Digimarc (DMRC) 10-K2022 FY Annual report

PART I

Unless the context otherwise requires, references in this Annual Report on Form 10-K to “Company,” “Digimarc,” “we,” “our” and “us” refer to Digimarc Corporation.

All dollar amounts are in thousands except per share amounts or unless otherwise noted. The percentages within the tables may not sum to 100% due to rounding.

Digimarc, Digimarc Barcode, The Barcode of Everything, Barcode of Everything, and the circle-d logo are registered trademarks of Digimarc Corporation. EVRYTHNG and EVRYTHNG PRODUCT CLOUD are registered trademarks of EVRYTHNG Limited, a wholly owned subsidiary of Digimarc.

ITEM 1:         BUSINESS

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

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

On January 3, 2022, the Company completed the acquisition of EVRYTHNG Limited and its subsidiaries (“EVRYTHNG”), a London-based product cloud company. Unless context otherwise requires, references to EVRYTHNG refer to our wholly owned subsidiaries following the acquisition.

Overview

Digimarc Corporation (“Digimarc” or the “Company”), an Oregon corporation, is a global leader in product digitization, delivering business value across industries through unique identities and cloud-based solutions. Digimarc’s technology highlights a product’s journey to provide greater visibility into all relevant product data, allowing companies to make more intelligent business decisions.

The Digimarc Illuminate Platform is a distinctive software as a service that combines Digimarc’s digital watermarks and/or Quick Response (“QR”) codes with product cloud technologies. By digitizing products using Digimarc's unique digital watermarks, QR codes, and/or other digital tags, products can connect with the web and interact with consumers and digital devices. Interactions are powered by the product cloud, where data and instructions are provided based on context, and which captures a record of every interaction.

The Digimarc product suite is built on top of the Digimarc Illuminate Platform to address specific business needs. All of the Company’s products are complementary to each other, providing exponential benefits when combined. By enabling customers to create digital identities for physical and digital media objects, Digimarc’s technologies provide many benefits, including:

Our technologies provide a powerful security element (the ability to apply a unique code in any media object), which gave rise to our long-term relationship with a consortium of central banks (“the Central Banks”). That relationship, centered on the counterfeit deterrence of banknotes, was the first commercially successful large-scale use of our technologies.

In January 2022, Digimarc announced the successful completion of its acquisition of EVRYTHNG, a market leader and pioneer in product cloud technology, linking every product item to a digital identity on the web and joining-up product data across the value chain for visibility, validation, real time intelligence and connection with people. Combining Digimarc’s and EVRYTHNG’s capabilities makes it possible to gather and apply traceability data from across the product lifecycle, unlocking end-to-end visibility and authenticity through item-level, real-time intelligence and analytics.

In March 2022, Digimarc and AIM – European Brands Association announced the completion of a semi-industrial trial of Digimarc digital watermarks as part of the Digital Watermarks Initiative HolyGrail 2.0. With an average detection rate of 99%, results demonstrated that Digimarc’s technology performs exceptionally well across all tested categories of plastic packaging material in conditions that represent routine industrial operations and maintains performance in harsher conditions.

In June 2022, Digimarc and Sealed Air (“SEE”), a global leader in digital printing and packaging, announced a partnership to bring product digitization at scale to markets like food proteins, eCommerce fulfillment, industrials, and consumer goods through smart packaging. The partnership provides the industry with a complete end-to-end smart packaging solution by combining Digimarc’s leading product digitization platform with prismiq™, SEE’s innovative digital packaging brand with a portfolio of solutions for design services, digital printing, and smart packaging.

In June 2022, Digimarc and the Circular Plastics Taskforce (“CPT”), an industry collaboration promoting the implementation of a circular economy for post-consumer plastics in Quebec and Canada, announced a partnership to test Digimarc Recycle for optimizing the sortation of flexible plastic packaging in Canada, a first in North America.

In October 2022, the results of the first part of the project with CPT were announced, confirming the effectiveness of Digimarc Recycle in improving recycling sortation. With a 99% accuracy of detection and sorting for films and flexibles, CPT concluded that Digimarc technology sorts films and flexibles accurately and efficiently on a SKU-level (deterministic) basis. Starting in 2023, CPT aims to implement the technology in facilities to enable the separation of flexibles by attributes, allowing the creation of new end-markets.

In December 2022, Digimarc announced an additional multi-year agreement with Walmart to help further optimize store operations. The agreement covers an expanded deployment of Digimarc Illuminate Platform capabilities beyond the scope of the existing agreement between the two companies.

In December 2022, Digimarc also announced a five-year extension of its agreement with the Central Banks. The agreement was renewed two years early and is effective through December 31, 2029. Digimarc has been a key, long-term partner in the central banks’ worldwide effort to deter counterfeiting of currency and a major contributor to the program’s success.

Integrated Environmental, Social and Governance Strategy

Digimarc is committed to becoming a leader in the Environmental, Social and Governance space (“ESG”). ESG is an integral element of Digimarc's strategy, covering the three key areas of our organization’s impacts on the world around us (impacts on the economy, environment, and people), as well as environmental, social, and governance risks or opportunities that have an impact on Digimarc (enterprise value creation). This supports our ability to create value sustainably.

We proactively manage our ESG impacts across People, Product, and Planet, the three pillars of Digimarc’s ESG Framework. In addition, our responsible management of Governance topics forms the foundation for this Framework.

In 2021, Digimarc started investing in ESG as an integrated element of its strategy and operations by forming an internal ESG team. A materiality assessment was performed by the ESG team that identified Digimarc’s material ESG impacts, based on a stakeholder mapping and the globally recognized standards published by the Sustainability Accounting Standards Board (“SASB”).

Some of the most prominent ESG impacts we identified are the following:

Management of material ESG impacts across People, Product, and Planet is integrated throughout our organization. Accountability and responsibility for impacts lies with functional leads and relevant subject-matter experts, who act as Impact Owners and Impact Managers, respectively. This approach allows effective incorporation of ESG considerations into our strategic decisions, policies, and processes. The ESG team plays a coordinating role, supporting Impact Owners and Impact Managers and reporting on progress to stakeholders.

In April 2022, Digimarc published its inaugural ESG Impact Report, aligned with industry standards, such as those published by SASB and the Task Force on Climate-related Financial Disclosures (“TCFD”). Throughout the year, Digimarc’s Impact Owners, Impact Managers, and the ESG team worked together to collect data, implement policies, and improve practices related to People, Product, Planet, and Governance.

More information on our commitment to ESG, including our ESG Impact Report, can be found at http://www.digimarc.com/company/impact. The content on any website referred to in this annual report is not incorporated by reference in this annual report unless expressly noted.

Customers and Business Partners

We generate revenue through two primary markets: government and commercial. Government includes the Central Banks and other government customers. Commercial includes retailers, consumer brands, their suppliers and related solution providers, as well as media, entertainment, and other customers.

We derive our revenue primarily from subscriptions for our software products and software development services. Subscriptions for our software products are generally sold to retailers, consumer brands, their suppliers and related solution providers. Software development services are generally provided to the Central Banks. During 2022, we generated 46% of our revenue under the long-term contract with the Central Banks, with whom we have been developing, deploying, supporting and enhancing a system to deter digital counterfeiting of currency for over 24 years. In December 2022, the 5-year extension option included in our contract with the Central Banks was exercised two years early. The contract now runs through December 31, 2029.

Technology and Intellectual Property

We seek patent protection for our inventions to differentiate our products and technologies, mitigate infringement risks, and develop opportunities for licensing. Our broad patent portfolio covers a wide range of methods, applications, system architectures and processes.

