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Document Security Systems Inc – ‘10-Q’ for 9/30/13

On:  Wednesday, 11/13/13, at 5:27pm ET   ·   For:  9/30/13   ·   Accession #:  1144204-13-61136   ·   File #:  1-32146

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  As Of               Filer                 Filing    For·On·As Docs:Size             Issuer                      Filing Agent

11/13/13  Document Security Systems Inc     10-Q        9/30/13   57:4.8M                                   Toppan Merrill/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Quarterly Report                                    HTML    434K 
 2: EX-18       Letter re: Change in Accounting Principles          HTML     19K 
 3: EX-31.1     Certification -- §302 - SOA'02                      HTML     22K 
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29: R9          Short-Term and Long-Term Debt                       HTML     36K 
16: R10         Stockholders' Equity                                HTML     36K 
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the transition period from                                                 to                                                 .

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 ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date 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 x   No ¨

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.

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

Yes ¨   No x

As of November 12, 2013, there were 49,230,159 shares of the registrant’s common stock, $0.02 par value, outstanding.

DOCUMENT SECURITY SYSTEMS, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

DOCUMENT SECURITY SYSTEMS, INC.  AND SUBSIDIARIES

Consolidated Balance Sheets

As of

See accompanying notes

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations and Comprehensive Income (Loss)

(unaudited)

See accompanying notes

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30,

(unaudited)

See accompanying notes.

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2013

(Unaudited)

1.     Basis of Presentation and Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 8.03 of Regulation S-X for smaller reporting companies. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and comprehensive income (loss) and cash flows include all adjustments, consisting only of normal recurring items necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated in consolidation.

Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc.’s (the “Company” or “DSS” ) accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K, as amended, for the fiscal year ended December 31, 2012.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions. In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure.

Completion of Merger with DSS Technology Management, Inc.

On July 1, 2013 (the “Closing Date”), DSSIP, Inc., a Delaware corporation (“Merger Sub”) and a wholly-owned subsidiary of DSS merged with and into Lexington Technology Group, Inc. (“Lexington”), n/k/a DSS Technology Management, Inc., a Delaware corporation (“DSS Technology Management”), pursuant to the terms and conditions of the previously announced Agreement and Plan of Merger, dated as of October 1, 2012 (as amended, the “Merger Agreement”), by and among the Company, DSS Technology Management, Merger Sub and Hudson Bay Master Fund Ltd. (“Hudson Bay”), as representative of DSS Technology Management’s stockholders (the “Merger”). Effective on July 1, 2013, as a result of the Merger, DSS Technology Management became a wholly-owned subsidiary of DSS. In connection with the Merger, the Company issued on the Closing Date, its securities to DSS Technology Management’s stockholders in exchange for the capital stock owned by DSS Technology Management’s stockholders, as follows (the “Merger Consideration”): (i) an aggregate of 16,558,387 shares of the Company’s common stock, par value $0.02 per share (the “Common Stock”) ; (ii) 7,100,000 shares of the Company’s Common Stock to be held in escrow pursuant to an escrow agreement, dated July 1, 2013, entered into by and among the Company, Hudson Bay and American Stock Transfer & Trust Company, LLC, as escrow agent (the “Escrow Agreement”); (iii) warrants to purchase up to an aggregate of 4,859,894 shares of the Company’s Common Stock, at an exercise price of $4.80 per share and expiring on July 1, 2018; and (iv) warrants to purchase up to an aggregate of 3,432,170 shares of the Company’s Common Stock, at an exercise price of $0.02 per share and expiring on July 1, 2023 (the “$.02 Warrants”), to DSS Technology Management’s preferred stockholders that would beneficially own more than 9.99% of the shares of the Company’s Common Stock as a result of the Merger (the “Beneficial Ownership Condition”). In addition, the Company assumed options to purchase an aggregate of 2,000,000 shares of the Company’s Common Stock at an exercise price of $3.00 per share, in exchange for 3,600,000 outstanding and unexercised stock options to purchase shares of DSS Technology Management’s common stock. In addition, the Company issued an aggregate of 786,678 shares of Common Stock to Palladium Capital Advisors, LLC (“Palladium”) as compensation for their services in connection with the transactions contemplated by the Merger Agreement. Of those shares issued to Palladium, 400,000 are currently being held in escrow pursuant to the same terms and conditions as those set forth in the Escrow Agreement.

As a result of the consummation of the Merger, as of the Closing Date, the former stockholders of DSS Technology Management owned approximately 51% of the outstanding common stock of the combined company and the stockholders of the Company prior to the completion of the Merger own approximately 49% of the outstanding common stock of the combined company.

Pursuant to the Escrow Agreement, the shares of the Company’s Common Stock deposited in the escrow account will be released to the holders of the DSS Technology Management common stock (pro rata on a fully-diluted basis as of the effective time of the Merger) if and when the closing price per share of the Company’s Common Stock exceeds $5.00 per share (as adjusted for stock splits, stock dividends and similar events) for 40 trading days within a continuous 90 trading day period following the closing of the Merger. If within one year following the closing of the Merger, such threshold is not achieved, the shares of the Company’s Common Stock held in escrow shall be cancelled and returned to the treasury of the Company. DSS Technology Management stockholders will have voting rights with respect to the Company’s shares owned by such stockholders and held in escrow for one year following the closing of the Merger even though such shares may be cancelled and returned to the treasury of the Company if the condition for release of the shares held in escrow is not met.

If after one year, the shares held in escrow are cancelled because the conditions discussed above were not met, the former stockholders of DSS Technology Management are expected to own approximately 42% of the outstanding common stock of the combined company and the stockholders of the Company prior to the completion of the Merger are expected to own approximately 58% of the outstanding common stock of the combined company (without taking into account any shares of the Company’s Common Stock held by DSS Technology Management’s stockholders prior to the completion of the Merger, and excluding the exercise of any options and warrants).

The transaction was accounted for as a business combination in accordance with the Business Combination Topic of the FASB ASC 805. (See Footnote 6)

Effective on August 2, 2013, Lexington Technology Group, Inc. changed its name to DSS Technology Management, Inc.

OUR BUSINESS

As a result of the Merger, the Company’s business has expanded. With its packaging, plastics and commercial and security printing businesses, 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. 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.

The Company’s subsidiary, Extradev, Inc. which does business as DSS Digital Group, develops, markets and sells digital information services, including data hosting, disaster recovery and data back-up and security services. The Company’s subsidiary, DSS Technology Management, Inc. formerly known as Lexington Technology Group, Inc., acquires or assists in the development of patented technology or intellectual property assets (or interests therein), with the purpose of monetizing these assets through a variety of value-enhancing initiatives, including, but not limited to, investments in the development and commercialization of patented technologies, licensing, strategic partnerships and commercial litigation.

Revenue Recognition - Sales of printed products including commercial and security printing, packaging, and plastic cards 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 technology sales and services, 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; and (4) the collection of our fees is reasonably assured. We recognize cloud computing revenue, including data backup, recovery and security services, on a monthly basis, beginning on the date the customer commences use of our services. Professional services are recognized in the period services are provided. For printing 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. For other technology licenses, revenue arrangements generally provide for the payment of contractually determined fees in consideration for the grant of certain intellectual property rights for patented technologies owned or controlled by the Company.  These rights typically include some combination of the following:  (i) the grant of a non-exclusive, retroactive and future license to manufacture and/or sell products covered by patented technologies owned or controlled the Company, (ii) a covenant-not-to-sue, (iii) the release of the licensee from certain claims, and (iv) the dismissal of any pending litigation.  The intellectual property rights granted may be perpetual in nature, extending until the expiration of the related patents, or can be granted for a defined, relatively short period of time, with the licensee possessing the right to renew the agreement at the end of each contractual term for an additional minimum upfront payment.  Pursuant to the terms of these agreements, the Company has no further obligation with respect to the grant of the non-exclusive retroactive and future licenses, covenants-not-to-sue, releases, and other deliverables, including no express or implied obligation on the Company’s part to maintain or upgrade the technology, or provide future support or services.  Generally, the agreements provide for the grant of the licenses, covenants-not-to-sue, releases, and other significant deliverables upon execution of the agreement, or upon receipt of the minimum upfront payment for term agreement renewals.  As such, the earnings process is complete and revenue is recognized upon the execution of the agreement, when collectibility is reasonably assured, or upon receipt of the minimum upfront fee for term agreement renewals, and when all other revenue recognition criteria have been met.

Certain of the Company’s revenue arrangements provide for future royalties or additional required payments based on future licensee activities.  Additional royalties are recognized in revenue upon resolution of the related contingency provided that all revenue recognition criteria, as described above, have been met.  Amounts of additional royalties due under these license agreements, if any, cannot be reasonably estimated by management.

Contingent Legal Expenses - Contingent legal fees are expensed in the consolidated statements of income in the period that the related revenues are recognized. In instances where there are no recoveries from potential infringers, no contingent legal fees are paid; however, the Company may be liable for certain out of pocket legal costs incurred pursuant to the underlying legal services agreement.

