PART I

The following discussion of Digimarc’s business contains forward-looking statements relating to future events or the future financial performance of Digimarc. Digimarc’s actual results could differ materially from those anticipated in these forward-looking statements. Please see the discussion regarding forward-looking statements included in this Annual Report on Form 10-K in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the caption “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995.”

Although Digimarc believes that the expectations reflected in such forward-looking statements are reasonable, it cannot give any assurances that these expectations will prove to be correct. Such statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from those described in such forward-looking statements, and Digimarc does not intend to update or revise any forward-looking statements as a result of new information, future events or otherwise. Readers are urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the caption “Factors Affecting Forward Looking Statements” in this Annual Report on Form 10-K, the audited consolidated financial statements and related notes included in this Annual Report on Form 10-K, and other reports and filings made with the SEC.

The following discussion should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Annual Report on Form 10-K.

This Annual Report on Form 10-K includes trademarks and registered trademarks of Digimarc Corporation. Products or service names of other companies mentioned in this Annual Report on Form 10-K may be trademarks or registered trademarks of their respective owners.

ITEM 1:                BUSINESS

Overview

Digimarc Corporation (“Digimarc,” “the Company,” “our” or “we”) is a leading supplier of secure identity solutions and advanced technologies for use in media management. Our solutions enable governments and businesses around the world to deter counterfeiting and piracy, enhance traffic safety and national security, combat identity theft and fraud, facilitate the effectiveness of voter identification programs, improve the management of media content, and support new digital media distribution models that provide consumers with more choice and access to media content.

The Company issues more than 60 million identification documents (“IDs”) annually and is the leading supplier of government-issued citizen IDs in the United States (“U.S.”), producing more than two-thirds of all driver licenses issued in the U.S. Digimarc also is a pioneer and leading owner of intellectual property in a signal processing technology innovation known as “digital watermarking”, which allows imperceptible digital information to be embedded in all forms of digitally-designed, produced or distributed media content, including personal identification documents, financial instruments, photographs, movies, music and product packages. The embedded data within various types of media content can be detected and read by software or hardware detectors in personal computers and other digital devices. We provide solutions based on this technology directly and through our licensees. As of December 31, 2005, the Company held rights in 222 issued U.S. patents and 59 issued foreign patents on this technology and related technologies, applications, systems, and processes and had more than 500 U.S. and foreign applications pending. Digimarc’s solutions and technologies are deployed by the Company and its business partners in media objects and digital devices around the world.

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Our principal administrative, sales, marketing, support, research, development and engineering facility is located in Beaverton, Oregon. Our secure ID systems business is headquartered in Burlington, Massachusetts, and our logistics center is in Fort Wayne, Indiana.

The substantial majority of the Company’s revenue is generated  pursuant to long-term contracts with government agencies—primarily U.S. state government agencies responsible for driver license issuance (“State DL Issuers”), a consortium of leading Central Banks, and national governments of a number of foreign countries. These systems rely on our systems design, integration and materials science expertise, and proprietary technologies such as digital watermarking, to implement issuance systems and processes that improve the security of identity documents and banknotes.

The remainder of our revenues is generated primarily from patent and technology license fees paid by business partners providing media and rights management solutions to movie studios and music labels, television and radio broadcasters, creative professionals and other customers around the world. Private sector media and entertainment industry customers use secure media management solutions from the Company and its business partners to identify, track, manage and protect content as it is distributed and consumed—either digitally or physically—and to enable new consumer applications to improve access to networks and information from PCs and mobile devices.

Financial information about geographic areas is incorporated by reference to Note 7 of our consolidated financial statements.

We make available through our website at www.digimarc.com our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these and other reports filed or furnished by us pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we file such materials with the Securities and Exchange Commission.

History

Digimarc was incorporated in 1995. The Company was founded to commercialize a signal processing innovation known as “digital watermarking.” Digital watermarking is a technology breakthrough that allows our customers to infuse digital data into any media content that is digitally processed at some point during its lifecycle. The technology can be applied to printed materials, video, audio, and images. The inclusion of such digital data enables a wide range of improvements in security and media management, and enables new business models for distribution and consumption of media content. We use digital watermarking as a value driver and differentiator in nearly all of our product offerings.

Banknote counterfeit deterrence was the first commercially successful use of digital watermarking. Digimarc, in cooperation with an international consortium of leading Central Banks, developed a system to deter the use of digital technologies in the unauthorized reproduction of banknotes. More recently, innovations based on the Company’s digital watermarking technology and experience have been leveraged to create new products to deter counterfeiting and tampering of driver licenses and other government-issued secure credentials. In parallel, Digimarc’s business partners, under patent license from Digimarc, are delivering digital watermarking solutions to track and monitor the distribution of music, television, movies and radio to consumers.

On the heels of 9/11, we realized that our expertise in security printing and digital imaging technologies and systems placed us in a position to understand both the digital threats to identity management credentials and the issuer’s environment. In late 2001, we acquired the Large Government Programs (“LGP”) business unit of Polaroid Corporation (“Polaroid”). The primary focus of this business is the production of driver licenses (“DLs”) and other IDs issued by government agencies. The acquired

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assets included all relevant software, hardware, services, materials science and distribution assets of Polaroid’s government-issued photo identification business.

