITY SYSTEMS, INC.  AND SUBSIDIARIES
Consolidated Balance Sheets
As of December 31,

   
2010
 
2009
         
ASSETS
               
                 
Current assets:
               
Cash and cash equivalents
 
$
       4,086,574
   
$
        448,895
 
Accounts receivable, net of allowance
               
of  $66,000 ($66,000- 2009)
   
       2,227,877
     
     1,143,939
 
Inventory
   
          601,359
     
        184,174
 
Prepaid expenses and other current assets
   
          231,190
     
          91,310
 
Total current assets
   
       7,147,000
     
     1,868,318
 
                 
Equipment and leasehold improvements, net
   
       2,543,494
     
     1,286,226
 
Other assets
   
          325,953
     
        305,507
 
Goodwill
   
       1,943,081
     
     1,315,721
 
Other intangible assets, net
   
       1,847,859
     
     1,588,969
 
Investment
   
                   -
     
        350,000
 
Total assets
 
13,807,387
   
6,714,741
 
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
         
                 
Current liabilities:
               
Accounts payable
 
$
1,828,138
   
 $
1,673,901
 
Accrued expenses and other current liabilities
   
1,312,363
     
934,595
 
Revolving line of credit
   
614,833
     
                  -
 
Current portion of long-term debt
   
300,000
     
                  -
 
Current portion of capital lease obligations
   
88,776
     
78,167
 
Total current liabilities
   
4,144,110
     
2,686,663
 
                 
Revolving notes from related party
   
          583,000
     
583,000
 
Long-term debt, net of unamortized discount of $0 in 2010 ($420,000 -2009)
   
       1,578,242
     
        954,616
 
Capital lease obligations
   
98,532
     
182,424
 
Deferred tax liability
   
89,779
     
70,830
 
Derivative liabilities
   
3,866,836
     
                  -
 
Commitments and contingencies (see Note 13)
               
                 
Stockholders' equity
               
Common stock, $.02 par value;  200,000,000 shares authorized,
               
19,391,319 shares issued and outstanding (16,397,887 in 2009)
   
387,825
     
327,957
 
Additional paid-in capital
   
44,178,569
     
38,399,033
 
Accumulated other comprehensive loss
   
          (25,834
   
                  -
 
Accumulated deficit
   
   (41,093,672
   
  (36,489,782
                 
Total stockholders' equity
   
3,446,888
     
2,237,208
 
                 
Total liabilities and stockholders' equity
 
$
13,807,387
   
$
6,714,741
 
 
See accompanying notes.

 
F-2

 
 
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
For the Years Ended December 31,
 
   
2010
 
2009
         
Revenue
               
Security and commercial printing
 
$
6,987,930
   
$
8,773,131
 
Packaging
   
5,752,601
     
-
 
Technology license royalties and digital solutions
   
641,050
     
783,453
 
Legal products
   
-
     
355,107
 
Total Revenue
   
13,381,581
     
9,911,691
 
                 
Costs of revenue
               
Security and commercial printing
   
5,303,952
     
6,063,479
 
Packaging
   
4,386,829
     
-
 
Technology license royalties and digital solutions
   
5,476
     
14,028
 
Legal products
   
-
     
178,892
 
Total costs of revenue
   
9,696,257
     
6,256,399
 
                 
Gross profit
   
3,685,324
     
3,655,292
 
                 
Operating expenses:
               
Selling, general and administrative
   
6,136,152
     
5,733,908
 
Research and development
   
265,360
     
291,538
 
Impairment of intangible assets
   
376,481
     
-
 
Amortization of intangibles
   
803,468
     
1,342,105
 
                 
        Operating expenses
   
7,581,461
     
7,367,551
 
                 
Operating loss
   
(3,896,137
   
(3,712,259
                 
Other income (expense):
               
Interest income
   
-
     
18,140
 
Loss on equity investment
   
(121,393
   
-
 
Interest expense
   
(290,087
   
(258,918
Amortizaton of note discount
   
(420,385
   
(250,102
Gain on deconsolidation of Legalstore.com division
   
-
     
25,755
 
Litigation settlements
   
-
     
(115,101
Registration rights penalties
   
-
     
(109,464
Gain on foreign currency transactions
   
-
     
15,050
 
Other income
   
143,061
     
415,838
 
                 
Loss before income taxes
   
(4,584,941
   
(3,971,061
                 
Income tax expense
   
18,949
     
18,952
 
                 
Net loss
 
$
(4,603,890
 
$
(3,990,013
                 
Other comprehensive loss:
               
Interest rate swap loss
   
(25,834
   
-
 
                 
Comprehensive Loss
 
$
(4,629,724
 
$
(3,990,013
                 
Divedend per share
 
$
0.01
   
$
-
 
                 
Net loss per share -basic and diluted:
 
$
(0.26
 
$
(0.27
                 
Weighted average common shares outstanding, basic and diluted
   
17,755,141
     
14,700,453
 
 
See accompanying notes.
 