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.

As of September 30, 2013 and 2012, there were 18,753,340 and 4,319,020, respectively, of common stock share equivalents potentially issuable under convertible debt agreements, employment agreements, options, warrants, and restricted stock agreements, including common shares being held in escrow pursuant to the Merger Agreement, that could potentially dilute basic earnings per share in the future. For the three months ended September 30, 2013, based on the average market price of the Company’s common stock during that period of $1.49, 3,286 common stock equivalents were added to the basic shares outstanding to calculate dilutive earnings per share. For the nine months ended September 30, 2013, based on the average market price of the Company’s common stock during that period of $2.16, 18,704 common stock equivalents were added to the basic shares outstanding to calculate dilutive earnings per share. Common stock equivalents were excluded from the calculation of diluted earnings per share because for periods in which the Company had net losses, their inclusion would have been anti-dilutive to the Company’s losses in the respective periods.

All $.02 Warrants issued to Lexington in the July 1, 2013 merger, which represent shares issuable for little or no cash consideration are considered outstanding common shares and are included in the computation of basic earnings per share in accordance with ASC 260. Further in accordance with ASC 260, escrow shares issued to Lexington and Palladium subject to be returned to treasury based on a contingency that is considered remote are not included in basic or diluted earnings per share. The following table presents the weighted-average number of common shares outstanding used in the calculation of basic and diluted income per share:

Concentration of Credit Risk - The Company maintains its cash 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 the nine months ended September 30, 2013 and 2012, one customer accounted for 24% and 26%, respectively, of the Company’s consolidated revenue. As of September 30, 2013 and 2012, this customer accounted for 23% and 22%, respectively, of the Company’s trade accounts receivable balance. 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.

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 are first allocated between the convertible debt and any detachable free standing instruments that are included, such as common stock warrants. The Company records 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. The Company amortizes the discount to interest expense over the life of the debt using the effective interest method.

Derivative Instruments - The Company maintains an overall interest rate risk management strategy that incorporates the use of interest rate swap contracts to minimize significant fluctuations in earnings that are caused by interest rate volatility. The Company has two interest rate swaps that change variable rates into fixed rates on a term loan and promissory note with RBS Citizens, N.A. These swaps qualify as Level 2 fair value financial instruments. These swap agreements are not held for trading purposes and the Company does not intend to sell the derivative swap financial instruments. The Company records the interest swap agreements on the balance sheet at fair value because the agreements qualify as cash flow hedges under accounting principles generally accepted in the United States of America. 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 valuations of the interest rate swaps have been derived from proprietary models of the bank based upon recognized financial principles and reasonable estimates about relevant future market conditions and may reflect certain other financial factors such as anticipated profit or hedging, transactional, and other costs. The notional amounts of the swaps decrease over the life of the agreements. The Company is exposed to a credit loss in the event of non-performance by the counter parties to the interest rate swap agreements. However, the Company does not anticipate non-performance by the counter parties. The fair value of interest rate swap hedging liabilities as of September 30, 2013 amounted to $49,166 ($127,883 - December 31, 2012) and the net gain attributable to this cash flow hedge recorded during the nine months ended September 30, 2013 amounted to $78,717 ($27,671 loss– September 30, 2012).

Fair Value of Financial Instruments - 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:

Fair Value of Financial Instruments - Financial instruments include cash, which is a short term investment and its carrying amount is a reasonable estimate of fair value, investments (see Note 6), interest rate swaps as discussed above, notes payable and a convertible note payable. Notes payable are valued based on rates currently available to financial institutions for debt with similar terms and remaining maturities. The carrying value approximates the fair value of these debt instruments as of September 30, 2013 and December 31, 2012. On May 24, 2013, the Company amended its convertible note to extend the maturity of the note. This resulted in a change in the fair value of the embedded conversion option that exceeded 10% of the carrying value of the original debt, and as a result, was accounted for in accordance with FASB Topic ASC 470-50 “Debt Modifications and Extinguishments”. The convertible note payable was recorded at its fair value as of May 24, 2013. As of September 30, 2013, the note has an estimated fair value of approximately $297,000 ($565,000 - December 31, 2012) based on the underlying shares the note can be converted into at the trading price on September 30, 2013. Since the underlying shares are trading in an active, observable market, the fair value measurement qualifies as a Level 1 input.

Change in Accounting Principle - Effective July 1, 2013, the Company made a policy decision to no longer capitalize and amortize patent defense costs, but rather to expense patent defense costs as incurred. The Company believes that this policy decision constitutes a change in accounting principle that is preferable because of the addition of an operating segment that incurs significant expense litigating patent infringement. Therefore, potential settlement revenue and related patent defense legal costs will be recorded in the same period in the statement of operations.

In accordance with ASC 250, a change in accounting principle requires retrospective application. There is no retrospective impact to the accompanying consolidated financial statements as all previously capitalized patent defense costs have been expenses through the statement of operations in periods prior to the comparable periods included in this filing. Therefore, there is no impact on earnings for nine months ended September 30, 2013 and 2012, and no impact on accumulated deficit or any other component of stockholders’ equity.

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

2.    Inventory

Inventory consisted of the following:

3.     Goodwill and Intangible Assets

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. Intangible assets include acquired other intangibles of customer lists and non-compete agreements and patent and patent rights recorded at estimated fair values in accordance with purchase accounting guidelines for acquisitions. In addition, other intangible assets includes costs for patent and patent rights purchased directly by the Company and patent application costs, such as legal and filing fees. Intangible assets are amortized over the expected useful life of the asset.

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. The Company accounts for purchases of intangible assets in accordance with the provisions of ASC 350 “Intangibles” (“ASC 350”) and ASC 360 “Fixed Assets” (“ASC 360”). The useful lives of intangible assets are determined at the date of purchase and are periodically evaluated for reasonableness. The assets will be tested for impairment at least annually, if determined to have an indefinite life, or whenever events or changes in circumstances indicate that the carrying amount may no longer be recoverable. Costs to investigate potential purchases of intangible assets will be treated as expense when incurred, until or unless the purchase of the respective assets will be deemed viable, after which time the costs to further investigate and purchase the assets will be capitalized. Subsequent to purchase, legal and associated costs incurred in prosecuting alleged infringements of the patents will be recognized as expense when incurred.

For the nine months ended September 30, 2013 and 2012, the Company spent approximately $72,000 and $103,000 on patent application costs and $2,500,000 and $0 on patent and patent rights acquisition costs, respectively. In addition, the Company acquired patents as a result of its acquisition of DSS Technology Management which were valued in conjunction with the Company’s purchase accounting at approximately $27,852,000 (see Note 6).  The patents and patent rights acquired have estimated economic useful lives of approximately 2.5 to 7.5 years.

The Company recorded goodwill of approximately $12.2 million in connection with its acquisition of DSS Technology Management in July 2013. The goodwill was recorded due to the establishment of a deferred tax liability which resulted from the increase in basis of the DSS Technology Management tangible and intangible assets, excluding goodwill, for book purposes but not for tax purposes. Under the acquisition method of accounting, the impact on the acquiring company's deferred tax assets is recorded outside of acquisition accounting. Accordingly, the valuation allowance on the Company’s deferred tax assets was partially released to offset part of the increase in deferred tax liability and resulted in an estimated financial statement income tax benefit of approximately $9.2 million, which was recorded in the statement of operations for the three and nine month periods ending September 30, 2013. The goodwill is not deductible for income tax purposes.

Refer to Note 6 to these consolidated financial statements for additions to patents and goodwill in connection with the Company’s acquisition of DSS Technology Management and the related application of the acquisition method of accounting.

Intangible assets are comprised of the following:

(1) patent application costs, patent and patent rights are amortized over their expected useful life which is generally the remaining legal life of the patent. As of September 30, 2013, the weighted average remaining useful life of these assets in service was approximately 7.0 years.

Amortization expense for the nine months ended September 30, 2013 amounted to $1,213,872 ($228,078 – 2012).

Approximate expected amortization for each of the five succeeding fiscal years is as follows:

The changes in the carrying amount of goodwill for the nine months ended September 30, 2013, are as follows.

During the nine months ended September 30, 2013, the Company determined that the intangible assets the Company recorded as a result of its acquisition of ExtraDev, Inc. in May 2011 were impaired as a result of a decline of customers for its historical IT hosting and custom programming and services businesses due to increased competition, including competition from Microsoft, and ExtraDev’s focus on new products such as the Company’s AuthentiGuard Suite, which has reduced resources directed to supporting its IT hosting and custom programming businesses. As a result of this decline, the Company performed a present value analysis of the expected future cash flows of the revenues and expenses associated with ExtraDev’s historical business and determined that the intangible assets that the Company had recorded as a result of the acquisition of ExtraDev were likely impaired. As a result, the Company wrote-off approximately $239,000 of goodwill, customer lists with a gross value of $258,000 and a net book value $198,000, and non-compete agreements with a gross value of $150,000 and a net book value of $80,000 associated with ExtraDev, Inc. in the third quarter of 2013.