In this strategic acquisition, we saw a unique opportunity to assist in efforts to deter identity theft and fraud and enhance transportation safety and Homeland Security through the combination of a new layer of security using our digital watermarking innovations and market-leading competence in secure ID solutions from Polaroid. The resulting business has more than 47 years of experience in the delivery and operation of secure ID issuance systems, has produced more than 2 billion issued IDs, and has guided customers through numerous major upgrades and technology migrations in ID security. We are the leader in deploying new solutions to meet driver license security and related service challenges. This includes being first to:

·        produce driver licenses with digital portraits;

·        deploy facial recognition and State-wide fingerprint matching in 1995 and 1996;

·        introduce market leading security features, including digital watermarking, Kinegrams, and secure card materials;

·        produce driver licenses in secure, networked central issuance factories;

·        offer driver license renewal by Internet; and

·        offer a comprehensive and modular ID validation and archiving suite to address recently enacted  Federal legislation, such as the REAL ID Act.

With increasing interest in issues surrounding Homeland Security, prevention of identity theft and fraud, traffic safety, copyright and intellectual property protection and establishment of new business models for digital distribution and use of media content, Digimarc has evolved from a technology-driven early stage company to an important supplier of critical infrastructure to government agencies and a strategic business partner to solution providers supporting the media and entertainment industry.

Vision and Mission

The Company’s vision is to improve the value of media content through technology. Its mission is two-fold:

·        Foster large-scale adoption of digital watermarking solutions licensed under the Company’s intellectual property

·        Be the most desired profitable supplier of driver license issuance systems

The provision of issuance systems for driver licenses and other government-issued credentials furthers the adoption of digital watermarking as this technology is increasingly included as a security feature of such documents.

Customers

The majority of Digimarc’s revenues is derived from supplying infrastructure to government agencies pursuant to long-term contracts, primarily State DL Issuers, a consortium of leading Central Banks, and national governments of various foreign countries. The retention rate for our driver license customers is high. Our contract with the Central Banks is in its eighth year. Last year we agreed upon a 5-year extension, with two additional 3-year extensions that we expect to be implemented.

The remainder of the Company’s revenue is generated through commercial applications of its digital watermarking and related technologies, primarily from patent and technology license fees paid by business partners providing media and rights management solutions to movie studios and music labels, television

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and radio broadcasters, creative professionals and other customers around the world. Patent licensing is expected to continue to contribute most of the revenues from non-government customers for the foreseeable future.

Digimarc views its patent licensees and government agency customers as long-term business partners and believes that a focus on customer satisfaction will foster future growth and improved financial performance.

Representative customers and business partners include:

·        State and national government agencies that issue driver licenses, national IDs and voter credentials, including 32 U.S. states, the District of Columbia, two Canadian provinces, Latvia, Mexico and Russia;

·        an international consortium of the world’s leading Central Banks; and

·        Activated Content, Dolby Laboratories/Cinea, GCS Research, MediaGrid, Nielsen Media Research, Royal Philips Electronics, Thomson, Signum, Verance and Verimatrix.

Government Products and Services

The Company provides financial document security and secure ID solutions to government agencies:

Financial Document Security.    The Company has a multi-year contract with an international consortium of Central Banks in which it has developed, deployed, and is supporting and continuing to enhance a system to deter digital counterfeiting of currency using personal computers and digital reprographics. Work on the system began in 1997. Details of the system are confidential for security reasons.

Secure ID Solutions .    As the leading provider of government-issued secure IDs in North America, Digimarc systems produce more than 60 million driver licenses and other secure personal identification documents per year. Two-thirds of the U.S. states and many foreign governments, including Russia, Latvia, Mexico, and Canada, use Digimarc secure ID solutions to issue credentials to citizens. In North America, we are generally a prime contractor, providing full issuance systems to Federal, State, and Provincial departments of motor vehicles or other government issuing authorities. Our North American driver license issuance systems vary from jurisdiction to jurisdiction. These systems are typically provided pursuant to long-term (normally five or more years) contracts. The systems provided include the hardware, software, consumable supplies (such as ribbons, blank or preprinted card marterials, and laminates), and on-going support necessary for a “turnkey” solution. They typically involve custom software and/or hardware development, integration services, and implementation services. When we provide a full issuance system to a customer, we generally retain title to all assets associated with the system and are responsible for maintaining the system over the contractual period. A digital driver license issuance system typically captures images (photo and signature) and demographic information, validates applicant identity, produces the actual driver license or identification document (either at the point of service or at a central production facility operated by us), provides or delivers the finished driver license or other identity document to the individual licensee, stores the images and associated data in a database, and communicates with the issuer’s other systems for completion of processing of the driver license applicants.

Digital driver license workstations installed in government driver license offices typically consist of a personal computer, digital camera system, signature capture device, network interface hardware, and other associated peripherals as required, including card printers, receipt printers, dossier printers, scanners, fingerprint capture devices, and bar code readers. Most of this hardware is sourced from third-party suppliers. We provide software application components that drive the specific peripherals and workflow to process the applicants through the capture and printing sequences. Graphical user interfaces, encoding of business rules into the work flow sequences, and communication interfaces are custom developed to the specific needs of the customer. We provide services in conjunction with State and National databases to

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confirm the validity of applicant provided information. Some commercial “off the shelf” software is also provided, such as operating systems (typically Microsoft Windows XP), and virus protection. Additionally, we often provide the necessary database design, hardware, and software to store portrait, signature, and biometric images for later retrieval. We generally supply the document consumables, including card materials, custom laminates, printer ribbons, mailing supplies, and receipt paper.