Our intellectual property contains many innovations in digital watermarking, content and object recognition, product authentication, and related fields. To protect our inventions, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contracts. As a result, we believe we have one of the world’s most extensive patent portfolios in digital watermarking and related fields, with approximately 950 U.S. and foreign patents granted and applications pending as of December 31, 2022. The patents in our portfolio each have a life of approximately 20 years from the patent’s effective filing date.

Our current patent licensees include, among others, AlpVision SA, Intellectual Ventures, Kantar SAS, NexGuard Labs B.V., Nielsen, OverDrive, Inc., Signum Technologies, Teletrax B.V., U-NICA Systems AG and Verance Corporation.

For a discussion of activities and costs related to our research and development in the last two years, see “Research, development and engineering” under Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Markets

Our patented technologies are used in various automatic identification products and solutions supporting a variety of media objects, from consumer goods to movies and music, digital images, and banknotes. Each media object enabled by our technology creates the potential for several applications, such as:

We believe that existing products and solutions represent only a small portion of the potential market for our technology.

Competition

No single competitor or small number of competitors dominate our market. Our competitors vary depending on the application of our products and services. We generally compete with non-digital watermarking technologies. These alternatives include, among other things, encryption-based security systems and technologies and solutions based on fingerprinting, pattern recognition, and traditional barcodes. Our competitive position in digital watermarking applications is strong because of our large, high-quality, sophisticated patent portfolio and our substantial and growing amount of intellectual property in related innovations for the automatic identification of physical and digital media objects that span basic technologies, applications, system designs and business processes. Our intellectual property portfolio allows us to use proprietary technologies that are well-regarded by our customers and partners, and not available to our competitors without a license. We compete based on the variety of features we offer and a traditional cost/benefit analysis against alternative technologies and solutions. We anticipate that our competitive position within some markets may be affected by factors such as reluctance to adopt new technologies and by changes in government regulations.

Some factors that lead to decreased backlog include:

The mix of these factors, among others, dictates whether our backlog increases or decreases for any given period. Our backlog may not result in actual revenue in any particular period, because the orders, awards and contracts included in our backlog may be subject to modification, cancellation or suspension. We may not realize revenue on certain contracts, orders or awards included in our backlog, or the timing of any realization may change.

Values

Culture is critically important to Digimarc’s success. We incorporate our core values in daily interactions with colleagues, customers, vendors and other stakeholders. Our core values are embodied in the words Collaborative, Curious and Courageous.

Digimarc follows a Purposeful Working approach which enables teams to determine the right balance of working between home and office locations, taking into consideration both the company and departmental needs, and those of our staff.

Diversity, Equity and Inclusion

We strive to create an environment where innovative ideas can flourish by demonstrating respect for each other and valuing the diverse opinions, backgrounds and viewpoints of our employees. We are committed to innovation and representing diversity in a myriad of ways, including race, color, national origin, ethnicity, gender, gender identity, sexual orientation, marital status, familial status, age, religion, expunged juvenile record, military or veteran status, physical or mental disability, and/or any other characteristic protected by law.  This applies to decisions involving talent acquisition, hiring, job placement, transfer, promotion, compensation, benefits, training and company-sponsored programs. We believe that diversity is a competitive asset. We believe that diversity in our teams leads to new ideas, helps us solve problems and allows us to better connect with our global customer base.

We have taken specific actions to continue to foster DEI in our culture, including transparency that we believe will lead to greater inclusion and innovation. Actions we have taken to promote DEI include the adoption of the Digimarc Methodology for organizational health, all-employee meetings, employee resource groups, flexible work policies, diverse recruiting partners and fireside chats with our Chief Executive Officer. Additionally, we have implemented learning resources, like unconscious bias in interviewing, DEI training and workplace harassment training to support the acquisition of the skills and behaviors expected from our employees. Digimarc provides reasonable accommodation for qualified individuals with disabilities, for employee’s religious practices or needs, and for pregnancy-related needs.

In 2021, we identified DEI specifically, and human capital management more broadly, as one of our most material ESG impacts under the People pillar of our ESG Framework. To further structure our approach to DEI, we assigned accountability and responsibility for this topic at various levels of our Human Resources organization, in line with our integrated ESG approach. Our Board of Directors also plays an important role in our DEI efforts. The Governance, Nominating, and Sustainability Committee oversees the Company’s ESG efforts and works closely with the Compensation and Talent Management Committee which oversees human capital management and DEI programs.

Compensation and Benefits

Our compensation program is designed to support, reinforce, and align our values, DEI initiatives, business strategy, and operational and financial goals of profitable growth and appreciation of our company’s value in the public equity markets.

Digimarc’s compensation program is designed to pay all our employees fairly for their performance and contributions. We do this by balancing a wide variety of important internal and external factors aligned to our company culture and values. Compensation and benefits are reviewed against the market annually, at a minimum.

We strive to provide a base salary and restricted stock units that are competitive with the market and compensate above market for outstanding performance. The Company uses restricted stock units to incentivize employees that contribute to the strategic goals of the company and drive company value. Performance stock units are used with our executive management team and are awarded based upon delivering established financial and strategic goals. Equity incentive compensation promotes a sense of ownership and reinforces our philosophy that all employees are valued shareholders in the long-term success of the business. In alignment with our company culture, we strive to communicate openly about the objectives of the company and the design of the compensation program. The compensation process is intended to be fair so that all employees and managers understand the goals and the outcomes of the process.

Digimarc recognizes a fair compensation program is a key component of diversity, equity, and inclusion. We are committed to administering the compensation program in a manner that is transparent, consistent, and free of discrimination. We post salary ranges for new positions and do not ask for the previous salary history of our candidates. We promote internal mobility and commit to transparency in how we level and promote our employees.

At Digimarc, we believe that employees require time to balance the many needs of their life, both at work and outside of work. Our policies for Paid Time Off (“PTO”) are designed to provide employees with time off for vacation, sick days, or other personal reasons. Full time employees at the exempt level in the U.S. are eligible for the Self-Managed PTO program. Non-exempt and part-time U.S. employees are eligible for the Granted PTO program. Under the Self-Managed PTO program, exempt employees are not subject to a specific limit on the amount of time off. 

We support our communities by providing focused outreach and support through our community outreach matching program, which matches donations made by our employees to their charities of choice.

Learning and Development

We invest resources to develop the talent needed to remain at the forefront of innovation. We have a performance management system to support continuous learning and development. Through frequent anonymous surveys, employees can voice their perceptions of the Company and their work experience, including learning and development opportunities. We have strong participation in our surveys and engage our managers to respond to areas that employees have identified as needing improvement or given low scores.

We support training and development programs for our employees through tuition reimbursement, online training programs such as Digimarc University, LinkedIn Learning, conferences, seminars, on-the-job training, and skill certifications. We also encourage and foster onsite training programs and mentoring. 

Health, Safety and Wellness

We are committed to a safe and drug-free workplace. We continually invest in programs designed to improve physical, mental, and social well-being. We provide access to a variety of innovative, flexible, and convenient health and wellness programs, for our employees and their families. We offer a wellness program through Regence Empower that currently has a 45% participation rate, which is an increase of 10% over the prior year. 

Governance and Oversight

The executive management team is entrusted with developing and advancing our key human capital strategy, which is reviewed with the Board of Directors. The Chief People Officer is charged with developing and stewarding this strategy on a company-wide basis. This incorporates a broad range of dimensions, including culture, values, labor and employee relations, leadership capabilities, performance management and total rewards. DEI are key to successfully achieving business and organizational objectives. Key processes include ongoing performance and development feedback, diversity, equity and inclusion reviews, and periodic engagement surveys that are reviewed by management and the Board of Directors. All employees have access to resources on topics regarding integrity, our code of conduct, diversity, compliance, and workplace harassment. Employees are encouraged to address any concerns through multiple channels, including anonymously whenever possible, without fear of retaliation or retribution.