 
F-3

 
 
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the Years Ended December 31,
 
      2010       2009  
Cash flows from operating activities:
               
Net loss   $ (4,603,890   $      (3,990,013
Adjustments to reconcile net loss to net cash and cash equivalents used by operating activities:                
Depreciation and amortization
    1,261,122       1,661,522  
Stock based compensation
    423,471       67,709  
Stock based payments for legal settlements
    -       115,101  
Warrants issuable for registration rights penalty
    -       109,464  
Amortization of note discount
    420,385       250,102  
Gain on deconsolidation of division
    -       (25,755 )
Loss on equity investment
    121,393       -  
Intangible asset impairment
    376,481       -  
(Increase) decrease in assets:
               
Accounts receivable
    200,339       109,108  
Inventory
    86,977       73,849  
Prepaid expenses and other assets
    (101,465 )     (81,547 )
Increase (decrease) in liabilities:
               
Accounts payable
    (209,516 )     276,070  
Accrued expenses and other current liabilities
    265,450       (160,711 )
Net cash used by operating activities
    (1,759,253 )     (1,595,101 )
                 
Cash flows from investing activities:
               
Decrease in restricted cash
    -       131,004  
Purchase of equipment and leashold improvements
    (157,422 )     (62,522 )
Purchase of other intangible assets
    (269,729 )     (176,083 )
Acquisition of business
    (2,000,000 )     -  
Net used by investing activities
    (2,427,151 )     (107,601 )
                 
Cash flows from financing activities:
               
Net borrowing on revolving note- related parties
    -       300,000  
Net borrowings on revolving line of credit
    342,428       -  
Payments on short-term debt
    -       (900,000 )
Borrowings on long-term debt
    1,553,242       575,000  
Payments of long-term debt
    (250,000 )     -  
Borrowings on long-term convertible notes
    -       800,000  
Payments of capital lease obligations
    (73,283 )     (86,124 )
Issuance of common stock, net
    6,251,696       1,374,901  
Net cash provided by financing activities
    7,824,083       2,063,777  
                 
Net increase in cash and cash equivalents
    3,637,679       361,075  
Cash and cash equivalents beginning of year
    448,895       87,820  
                 
Cash and cash equivalents end of year
  $ 4,086,574     $ 448,895  

See accompanying notes.

 
F-4

 
 
Consolidated Statements of Changes in Stockholders' Equity
For the Years Ended December 31, 2010 and 2009
 
   
Common Stock
               
Accumulated
             
   
Shares
   
Amount
   
Additional
Paid-in
Capital
   
Subscriptions Receivable
   
Other
Comprehensive Income
   
Accumulated
Deficit
   
Total
 
                                           
Balance, December 31, 2008
    14,369,764     $ 287,395     $ 35,538,695     $ (1,300,000 )   $ -     $ (32,499,769 )   $ 2,026,321  
                                                         
Issuance of common stock, net
    1,010,000       20,200       1,354,702       -       -       -       1,374,902  
Conversion of debt to equity
    1,250,000       25,000       1,975,000       -       -       -       2,000,000  
Discount on debt
    -       -       72,126       -       -       -       72,126  
Fair value of beneficial conversion features
    -       -       350,871       -       -       -       350,871  
Stock based payments, net of tax effect
    93,123       1,862       401,139       -       -       -       403,001  
Cancellation of subscribed shares
    (325,000 )     (6,500 )     (1,293,500 )     1,300,000       -       -       -  
Net Loss
                            -       -       (3,990,013 )     (3,990,013 )
                                                         
Balance, December 31, 2009
    16,397,887     $ 327,957     $ 38,399,033     $ -     $ -     $ (36,489,782 )   $ 2,237,208  
                                                         