4.    Short-Term and Long-Term Debt

Revolving Credit Lines - The Company entered into a credit facility agreement with RBS Citizens, N.A. (“Citizens Bank”) in connection with the Company’s acquisition of Premier Packaging Corporation (“Premier Packaging”). As amended, the credit facility agreement provides Premier Packaging with a revolving credit line of up to $1,000,000.  The revolving line bears interest at 1 Month LIBOR plus 3.75% (3.93% as of September 30, 2013) and matures on May 31, 2014. As of September 30, 2013, the revolving line had a balance of $261,900 ($194,680, net of sweep account of $349,976 as of December 31, 2012).

Short–Term Debt - On May 24, 2013, the Company entered into a promissory note in the principal sum of $850,000 to purchase three printing presses that were previously leased by the Company’s wholly-owned subsidiary, Secuprint, Inc. The Note is secured by all of the assets of Secuprint, Inc., including the equipment. The Note matures on May 24, 2014, and carries an interest rate of 9% per annum. Interest is payable quarterly, in arrears. On May 24, 2013, as additional consideration for the loan, the Company issued the lender a five-year warrant to purchase up to 60,000 shares of the Company’s common stock at an exercise price of $3.00 per share. In conjunction with the issuance of the warrants, the Company recorded a discount on debt of approximately $69,000, which will be amortized over the term of the note.

Long-Term Debt - On December 30, 2011, the Company issued a $575,000 convertible note that was due on December 29, 2013, and carries an interest rate of 10% per annum. Interest is payable quarterly, in arrears. The convertible note can be converted at any time during the term at lender’s option into a total of 260,180 shares of the Company’s common stock at a conversion price of $2.21 per share. In conjunction with the issuance of the convertible note, the Company determined a beneficial conversion feature existed amounting to approximately $88,000, which was recorded as a debt discount and will be amortized over the term of the note. The note is secured by all of the assets (excluding assets leased) of Secuprint Inc., a subsidiary of the Company, is subject to various events of default. On May 24, 2013, the Company amended the convertible note to extend the maturity date of the note from December 29, 2013 to December 29, 2015. The change in the fair value of the embedded conversion option exceeded 10% of the carrying value of the original debt, therefore the Company accounted for this restructuring as an extinguishment in accordance with FASB Topic ASC 470-50 “Debt Modifications and Extinguishments”. The note had a fair value of approximately $650,000 on the date of modification and had a balance of approximately $640,000 as of September 30, 2013 ($575,000 - December 31, 2012).

Term Loan Debt -On February 12, 2010, in conjunction with the credit facility agreement with Citizens Bank, the Company entered into a term loan with Citizens Bank for $1,500,000.    As amended on July 26, 2011, the term loan requires monthly principal payments of $25,000 plus interest through maturity of February 2015. Interest accrues at 1 Month LIBOR plus 3.75% (3.93% at September 30, 2013).  The Company entered into an interest rate swap agreement to lock into a 5.7% effective interest rate over the remaining life of the amended term loan. As of September 30, 2013, the balance of the term loan was $425,000 ($650,000 - December 31, 2012).

On July 19, 2013, Premier Packaging, the Company’s wholly-owned subsidiary, entered into a Master Loan and Security Agreement (the “Master Agreement”) with People’s Capital and Leasing Corp. (“Peoples Capital”) pursuant to which Premier Packaging purchased a 2006 Heidelberg Model XL105-6LX CP2000 printing press for use in its Victor, New York facility. Pursuant to the Master Agreement, People’s Capital provided Premier Packaging with a loan in the principal amount of $1,303,900, repayable over a 60-month period in monthly payments of $24,356, subject to certain adjustments which will commence when the equipment is placed in service. The repayment of the loan is secured by a security interest in (i) the equipment; and (ii) all proceeds obtained from the equipment. On July 19, 2013, Premier Packaging also issued a Demand Promissory Note (the “Note”) to the Lender in the principal amount of $1,350,000, to be used to make progress payments as required for the purchase and installation of the equipment. The Note bears a fluctuating interest at the rate of 3% above the Libor Rate (as defined in the Note), and shall become due and payable on a date to be determined by the Lender. The Note contains customary default provisions. The Note is secured by the Security Agreement entered into by and among Premier Packaging and the Lender on July 19, 2013, pursuant to which the Lender was granted a security interest in (i) the Equipment, (ii) all proceeds obtained from the Equipment, and (iii) all inventory and any other goods, merchandise or other personal property held by debtor for sale or lease and all raw materials, work or goods in process or materials or supplies of every nature used, consumed or to be consumed in debtor’s business, now owned or hereafter acquired and all proceeds, including insurance proceeds and products of any of the foregoing. The aggregate amount borrowed under the Note will be transferred to the Master Agreement in an amount up to $1,303,900 when the equipment is placed in service and accepted by the Company. As of September 30, 2013, the Note had a balance of $1,008,900 and the equipment has not yet been placed in service.

Promissory Note - On August 30, 2011, the Company’s wholly owned subsidiary Premier Packaging purchased the packaging plant it occupies in Victor, New York for $1,500,000, which was partially financed with a $1,200,000 promissory note obtained by Premier from Citizens Bank (“Promissory Note”). The Promissory Note calls for monthly payments of principal and interest in the amount of $7,658, with interest calculated as 1 month LIBOR plus 3.15% (3.33% at September 30, 2013). Concurrently with the transaction, the Company entered into an interest rate swap agreement to lock into a 5.865% effective interest rate for the life of the loan.  The Promissory Note matures in August 2021 at which time a balloon payment of the remaining principal balance of $919,677 is due. As of September 30, 2013, the Promissory Note had a balance of $1,146,389 ($1,170,831 - December 31, 2012).

Standby Term Note - On October 8, 2010, the Company amended its credit facility Agreement with Citizens Bank to add a standby term loan note pursuant to which Citizens Bank will provide Premier Packaging with up to $450,000 towards the funding of eligible equipment purchases. In October 2011, the standby term loan note was converted into a term note payable in monthly installments of $887 plus interest over 5 years. As of September 30, 2013, the balance under this term note was $32,833 ($40,819 - December 31, 2012).

All of the Citizens Bank credit facilities are secured by all of the assets of Premier, and are also secured through cross guarantees by the Company and two of its other wholly owned subsidiaries, Plastic Printing Professionals, Inc. and Secuprint Inc. Under the Citizens Bank credit facilities, the Company’s subsidiary, Premier is subject to various covenants including fixed charge coverage ratio, tangible net worth and current ratio covenants.

5.     Stockholders’ Equity

Stock Warrants - On January 21, 2013, the Company issued Century Media Group Inc. (“Century Media”) a two year warrant to purchase up to 50,000 shares of the Company’s common stock at an exercise price of $3.00 per share (“Warrant”). The Warrant vested on the date of grant (“Grant Date”), and carries a term of two years commencing from the Grant Date. In conjunction with the issuance of the above-described Warrant, the Company cancelled a warrant previously issued to Century Media on February 20, 2012 (the “February 2012 Warrant”). The February 2012 Warrant consisted of a 14-month, immediately vested warrant to purchase up to 250,000 shares of the Company’s common stock, par value $.02 per share, at exercise prices of $4.50, $4.75, $5.00, $5.25 and $6.00 for each 50,000 block of shares covered by the February 2012 Warrant. The February 2012 Warrant was issued as partial consideration for a one-year investor relations consulting agreement previously entered into between the Company and Century Media on February 20, 2012 (the “Century Media Consulting Agreement”). The Century Media Consulting agreement expired on its stated termination date of February 20, 2013. As a result of the new Warrant, approximately $33,000 of stock based compensation expense was recorded in the nine months ended September 30, 2013.

On July 1, 2013 in conjunction with its Merger with DSS Technology Management, the Company issued warrants to purchase up to an aggregate of 4,859,894 shares of the Company’s Common Stock, at an exercise price of $4.80 per share and expiring on July 1, 2018; and warrants to purchase up to an aggregate of 3,432,170 shares of the Company’s Common Stock, at an exercise price of $0.02 per share and expiring on July 1, 2023 (the “$.02 Warrants”), to DSS Technology Management’s preferred stockholders that would beneficially own more than 9.99% of the shares of the Company’s Common Stock as a result of the Merger (the “Beneficial Ownership Condition”). (See Footnote 6)

Stock Options - During the nine months ended September 30, 2013, the Company issued options to purchase up to an aggregate of 178,750 shares of its common stock to its non-executive board members at exercise prices between $1.40 and $2.51 per share. The fair value of these options amounted to approximately $123,000 determined by utilizing the Black Scholes Merton option pricing model.

On January 10, 2013, the Company modified 80,000 fully vested options held by former non-executive board members that were set to expire on January 14, 2013 by extending the expiration dates to between January 2, 2014 and January 14, 2014. These options had been granted between 2009 and 2012. The incremental compensation costs associated with this modification of approximately $34,000 was recognized during the nine months ended September 30, 2013 and is included in selling, general and administrative expenses.