Available Information

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

ITEM 1A:         RISK FACTORS

Our business, financial condition, results of operations and cash flows may be affected by a number of factors. The following risk factors identify risks of which we are aware and that we consider to be material to our business. If any of the following risks and uncertainties develops into actual events, our business, financial condition, results of operations or cash flows could be materially adversely affected. In that case, the trading price of our common stock could decline.

RISKS RELATED TO OUR BUSINESS

(1) As a purveyor of disruptive technology, if our partners and potential customers defer or delay adopting and implementing our technology, or if competitors or other market participants successfully engage in campaigns to discredit our technology, our revenues will be negatively affected.

While the Company’s business in the government market remains relatively strong and predictable, our primary source of revenue growth—the commercial market—is subject to the market forces and adoption curves common to other disruptive technologies. The commercial market is in its early stages of development. If widespread adoption of Digimarc technology in the commercial market takes longer than anticipated, we will continue to experience operating losses.

We expect companies marketing competing technologies to compete vigorously in the marketplace, and to seek to preserve their market share. To the extent these companies succeed in defending their market position, our ability to achieve profitable operations will be impeded.

With respect to anticipated sales growth and prospects for the commercial market, our two major avenues for revenue generation are direct sales and partners. Our growing direct sales force is relatively new. Most of our partners are relatively new to our products. Thus, the anticipated sources of revenue growth for the commercial market are unproven. We are executing strategies intended to make each of these means of revenue generation more effective, but we provide no assurance that we will execute these strategies successfully.

(2) Our future growth will depend to a material extent on the successful advocacy of our technology by our partners to their members and customers, and implementation of our technology in solutions propagated by our partners and provided by third parties.

Our business has long relied on the success of business partners. Our continuing success is largely dependent on a new generation of business partners supporting Digimarc technology in the commercial market. We have entered into agreements with numerous partners to propagate and support our technology, including brand deployment and pre-media service providers and consumer packaging solutions companies, all of which offer Digimarc digital watermarking services to consumer brands companies. We have also entered into agreements with numerous scanner manufacturers to enable their devices to read Digimarc watermarks. We provide no assurance that these collaborations will successfully generate revenue for our business.

If our partners are not successful in advocating and deploying our technology, we may not be able to achieve and sustain profitable operations. If other business partners who include our technology in their products cease to do so, or we fail to successfully collaborate with third parties or to obtain other partners who will do so, or these partners are unsuccessful in their efforts, expanding deployment of our technology will be adversely affected. Consequently, our ability to increase revenue could be adversely affected, and we may suffer other adverse effects to our business. In addition, if our technology does not perform according to market expectations, our future sales would suffer as customers employ alternative technologies.

(3) If leading companies in the consumer brands industries downplay, minimize or reject the use of our technology, our product deployment may be slowed, and we may be unable to achieve profitable operations.

Our business endeavors in the commercial market may be impeded or frustrated by larger, more influential companies downplaying, minimizing or rejecting the value or use of our technology. A negative position by such companies could result in obstacles for us that we would be incapable of overcoming and may block or impede the adoption of our technology. Such a development would make the achievement of our business objectives in this market difficult or impossible.

(4) We are subject to risks encountered by companies developing and relying upon new technologies, products, and services to achieve and sustain profitable operations.

Our business and prospects must be considered in light of the risks and uncertainties to which companies with new and rapidly evolving technology, products, and services are exposed. These risks include the following:

(5) A significant portion of our current and potential future revenue is subject to commercial and government contracts and the development of new markets that may involve unpredictable delays and other unexpected changes. Such volatility and uncertainty might limit our actual revenue in any given quarter or year.

We derive a significant portion of our revenue from contracts tied to development schedules or development of new markets, which could shift for months, quarters, or years as the needs of our customers and the markets in which they participate change. Government agencies and commercial customers also face budget pressures that introduce added uncertainty. Any shift in development schedules, the markets in which we or our partners participate, or customer procurement processes, which are outside our control and may not be predictable, could result in delays in revenues forecasted for any particular period, could affect the predictability of our quarterly and annual results, and might limit our actual revenue recognized in any given quarter or year, resulting in reduced and less predictable revenue, adversely affecting profitability.

We are expanding into new markets, which involve inherent risk and unpredictability. With our acquisition of EVRYTHNG and its Product Cloud offering, we are expanding into applications of the product cloud in conjunction with Digimarc watermarks and other data carriers. As we seek to expand outside our areas of historical expertise, we lack the history and insight that benefited us in fields conventionally using digital watermarking. Although we have extensive experience in the commercial application of digital watermarking, we are investing in but may not be as well-positioned for these other opportunities. Accordingly, it may be difficult for us to achieve success in other technologies we might pursue.

(6) A small number of customers account for a substantial portion of our revenue, and the loss of any large contract could materially disrupt our business.

Historically, we have derived a significant portion of our revenue from a limited number of customers. Five customers represented approximately 72% of our revenue for the year ended December 31, 2022.

Nearly half of our revenue came from our contract with the Central Banks in 2022. That contract was recently extended and now expires at the end of 2029. The customer contracts we enter into may contain termination for convenience provisions. If we were to lose any such contract for any reason, or if our relationship with these customers or the Central Banks were materially modified, our financial results would be adversely affected.

We expect to continue to depend upon a small number of customers for a significant portion of our revenue for the foreseeable future. The loss of, or decline in, orders or backlog from one or more major customers could reduce our revenue and have a material adverse effect on our financial results.

(7) The market for our products is highly competitive, and alternative technologies or larger companies that compete with us may be more successful than us in gaining market share, which would decrease our revenue and profits.

The markets in which we compete for business are intensely competitive and rapidly evolving. We expect competition to continue from both existing competitors and new market entrants. We face competition from other companies and from alternative technologies, including some of our customers, partners, and licensees. We also may face competition from unexpected sources.

Alternative technologies that may directly or indirectly compete with our products include:

In the competitive environments in which we operate, product generation, development and marketing processes relating to technology are uncertain and complex and require accurate prediction of demand as well as successful management of various risks inherent in technology development. In light of these uncertainties, it is possible that our failure to successfully accommodate future changes in technologies related to our technology could have a long-term negative effect on our growth and results of operations.

As we work to achieve market acceptance of our products and services, new developments are expected to continue, and discoveries by others, including current and potential competitors, could render our services and products uncompetitive. Moreover, because of rapid technological changes, we may be required to expend greater amounts of time and money than anticipated to develop new products and services, which in turn may require greater revenue streams from those products and services to cover developmental costs. Many of the companies that compete with us for some of our business, as well as other companies with whom we may compete in the future, are larger and may have stronger brand recognition and greater technical, financial, marketing, and political resources than we do. These attributes could enable these companies to have more success in the market than we have, either by providing better products or better pricing than we can provide. We may be unable to compete successfully against current or future participants in our market or against alternative technologies, and the competitive pressures we face may have a materially adverse effect on our financial position, results of operations or cash flows.

(8) An increase in our operations outside of the U.S. subjects us to risks additional to those to which we are exposed in our domestic operations.

We believe that revenue from sales of products and services to commercial customers outside the U.S. could represent a growing percentage of our total revenue in the future. Digimarc technology is not bounded geographically, and we believe our technology will be deployed globally. As such, certain contracts may be made and performed, in whole or in part, outside of the United States. Additionally, with the acquisition of EVRYTHNG, our workforce expanded significantly into the United Kingdom and other European countries.