Issuance of common stock, net
    1,729,129       34,583       5,977,113       -       -       -       6,011,696  
Acquisition of Premier Packaging
    735,437       14,709       2,551,966       -       -       -       2,566,675  
Stock based payments, net of tax effect
    50,000       1,000       555,476       -       -       -       556,476  
Property dividend
                    (228,607 )     -       -       -       (228,607 )
Conversion of debt
    478,866       9,576       790,424       -       -       -       800,000  
Other comprehensive loss
    -       -               -       (25,834 )     -       (25,834 )
Derivative liabilities
    -       -       (3,866,836 )     -       -       -       (3,866,836 )
Net Loss
    -       -               -       -       (4,603,890 )     (4,603,890 )
                                                         
Balance, December 31, 2010
    19,391,319     $ 387,825     $ 44,178,569     $ -     $ (25,834 )   $ (41,093,672 )   $ 3,446,888  
 
See accompanying notes.
 
 
F-5

 

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1. - DESCRIPTION OF BUSINESS

The Company develops, markets, manufactures and sells paper and plastic 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.  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 protection and verification of critical financial instruments and vital records, or where there are concerns of counterfeiting, fraud, identity theft, brand protection and liability.

NOTE 2. - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation - The consolidated financial statements include the accounts of Document Security System and its subsidiaries.  All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates - The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable, fair values of intangible assets and goodwill, useful lives of intangible assets and property and equipment, fair values of options and warrants to purchase our common stock, valuation of derivative liabilities arising from issuances of common stock and associated warrants and other rights to acquire common stock in the future, deferred revenue and income taxes, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We engage third-party valuation consultants to assist management in the allocation of the purchase price of significant acquisitions and the determination of the fair value of derivative liabilities.

Reclassifications - Certain prior year amounts have been reclassified to conform to the current year presentation.

Cash and Cash Equivalents – The Company maintains its cash in bank deposit accounts and, from time to time, short term Certificates of Deposits with original maturities of three months or less.  For financial statement presentation purposes, the Company considers those short-term, highly liquid investments with original maturities of three months or less to be cash or cash equivalents.

Accounts Receivable - The Company carries its trade accounts receivable at invoice amount less an allowance for doubtful accounts.  On a periodic basis, the Company evaluates its accounts receivable and establishes an allowance for doubtful accounts based upon management’s estimates that include a review of the history of past write-offs and collections and an analysis of current credit conditions.  At December 31, 2010, the Company established a reserve for doubtful accounts of approximately $66,000 ($66,000 – 2009). The Company does not accrue interest on past due accounts receivable.

Inventory - Inventories consist primarily of paper, plastic materials and cards, pre-printed security paper, paperboard and fully-prepared packaging which and are stated at the lower of cost or market on the first-in, first-out (“FIFO”) method. Packaging Work-in-process and finished goods included the cost of materials, direct labor and overhead.

Equipment and Leasehold Improvements - Equipment and leasehold improvements are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives or lease period of the assets whichever is shorter. Expenditures for renewals and betterments are capitalized. Expenditures for minor items, repairs and maintenance are charged to operations as incurred.  Any gain or loss upon sale or retirement due to obsolescence is reflected in the operating results in the period the event takes place. Depreciation expense in 2010 was approximately $458,000 ($319,000- 2009).

 
F-6

 
 
Investment - On October 8, 2009, the Company entered into an Asset Purchase Agreement with Internet Media Services whereby the Company sold the assets and liabilities of Legalstore, a division of the Company, in exchange for 7,500,000 shares of common stock of the Internet Media Services.  The Company recorded its investment in Internet Media Services as an equity method investment at the fair market value of the business sold.   Management determined that the transaction qualified as a derecognition of a subsidiary under FASB ASC 810-10-40.  Therefore, the Company accounted for the deconsolidation of a subsidiary (“the business”) by recording the consideration received at fair market value and recognizing a gain in net income measured as the difference between: the fair value of the consideration received (7,500,000 shares of common stock of Internet Media Services or a 37% interest) and the carrying value of the assets and liabilities sold.  Given that the consideration received is not readily measurable because of the lack of activity in Internet Media Services shares prior to the transaction, the Company determined that the value of the “business transferred” is more readily measurable by determining the fair market value of the business transferred based on a discounted cash flow model.   The Company recorded the equity method investment at fair value.  Under the equity method investment the Company is required to account for the difference between the cost of an investment and the amount of the underlying equity in net assets of an investee as if the investee were a consolidated subsidiary.  If the investor is unable to relate the difference to specific accounts of the investee (e.g., property and equipment), the difference should be considered to be the same as goodwill.  Investors shall not amortize goodwill associated with equity method investments after the date FASB ASC 350 is initially applied by the entity in its entirety.  The Company determined that given the lack of activity in Internet Media Services shares prior to the transaction, the difference between the cost of the investment (fair market value) and the underlying equity interest is attributable to goodwill which difference amounted to approximately $243,000 at December 31, 2009.   For the period from October 9, 2009 through December 31, 2009, the Company’s equity in the earnings of Internet Media Services was di minimus and not recorded by the Company.  The total assets and liabilities of Internet Media Services as of December 31, 2009 amounted to approximately $350,000 and $60,000, respectively.