On July 1, 2013 in conjunction with its Merger with DSS Technology Management, the Company assumed options to purchase an aggregate of 2,000,000 shares of the Company’s Common Stock at an exercise price of $3.00 per share, in exchange for 3,600,000 outstanding and unexercised stock options to purchase shares of DSS Technology Management’s common stock. (See Footnote 6)

Stock-Based Compensation - The Company records stock-based payment expense related to options and warrants based on the grant date fair value in accordance with FASB ASC 718. Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. During the nine months ended September 30, 2013, the Company had stock compensation expense of approximately $1,580,000 or $0.06 basic earnings per share ($631,000; $0.03 basic earnings per share - 2012). This amount includes approximately $774,000 of stock based compensation expense for fair value of 386,678 shares issued to Palladium upon the closing of the Merger on July 1, 2013 and the expense associated with 400,000 shares issued to Palladium upon the closing of the Merger on July 1, 2013 that are being held in escrow.

As of September 30, 2013, there was approximately $1,939,000 of total unrecognized compensation costs related to options and restricted stock granted under the Company’s stock option plans, which the Company expects to recognize over the weighted average period of approximately three years. This amount excludes $536,000 of potential stock based compensation for stock options that vest upon the occurrence of certain events which the Company does not believe are likely.

6.     Business Combination

On July 1, 2013 (the “Closing Date”), DSSIP, Inc., a Delaware corporation (“Merger Sub”) and a wholly-owned subsidiary of DSS merged with and into Lexington Technology Group, Inc, pursuant to the terms and conditions of the previously announced Agreement and Plan of Merger, dated as of October 1, 2012 (as amended, the “Merger Agreement”). Effective on July 1, 2013, as a result of the Merger, Lexington Technology Group, Inc, which changed its name to DSS Technology Management, Inc. on August 2, 2013, became a wholly-owned subsidiary of DSS. The Company believes the merger with Lexington Technology Group was an opportunity to significantly increase its intellectual property assets and expand its intellectual property development, acquisition and monetization business. In connection with the Merger, the Company issued on the Closing Date, its securities to DSS Technology Management’s stockholders in exchange for the capital stock owned by DSS Technology Management’s stockholders, as follows (the “Merger Consideration”): (i) an aggregate of 16,558,387 shares of the Company’s common stock, par value $0.02 per share (the “Common Stock”), which includes 240,559 shares of the Company’s common stock owned by DSS Technology Management prior to the merger that were exchanged for shares issuable to DSS Technology Management stockholders pursuant to the merger (the “Exchange Shares”); (ii) 7,100,000 shares of the Company’s Common Stock to be held in escrow pursuant to an escrow agreement, dated July 1, 2013. Pursuant to the escrow agreement, the shares of the Company’s Common Stock deposited in the escrow account will be released to the holders if and when the closing price per share of the Company’s Common Stock exceeds $5.00 per share (as adjusted for stock splits, stock dividends and similar events) for 40 trading days within a continuous 90 trading day period following the closing of the Merger. If within one year following the closing of the Merger, such threshold is not achieved, the shares of the Company’s Common Stock held in escrow shall be cancelled and returned to the treasury of the Company. The holders of the escrow shares will have voting rights with respect to the shares until such shares are released or retired after one year (the “Escrow Agreement”); (iii) warrants to purchase up to an aggregate of 4,859,894 shares of the Company’s Common Stock, at an exercise price of $4.80 per share and expiring on July 1, 2018; and (iv) warrants to purchase up to an aggregate of 3,432,170 shares of the Company’s Common Stock, at an exercise price of $0.02 per share and expiring on July 1, 2023 (the “$.02 Warrants”), to DSS Technology Management’s preferred stockholders that would beneficially own more than 9.99% of the shares of the Company’s Common Stock as a result of the Merger (the “Beneficial Ownership Condition”). In addition, the Company assumed options to purchase an aggregate of 2,000,000 shares of the Company’s Common Stock at an exercise price of $3.00 per share, in exchange for 3,600,000 outstanding and unexercised stock options to purchase shares of DSS Technology Management’s common stock. In addition, the Company issued an aggregate of 786,678 shares of Common Stock to Palladium as compensation for their services in connection with the transactions contemplated by the Merger Agreement. Of those shares issued to Palladium, 400,000 are currently being held in escrow pursuant to the same terms and conditions as those set forth in the Escrow Agreement. The Company spent approximately $1,445,000 in legal, accounting, consulting and filing fees related to the Merger

Accounting Treatment of the Merger

U.S. Generally Accepted Accounting Principles (hereafter — GAAP), require that for each business combination, one of the combining entities shall be identified as the acquirer, and the existence of a controlling financial interest shall be used to identify the acquirer in a business combination. In a business combination effected primarily by exchanging equity interests, the acquirer usually is the entity that issues its equity interests. However, it is sometimes not clear which party is the accounting acquirer.

In accordance with FASB Topic ASC 805 “Business Combinations”, if a business combination has occurred, but it is not clear which of the combining entities is the acquirer, GAAP requires considering additional factors in making that determination. These factors include the relative voting rights of the combined entity after the business combination, the existence of a large minority voting interest in the combined entity, the composition of the governing body of the combined entity, the composition of senior management in the combined entity and the relative size of the combining entities.

Based on the aforementioned, and after taking in consideration all relevant facts and circumstances, management came to the conclusion that DSS, as the legal acquirer was also the accounting acquirer in the transaction. The conclusion was based on the determination that although, the former stockholders of DSS Technology Management had 51% of the voting interest in the combined company as of the closing date of the merger, the former stockholders of DSS Technology Management did not have clear indications of control when analyzed in the context of the other factors listed by FASB Topic ASC 805, such as the existence of a large minority voting interest, the composition of the governing body of the combined entity, the composition of senior management in the combined entity and the relative size of the combining entities. In addition, the ownership of the combined company by the former stockholders of DSS Technology Management could reduce to approximately 42% of the outstanding common stock of the combined company if, after one year, the shares held in escrow are cancelled because the conditions of the escrow agreement were not met. At the time of the Merger, management determined the likelihood of meeting the conditions in the escrow agreement to be remote. As a result, the merger will be accounted for as a business combination in accordance with the Business Combination Topic of the FASB ASC 805.

Purchase Price Allocation

The Merger was accounted for in accordance with the acquisition method of accounting under FASB ASC Topic 805, “Business Combinations” (“Topic 805”). Under the guidance, the assets and liabilities of the acquired business, DSS Technology Management, 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, if any. If the fair value of the assets acquired exceeds the purchase price and the liabilities assumed then a gain on acquisition is recorded. The purchase price is based on the fair value of the DSS common stock, DSS common stock to be held in escrow and issued if certain contingencies are met, warrants to purchase DSS common stock issued by DSS to DSS Technology Management stockholders, and replacement options awards related to pre-combination services granted to certain DSS Technology Management employees pursuant to the Merger Agreement. The Company measured the identifiable assets acquired and liabilities assumed based on the acquisition date fair value. The fair value of the equity instruments issued to former stockholders of DSS Technology Management is based on a $1.87 share price of DSS common stock which was the closing share price of DSS’s stock on July 1, 2013 on the closing date of the Merger. For warrants and employee options to purchase DSS common stock issued or assumed as consideration in the Merger, the Company used the Black Scholes Merton option pricing model to determine fair values, with terms set at the remaining life of the option or warrant, a volatility of approximately 59%, and a risk free rate of return of approximately 0.9% with zero forfeitures expected. For the DSS common stock to be held in escrow, the Company used a Monte Carlo simulation model to determine an average expected fair value. While DSS uses its best estimates and assumptions as part of the purchase price allocation process to value the assets acquired and liabilities assumed, the purchase price allocation is preliminary and could change during the measurement period (not to exceed one year) if new information is obtained about the facts and circumstances that existed as of the Merger date that, if known, would have resulted in the recognition of additional or changes to the value of the assets and liabilities presented in this purchase price allocation.

Management is responsible for determining the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed as of the Acquisition Date. Management considered a number of factors, including reference to an analysis under Topic 805 solely for the purpose of allocating the purchase price to the assets acquired and liabilities assumed. The company’s estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management’s assumptions, which would not reflect unanticipated events and circumstances that occur. A relief from royalty methodology was used to value the patent portfolio and the analysis included a discounted cash flow which estimated future net cash flows resulting from the licensing and enforcement of the patent portfolio based on information as of the date of acquisition, considering assumptions and estimates related to potential infringers of the patents, applicable industries, usage of the underlying patented technologies, estimated license fee revenues, contingent legal fee arrangements, other estimated costs, tax implications and other factors. A discount rate consistent with the risks associated with achieving the estimated net cash flows was used to estimate the present value of estimated net cash flows.