If we fail to comply with the many international laws and regulations to which we may be subject, we may be subject to significant fines, penalties, or liabilities for noncompliance. These factors may result in greater risk of performance problems or of reduced profitability with respect to our international programs in these markets. In addition, if foreign customers, in particular foreign government authorities, terminate or delay the implementation of our products and services, it may be difficult for us, or we may not be able, to recover our potential losses.

(9) We depend on our key employees for our future success. If we are not able to retain, hire, or integrate these employees, we may not be able to meet our commitments.

Due to the high level of technical expertise that our industry requires, our ability to successfully develop, market, sell, license and support our products, services, and intellectual property depends to a significant degree upon the continued contributions of our key personnel in engineering, sales, marketing, operations, and legal, many of whom would be difficult to replace. We believe our future success will depend in large part upon our ability to retain our current key employees and our ability to attract, integrate, and retain new personnel in the future. It may not be practical for us to match the compensation some of our employees could be offered by other employers. In addition, we may encounter difficulties in hiring and retaining employees because of concerns related to our financial performance. These circumstances may have a negative effect on the market price of our common stock, and employees and prospective employees may factor in the uncertainties relating to our stability and the value of any equity-based incentives in their decisions regarding employment opportunities and decide to leave our employ or decline employment offers. Increasingly, prospective and current employees hold certain expectations of their employer related to DEI, community involvement, and other material ESG topics. Insufficient or slow progress on emerging ESG considerations may negatively affect our ability to attract, retain, and integrate key employees. Moreover, our business is based in large part on unique and sophisticated technology. New employees require substantial training, involving significant resources and management attention. Competition for experienced personnel in our business can be intense. If we do not succeed in attracting new, qualified personnel or in integrating, retaining, and motivating our current personnel, our growth and ability to deliver products and services that our customers require may be hampered. Although our employees generally have executed agreements containing non-competition clauses, these clauses are becoming increasingly disfavored by policymakers, and we do not assure you that a court would enforce all of the terms of these clauses or the agreements generally. If these clauses were not fully enforced, our employees could join our competitors. Although we generally attempt to control access to and distribution of our proprietary information by our employees, we do not assure you that the confidential nature of our proprietary information will be maintained in the course of such future employment. Any of these events could have a material adverse effect on our financial position, results of operations, or cash flows.

(10) We may acquire or invest in other companies or technologies in the future, which could divert management’s attention, result in additional dilution to our shareholders, increase expenses, disrupt our operations and harm our operating results.

We acquired EVRYTHNG in January 2022, and we may in the future acquire or invest in businesses, products or technologies that we believe could complement or expand our current product and service offerings, enhance our technical capabilities, expand our operations into new markets, or otherwise offer growth opportunities. The pursuit of potential acquisitions or other strategic transactions may divert the attention of management and cause us to incur various expenses related to identifying, investigating, and pursuing suitable acquisitions or strategic transactions, whether or not they are completed.

There are inherent risks in integrating and managing acquisitions. We may not be able to assimilate or integrate the acquired personnel, operations and technologies successfully or effectively manage the combined business following an acquisition. We also may not achieve the anticipated benefits from an acquired business due to a number of factors, including:

Acquisitions could also result in dilutive issuances of equity securities or the incurrence of debt, which could adversely affect our financial position. In addition, if an acquired business fails to meet our expectations, our operating results and business and financial condition may suffer.

(11) If our revenue models and pricing structures relating to products and services that are under development do not gain market acceptance, the products and services may fail to attract or retain customers and we may not be able to generate new revenue or sustain existing revenue.

Our revenues result from a combination of subscriptions for software products and software development services. We have not fully developed our revenue models for some applications in the commercial market. Because some of our products and services are not yet well-established in the marketplace, and because some of these products and services will not directly displace existing solutions, we cannot be certain that the pricing structure for these products and services will gain market acceptance or be sustainable over time, or that the marketing for these products and services will be effective.

(12) An unfavorable assessment of digital watermarking technology by members of the HolyGrail 2.0 initiative could discourage adoption of our technology.

In September 2020, AIM – European Brands Association, in conjunction with over 85 companies and organizations including many of Europe’s largest consumer brands companies, launched the HolyGrail 2.0 initiative. The purpose of the initiative is to assess whether digital watermarking technology can improve waste sorting and recycling rates for product packaging in the European Union. Digimarc is a technology provider for this ongoing assessment.

An unfavorable assessment of digital watermarking technology generally, or of Digimarc’s digital watermarking technology particularly, could cause its members to consider alternative technologies. This outcome could dissuade HolyGrail 2.0 members and others following its lead from adopting digital watermarking technology for sortation and recycling. This in turn could have a materially adverse effect on our ability to grow adoption of our technology.

(13) The technological viability and economic attractiveness of competing technologies could cause the consumer-packaged goods industry and related industries to adopt a technology other than digital watermarking to support its waste sortation and recycling initiatives.

We have identified two technologies that could be perceived by industry participants to out-perform or be available on more economically favorable terms than Digimarc’s digital watermarking technology for waste sortation and recycling: chemical tracers and artificial intelligence. Industry leaders in a position to influence the industry at large could determine that chemical tracers or artificial intelligence represent a more technologically viable or economically attractive solution, including due to the greater number of potential suppliers, which in turn could increase pricing competition and lower barriers to entry. Such a determination could result in the devaluation of digital watermarking technology’s ability to support the product packaging lifecycle and negatively affect our revenue growth prospects.

(14) COVID-19 Pandemic

The continuation of the coronavirus 2019 (“COVID-19”) pandemic around the world, and particularly in the United States and Europe, presents significant risks to the Company, not all of which we are able to fully evaluate or foresee. Some of the effects that could directly or indirectly result from the COVID-19 pandemic include, without limitation, possible impacts on the health of the Company’s management and employees, impairment of the Company’s administrative, research, and development operations, disruption in supplier and customer relationships, changes in demand for our technology and services, and the collectability of accounts receivable. Some of our projects with commercial customers and partners have been delayed as a result of the COVID-19 pandemic, thereby potentially affecting our ability to fund our business through near-term revenue growth. The scope and nature of these impacts, most of which are beyond our control, continue to evolve and the outcomes remain uncertain.

These short-term effects may change over the long-term depending on the duration and severity of the COVID-19 pandemic, the length of time before normal economic and operating conditions resume, the additional governmental actions that may be taken, the extensions of social restrictions that have been imposed to date, and many other factors that can vary materially by geography. Due to the above circumstances, the Company’s results of operations for the year ended December 31, 2022, are not necessarily indicative of the results to be expected for subsequent years.

RISKS RELATED TO INFORMATION SECURITY

(15) The security systems used in our business and our product and service offerings may be circumvented or sabotaged by third parties, which could result in the disclosure of sensitive information or private personal information or cause other business interruptions that could damage our reputation and disrupt our business.

Our business relies on computers and other information technologies, both internal and external. The protective measures that we use may not prevent all security breaches, and failure to prevent security breaches may disrupt our business, damage our reputation, and expose us to litigation and liability. A party who circumvents our security measures could misappropriate sensitive or proprietary information or materials or cause interruptions or otherwise damage our products, services, and reputation, and the property of our customers. If unintended parties obtain sensitive data and information or create bugs or viruses or otherwise sabotage the functionality of our systems, we may receive negative publicity, incur liability to our customers, or lose the confidence of our customers, any of which may cause the termination or modification of our contracts. Further, our insurance coverage may be insufficient to cover losses and liabilities that may result from these events.

In addition, we may be required to expend significant capital and other resources to protect ourselves against the threat of security breaches or to alleviate problems caused by these breaches. Any protection or remedial measures may not be available at a reasonable price or at all or may not be entirely effective if commenced.