In the case of installations that issue documents from a central location, we provide a large-scale central production system, including high-volume personalization printers, lamination and die cutting machinery, encoding equipment, workstations, files servers, and proprietary software to control the production process and adhere to process and product quality levels. The typical central production capability is designed to produce tens of thousands of documents per day. We usually provide the production facility and staffing for turnkey production of the documents pursuant to a fixed price contract.

Our sales and marketing organization for North America ID issuing systems is organized into geographic territories with senior level sales/business development professionals and program management assigned to each territory. Because our contracts are long-term in nature, and the market is relatively homogeneous and stable, long-term relationships are key to our successful positioning for new opportunities and for maximizing potential within existing accounts. Contracts are most often granted through competitive bidding based on either “best value” or “low compliant cost” to the issuing jurisdiction. A “Bids & Proposals” organization, consisting of bid managers, technical writers, production assistants and technical support, is responsible for working with our sales and program management staffs to deliver winning bids based on sales positioning and strategy. Our marketing group is responsible for translating market/sales needs into product plans, supporting the sales effort with necessary collateral and market positioning, and managing long-term company strategy. An industry association, the American Association of Motor Vehicle Administrators, to which all North American driver license agencies belong, provides us with another vehicle for marketing and education within our North American customer community through regional and international conferences, seminars, and trade shows.

In non-U.S. markets, where we provide driver licenses, national identification, and voter identification systems, services, and components in partnership with local card producers, security printers, system integrators, and others, we may serve as prime contractor or sub-contractor, depending on the circumstances. International sales for us have typically taken the form of an outright sale of equipment and/or consumables to international government agencies or their prime contractors. When we provide a partial credential issuance system to a customer, we usually transfer title of the assets to the customer upon delivery and typically have no further obligations. We are paid on standard billing terms upon delivery of the assets. When we provide services for a partial credential issuance system, we usually are paid in accordance with customary commercial practice upon performance of the services.

Our customers are increasingly sensitive to the issue of identity theft and fraud, to concerns around verifying personal identity and, in the case of U.S. customers, to the role that the U.S. driver license plays as a primary form of identity verification for personal access to secure facilities and public transportation, the conduct of financial transactions, and at point-of-sale for age restricted products such as alcohol and tobacco. As a result, we believe there will be increasing interest from our customers in a variety of fraud detection and prevention systems, including biometric-based solutions based on third-party technologies. We are a leading provider of biometric solutions in the driver license market, operating systems that process tens of millions of fingerprint or facial images. As an example, our facial recognition solutions can help our customers determine if an applicant may have already been issued a valid license within a particular jurisdiction, and our fingerprinting and fingerprint matching solutions can be used to verify an applicant’s identity prior to issuance of credentials such as a commercial driver license. Several States incorporate identity verification solutions which employ a background check on the applicant-supplied demographic data during the initial enrollment process, further enhancing the integrity of the issuance process.

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We are working on broadening our security offerings to provide more integrated identity verification and fraud detection capabilities within the issuance workflow of our customers. Many aspects of our advanced technology solutions anticipate both the mandate of Federal legislation passed in May 2005 known as the REAL ID Act (the “REAL ID Act”) and the emerging consensus on best practices consistent with our product and service strategy. Some of the requirements of the REAL ID Act that may require states to upgrade to be in compliance include:

Applicant Data Capture

·        capture digital images of identity source documents in a transferable format

·        retain copies of source documents—7 years for paper or 10 years for image

·        conduct mandatory facial image capture

Identity Verification

·        verify, with the issuing agency, the issuance, validity, and completeness of each document

·        verify the legal residency of a person

·        confirm or verify a renewing applicant’s information

·        confirm with Social Security Administration all applicant Social Security Numbers using the full 9-digit number

·        confirm termination of previous license in another State before issuance

·        provide electronic access to all other States to information contained in the motor vehicle database of the State

Secure Credential and ID Validation

·        limit validity period of IDs

·        implement physical security features designed to prevent tampering, counterfeiting, or duplication

·        deploy common machine-readable technology, with defined minimum data elements

Serving government needs for citizen identity management involves successfully delivering solutions that span the secure ID lifecycle, ranging from demographic data capture, identity validation, and applicant data and biometric verification systems, to the design and secure production of credentials incorporating linked and layered security features, culminating with effective ID authentication deployed at various points of inspection. It also requires the expertise to integrate these solutions with existing government agency applications and IT infrastructure, and the service, support and training necessary to effectively manage the implementations over the course of long-term customer relationships. Digimarc has worked extensively with driver license issuers across the U.S. to strengthen their issuance systems and secure credential designs. As a result, the Company has identified and implemented numerous “best practices” throughout its processes and developed modular, flexible solutions designed to improve security within each component of the secure ID lifecycle—from the time an applicant applies for or renews his or her driver license; to the secure production and issuance of the ID to the legitimate cardholder; to the authentication of that document at a traffic stop, a bank, a border crossing, a store, or the DMV. The chart below maps Digimarc’s solutions to an overview of the secure ID lifecycle.