The Company recognized gains or losses on its investment under the equity method of accounting for investments.   During 2010, the Company recorded a cumulative loss on its investment of approximately $121,000.   On September 23, 2010, the Company’s Board of Directors declared a dividend whereas the Company distributed to its stockholders of record on October 8, 2010 on a pro-rata basis its 7,500,000 shares of stock of Internet Media Services.  As a result, the Company has recorded a dividend of approximately $229,000 which was the book value of the investment as of September 23, 2010.

Business Combinations -The Company adopted new FASB guidance on business combinations and non-controlling interests. The new guidance on business combinations retains the underlying concepts of the previously issued standard in that the acquirer of a business is required to account for the business combination at fair value. As under previous guidance, the assets and liabilities of the acquired business are recorded at their fair values at the date of acquisition. The excess of the purchase price over the estimated fair values is recorded as goodwill. The new pronouncement results in some changes to the method of applying the acquisition method of accounting for business combinations in a number of significant aspects. Under the new guidance, all acquisition costs are expensed as incurred and in-process research and development costs are recorded at fair value as an indefinite-lived intangible asset. The application of business combination and impairment accounting requires the use of significant estimates and assumptions.

Goodwill - 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.  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.  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 performs annual assessments and has determined that no impairment is necessary during the years ended December 31, 2010 and 2009.

Other Intangible Assets, Patent Defense Costs and Patent Application CostsOther intangible assets consists of costs associated with the application, acquisition and defense of the Company’s patents, contractual rights to patents and trade secrets associated with the Company’s technologies and a customer list obtained as a result of acquisitions. The Company’s patents and trade secrets are for document anti-counterfeiting and anti-scanning technologies and processes that form the basis of the Company’s document security business.  Patent application costs are capitalized and amortized over the estimated useful life of the patent, which generally approximates its legal life.  External legal costs incurred to defend the Company’s patents are capitalized to the extent of an evident increase in the value of the patents and an expected successful outcome. Patent defense costs are expensed at the point when it is determined that the outcome is expected to be unsuccessful.   The Company capitalizes the cost of an appeal until it is determined that the appeal will be unsuccessful.     The Company’s capitalized patent defense costs expenses are analyzed for impairment based on the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent in excess of the costs.    Legal actions related to the same patent defense case are unified into one asset group for the purposes on the impairment analysis.  Intangible asset amortization expense is classified as an operating expense.  The Company believes that the decision to incur patent costs is discretionary as the associated products or services can be sold prior to or during the application process.   The Company accounts for other intangible amortization as an operating expense, unless the underlying asset is directly associated with the production or delivery of a product.  Costs incurred to renew or extend the term of recognized intangible assets, including patent annuities and fees, are expensed as incurred. To date, the amount of related amortization expense for other intangible assets directly attributable to revenue recognized is not material.

 
F-7

 
 
Impairment of Long-Lived Assets - The Company accounts for long-lived assets and certain identifiable intangibles 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 generated by the asset including its ultimate disposition.  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.

Fair Value of Financial Instruments - Effective January 1, 2008, the Company adopted the new accounting guidance relating to fair value measurements as required by the Fair Value Measurement Topic of the FASB ASC for financial instruments measured at fair value on a recurring basis and effective January 1, 2009 on a non-recurring basis. The new accounting guidance defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP and expands disclosures about fair value measurements.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Fair Value Measurement Topic of the FASB ASC establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include:

·
Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets;

·
Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and

·
Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
 
The carrying amounts reported in the balance sheet of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value because of the immediate or short-term maturity of these financial instruments. The fair value of revolving credit lines, notes payable and long-term debt approximates their carrying value as the stated or discounted rates of the debt reflect recent market conditions. Derivative instruments are recorded as assets and liabilities at estimated fair value based on available market information. One of the Company's derivative instruments is an interest rate swap that changes a variable rate into a fixed rate on the term loan and qualifies as a cash flow hedge and is included in accrued expenses on the accompanying Consolidated Balance Sheet as of December 31, 2010.   Gains and losses on these instruments are recorded in other comprehensive income (loss) until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income (loss) (AOCI) to the Consolidated Statement of Operations on the same line item as the underlying transaction.   The cumulative net loss attributable to this cash flow hedge recorded in AOCl at December 31, 2010, was approximately $26,000.