(16) We may experience outages and disruptions of our infrastructure that may harm our business, prospects, financial condition and results of operations.

We may be subject to outages or disruptions of our infrastructure, including information technology system failures and network disruptions. We use third-party cloud service providers, which are also susceptible to outages and disruptions. System redundancy may be ineffective or inadequate, and our disaster recovery planning may not be sufficient for all eventualities.

(17) Data breaches and cyber-attacks or cyber-fraud could compromise our intellectual property or other sensitive information or result in losses.

We maintain sensitive data on our networks and the networks of our business partners and third-party providers, including proprietary and confidential information relating to our intellectual property, personnel, and business, and that of our customers and third-party providers. Companies have been increasingly subject to a wide variety of security incidents, cyber-attacks, hacking, phishing, and other attempts to gain unauthorized access or engage in fraudulent behavior. Our policies and security measures cannot guarantee security, and our information technology infrastructure, including our networks and systems, may be vulnerable to data breaches, cyber-attacks, or fraud. Third parties may attempt to penetrate or infect our network and systems with malicious software and phishing attacks in an effort to gain access to our network and systems. We may be subject to the risk of third parties falsifying invoices and similar fraud, frequently by obtaining unauthorized access to our vendors’ and business partners’ networks.

In some circumstances, we may partner with third-party providers and provide them with sensitive data. If these third parties fail to adopt or adhere to adequate data security practices, or in the event of a breach of their networks, this sensitive data may be improperly accessed, used, or disclosed. These data breaches and any unauthorized access or disclosure of sensitive data could compromise our intellectual property, expose sensitive business information, and subject us to liability.

The increase in cyber-attacks has resulted in an increased focus on cybersecurity by various government agencies. Cyber-attacks or any investigation or enforcement action related to cybersecurity could cause us to incur significant remediation costs, disrupt key business operations, and divert attention of management and key information technology resources. We may incur losses as a result of cyber-fraud, such as making unauthorized payments, irrespective of robust internal controls. Our reputation and business could be harmed, and we could be subject to third-party claims in the event of such a security breach.

RISKS RELATED TO FINANCIAL REPORTING

(18) Changes to financial accounting standards may affect our results of operations and could cause us to change our business practices.

We prepare our consolidated financial statements to conform to generally accepted accounting principles in the United States (“U.S. GAAP”). These accounting principles are subject to interpretation by the Securities and Exchange Commission and various bodies formed to interpret and create accounting rules and regulations. Changes in these rules, or guidance relating to interpretation and adoption of these rules, could have a significant effect on our financial results and could affect portions of our business differently.

(19) We were not profitable in 2022 or 2021 and may not be able to become profitable in the future, particularly if we were to lose large contracts or fail in our new market development initiatives. Sustained lack of profitability could cause us to incur asset impairment charges for long-lived assets or record valuation allowances against our deferred tax assets.

We incurred net losses in 2022 and 2021 largely due to increased levels of investments in our business to support product development and sales growth initiatives.

Becoming profitable in the future will depend upon a variety of factors, including our ability to maintain and obtain more significant partnerships like we have with the Central Banks and Walmart, and to acquire new commercial customers. Profitability will also depend on our efficiency in executing our business strategy and capitalizing on new opportunities. Various adverse developments, including the loss of large contracts or cost overruns on our existing contracts, could adversely affect our revenue, margins, and profitability.

If we continue to incur operating losses, an impairment to the carrying value of our long-lived assets, including goodwill, acquired intangible assets, patent assets and property and equipment could result. We test for impairment of our long-lived assets when a triggering event occurs that would indicate that the carrying value may not be recoverable. Our methodology for assessing impairment may require management to make judgments and assumptions regarding future cash flows. Our projections of future cash flows are largely based on historical experience, and these projections may not be achieved. Changes to these financial projections used in our impairment analysis could lead to an impairment of all or a portion of our long-lived assets. Any such impairment charge could adversely affect our results of operations and our stock price. We evaluated our long-lived assets for impairment as of December 31, 2022, and 2021 and concluded there was no impairment for either period. We do not guarantee, however, that our long-lived assets will not become impaired in the future.

We record valuation allowances on our deferred tax assets if, based on available evidence, it is more-likely-than-not that all or some portion of the value of the assets will not be realized. The determination of whether our deferred tax assets are realizable requires management to identify and weigh all available positive and negative evidence. Management considers recent financial performance, projected future taxable income, scheduled reversals of deferred tax liabilities, tax planning strategies and other evidence in assessing the realizability of our deferred tax assets. Adjustments to our deferred tax assets could adversely affect our results of operations and our stock price. In 2014, we recorded a full valuation allowance against our deferred tax assets largely due to the cumulative loss we had incurred over the previous three years, which is considered a significant piece of negative evidence in assessing the realizability of deferred tax assets. As of December 31, 2022, and 2021, we determined a valuation allowance was still appropriate given continued losses. We will not record tax benefits on any future losses until it is determined that those tax benefits will be realized.

(20) We may be adversely affected by variability of contracted arrangements.

We periodically agree to modify the terms of contractual arrangements with our customers, partners and licensees in response to changes in circumstances underlying the original contractual arrangements, and it is likely that we will do so in the future. As a result of this practice, the terms of our contractual arrangements with our customers, partners, and licensees may vary over time and, depending on the particular modification, could have a material adverse effect on our financial position, results of operations, or cash flows.

RISKS RELATED TO INTELLECTUAL PROPERTY AND LEGAL

(21) (a) We may not be able to adequately secure patent or other protection for our technologies.

Our business depends in part on securing protection for our proprietary technology. To protect our intellectual property portfolio, we rely on a combination of patent, copyright, trademark and trade secret rights, confidentiality procedures, and licensing arrangements. Although we regularly apply for patents to protect our intellectual property, there is no guarantee that we will secure patent protection for any particular technology we develop.

Changes in the U.S. and foreign patent laws, or in the interpretation of existing laws, may adversely affect our ability to secure or enforce patents. For example, the U.S. Supreme Court issued a decision in 2014 limiting patent eligibility of computer implemented inventions. The Leahy-Smith America Invents Act of 2011 (the “America Invents Act”) also codifies several changes to the U.S. patent laws, including the creation of a post-grant inter partes review process to challenge patents after they have issued. The America Invents Act allows third parties to petition the U.S. Patent and Trademark Office or comparable government authorities in other jurisdictions to review and reconsider the patentability of any of our inventions claimed in our issued patents. Any such proceeding may result in one or more of our patent claims becoming limited or being invalidated altogether. Additionally, certain foreign jurisdictions may not recognize or enforce our patents in those jurisdictions. A limitation or invalidation of our patent claims could adversely affect our financial position and our operating results.

Patents have finite lives, and our ability to continue to rely on our patents as a barrier to entry is limited to the term of the patents. Our earliest patents began expiring in July 2012, and the patents in our portfolio expire at various times between 2023 and 2040. The size and strength of our portfolio depends on the number of patents that have been granted, offset by the number of patents that expire, in any given year.

As part of our confidentiality procedures, we generally enter into non-disclosure agreements with our employees, directors, consultants, and corporate partners, and attempt to control access to and distribution of our technology, solutions, documentation, and other proprietary information. Despite these procedures, third parties could copy or otherwise obtain and make unauthorized use of our technology, solutions or other proprietary information or independently develop similar technologies, solutions, or information. The steps that we have taken to prevent misappropriation of our solutions, technology or other proprietary information may not succeed.

We do not assure you that the protection of our proprietary rights will be adequate or that our competitors will not independently develop similar technologies, duplicate our services, or design around any of our patents.