In March 2013, DSS Technology Management made a strategic investment in VirtualAgility, a developer of programming platforms that facilitate the creation of business applications without programming or coding. The investment involved a non-recourse note that would reward the Company a portion of the proceeds derived from the patent portfolio owned by VirtualAgility, plus an equity stake of 1/8 of 7% of the outstanding common stock of VirtualAgility, for $250,000 cash, plus options to make seven additional quarterly investments of $250,000 apiece, for a total investment of up to $2 million in cash. If all of such options are exercised, DSS Technology Management will have invested an aggregate of $2 million and, based on the current capitalization of VirtualAgility, would own approximately 7% of the outstanding common stock of VirtualAgility. In conjunction with its purchase accounting, the Company assessed the fair value of the VirtualAgility investment as of the Acquisition Date. A relief from royalty methodology was used to value the potential proceeds to be derived from the patent portfolio and the analysis included a discounted cash flow which estimated future net cash flows resulting from the licensing and enforcement of the VirtualAgility patent portfolio to which DSS Technology Management’s has or can obtain rights to based on information as of the date of acquisition, considering assumptions and estimates related to potential infringers of the patents, applicable industries, usage of the underlying patented technologies, estimated license fee revenues, contingent legal fee arrangements, other estimated costs, tax implications and other factors. A discount rate consistent with the risks associated with achieving the estimated net cash flows was used to estimate the present value of estimated net cash flows. The measurement of the VirtualAgility constitutes a Level 3 input.

Set forth below is the unaudited pro-forma revenue, operating loss, net loss and loss per share of the Company as if DSS Technology Management had been acquired by the Company as of January 1, 2012.

The pro-forma amounts for the nine months ended September 30, 2013 and the year ended December 31, 2012 were adjusted to exclude merger related costs of $1,400,000 and $768,000, respectively, and exclude a non-recurring income tax benefit of $9,210,000 related to the merger. Since the acquisition, DSS Technology Management had revenue of approximately $329,000 and a loss of approximately $1,118,000.

7.     Commitments and Contingencies

Legal Matters -From August 2005 until May 2013, the Company was involved in lawsuits in various foreign jurisdictions against the European Central Bank (“ECB”) alleging patent infringement by the ECB and claimed unspecified damages (the “ECB Litigation”). The Company brought the suit in the European Court of First Instance in Luxembourg.   The Company alleged that all Euro banknotes in circulation infringed the Company’s European Patent 0 455 750B1 (the “Patent”) which covered 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 ECB then filed claims against the Company in eight Euro pean countries seeking to invalidate the patents. During the course of the ECB Litigation, the losing party, in certain jurisdictions, was responsible for the prevailing party’s legal fees and disbursements. As of September 30, 2013, pursuant to foreign judgments for costs and fees, the Company has recorded as accrued liabilities approximately €264,000 ($356,000) for such fees. In February 2013, the ECB filed an action in the United States District Court, Western District of New York to domesticate the amounts due under a foreign judgment issued in Germany, included in the amount above. In addition, the ECB formally requested the Company to pay attorneys and court fees for the Court of First Instance case in Luxembourg which amounts to €93,752 ($127,000) as of September 30, 2013, which, unless the amount is settled, will be subject to an assessment procedure that has not been initiated. The Company will accrue the assessed amount, if any, as soon as it is reasonably estimable.

On August 20, 2008, the Company entered into an agreement (the “Trebuchet Agreement”) with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet agreed to pay substantially all of the litigation costs associated with validity proceedings in eight European countries relating to the ECB Litigation, and 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 Trebuchet Agreement. 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..  The Netherlands Court determined in December 2010 that the patent was invalid in The Netherlands, and the infringement case was terminated by Trebuchet. Trebuchet was responsible for cost and fee reimbursements associated with the case which Trebuchet paid in February 2012. On July 7, 2011, Trebuchet and the Company entered into a series of related agreements and general releases wherein Trebuchet effectively ended its ongoing participation in the ECB Litigation.

On October 24, 2011 the Company initiated a law suit against Coupons.com Incorporated (“Coupons.com”). The suit was filed in the United States District Court, Western District of New York, located in Rochester, New York. Coupons.com is a Delaware corporation having its principal place of business located in Mountain View, California. In the Coupons.com suit, the Company alleged breach of contract, misappropriation of trade secrets, unfair competition and unjust enrichment, and is seeking in excess of $10 million in money damages from Coupons.com for those claims. The Company’s breach of contract claim remains intact as of the date of this report.

On October 3, 2012, DSS Technology Management’s subsidiary, Bascom Research, LLC, commenced legal proceedings against five companies, including Facebook, Inc. and LinkedIn Corporation, pursuant to which Bascom Research, LLC alleges that such companies infringe on one or more of its patents.  The Company anticipates that these legal proceedings may continue for several years and may require significant expenditures for legal fees and other expenses. Disputes regarding the assertion of patents and other intellectual property rights are highly complex and technical. Once initiated, the Company may be forced to litigate against others to enforce or defend Bascom Research’s intellectual property rights or to determine the validity and scope of other parties’ proprietary rights. The defendants or other third parties involved in the lawsuits in which the Company is involved may allege defenses and/or file counterclaims in an effort to avoid or limit liability and damages for patent infringement. If such defenses or counterclaims are successful, they may have a material adverse effect on the value of the patents and preclude the Company’s ability to derive licensing revenue from the patents, or any revenue.

The Company estimates that its legal fees and expenses to pursue the Bascom case to trial will be approximately $2,000,000. This estimate depends on several variables, including the cost of retaining experts, actions taken by defendants in the litigation, and any potential proceedings with the USPTO.  Expenses thereafter are dependent on the outcome of the litigation; in the event the case is appealed, legal fees and expenses through appeal over the course of the subsequent twelve months could range from $250,000 to over $750,000.   The Company expects it will receive between 45 to 60% of the total consideration (including cash payments, equity, assets, or any other form of consideration) received from any license, settlement, judgment or other award relating to the Bascom Research patents, depending on the total amount of consideration earned and the stage of the case in which consideration is earned.

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

Contingent Litigation Payments –  The Company has a legal fee agreement with Niro, Haller & Niro in connection with its law suit against Coupons.com. Under the agreement, the Company would pay Niro, Haller & Niro 33% of any settlements or damages awards collected from Coupons.com in connection with the suit. Under the agreement, the Company is responsible for payment of out-of-pocket charges and disbursements of Niro, Haller & Niro necessarily accrued during the prosecution of the suit. This fee agreement replaced an agreement the Company had with Nixon Peabody LLP, the Company’s former legal counsel in the Coupons.com litigation.

The Company retains the services of professional service providers, including law firms that specialize in intellectual property licensing, enforcement and patent law. These service providers are often retained on an hourly, monthly, project, contingent or a blended fee basis. In contingency fee arrangements, a portion of the legal fee is based on predetermined milestones or the Company’s actual collection of funds. The Company accrues contingent fees when it is probable that the milestones will be achieved and the fees can be reasonably estimated.

Contingent Purchase Price -In December, 2008, the Company acquired substantially all of the assets of DPI of Rochester, LLC in which the Company guaranteed up to $50,000 to certain parties depending on whether certain conditions occurred within five years of the acquisition.   As of September 30, 2013, the Company considers the likelihood that the payment will be required as remote.

Related Party Consulting Payments –  The Company has a consulting agreement with Patrick White, its former CEO. During the nine months ended September 30, 2013, the Company paid approximately $139,000 to Mr. White and expects to pay approximately $220,000 in future monthly payments through the expiration of the agreement in March 2015.

Employment Agreements -On July 1, 2013, the Company assumed all of the duties, obligations and liabilities of DSS Technology Management under (i) the employment agreement with Jeffrey Ronaldi, dated November 20, 2012 (the “Ronaldi Agreement”), and (ii) the amended employment agreement with Peter Hardigan, dated November 20, 2012 (the “Hardigan Agreement”).

The Ronaldi Agreement has an initial term of three years, commencing on November 9, 2012, and is automatically renewable for additional consecutive one year terms, unless at least ninety days written notice is given by either the Company or Mr. Ronaldi prior to the commencement of the next renewal term. The Ronaldi Agreement provides for an annual base salary of $350,000 and an annual discretionary bonus based upon Mr. Ronaldi’s and the Company’s achievement of annual performance objectives, as determined by the Board. The Company also assumed the non-statutory option to purchase shares of DSSTM’s common stock previously granted to Mr. Ronaldi. The Ronaldi Agreement also provides for Mr. Ronaldi’s participation in all benefit programs the Company establishes and makes available to its executive employees, and for reimbursement to Mr. Ronaldi for reasonable travel, entertainment, mileage and other business expenses.

The Ronaldi Agreement is terminable by the Company for cause or upon thirty days prior written notice without cause, and terminable at Mr. Ronaldi’s election upon thirty days prior written notice. If the Company terminates Mr. Ronaldi without cause, then the Company will pay Mr. Ronaldi: (i) a lump sum amount equal to his base salary for the balance of the then-remaining term of the Ronaldi Agreement, but no less than six months’ base salary (ii) the Company’s share of the cost of health insurance coverage pursuant to COBRA for the then-remaining term of the Ronaldi Agreement and (iii) reimbursement of business expenses incurred by Mr. Ronaldi prior to termination.