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Applicant Data Capture and Identity Verification.    Validation of documents and verification of applicant identity are keys to the secure intake and enrollment process, and a critical step toward ensuring that driver licenses are only issued to legitimate applicants. In 2005, Digimarc introduced the Digimarc Identity Validation Suite (“IDVS”) to validate identity documents and verify the biometric and demographic data presented to establish an applicant’s identity. As identity credentials become more secure and difficult to counterfeit, counterfeiters turn to producing false breeder documents to fuel attempts to fraudulently obtain valid secure credentials. Thus the process of validating identity is becoming central to secure ID issuance as document quality improves, ensuring that only valid applicants receive genuine IDs. This market development is underscored by the focus of the REAL ID Act on identity validation. IDVS is the Company’s most strategic product offering in 2006, enabling migration to compliance with the REAL ID Act, and serving a growing demand by our customers for effective multi-factor identification of applicants. Digimarc’s role in the secure ID lifecycle is expanding to one that encompasses identity validation and leads the Company toward a larger role in the enrollment application. IDVS works in concert with other aspects of our solution such as our DL Imaging Capture Suite. The Capture Suite enables secure ID and driver license issuers to capture high-quality portraits, signatures and fingerprints needed to complete the intake and enrollment process. This step is important to security and customer satisfaction, providing high-quality photos and reliable biometric verification.

Secure Production.    Once an applicant’s demographic information and images have been captured, screened and verified, Digimarc solutions enable issuers to securely produce and personalize a secure and highly-durable driver license. Digimarc offers several flexible options, including secure over-the-counter instant issuance systems, central issuance systems, and hybrid over-the-counter / central issue systems.

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Secure Credential.    An integral part of enhancing ID security is the design and production of the secure credential itself. Cost-effective security is achieved through a card architecture that combines multiple layered and linked security features such as digital watermarks, special printing and Kinegrams with durable, counterfeit-resistant materials in Digimarc’s line of proprietary card products. With its industry-leading Exian card products, Digimarc has developed and incorporated many innovative security features in its driver license credentials. Key among these is IDMarc, a Digimarc proprietary security feature built around the Company’s proprietary digital watermarking technology. This feature links together elements of the ID in a way that is imperceptible under normal use, can be added to existing designs, and is readily detected by enabled software and hardware. IDMarc enables post-issuance cross-jurisdictional validation of documents. Digimarc secure credentials often contain more than a dozen separate overt and covert security elements that protect against tampering or counterfeiting, and digital watermarking provides the core machine-readable security feature.

Point of Inspection Validation.    The secure ID lifecycle is not complete unless that document is routinely validated at the point of use. With the introduction of security features such as IDMarc, Digimarc’s secure IDs carry machine-readable features that allow for low-cost and effective cross-jurisdictional authentication, augmenting visual inspection to determine if a presented driver license matches one of the more than 240 valid driver license designs. Digimarc conducted a pilot study on point of inspection validation with the U.S. Department of Transportation and the State of Nebraska. The project included pilots with law enforcement and the retail sale of age-controlled products, demonstrating valuable applications to enhance citizen and traffic safety.

Media and Entertainment

The Company licenses its technology and patents and otherwise fosters development of the market for digital watermarking-based solutions for commercial as well as governmental uses. As of the filing date of this Annual Report on Form 10-K, these licenses have primarily involved use of our technology and patents in the media and entertainment area. Commercial customers use secure media solutions from Digimarc and its business partners to identify, track, manage and protect content as it is distributed and consumed—either digitally or physically—and to enable new consumer applications to access networks and information from PCs and mobile devices. Many movie studios, record labels, broadcasters, creative professionals and other customers rely on digital watermarking as a cost-effective means to:

·        deter piracy and illegal use of movies, music and images;

·   protect entertainment content from copyright infringement;

·        track and monitor entertainment content for rights usage and licensing compliance;

·        monitor advertisements to verify ad placement and measure return on investment; and

·        enable fair and legitimate use of content by consumers.

Our business partners include Activated Content,  Dolby Laboratories/Cinea, GCS Research, MediaGrid, Nielsen Media Research, Royal Philips Electronics, Signum, Thomson, Verance and Verimatrix. While each partner addresses particular customer needs, as a whole they are propagating digital watermarking in music, movies, images, and television and radio as a means to improve media rights and asset management, reduce piracy losses, improve marketing programs, and provide more efficient and effective distribution of valuable media content.

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Our business partners’ applications of digital watermarking include the following:

Forensic Tracking:    Forensic tracking allows content owners to determine when and where a unit of media content leaves its authorized distribution channel. The most common use of forensic tracking is in the entertainment industry, where music and movies are routinely distributed to executives, critics and other media outlets for promotion before they are released to the public. In recent years, copies of these ‘pre-release’ products have been leaked onto the Internet, or copied onto CDs and DVDs, and sold as “bootlegs” well ahead of their commercial release. These unauthorized activities result in loss of revenues for the artists, the studios and the music labels.

To combat pre-release piracy, music companies and movie studios embed pre-release content with digital watermarks that are unique to each authorized recipient. This allows the content creators to forensically track the source of leaks and take appropriate actions. As a result, recipients of pre-release music and movies have begun to police themselves in order to avoid liability for unauthorized use.