(b) We may be subject to infringement claims and other litigation, which could adversely affect our business.

As more companies engage in business activities relating to digital watermarking and IoT services, and develop corresponding intellectual property rights, it is increasingly likely that claims may arise which assert that some of our products or services infringe other parties’ intellectual property rights. These claims could subject us to costly litigation and divert management resources. These claims may require us to pay significant damages, cease production of infringing products, terminate our use of infringing technology, or develop non-infringing alternative technologies. In these circumstances, continued use of our technology may require that we acquire licenses to the intellectual property that is the subject of the alleged infringement, and we might not be able to obtain these licenses on commercially reasonable terms or at all. Our use of protected technology may result in liability that threatens our continuing operation.

Some of our contracts include indemnity and similar provisions regarding our non-infringement of third-party intellectual property rights. As deployment of our technology increases, and more companies enter our markets, the likelihood of a third-party lawsuit resulting from these provisions increases. If an infringement arose in a context governed by such a contract, we may have to expend significant sums to defend our customer, refund to our customer amounts already paid to us, pay significant damages, or cease distributing our allegedly infringing products entirely.

(22) We are periodically involved in litigation in the ordinary course of business, and an adverse resolution of such litigation may adversely affect our business, financial condition, results of operations, and cash flows.

From time to time, in our normal course of business, we are a party to various legal claims, actions and complaints. Given the uncertain nature of litigation, we are not able to estimate the amount or range of gain or loss that could result from an outcome of litigation. Litigation can be expensive, lengthy, and disruptive to normal business operations. The results of complex legal proceedings are often uncertain and difficult to predict. We could incur costs in excess of any established accruals and, to the extent available, excess liability insurance. An unfavorable outcome in any legal proceedings could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

(23) The terms and conditions of our contracts could subject us to damages, losses and other expenses if we fail to meet delivery and performance requirements.

Our service contracts typically include provisions imposing:

To the extent these provisions involve performance over extended periods of time, risks of noncompliance may increase. From time to time, we have experienced delays in system implementation, timely acceptance of deliverables, concerns regarding deliverable performance, and other contractual disputes. If we fail to meet contractual performance requirements as promised, or to successfully resolve customer disputes, we could incur liability for damages, as well as increased costs, lower margins, or compensatory obligations in addition to other losses, such as harm to our reputation. Any unexpected increases in costs to meet our contractual obligations or any other requirements necessary to address claims and damages with regard to our customer contracts could have a material adverse effect on our business and financial results.

RISKS RELATED TO OUR CAPITAL STOCK

(24) Our corporate governance documents and Oregon law may delay or prevent an acquisition of us that shareholders may consider favorable, which could decrease the value of your shares.

Our articles of incorporation, bylaws and Oregon law contain provisions that could make it more difficult for a third party to acquire us without the consent of our Board of Directors. These provisions include supermajority voting requirements for shareholders to amend our organizational documents and limitations on actions by our shareholders by written consent. In addition, our Board of Directors has the right to issue preferred stock without shareholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Oregon law restricts the ability to vote shares of stock acquired in a transaction that causes the acquiring person to control at least one-fifth, one-third or one-half of the votes entitled to be cast in the election of directors (a “control share acquisition”). Shares acquired in a control share acquisition have no voting rights except as authorized by a vote of the shareholders. Although we believe these provisions protect our shareholders from coercive or otherwise unfair takeover tactics and thereby provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our Board of Directors, these provisions apply even if the offer may be considered beneficial by some shareholders.

(25) Our common stock price may be volatile, and you could lose all or part of your investment in shares of our common stock.

The price of shares of our common stock may fluctuate as a result of changes in our operating performance or prospects and other factors. Some specific factors that may have a significant effect on the price of shares of our common stock include:

GENERAL RISK FACTORS

(26) If we are unable to respond to regulatory or industry standards effectively, or if we are unable to develop and integrate new technologies effectively, our growth and the development of our products and services could be delayed or limited.

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

(27) We may need to hire additional employees or contract labor in the future in order to take advantage of new business opportunities arising from increased demand, which could increase costs and impede our ability to achieve or sustain profitability in the short term.

We have staffed our company with the intent of accelerating our product development and sales growth initiatives while also focusing on achieving and sustaining profitability. Our current staffing levels could affect our ability to respond to increased demand for our services. In addition, to meet any increased demand and take advantage of new business opportunities in the future, we may need to increase our workforce through additional employees or contract labor. Although we believe that increasing our workforce would potentially support anticipated growth and profitability, it would increase our costs. If we experience such an increase in costs, we may not succeed in achieving or sustaining profitability in the short term.

(28) Products deploying our technology could have unknown defects or errors, which may give rise to claims against us, divert application of our resources from other purposes or increase our project implementation and support costs.

Products and services as complex as ours may contain undetected defects or errors. Furthermore, we often provide complex implementation, integration, customization, consulting, and other technical services in connection with the implementation and ongoing maintenance of our products. Despite testing, defects or errors in our products and services may occur, which could result in delays in the development and implementation of products and systems, inability to meet customer requirements or expectations in a timely manner, loss of revenue or market share, increased implementation and support costs, failure to achieve market acceptance, diversion of development resources, injury to our reputation, increased insurance costs, increased service and warranty costs, and warranty or breach of contract claims. Although we attempt to reduce the risk of losses resulting from warranty or breach of contract claims through warranty disclaimers and liability limitation clauses in our agreements when we can, these contractual provisions are sometimes rejected or limited and may not be enforceable in every instance. If a court refuses to enforce the liability limiting provisions of our contracts for any reason, or if liabilities arise that were not contractually limited or adequately covered by insurance, the expense associated with defending these actions or paying the resultant claims could be significant.

ITEM 1B:         UNRESOLVED STAFF COMMENTS

None.

ITEM 2:         PROPERTIES

In February 2022, we entered into a sublease agreement and lease extension agreement on a new facility in Beaverton, Oregon in order to move our principal corporate offices. The new facility is approximately 65,500 square feet in size. The term of the sublease and lease extension runs through September 2030. The remaining rent payments as of December 31, 2022 were $8.8 million plus operating expenses, payable in monthly installments. The first 26 months of rent payments and operating expenses are abated to cover the remaining term of our existing corporate office lease.

We continue to lease our former principal corporate office space, which is approximately 47,000 square feet in size and also located in Beaverton, Oregon. In July 2015, we entered into an amendment with the landlord of this office space to extend the lease term through March 2024. The remaining rent payments as of December 31, 2022 were $1.1 million plus operating expenses, payable in monthly installments.

We continue to lease office space in London, England under an existing lease entered into by EVRYTHNG in July 2019. The term of the lease runs through July 2023. The remaining rent payments as of December 31, 2022 were $0.1 million plus operating expenses, payable in quarterly installments.

We believe that our existing facilities are suitable and adequate for our current and foreseeable future needs. The new corporate office space will provide more collaborative working space and additional room for growth. We are marketing our previous corporate office space for sublease. See Note 12 of our Notes to Consolidated Financial Statements for further lease-related disclosures.

ITEM 3:         LEGAL PROCEEDINGS

We are subject from time to time to legal proceedings and claims arising in the ordinary course of business. At this time, we do not believe that the resolution of any such matters will have a material adverse effect on our financial position, results of operations or cash flows.

ITEM 4:         MINE SAFETY DISCLOSURES

Not applicable.

PART II

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

Our common stock began trading on the Nasdaq Stock Market LLC in October 2008 under the symbol “DMRC.”