The Company accounts for warrants and other rights to acquire capital stock with exercise price reset features, or “down-round” provisions, as derivative liabilities. Similarly, down-round provisions for issuances of common stock are also accounted for as derivative liabilities. These derivative liabilities are measured at fair value with the changes in fair value at the end of each period reflected in current period income or loss. The fair value of derivative liabilities is estimated using a binomial model or Monte Carlo simulation to model the financial characteristics, depending on the complexity of the derivative being measured.  A Monte Carlo simulation provides a more accurate valuation than standard option valuation methodologies such as the Black-Scholes or binomial option models when derivatives include changing exercise prices or different alternatives depending on average future price targets. In computing the fair value of the derivatives, the Company uses significant judgments, which, if incorrect, could have a significant negative impact to the Company’s consolidated financial statements.  The input values for determining the fair value of the derivatives include observable market indices such as interest rates, and equity indices as well as unobservable model-specific input values such as certain volatility parameters.  Future changes in the fair value of the derivatives liabilities, if any, will be recorded in the statement of operations as gains or losses from derivative liabilities.

 
F-8

 

Conventional Convertible Debt -When the convertible feature of the conventional convertible debt provides for a rate of conversion that is below market value, this feature is characterized as a beneficial conversion feature (“BCF"). Prior to the determination of the BCF, the proceeds from the debt instrument were first allocated between the convertible debt and any detachable free standing instruments that are included, such as common stock warrants.  We record a BCF as a debt discount pursuant to FASB ASC Topic 470-20. In those circumstances, the convertible debt will be recorded net of the discount related to the BCF. We amortize the discount to interest expense over the life of the debt using the effective interest method. During 2010, the holders of both of the Company’s convertible notes totaling $800,000 exercised the conversion features of the respective convertible notes for an aggregate of 478,866 shares of the Company’s common stock, which retired the debt in full.  In conjunction with the conversions, the Company recognized approximately $263,000 of unamortized note discount expense.

Share-Based Payments - Compensation cost for stock awards are measured at fair value and recognize compensation expense over the service period for which awards are expected to vest. The Company uses the Black-Scholes option pricing model for determining the estimated fair value for stock-based awards. The Black-Scholes model requires the use of subjective assumptions which determine the fair value of stock-based awards, including the option’s expected term and the price volatility of the underlying stock.  For equity instruments issued to consultants and vendors in exchange for goods and services follows the Company determines the measurement date for the fair value of the equity instruments issued 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.

Revenue Recognition - Sales of security and commercial 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 FASB ASC 985-605. 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.
 
For technology licenses revenue is recognized 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.

Advertising Costs– Generally consist of online, keyword advertising with Google with additional amounts spent on certain print media in targeted industry publications.   Advertising costs were $32,000 in 2010 ($23,000 – 2009).

Research and Development– Research and development costs are expensed as incurred.
 
Foreign Currency- Net gains and losses resulting from transactions denominated in foreign currency are recorded as other income or loss.

Income Taxes - The Company recognizes estimated income taxes payable or refundable on income tax returns for the current year and for the estimated future tax effect attributable to temporary differences and carry-forwards. Measurement of deferred income items is based on enacted tax laws including tax rates, with the measurement of deferred income tax assets being reduced by available tax benefits not expected to be realized.  We recognize penalties and accrued interest related to unrecognized tax benefits in income tax expense.

Earnings Per Common Share - The Company presents basic and diluted earnings per share.  Basic earnings per share reflect the actual weighted average of shares issued and outstanding during the period. Diluted earnings per share are computed including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In a loss year, the calculation for basic and diluted earnings per share is considered to be the same, as the impact of potential common shares is anti-dilutive.