The use of digital watermarking solutions from our business partners for forensic tracking of pre-release movies and music has gained a strong foothold in Hollywood. For instance, digital watermarking is incorporated in millions of audio tracks from major record labels to identify and track leaks of promotional, pre-release music onto the Internet. Customers of these solutions from Digimarc and business partners such as Activated Content and Philips Electronics include SonyBMG, Universal Music Group and Warner Music, mastering studios, disk duplicators and online business-to-business music distributors. In a similar application for movies, digital watermarking has been identified by representatives of the movie studios as dramatically reducing piracy of movies in the Academy Award screener program.

Digital watermarking may also play a role in the movie industry’s transition from film reel distribution to digital file format distribution for theatrical release. In July 2005, the Digital Cinema Initiative, which is supported by Disney, Fox, MGM, Paramount, Sony Pictures Entertainment, Universal and Warner Bros. Studios, released its Digital Cinema System Specification, which details industry guidelines designed to help spur deployment of digital cinema systems for the hundreds of thousands of movie theater screens in the United States and around the world while establishing uniform levels of security, distribution, performance, reliability and quality control. The specification requires that digital cinema systems be capable of applying digital watermarks in both the video and audio streams of digital movies upon request of the studios or other content providers. The digital watermarks can be used as a forensic tool to help identify the theater, location, and production version and the date and time that a film plays in a specific theater.

Broadcast Monitoring:    Broadcast monitoring allows clients to identify where, when and how their media content is being aired. This type of information is important to many different types of users. For example, every day, thousands of advertisements run in thousands of markets across the country. With highly regionalized cable, satellite and terrestrial delivery, advertising agencies and their clients need to know that the advertisements they pay for are actually being broadcast. By using digital watermarking-based services, these companies can monitor broadcasts in major media markets around the world, verify compliance by broadcast partners, and measure the effectiveness of the campaign. As another example of how such information is used, advertisers such as Coca Cola and Pepsi, and broadcast networks such as ABC Television Network, NBC News Channel, BBC and Reuters Television, currently apply solutions from Digimarc partners that enable monitoring of broadcasts on over a thousand channels in more than 50 countries worldwide, studying the distribution of their content, verifying compliance by broadcast partners, and measuring the effectiveness of broadcasts.

Copy Prevention:    Digital watermarks allow companies to control the use of copyrighted image, audio and video content. A watermark travels with the content, persisting through the changes in file format, and through transformation between digital and analog form and back again. This allows the content owner to specify whether or how often the work can be legally copied or shared without visually or audibly impairing the work. It also allows greater and safer dissemination of copyrighted works while at the same time ensuring appropriate compensation to the owners. Digital watermarking from Verance, a Digimarc

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business partner, has been deployed in conjunction with licensed DVD-audio implementations to prevent playback of unauthorized copies. Digital watermarking is currently under consideration as an important security layer for additional audiovisual media content and in October of 2005, DVD Copy Control Association (DVD-CCA) issued a Request for Expressions of Interest to evaluate technologies for the purpose of selecting a technology for use in marking audio-visual content to convey certain content control information (“CCI”). The selected technology will be used to enhance the Content Scramble System (“CSS”) copy protection system for audio-visual content that is used to protect DVD movies. The DVD-CCA’s earlier watermarking evaluation efforts concluded in July of 2002 without selection of a watermarking technology. According to the Request, it appears that the DVD-CCA anticipates that the optimal solution for addressing their needs is likely to be audio watermarking. More information can be found at www.dvdcca.org.

Digital Image Management:    Our own digital watermarking product portfolio includes our Digimarc ImageBridge and Digimarc MyPictureMarc products, focused on digital image management during the first half of 2005. Digimarc also announced upgrades to its image protection products targeted to creative professionals, and published a beta version of an enhanced desktop image search made possible by digital watermarking.

In addition to these solutions, we believe that further digital watermark media solutions may emerge such as the following:

Rights Management:    Because digital watermarks can be applied and detected at various points between distribution and playback, they can be valuable for rights management and re-association. Among other things, new applications could be developed to allow consumers to move their digitally watermarked content through their various playback devices (e.g. personal computers and CD players) and different DRM encryption and decryption environments while preserving the identity of the content through use of a digital watermark and enabling rights re-association as appropriate in downstream devices.

Filtering/Classification:    The popularity of peer-to-peer (“P2P”) music swapping services, such as Napster, brought the issue of content and rights management to a crisis point. Because P2P systems have difficulty determining which media files are copyrighted and which are not, it is relatively easy for content to be illegally distributed across these networks. Digital watermarks could allow P2P systems to better identify and distinguish copyrighted from non-copyrighted audio or video files and thereby facilitate legal file sharing. Digital watermarks could also enhance P2P systems by enabling them to collaborate with record labels and other audio retailers to link to and market legitimate copyrighted songs. A June 2005 U.S. Supreme Court ruling (Metro-Goldwyn-Mayer Studios vs. Grokster)  identified digital watermarking as one of the solutions that could help curb copyright infringement and illegal distribution of music or movies shared across P2P networks. The ruling recognizes the possibility that digital watermarks could be used to identify media content and associated rights and enable downstream consumers and systems to act appropriately as they access such content.