At February 23, 2023, we had 289 shareholders of record of our common stock, as shown in the records of our transfer agent. Since many holders hold shares in “street name,” we believe that there is a significantly larger number of beneficial owners of our common stock than the number of record holders.

We withhold (purchase) shares of common stock in connection with stock option exercises and the vesting of restricted shares, restricted stock units and performance restricted stock units, to satisfy required tax withholding obligations.

The following table sets forth information regarding purchases of our equity securities during the three-month period ended December 31, 2022:

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements relating to future events or the future financial performance of Digimarc, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements. Please see the discussion regarding forward-looking statements included at the end of this discussion, under the caption “Forward-Looking Statements,” and Item 1A, “Risk Factors” for a discussion of some of the uncertainties, risks and assumptions associated with these statements.

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

All dollar amounts are in thousands except per share amounts or unless otherwise noted. The percentages within the tables included in this section may not sum to 100% due to rounding.

Overview

Digimarc Corporation is a global leader in product digitization, delivering business value across industries through unique identities and cloud-based solutions. Our technology highlights a product’s journey to provide greater visibility into all relevant product data, allowing companies to make more intelligent business decisions.

The Digimarc Illuminate Platform is a distinctive software as a service that combines Digimarc’s digital watermarks and/or Quick Response (“QR”) codes with product cloud technologies. By digitizing products using our unique digital watermarks, QR codes, and/or other digital tags, products can connect with the web and interact with consumers and digital devices. Interactions are powered by our product cloud, where we provide data and instructions based on context, and which captures a record of every interaction.

The Digimarc product suite is built on top of the Digimarc Illuminate Platform to address specific business needs. All our products are complementary to each other, providing exponential benefits when combined. By enabling customers to create digital identities for physical and digital media objects, Digimarc’s technologies provide many benefits, including:

Digimarc has also maintained a relationship with a consortium of central banks (the “Central Banks”) for over 24 years, providing trusted technology to help deter digital counterfeiting of currency. The relationship was the first commercially successful large-scale use of our technologies and protects billions of banknotes in circulation globally.

Our intellectual property contains many innovations in digital watermarking, content and object recognition, product authentication, and related fields. To protect our inventions, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contracts. We seek patent protection for our inventions to differentiate our products and technologies, mitigate infringement risks, and develop opportunities for licensing. Our broad patent portfolio covers a wide range of methods, applications, system architectures and processes. As a result, we believe we have one of the world’s most extensive patent portfolios in digital watermarking and related fields, with approximately 950 U.S. and foreign patents granted and applications pending as of December 31, 2022. The patents in our portfolio each have a life of approximately 20 years from the patent’s effective filing date.

On January 3, 2022, we completed the acquisition of EVRYTHNG. The EVRYTHNG Product Cloud allows the combined company to now offer a complete automatic identification solution to existing and prospective customers. The aggregate initial consideration for the acquisition was 772 thousand shares of common stock of the Company and warrants to purchase 231 thousand shares of common stock of the Company at the closing. We also paid $4.0 million of closing costs on behalf of the EVRYTHNG sellers. In August 2022, we issued an additional 22 thousand shares of common stock of the Company to EVRYTHNG sellers as a post-closing adjustment to the initial consideration, consisting primarily of shares that were previously held back for such adjustments. In January 2023, we issued an additional 10 thousand shares of common stock of the Company to EVRYTHNG sellers for shares previously held back to cover any indemnification obligations identified by the Company post-acquisition. The financial results of EVRYTHNG are consolidated with Digimarc’s financial results for the post-acquisition period.

COVID-19 Pandemic

The coronavirus 2019 (“COVID-19”) pandemic continues to pose significant risks to our business. The ongoing public health actions attempting to reduce the spread of COVID-19 created and may continue to create significant disruptions to consumer demand, customer and supplier relationships, sales and support processes, and general economic conditions. Accordingly, our management continuously evaluates our business operations, communicates with and monitors the actions of our customers and partners, and reviews our near-term financial performance as we manage the Company through the uncertainty related to the COVID-19 pandemic. Some of our projects with commercial customers and partners have been delayed as a result of the COVID-19 pandemic. Delays in these projects have affected the timing of closing new business.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”) requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, contingencies, goodwill, income taxes, intangible assets, marketable securities, property and equipment and revenue recognition. We base our estimates on historical experience and on other assumptions we believe to be reasonable in the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

Some of our accounting policies require higher degrees of judgment than others in their application. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Business Combinations:

We allocate purchase price consideration to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The purchase price is determined based on the fair value of the assets transferred, liabilities assumed and equity interests issued, after considering any transactions that are separate from the business combination. The fair value of equity issued as part of a business combination is determined based on the closing price of our stock on the date the acquisition closed. The excess of fair value of purchase price consideration over the fair values of the identifiable assets and liabilities is recorded as goodwill. Such fair value calculations require us to make significant estimates and assumptions, especially with respect to intangible assets and contingent liabilities. Significant estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from acquired customers, the cost to develop acquired technology, useful lives, discount rates, and customer attrition rate.

The estimates are inherently uncertain and subject to revision as additional information is obtained during the measurement period for an acquisition, which may last up to one year from the acquisition date. During the measurement period, we may record adjustments to the fair value of tangible and intangible assets acquired and liabilities assumed, with a corresponding offset to goodwill. After the conclusion of the measurement period or the final determination of the fair value of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to earnings.

Revenue recognition:

Revenue is recognized in accordance with Accounting Standards Codification (“ASC”) 606 “Revenue from Contracts with Customers” by applying the following steps:

Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligation(s) in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligation(s) in the contract.

Step 5: Recognize when (or as) the entity satisfies the performance obligation(s).

We derive our revenue primarily from software subscriptions and software development services. Applicable revenue recognition criteria are considered separately for each performance obligation as follows:

Customer arrangements may contain multiple performance obligations such as software development services, software products, and maintenance and support fees. We account for individual products and services separately if they are distinct. To determine the transaction price, we consider the terms of the contract and our customary business practices. Some contracts may contain variable consideration. In those cases, we estimate the amount of variable consideration based on the sum of probability-weighted amounts in a range of possible consideration amounts. As part of this assessment, we will evaluate whether any of the variable consideration is constrained and if it is, we will not include it in the transaction price. The consideration is allocated between distinct products and services based on their stand-alone selling prices. For items that are not sold separately, we estimate the standalone selling price based on reasonably available information, including market conditions, specific factors affecting us, and information about the customer. For distinct products and services, we typically recognize the revenue associated with these performance obligations as they are delivered to the customer. Products and services that are not capable of being distinct are combined with other products or services until a distinct performance obligation is identified.

All revenue recognized in the Consolidated Statements of Operations is considered to be revenue from contracts with customers.

Results of Operations—the Years Ended December 31, 2022 and December 31, 2021

The following tables present our consolidated statements of operations data for the periods indicated.

Summary

Total revenue increased $3.7 million, or 14%, to $30.2 million, primarily reflecting the contribution of subscription and service revenue post acquisition from EVRYTHNG and $2.6 million of subscription revenue from new commercial contracts, partially offset by $1.5 million of lower subscription revenue as a result of sunsetting our Piracy Intelligence product, $1.0 million of lower subscription revenue from the sale of 10 non-core patents in 2021, $0.5 million of lower service revenue due to the timing of HolyGrail 2.0 recycling projects, and $0.4 million of upfront subscription revenue on a two-year contract signed in 2021.