The Ronaldi Agreement also includes certain confidentiality, non-compete and non-solicitation provisions effective for a period of twelve months following the termination of Mr. Ronaldi’s employment with the Company.

The Hardigan Agreement has an initial term of one year, commencing on August 1, 2012, and is automatically renewable for additional consecutive one year terms, unless at least ninety days written notice is given by either the Company or Mr. Hardigan prior to the commencement of the next renewal term. The Hardigan Agreement provides for an annual base salary of $250,000, effective August 1, 2012, and an annual discretionary bonus based upon Mr. Hardigan’s and the Company’s achievement of annual performance objectives, as determined by the Board.

The Company also assumed the non-statutory option to purchase shares of DSSTM’s common stock previously granted to Mr. Hardigan. The Hardigan Agreement also provides for Mr. Hardigan’s participation in all benefit programs the Company establishes and makes available to its executive employees, and for reimbursement to Mr. Hardigan for reasonable travel, entertainment, mileage and other business expenses.

The Hardigan Agreement is terminable by the Company for cause or upon thirty days prior written notice without cause, and terminable at Mr. Hardigan’s election upon thirty days prior written notice. If the Company terminates Mr. Hardigan without cause, then the Company will pay Mr. Hardigan: (i) a lump sum amount equal to his base salary for the balance of the then-remaining term of the Hardigan Agreement, but no less than six months’ base salary, (ii) the Company’s share of the cost of health insurance coverage pursuant to COBRA for the then-remaining term of the Hardigan Agreement and (iii) reimbursement of business expenses incurred by Mr. Hardigan prior to termination.

The Hardigan Agreement also includes certain confidentiality, non-compete and non-solicitation provisions effective for a period of twelve months following the termination of Mr. Hardigan’s employment with the Company.

8.     Supplemental Cash Flow Information

Supplemental cash flow information for the nine months ended September 30, 2013 and 2012 is approximately as follows:

9.     Segment Information

The Company's businesses are organized, managed and internally reported as five operating segments.  Three of these operating segments, Premier Packaging Corporation, dba DSS Packaging Group, Plastic Printing Professionals, Inc., dba DSS Plastics Group, and Secuprint Inc., dba DSS Printing Group are engaged in the printing and production of paper, cardboard and plastic documents with a wide range of features, including the Company’s patented technologies and trade secrets designed for the protection of documents against unauthorized duplication and altering.     The two other operating segments, ExtraDev, Inc., dba DSS Digital Group, and DSS Technology Management, Inc., f/k/a Lexington Technology Group, Inc. are engaged in various aspects of developing, acquiring, selling and licensing technology assets and are grouped into one reportable segment called Technology. DSS Technology Management acquires or internally develops patented technology or intellectual property assets (or interests therein), with the purpose of monetizing these assets through a variety of value-enhancing initiatives, including, but not limited to, investments in the development and commercialization of patented technologies, licensing, strategic partnerships and commercial litigation. DSS Digital Group researches and develops intellectual property, products and services for purposes of creating commercial sales of products that are based on internally developed intellectual property and intellectual property assets and rights acquired by DSS Technology Management. DSS Digital Group also provides IT sales and services including remote server and application hosting, cloud computing, secure document systems, back-up and disaster recovery services and custom program development services.

Approximate information concerning the Company’s operations by reportable segment for the three and nine months ended September 30, 2013 and 2012 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:

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

FORWARD-LOOKING STATEMENTS

Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors, as set forth in Item IA of this report that could cause actual results to differ materially from the results anticipated in the forward-looking statements.

Overview

Document Security Systems, Inc. (referred to in this report as “Document Security Systems”, “Document Security,” “DSS,” “we,” “us,” “our” or “Company”) was formed in New York in 1984. We specialize in fraud and counterfeit protection for all forms of printed documents and digital information. The Company holds numerous patents for optical deterrent technologies that provide protection of printed information from unauthorized scanning and copying. We operate three production facilities, a security and commercial printing facility, a packaging facility and a plastic card facility- where we produce secure and non-secure documents for our customers. We license our anti-counterfeiting technologies to printers and brand-owners. In addition, we have a digital division which provides cloud computing services for its customers, including disaster recovery, back-up and data security services.

Prior to 2006, the Company’s primary revenue source in its document security division was derived from the licensing of its technology. In 2006, the Company began a series of acquisitions designed to expand its ability to produce its products for end-user customers. In 2006, we acquired Plastic Printing Professionals, Inc. (“P3”), a privately held plastic cards manufacturer located in the San Francisco, California area. P3 is also referred to herein as the “DSS Plastics Group”. In 2008, we acquired substantially all of the assets of DPI of Rochester, LLC, a privately held commercial printer located in Rochester, New York, referred to herein as “Secuprint” or “DSS Printing Group”. In 2010, the Company acquired Premier Packaging Corporation (“Premier Packaging”), a privately held packaging company located in the Rochester NY area. Premier Packaging is also referred to herein as the DSS Packaging Group. In May 2011, the Company acquired all of the capital stock of ExtraDev, Inc. (“ExtraDev”), a privately held information technology and cloud computing company located in the Rochester, New York area. ExtraDev is also referred to herein as the “DSS Digital Group”.

On July 1, 2013, the Company merged with DSS Technology Management, Inc. (f/k/a Lexington Technology Group, Inc.), a private intellectual property monetization company that recently acquired a patent portfolio of six patents and four pending patent applications relating to technology invented by Thomas Bascom (the “Bascom Portfolio”) and invested in VirtualAgility, a developer of user-friendly programming platforms that facilitate the creation of sophisticated business applications without programming or coding. DSS Technology Management is focused on the economic benefits of intellectual property assets through acquiring or internally developing patents or other intellectual property assets (or interests therein) and then monetizing such assets through a variety of value enhancing initiatives, including, but not limited to:

On October 3, 2012, DSS Technology Management, through its wholly-owned subsidiary, Bascom Research, initiated patent infringement lawsuits in the United States District Court for the Eastern District of Virginia against five companies, including Facebook, Inc. and LinkedIn Corporation, for unlawfully using systems that incorporate features claimed in patents owned by Bascom Research. The patents included in the lawsuit relate to the data structure used by social and business networking web sites and Web 2.0 corporate intranets. On December 12, 2012, the lawsuits were transferred to the United States District Court for the Northern District of California.

Effective on August 2, 2013, Lexington Technology Group, Inc. changed its name to DSS Technology Management, Inc. (“DSS Technology Management”).

On July 8, 2013, the Company’s subsidiary, DSS Technology Management, purchased 2 patents for $500,000 covering certain methods and processes related to Bluetooth devices. In conjunction with the patent purchases, the Company entered into a Proceed Right Agreement with investors whereby the Company initially received $250,000 of a total of $750,000 the Company will ultimately receive thereunder, subject to certain payment milestones, in exchange for 40% of the proceeds the Company receives, if any, from the use, sale or licensing of the 2 patents.

On August 16, 2013, DSS Technology Management made an additional investment in VirtualAgility, including a non-recourse note receivable and an equity portion for $250,000.

On September 27, 2013, DSS Technology Management purchased 10 patents covering certain methods and processes in the semiconductor industry for $2,000,000.

The Company does business in five operating segments as follows:

DSS Packaging Group — Produces custom paperboard packaging serving clients in the pharmaceutical, beverage, photo packaging, toy, specialty foods and direct marketing industries, among others. The division incorporates our security technologies into printed packaging to help companies prevent or deter brand and product counterfeiting.

DSS Printing Group — Provides secure and commercial printing services for end-user customers along with technical support for the Company’s technology licensees. The division produces a wide array of printed materials such as security paper, vital records, prescription paper, birth certificates, receipts, manuals, identification materials, entertainment tickets, secure coupons, parts tracking forms, brochures, direct mailing pieces, catalogs, business cards, etc. The division also provides the basis of research and development for the Company’s security printing technologies.

DSS Plastics Group — Manufactures laminated and surface printed cards which can include magnetic stripes, bar codes, holograms, signature panels, invisible ink, micro fine printing, guilloche patterns, Biometric, Radio Frequency Identification (RFID) and watermarks for printed plastic documents such as ID cards, event badges, and driver’s licenses.

DSS Digital Group — Provides data center centric solutions to businesses and governments delivered via the “cloud”. This division developed the Company’s iPhone based application that integrates some of the Company’s traditional optical deterrent technologies into proprietary digital data security based solutions for brand protection and product diversion prevention.

DSS Technology Management — acquires or internally develops patented technology or intellectual property assets (or interests therein), with the purpose of monetizing these assets through a variety of value-enhancing initiatives, including, but not limited to, investments in the development and commercialization of patented technologies, licensing, strategic partnerships and commercial litigation.