Digital watermarking technology can also enable consumers to more easily access and effectively control digital content. Digital watermarking can be used to sort and search through audio, image and video files. For example, digital images could be embedded with digital watermarks that allow devices to classify or filter them in order to help parents better manage the media intake of their children, especially over the web.

Remote Triggering:    Another potential application of digital watermarking is use as a trigger—to make a playback device, such as a cell phone or a digital video recorder, perform an automatic action. When images, audio files or video files are distributed or received, digital watermarks can signal these playback devices to display notification that the content is copyrighted, trip a download counter, or display additional related content and choices to consumers.

E-Commerce:    Digimarc believes that digital watermarking could also be used to further enhance the consumer experience through improved electronic- and mobile-commerce applications. For example, if a

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digitally watermarked song is played on a cell phone, a content ID could be used to look up information about the artist or find other songs that can be purchased with the click of a button. In such an application, digital watermarking has the potential to give consumers more choices, better access and faster delivery of the products and entertainment they want.

Technology and Intellectual Property

The Company uses intellectual property (“IP”) to differentiate its products and technologies, mitigate infringement risk, and develop opportunities for licensing. Licensing of our digital watermarking and related technologies is supported by a broad patent portfolio covering a wide range of methods, applications, and system architectures.

Most of our patents relate to various methods for embedding digital information in video, audio, and images, whether such content is rendered in analog or digital formats. The digital information is generally embedded by making subtle modifications to the fundamental elements of the content itself, generally at a signal processing level. The changes necessary to embed  this information are so subtle that they are generally not noticeable by people during normal use. Because the message is carried by the content itself, it is file-format independent. The message generally survives most normal compression, edits, rotation, scaling, re-sampling, file-format transformations, copying, scanning and printing.

To protect our significant efforts in creating these technologies, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contractual provisions. As a result, we believe we have established one of the world’s most extensive patent portfolios in the field of digital watermarking, holding rights in the areas of digital watermarking, personal identification, and related technologies, with 222 U.S. and 59 foreign issued patents and more than 500 U.S. and foreign patent applications on file as of December 31, 2005. Separately, we own registered trademarks in both the U.S. and other countries and have applied for other trademarks. We continue to develop and broaden our portfolio of patented technologies, including digital watermarking and related applications and systems, and other technologies related to secure ID systems. For ID systems-related technologies, the focus of patent development has been in the areas of imaging and printing systems, card architecture and materials, and security features. Some patents relate to future offerings or related technologies like smart cards, laser engraving and alternative card systems.

Although we devote significant resources to developing and protecting our technologies, and periodically evaluate potential competitors of our technologies for infringement of our intellectual property rights, these infringements may nonetheless go undetected or may arise in the future. We expect that infringement claims may increase as companies become more concerned with protecting their content from electronic copying.

Markets

The Company believes that the global market for secure identity management solutions is in the early adoption stage characterized by a fragmented supply chain with no dominant brands, emerging standards, and increasing concerns about national and economic security, entitlement programs, and requirements for controlling access to information and physical assets.

Digimarc believes that U.S. driver license revenues will continue to grow due to broadening use of the driver license as a secure credential beyond its traditional role as evidence of competence to drive a motor vehicle, technological innovation, desire among issuers to improve security and efficiency, and new governmental regulations such as the REAL ID Act. We anticipate that these regulations will result in more opportunities for States to expand their existing driver license systems using Federal dollars. For example, Congress has appropriated $40 million for the fiscal year ending September 30, 2006 for grants to States to assist them in making necessary upgrades, and the U.S. Department of Transportation has provided funding for pilot programs to demonstrate the utility of embedded data in a number of transportation safety scenarios.

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The Company is diligently pursuing these funding opportunities, working with customers who are writing grant proposals to upgrade and expand their operations. For example, the REAL ID Act mandates certain changes in workflow and business rules. Several states are taking advantage of these changes to drive an upgrade of legacy mainframe applications, and are embarking on business process reengineering and mainframe migration or data center consolidation projects. These data center moves, combined with the availability of Federal dollars are drawing new competitors to the U.S. DL market.

The industry model for the U.S. DL market is characterized by long-term contracts awarded through competitive bids to prime contractors who take full responsibility for delivery and maintenance of driver license issuance systems. The retention rate for driver license customers is high. The influx of grant money from the Department of Homeland Security and the Department of Transportation for projects relating to compliance with the REAL ID Act, commercial driver license systems, and protection of the Homeland may cause some changes in the procurement model, but we cannot predict the likelihood or outcome of those changes at this time.

We believe that many aspects of our driver license issuance solutions may have value in other forms of credentials and secure personal identification systems.  As the global market for secure personal identification solutions develops, the Company believes that its position as the largest supplier of government issued citizen identification documents in the United States and Mexico and its extensive investments in research and development provide a good foundation for participation in the global market for government programs in establishing the identities of citizens and issuing associated credentials.

The Company’s technology and IP have already established broad relevance, as they are used in various products and solutions affecting a variety of media objects, from movies and music, to banknotes and secure credentials. Our vision contemplates that the aggregation of these print and digital content markets creates an enormous overall opportunity for the Company to address. Each media object enabled by the Company’s technology creates the potential for several applications, such as tracking and monitoring, authentication, anti-counterfeiting, or linking to networks and enhanced services. The Company believes the market for digital watermarking applications is in the early stages of development and that existing solutions represent only a nominal portion of the potential market for Digimarc’s products, services, and technologies. The Company cannot provide reliable estimates of the size of these markets as of the date of this report.