 
F-9

 
 
For the years ended December 31, 2010 and 2009, there were up to 2,767,131 and 2,652,886, respectively, of shares potentially issuable under convertible debt agreements, options, warrants and restricted stock agreements that could potentially dilute basic earnings per share in the future were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive to the Company’s losses in the respective years.   This amount includes the warrants issued to Fletcher on December 31, 2010 (as amended on February18, 2011 and March 14, 2011).  These amounts do not include potentially issuable shares under Fletcher’s Later Investment rights which provide Fletcher the right to acquire up to 756,387 shares of the Company’s common stock at a price per share of $5.38 anytime prior to July 2, 2011. For each share purchased by Fletcher pursuant to the Later Investment, Fletcher would receive a warrant to purchase an additional share of the Company’s commons stock at $5.38 for up to nine years.   If Fletcher exercises all of its Later Investment Rights, then an additional 756,387 warrants would be issued.  (See Note 7).

Concentration of Credit Risk - The Company maintains its cash and cash equivalents in bank deposit accounts, which at times may exceed federally insured limits.  The Company believes it is not exposed to any significant credit risk as a result of any non-performance by the financial institutions.

During 2010, two customers accounted for 25% and 10% of the Company’s total revenue from continuing operations, respectively.   As of December 31, 2010, these customers accounted for 37% and 7% of the Company’s trade accounts receivable balance, respectively.  During 2009, two customers accounted for 19% and 12% of the Company’s total revenue from continuing operations, respectively.  As of December 31, 2009, two customers’ account receivable balance accounted for 21% and 17% of the Company’s trade accounts receivable balance, respectively.  The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.
 
Recent Accounting Pronouncements

 In January 2010, the FASB issued ASU 2010-6, “Improving Disclosures About Fair Value Measurements” (“ASU 2010-6”), which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair- value measurements. ASU 2010-6 is effective for interim and annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for interim and annual periods beginning after December 15, 2010. The Company partially adopted the requirements within ASU 2010-6 as of January 1, 2010. The adoption did not have an impact on our financial statements.
 
In December 2010, the FASB issued ASU 2010-29, Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. This ASU specifies that when comparative financial statements are presented, the revenue and earnings of the combined entity should be disclosed as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 is effective for business combinations with acquisition dates on or after the beginning of the first annual reporting period beginning on or after December 15, 2010; early adoption is permitted.  Management is currently evaluating the impact that the adoption of ASU 2010-29 will have and does not believe the adoption will have a material impact on our consolidated financial statements.

 
F-10

 
 
NOTE 3. – INVENTORY

Inventory consisted of the following at December 31,:

   
2010
   
2009
 
             
             
Finished Goods
  $ 193,346     $ 38,093  
Work in process
    86,776       58,493  
Raw Materials
    321,237       87,588  
                 
    $ 601,359     $ 184,174  
 
NOTE 4. - EQUIPMENT AND LEASEHOLD IMPROVEMENTS

Equipment and leasehold improvements consisted of the following at December 31:
 
     
2010
   
2009
 
 
Estimated
Useful Life
 
Purchased
   
Under Capital Leases
   
Purchased
   
Under Capital Leases
 
                           
Machinery & equipment
5-7 years
  $ 2,514,045     $ 369,114     $ 752,387     $ 547,936  
Leasehold improvements
up to 13 years (1)
    741,919       -       735,434       -  
Furniture & fixtures
7 years
    104,709       -       70,209       -  
Software & websites
3 years
    356,125       -       270,725       -  
                                   
  Total cost
    $ 3,716,798     $ 369,114     $ 1,828,755     $ 547,936  
Less accumulated depreciation
      1,391,693       150,725       809,082       281,383  
                                   
Net
    $ 2,325,105     $ 218,389     $ 1,019,673     $ 266,553  
 
(1) Expiration of lease term

NOTE 5. - INTANGIBLE ASSETS

Goodwill - The Company performs an annual fair value test of its recorded goodwill for its reporting units using a discounted cash flow and capitalization of earnings approach.   As of December 31, 2010, the Company had goodwill of approximately $1,943,000 ($1,316,000- December 31, 2009) attributable to the commercial and security printing segment ($1,316,000) and the packaging segment ($627,000) which was recorded in 2010 as a result of our acquisition of Premier Packaging (See Note 9).   In October 2009, we sold the assets and liabilities associated with Legalstore in exchange for common stock of  Internet Media Services.  The sale included goodwill with a net book value of approximately $81,000.


Other Intangible Assets - Other intangible assets are comprised of the following at December 31:

     
2010
   
2009
 
 
Useful
Life
 
Gross
Carrying A
mount
 
Accumulated Amortizaton
 
Net Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated Amortizaton
 
Net Carrying
Amount
 
Acquired intangibles
5 -10 years
    2,038,300       815,177       1,223,123