Completion of Merger with DSS Technology Management

On July 1, 2013 (the “Closing Date”), DSSIP, Inc., a Delaware corporation (“Merger Sub”) and a wholly-owned subsidiary of DSS merged with and into Lexington Technology Group, Inc., a Delaware corporation, n/k/a DSS Technology Management, Inc. (“DSS Technology Management”), pursuant to the terms and conditions of the previously announced Agreement and Plan of Merger, dated as of October 1, 2012 (as amended, the “Merger Agreement”), by and among the Company, DSS Technology Management, Merger Sub and Hudson Bay Master Fund Ltd. (“Hudson Bay”), as representative of DSS Technology Management’s stockholders (the “Merger”). Effective on July 1, 2013, as a result of the Merger, DSS Technology Management became a wholly-owned subsidiary of DSS. In connection with the Merger, the Company issued on the Closing Date, its securities to DSS Technology Management’s stockholders in exchange for the capital stock owned by DSS Technology Management’s stockholders, as follows (the “Merger Consideration”): (i) an aggregate of 16,558,387 shares of the Company’s common stock, par value $0.02 per share (the “Common Stock”) (which includes 2,500,000 Additional Shares and 240,559 Exchanged Shares, as such terms are defined in the Merger Agreement); (ii) 7,100,000 shares of the Company’s Common Stock to be held in escrow pursuant to an escrow agreement, dated July 1, 2013, entered into by and among the Company, Hudson Bay and American Stock Transfer & Trust Company, LLC, as escrow agent (the “Escrow Agreement”); (iii) warrants to purchase up to an aggregate of 4,859,894 shares of the Company’s Common Stock, at an exercise price of $4.80 per share and expiring on July 1, 2018; and (iv) warrants to purchase up to an aggregate of 3,432,170 shares of the Company’s Common Stock, at an exercise price of $0.02 per share and expiring on July 1, 2023 (the “$.02 Warrants”), to DSS Technology Management’s preferred stockholders that would beneficially own more than 9.99% of the shares of the Company’s Common Stock as a result of the Merger (the “Beneficial Ownership Condition”). In addition, the Company assumed options to purchase an aggregate of 2,000,000 shares of the Company’s Common Stock at an exercise price of $3.00 per share, in exchange for 3,600,000 outstanding and unexercised stock options to purchase shares of DSS Technology Management’s common stock. In addition, the Company issued an aggregate of 786,678 shares of Common Stock to Palladium as compensation for their services in connection with the transactions contemplated by the Merger Agreement. Of those shares issued to Palladium, 400,000 shall be held in escrow pursuant to the same terms and conditions as those set forth in the Escrow Agreement.

As a result of the consummation of the Merger, as of the Closing Date, the former stockholders of DSS Technology Management owned approximately 51% of the outstanding common stock of the combined company and the stockholders of the Company prior to the completion of the Merger own approximately 49% of the outstanding common stock of the combined company.

Pursuant to the Escrow Agreement, the shares of the Company’s Common Stock deposited in the escrow account will be released to the holders of the DSS Technology Management common stock (pro rata on a fully-diluted basis as of the effective time of the Merger) if and when the closing price per share of the Company’s Common Stock exceeds $5.00 per share (as adjusted for stock splits, stock dividends and similar events) for 40 trading days within a continuous 90 trading day period following the closing of the Merger. If within one year following the closing of the Merger, such threshold is not achieved, the shares of the Company’s Common Stock held in escrow shall be cancelled and returned to the treasury of the Company. DSS Technology Management stockholders will have voting rights with respect to the Company’s shares owned by such stockholders and held in escrow for one year following the closing of the Merger even though such shares may be cancelled and returned to the treasury of the Company if the condition for release of the shares held in escrow is not met.

If after one year, the shares held in escrow are cancelled because the conditions discussed above were not met, the former stockholders of DSS Technology Management are expected to own approximately 42% of the outstanding common stock of the combined company and the stockholders of the Company prior to the completion of the Merger are expected to own approximately 58% of the outstanding common stock of the combined company (without taking into account any shares of the Company’s Common Stock held by DSS Technology Management’s stockholders prior to the completion of the Merger, and excluding the exercise of any options and warrants).

The transaction was accounted for as a business combination in accordance with the Business Combination Topic of the FASB ASC 805. DSS Technology Management

Results of Operations for the Three and Nine Months Ended September 30, 2013 Compared to the Three and Nine Months Ended September 30, 2012

This discussion should be read in conjunction with the financial statements and footnotes contained in this quarterly report and in our Annual Report on Form 10-K and 10-K (A) for the year ended December 31, 2012.

Revenue

For the three months ended September 30, 2013, total revenue was approximately $4.3 million, an increase of 2% from the three months ended September 30, 2012. Revenues from the sale of printed products rose slightly, and increases in revenues from the sale of plastics products were offset by a decline in commercial printing sales. Technology sales, services and licensing revenue increased 14% for the three months ended September 30, 2013, as compared to the same period in 2012, primarily due to revenue from licenses from litigation settlements from the Company’s DSS Technology Management subsidiary, acquired on July 1, 2013, and as such were not part of the Company’s revenues in the 2012 third quarter, offset by a 27% decrease in technology hardware sales and cloud-based technology services at the Company’s Digital Group.

For the nine months ended September 30, 2013, total revenue was approximately $12.3 million, an increase of 5% from the nine months ended September 30, 2012. For the nine months ended September 30, 2012, as compared to the same period in 2012, revenues from the sales of printed products increased 4%, sales of plastic products increased 16%, and security printing sales increased 82%, offset by an approximately 14% decrease in traditional commercial printing sales. In addition, packaging sales for the nine months ended September 30, 2013 increased 1% from the same period of 2012. Technology sales, services and licensing revenue increased 14% during the first nine months of 2013 as compared to the same period in 2012, primarily due to a 48% increase in revenues from licenses, including licenses from litigation settlements from its subsidiary DSS Technology Management, acquired on July 1, 2013, offset by an 9% decrease of technology hardware sales and cloud-based technology services

Cost of Revenue and Gross Profit

For the three months ended September 30, 2013, gross profit increased 6% to approximately $1.6 million as compared to the three months ended September 30, 2012. The increase in gross profit for the three months ended September 30, 2013, as compared to the same period in 2012 was primarily due to a 31% increase in gross profits from technology sales, services and licensing, which benefited from an increase in revenues from licenses from litigation settlements from DSS Technology Management, acquired on July 1, 2013. Gross profits from printed products decreased 2% for the three months ended September 30, 2013, as compared to the same period in 2012.

For the nine months ended September 30, 2013, gross profit increased 14%, to approximately $4.7 million, as compared to the nine months ended September 30, 2012. This increase in gross profit for this period reflects a 18% increase in gross profits from technology sales, services and licensing, which benefited from an increase in revenues from licenses from litigation settlements from DSS Technology Management, acquired in July 2013. Gross profits from printed products increased 13% which reflected a favorable product sales mix as the Company focused on higher margin projects.

Operating Expenses

Sales, general and administrative compensation costs, excluding stock base compensation, were 13% and 12% higher for the three and nine months ended September 30, 2013, respectively, as compared to those same periods in 2012, primarily due to the addition of employees from the Company’s acquisition of DSS Technology Management on July 1, 2013.

Professional fees during the three months ended September 30, 2013 were consistent compared to the three months ended September 30, 2012. During the 2013 quarter, the Company had a significant reduction in legal and filing fees and other costs relating to the Company’s merger with DSS Technology Management, which closed on July 1, 2013. Such merger related professional fees totaled $461,000 in the three month period ended September 30, 2012, as compared to $90,000 in the three month period ended September 30, 2013. However, these decreases were offsetting by approximately $273,000 of legal, consulting and advisory expenses incurred in connection with the intellectual property monetization business of DSS’s subsidiary, DSS Technology Management, acquired on July 1, 2013,

Professional fees increased 67% for the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012 primarily due to the significant increase in legal and filing fees and other costs relating to the Company’s merger with DSS Technology Management, which closed on July 1, 2013. Such merger related professional fees totaled $461,000 for the nine months ended September 30, 2012, compared to $677,000 for the nine months ended September 30, 2013. In addition, during the nine months ended September 30, 2013, there was approximately $273,000 of legal, consulting and advisory expenses incurred in connection with the intellectual property monetization business of DSS’s subsidiary, DSS Technology Management, acquired on July 1, 2013.

Sales and marketing costs which consist of internet and trade publication advertising, travel costs, sales broker commissions, and trade show participation expenses increased during the third quarter and the first nine months of 2013, as compared to the same periods in 2012, primarily due to broker commission costs incurred by the packaging division and increases in sales travel costs primarily associated with the Company’s sales and marketing efforts for its AuthentiGuard smart phone based products.

Rent and utilities increases during the three and nine months ended September 30, 2013 as compared to those same periods in 2012 are due to the increased costs associated with the leasing of additional space at the Company’s Rochester, New York location, which now houses both the corporate and DSS Digital Group personnel, along with the rental cost for the New York City and Virginia offices of the Company’s new subsidiary, DSS Technology Management, acquired on July 1, 2013.

Other operating expenses consist primarily of equipment maintenance and repairs, office supplies, IT support, bad debt expense and insurance costs. Other expenses for the three months ended September 30, 2013 as compared to the same period in 2012 increased 13% primarily due to increases in business insurance costs and office expenses. Other operating expenses decreased 3% for the first nine months of 2013 as compared to the same period in 2012, primarily due to lower equipment maintenance costs.