Competition

Digimarc competes for government business with system integrators, biometrics suppliers, security printers, card manufacturers, and smart card and other security technology suppliers, including companies like Viisage (biometrics), Unisys (system integration) and De La Rue (security printer).  Each of these companies is a supplier to U.S. driver license issuers.  As U.S. driver licenses gain utility as general credentials and the federal government is demanding higher security and a certain amount of standardization, the Company expects increasing competition.  For instance, certain aspects of the REAL ID Act may expedite an existing trend toward cental issuance of driver licenses and Smart Card (“SC”) technologies.  While the Company is proficient at central issuance, the possible acceleration of this trend could draw new competition from classic security printers such as Canadian Banknote (CBN) and Giesieke & Devrient (G&D).

The possibility of including SC technologies in driver licenses is generating a great deal of public debate.  The SC industry is generally driven by European chip manufacturers such as Infineon and Axalto seeking to monetize investments to create contact and contactless microprocessor packages and embedded operating systems, as well as chips for memory cards.  While successful in bank cards, mobile phone SIMs and phone cards, Smart Cards have only recently begun to gain distribution as government-issued credentials.  The U.S. government is a strong advocate.  Federal identity standards are embracing Smart Cards for the military, transportation workers, and government employees and contractors, and new “ePassports” will carry a portrait in an on-book chip.  Despite considerable investment by the federal

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government, we believe no States have attempted or even piloted SC DLs.  We understand that in recent years, at least two States have expressly considered and rejected SC DLs.  Emerging border control and Federal traveler programs are considering SC concepts, but have not gained traction and face privacy issues.  The Company anticipates that it will be prepared to support requirements from customers for SC technology if, and when, such requirements arise. 

The Company is seeing increased interest in the U.S. market from large systems integrators such as EDS, IBM Global Services, and Bearing Point.  Smaller application providers are also emerging as point-product competition, including Covansys and Archon.

Internationally, Digimarc supplies credentialing systems, components or supplies to numerous foreign governments, including two Canadian provinces, Latvia, Mexico, Colombia and Russia.  Competition in international markets, like in the U.S., comes from security printers, card producers, biometric companies and systems integrators, such as Sagem, De La Rue, Gemplus, Siemens Nixdorf, Unisys, and EDS.

In all markets, Digimarc’s product and account strategy is intended to protect its existing customer base, continue to expand into accounts it does not presently service, and grow its business and workflow with existing customers.  The key to success is building a strong customer relationship, based on delivery of superior solutions, excellent service and profound understanding of customer needs.

In media and entertainment, Digimarc and its business partners generally compete with application-specific alternative technologies for the security budget of the producers and distributors of the media objects. Such alternatives include technologies and solutions based on encryption or on pattern recognition. Going forward, the Company’s competitive position within certain markets may be affected by factors such as inertia of the status quo and, positively or negatively, by changes in government regulations.

Employees

As of December 31, 2005 we had 449 full-time employees, including 67 in sales, marketing, technical support and customer support; 132 in research, development and engineering; 81 in finance, administration, information technology and legal; and 169 in field operations, manufacturing and supply chain. We also had approximately 95 contract workers at December 31, 2005. Our future success will depend, in part, on our ability to continue to attract, retain and motivate highly qualified technical and management personnel, for whom competition is intense. Our employees are not covered by any collective bargaining agreement, and we have never experienced a work stoppage. We believe that our relations with our employees are good.

Available Information

We make available through our website at www.digimarc.com our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these and other reports filed or furnished by us pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we file such materials with the Securities and Exchange Commission.

ITEM 1A:        RISK FACTORS

Certain risk factors that may affect our business, financial condition, results of operation and cash flows, or that may cause our actual results to vary from the forward-looking statements contained in this Annual Report on Form 10-K are set forth in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the caption “Factors Affecting Forward Looking Statements,” in this Annual Report on Form 10-K.

ITEM 1B:       UNRESOLVED STAFF COMMENTS

None.

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ITEM 2:     PROPERTIES

Our principal administrative, sales, marketing, support, research, development and engineering facility is located in Beaverton, Oregon. Our ID systems business is headquartered in Burlington, Massachusetts, with additional space in Fort Wayne, Indiana. Information about our office leases is set forth below.

		Square Feet				Expires
Beaverton, Oregon			46,000			August 2011
Burlington, Massachusetts			60,000			October 2010
Ft. Wayne, Indiana			48,000			January 2007

 

We also lease sales and support offices in multiple locations throughout the United States and internationally.

ITEM 3:                LEGAL PROCEEDINGS

Beginning in September 2004, three purported class action lawsuits were commenced against us and certain of our current and former directors and officers by or on behalf of persons claiming to have purchased or otherwise acquired our securities during the period from April 17, 2002 to July 28, 2004. These lawsuits were filed in the United States District Court for the District of Oregon and were consolidated into one action for all purposes on December 16, 2004. On May 16, 2005, plaintiffs filed an amended complaint. The complaint asserted claims under the federal securities laws, specifically Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, relating to our announcement that we had discovered errors in our accounting for software development costs and project capitalization and other project cost capitalization accounting practices, and that we likely would be required to restate our previously reported financial statements for full fiscal year 2003 and the first two quarters of 2004. Specifically, the complaint alleged that we issued false and misleading financial statements and created a misperception regarding the profitability of the company in order to inflate the value of Digimarc stock, which permitted insider sales of personal holdings at inflated values, and that we maintained insufficient accounting controls, which created an environment where improper accounting could be used to manipulate financial results. The complaint sought unspecified damages.  On November 30, 2005, the Court granted our motion to dismiss the amended complaint on the grounds that plaintiffs had failed to allege facts sufficient to support their allegation that the defendants knowingly or recklessly acted in violation of the securities laws. Plaintiffs filed a second amended complaint on January 17, 2006. On February 14, 2006, we filed a motion to dismiss the second amended complaint on the grounds that plaintiffs still fail to allege facts sufficient to support their allegation that the defendants knowingly or recklessly acted in violation of the securities laws. This motion is pending. Due to the inherent uncertainties of litigation and because the lawsuits are still at a preliminary stage, the ultimate outcome of the matter cannot be predicted.

On or about October 19, 2004, two purported shareholder derivative lawsuits were filed against certain of the Company’s officers and directors, naming the Company as a nominal defendant, in the Superior Court of the State of California for the County of San Luis Obispo. These lawsuits were consolidated into one action for all purposes on March 14, 2005. On July 19, 2005, the court granted the Company’s motion to stay these consolidated actions in favor of a shareholder derivative action to be filed by plaintiffs in the Circuit Court of the State of Oregon for the County of Washington. On August 25, 2005, the California plaintiffs filed two new derivative lawsuits in the United States District Court for the District of Oregon. On October 17, 2005, defendants filed a motion to dismiss these complaints for lack of subject matter jurisdiction and failure to state a claim. This motion currently is pending. Separately, on November 8, 2004, a letter was mailed to the chairman of the Company’s Board of Directors by a law firm purporting to represent a shareholder of the Company, demanding that the board commence a civil action against each of the directors and officers on behalf of the Company to recover for damages alleged to have

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been incurred as a result of alleged breaches of fiduciary duties. On or about April 6, 2005, this shareholder filed a purported shareholder derivative suit against certain of the Company’s officers and directors, naming the Company as a nominal defendant, in the Circuit Court of the State of Oregon for the County of Washington. On August 25, 2005, the individual defendants filed a motion to stay this state court derivative lawsuit, and on September 26, 2005, the court entered a stipulated order granting the motion and staying the case pending the outcome of an investigation by a committee appointed by the Company’s Board of Directors of the claims asserted in the demand letter and in the derivative lawsuits. That stay expired on February 28, 2006, and defendants have until March 31, 2006 to respond to the complaints in this lawsuit. These suits claim that certain of these officers and directors breached their fiduciary duties to the Company’s shareholders and to the Company. The complaints are derivative in nature and do not seek relief from the Company. The Company’s Board of Directors has appointed a committee to investigate the claims asserted in the demand letter and in the derivative lawsuits.

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of the Company’s initial public offering as defendants. The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint alleges, among other things, that the underwriters of the Company’s initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the Company’s initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of the Company’s stock in the after-market subsequent to the Company’s initial public offering. The Company and certain of its officers and directors are named in the amended complaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters’ alleged compensation arrangements and manipulative practices. The complaint seeks unspecified damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a court order dated October 9, 2002, were dismissed from the litigation without prejudice. Furthermore, in July 2002, the Company and the other defendants in the consolidated cases filed motions to dismiss the amended complaint for failure to state a claim. The motion to dismiss claims under Section 11 was denied as to virtually all the defendants in the consolidated actions, including the Company. The claims against the Company under Section 10(b), however, were dismissed. In June 2003, a committee of the Company’s board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. In June 2004, an agreement of settlement was submitted to the court for preliminary approval. The settlement would provide, among other things, a release of the Company and of the individual defendants for the conduct alleged in the amended complaint to be wrongful. The Company would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims the Company may have against its underwriters. Any direct financial impact of the proposed settlement (other than defense costs incurred and expensed prior to May 31, 2003) is expected to be borne by the Company’s insurers. The court granted the preliminary approval motion on February 15, 2005, subject to certain modifications. On August 31, 2005, the court issued a preliminary order further approving the modifications to the settlement and certifying the settlement classes. The court also appointed the Notice Administrator for the settlement and ordered that notice of the settlement be distributed to all settlement class members beginning on November 15, 2005 and completed by January 15, 2006. The settlement fairness hearing has been set for April 26, 2006. Following the hearing, if the court determines that the settlement is fair to the class members, the settlement will be approved. There can be no assurance that this proposed settlement will be approved and implemented in its current form, or at all. Due to the inherent uncertainties of litigation and because the settlement approval process is at a preliminary stage, we cannot accurately predict the ultimate outcome of the matter.

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The Company is subject from time to time to other legal proceedings and claims arising in the ordinary course of business. Although the ultimate outcome of these other matters cannot be determined, management believes that the final disposition of these proceedings will not have a material adverse effect on the consolidated financial position, results of operations, or liquidity of the Company.

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

None.

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