Research and development costs consist primarily of compensation costs for research personnel, third-party research costs, and consulting costs. During the three and nine months ended September 30, 2013, the Company’s research and development costs decreased from the same periods in 2012, primarily due to the absence of costs, including stock based payment expenses for ipCapital Group, Inc., a third party consulting firm that the Company used during 2012 to assist with the enhancement of its intellectual property portfolio of patents and trade secrets in the security field.

Stock based compensation includes expense charges for all stock based awards to employees, directors and consultants, except for stock based compensation allocated to research and development. Such awards include option grants, warrant grants, and restricted stock awards. Stock based compensation for the three and nine months ended September 30, 2013 increased 40% and 252%, respectively, from the same periods in 2012, primarily due to the value of options issued to certain of the Company’s management and board members that vested upon the completion of the Company’s Merger and $723,000 of stock based compensation expense for the fair value of shares issued to Palladium in conjunction with the Merger, which closed on July 1, 2013, which were accrued for as of June 30, 2013.

Impairment of intangible assets:  In the third quarter of 2013, the Company determined that the intangible assets the Company recorded as a result of its acquisition of ExtraDev in May of 2011 were impaired as a result of a loss of customers of its historical IT hosting and custom programming and services businesses due to increased competition, including competition from Microsoft. As a result, the Company wrote-off approximately $239,000 of goodwill, $198,000 of customer list net book value and $80,000 of non-compete agreement net book value associated with ExtraDev, Inc. in the third quarter of 2013. There were no intangible asset impairments recorded in the 2012 periods.

Amortization of intangibles expense increased during the three months ended September 30, 2013 as compared to the same period in 2012, due to the $1,139,000 of amortization of the other intangibles- patent assets that were acquired from DSS Technology Management on July 1, 2013. As a result of the purchase accounting for the acquisition of DSS Technology Management, the Company determined that the fair value of the patents acquired was approximately $28 million and the weighted average remaining life of the acquired patents was 7.5 years as of July 1, 2013.

Deferred Tax Benefit: The Company recognized a $9,205,000 deferred tax benefit as a result of the acquisition of DSS Technology Management. Due to the acquisition, a temporary difference between the book fair value and the tax basis for the other intangible assets acquired of $12,221,000 was created resulting in a deferred tax liability and additional goodwill. With the increase in the deferred tax liability the Company reduced the deferred tax asset valuation allowance  by the amount of net operating loss that could offset the amortization of the deferred tax liability associated with the value of the patents acquired and recognized a deferred tax benefit of approximately $9,210,000.

Net Loss and Loss per Share

During the three months ended September 30, 2013, the Company had net income of $6,462,000, representing a 690% change from the net loss incurred during the three months ended September 30, 2012. The change to net income was primarily the result of a $9,210,000 deferred tax benefit recognized by the Company for the quarter ended September 30, 2013, resulting from a change in the deferred tax position of the Company due to the merger. Absent this merger-related deferred tax benefit, the Company would have incurred a net loss before income taxes of approximately $2,741,000 for the quarter ended September 30, 2013. The increase in net loss before income taxes that the Company would have incurred but for the deferred tax benefit was primarily the result of a $979,000 increase in amortization expense of intangible assets resulting from the value allocated to patent assets acquired by the Company in connection with the Company’s merger with DSS Technology Management.

LIQUIDITY AND CAPITAL RESOURCES

The Company has historically met its liquidity and capital requirements primarily through the private placement of its equity securities and debt financings. As of September 30, 2013, the Company had cash of approximately $3.2 million. In addition, the Company had approximately $738,000 available to its packaging division under a revolving credit line.

Operating Cash Flow – During the first nine months of 2013, the Company used approximately $1,920,000 of cash for operations, an 8% decrease from the Company’s use of cash for operations during the first nine months of 2012.

Investing Cash Flow - During the first nine months of 2013, the Company spent approximately $321,000 on equipment additions, $230,000 of which were payments made by the Company’s Packaging division for a new 6 color printing press expected to be placed in service in the fourth quarter of 2013. In addition, the Company received approximately $6.6 million of cash as a result of its acquisition of DSS Technology Management on July 1, 2013. Subsequent to the merger, the Company’s subsidiary, DSS Technology Management, used $2,750,000 of the Company’s cash to acquire patents and rights to patents, and make an additional investment in VirtualAgility.

Financing Cash Flows - During the first nine months of 2013, the Company made approximately $233,000 in long-term debt payments, received approximately $49,000 from the exercise of warrants, and borrowed a net of $24,000 from the revolving line of credit available to Premier Packaging, a subsidiary of the Company.

Off-Balance Sheet Arrangements

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

Critical Accounting Policies and Estimates

As of September 30, 2013, the following critical accounting policies and estimates have changed from those set forth in our Annual Report on Form 10-K for the year ended December 31, 2012.

Revenue Recognition - Sales of printed products including commercial and security printing, packaging, and plastic cards 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 technology sales and services, 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; and (4) the collection of our fees is reasonably assured. We recognize cloud computing revenue, including data backup, recovery and security services, on a monthly basis, beginning on the date the customer commences use of our services. Professional services are recognized in the period services are provided. For printing 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. For other technology licenses, revenue arrangements generally provide for the payment of contractually determined fees in consideration for the grant of certain intellectual property rights for patented technologies owned or controlled by the Company.  These rights typically include some combination of the following:  (i) the grant of a non-exclusive, retroactive and future license to manufacture and/or sell products covered by patented technologies owned or controlled by the Company, (ii) a covenant-not-to-sue, (iii) the release of the licensee from certain claims, and (iv) the dismissal of any pending litigation.  The intellectual property rights granted may be perpetual in nature, extending until the expiration of the related patents, or can be granted for a defined, relatively short period of time, with the licensee possessing the right to renew the agreement at the end of each contractual term for an additional minimum upfront payment.  Pursuant to the terms of these agreements, the Company has no further obligation with respect to the grant of the non-exclusive retroactive and future licenses, covenants-not-to-sue, releases, and other deliverables, including no express or implied obligation on the Company’s part to maintain or upgrade the technology, or provide future support or services.  Generally, the agreements provide for the grant of the licenses, covenants-not-to-sue, releases, and other significant deliverables upon execution of the agreement, or upon receipt of the minimum upfront payment for term agreement renewals.  As such, the earnings process is complete and revenue is recognized upon the execution of the agreement, when collectibility is reasonably assured, or upon receipt of the minimum upfront fee for term agreement renewals, and when all other revenue recognition criteria have been met.

Certain of the Company’s revenue arrangements provide for future royalties or additional required payments based on future licensee activities.  Additional royalties are recognized in revenue upon resolution of the related contingency provided that all revenue recognition criteria, as described above, have been met.  Amounts of additional royalties due under these license agreements, if any, cannot be reasonably estimated by management.

Patent Defense Costs - Effective July 1, 2013, the Company made a policy decision to no longer capitalize and amortize patent defense costs, but rather to expense patent defense costs as incurred. The Company believes that this policy decision constitutes a change in accounting principle that is preferable because of the addition of an operating segment that incurs significant expense litigating patent infringement. Therefore, potential settlement revenue and related patent defense legal costs will be recorded in the same period in the statement of operations.

In accordance with ASC 250, a change in accounting principle requires retrospective application. There is no retrospective impact to the accompanying consolidated financial statements as all previously capitalized patent defense costs have been expenses through the statement of operations in periods prior to the comparable periods included in this filing. Therefore, there is no impact on earnings for nine months ended September 30, 2013 and 2012, and no impact on accumulated deficit or any other component of stockholders’ equity.

ITEM 4 - 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 September 30, 2013. 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 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.

Management has identified two material weaknesses in its internal control over financial reporting in its annual assessment of internal controls over financial reporting that management performed for the year ended December 31, 2012. Those identified material weaknesses remain as of the date of this report.

We did not maintain a sufficient complement of qualified accounting personnel and controls associated with segregation of duties. We have two people on staff that perform 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. 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 agree with appropriate supporting detail, calculations or other documentation. These control deficiencies could potentially result in a material misstatement to our interim consolidated financial statements that may not be prevented or readily detected.

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.

Plan for Remediation of Material Weaknesses

In response to the identified material weaknesses, management, with oversight from the Company’s audit committee, plans to continue to monitor and 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. In addition, moving forward, the Company expects to be able to utilize the additional accounting and financial resources of its wholly-owned subsidiary, DSS Technology Management, which management believes will help the Company to further remediate its material weaknesses.

Changes in Internal Control over Financial Reporting

In the ordinary course of business, we may routinely modify, upgrade or enhance our internal controls and procedures for financial reporting. There have not been any changes in our internal controls over financial reporting as defined in Rule 13a-15(f) and Rule 15d-15(f) of the Exchange Act during the third quarter of 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, except changes resulting from the merger with DSS Technology Management being implemented to incorporate DSS Technology Management’s operations with the Document Security System’s system of internal control