Total operating expenses increased $19.5 million, or 34%, to $77.1 million, primarily reflecting $15.8 million of EVRYTHNG operating expenses post acquisition, $6.6 million of higher compensation costs due to annual compensation adjustments and higher headcount, of which included $2.3 million of higher stock-based compensation expense, $1.4 million of severance costs incurred for organizational changes we made in the third quarter of 2022, $0.9 million of higher lease asset amortization and moving costs, $0.9 million related to a non-cash impairment charge to write-down our lease right of use assets and leasehold improvements, and $0.8 million of higher travel and conference costs, partially offset by $6.2 million of costs recognized in the second quarter of 2021 associated with the Separation Agreement we entered into with our former chief executive officer and $1.3 million of severance costs incurred for organizational changes we made in the second quarter of 2021.

Revenue

Service. Service revenue consists primarily of revenue earned from the performance of software development services and, to a lesser extent, professional services. The majority of software development contracts are structured as time and materials agreements. Revenue for services is generally recognized as the services are performed. Billing for services rendered generally occurs within one month after the services are provided. Service contracts can range from days to several years in length. Our contract with the Central Banks, which accounts for the majority of service revenue, has a contract term through December 31, 2029. The contract is subject to work plans that are reviewed and agreed upon quarterly. The contract provides for predetermined billing rates, which are adjusted annually to account for cost of living variables, and provides for the reimbursement of third party costs incurred to support the work plans.

There was no change in service revenue, primarily due to the contribution of service revenue post acquisition from EVRYTHNG offsetting $0.5 million of lower service revenue due to the timing of HolyGrail 2.0 recycling projects and less service revenue from program work with the Central Banks. 

Subscription. Subscription revenue consists primarily of revenue earned from the sale of software products and, to a lesser extent, the licensing or sale of intellectual property. The majority of subscription contracts are recurring, paid in advance and recognized over the term of the subscription, which is typically one to three years.

The increase in subscription revenue was primarily due to the contribution of subscription revenue post acquisition from EVRYTHNG and $2.6 million of subscription revenue from new commercial contracts, partially offset by $1.5 million of lower subscription revenue as a result of sunsetting our Piracy Intelligence product, $1.0 million of lower subscription revenue from the sale of 10 non-core patents in 2021, and $0.4 million of upfront subscription revenue on a two-year contract signed in 2021. 

Revenue by geography

Domestic. The increase in domestic revenue was due to the contribution of domestic revenue post acquisition from EVRYTHNG and $2.1 million of domestic revenue from new commercial contracts, partially offset by $1.1 million of lower domestic revenue as a result of sunsetting our Piracy Intelligence product.

International. The increase in international revenue primarily reflects the contribution of international revenue post acquisition from EVRYTHNG and $0.5 million of international revenue from new commercial contracts, partially offset by $1.0 million of lower subscription revenue from the sale of 10 non-core patents in 2021, $0.5 million of lower service revenue due to the timing of HolyGrail 2.0 recycling projects, $0.4 million of upfront subscription revenue on a two-year contract signed in 2021, and $0.4 million as a result of sunsetting our Piracy Intelligence product. 

Revenue by market

Government. The decrease in government revenue reflects less program work with the Central Banks, partially offset by a $0.2 million one-time license fee payment from a government supplier in 2022.

Commercial. The increase in commercial revenue was primarily due to the contribution of subscription and service revenue post acquisition from EVRYTHNG and $2.6 million of subscription revenue from new commercial contracts, partially offset by $1.5 million of lower subscription revenue as a result of sunsetting our Piracy Intelligence product, $1.0 million of lower subscription revenue from the sale of 10 non-core patents in 2021, $0.5 million of lower service revenue due to the timing of HolyGrail 2.0 recycling projects, and $0.4 million of upfront subscription revenue on a two-year contract signed in 2021. 

Cost of revenue

Service. Cost of service revenue primarily includes:

Subscription. Cost of subscription revenue primarily includes:

Amortization expense on acquired intangible assets. Amortization expense includes:

Gross profit

The decrease in total gross profit was primarily due to $4.4 million of amortization expense recognized on the developed technology intangible asset acquired in the EVRYTHNG acquisition and $0.3 million lower service gross profit due to higher costs, partially offset by the $2.3 million of gross profit contribution from higher subscription revenue.

The decrease in service gross profit margin, excluding amortization expense on acquired intangible assets, was primarily due to higher employee compensation costs.

The decrease in subscription gross profit margin, excluding amortization expense on acquired intangible assets, was primarily due to the mix of subscription revenue as some subscription products have higher or lower margins than others.

Operating expenses

Sales and marketing

Sales and marketing expenses consist primarily of:

The increase in sales and marketing expenses was primarily due to:

Research, development and engineering

Research, development and engineering expenses arise primarily from three areas that support our business model: fundamental research, platform development and product development.

Research, development and engineering expenses consist primarily of:

The increase in research, development and engineering expenses was primarily due to:

General and administrative

We incur general and administrative costs in the functional areas of finance, legal, human resources, intellectual property, executive and board of directors. Costs for facilities and information technology are also managed as part of the general and administrative processes and are allocated to this area as well as each of the areas in sales and marketing and research, development and engineering.

General and administrative expenses consist primarily of:

The decrease in general and administrative expenses was primarily due to:

Amortization expense on acquired intangible assets

Amortization expense on acquired intangible assets relates to amortization expense recognized on the customer relationships intangible asset acquired in the EVRYTHNG acquisition.

Impairment of lease right of use assets and leasehold improvements

The impairment of lease right of use assets and leasehold improvements was triggered upon moving out of our old corporate offices in both the United States and United Kingdom during 2022.

Stock-based compensation

The decrease in stock-based compensation expense was primarily due to $4.0 million of non-cash stock-based compensation expense from the acceleration of stock awards associated with the Separation Agreement we entered into with our former chief executive officer and $1.0 million from the organizational changes we made in the second quarter of 2021, partially offset by $2.5 million of stock-based compensation expense from one-time stock awards granted related to the EVRYTHNG acquisition and integration, $0.6 million of non-cash stock-based compensation expense from the acceleration of stock awards associated with organizational changes we made in the third quarter of 2022, and the impact of higher annual stock award grants reflecting higher headcount largely due to the EVRYTHNG acquisition.

We anticipate incurring an additional $16,051 in stock-based compensation expense through December 31, 2026 for awards outstanding as of December 31, 2022.

Leases

In February 2022, we entered into a sublease agreement and lease extension agreement on a new facility in Beaverton, Oregon in order to move our principal corporate offices. The new facility is approximately 65,500 square feet in size. The term of the sublease and lease extension runs through September 2030. The remaining rent payments as of December 31, 2022 were $8.8 million plus operating expenses, payable in monthly installments. The first 26 months of rent payments and operating expenses are abated to cover the remaining term of our existing corporate office lease.

We continue to lease our former principal corporate office space, which is approximately 47,000 square feet in size and also located in Beaverton, Oregon. In July 2015, we entered into an amendment with the landlord of this office space to extend the lease term through March 2024. The remaining rent payments as of December 31, 2022 were $1.1 million plus operating expenses, payable in monthly installments. 

We lease office space in London, England under an existing lease entered into by EVRYTHNG in July 2019. The term of the lease runs through July 2023. The remaining rent payments as of December 31, 2022 were $0.1 million plus operating expenses, payable in quarterly installments.

Other income, net

The decrease in other income, net was primarily due to the $5.1 million gain on the forgiveness of our Paycheck Protection Program (“PPP”) loan in September 2021, partially offset by a $1.3 million estimated refundable research and development tax credit to be filed for in the United Kingdom for the 2022 tax year and by $0.7 million higher interest income due to higher interest rates on investments.

Provision for income taxes

The provision for income taxes reflects current taxes, deferred taxes and withholding taxes in certain foreign jurisdictions.

For the year ended December 31, 2022, our effective tax rate was 0%, reflecting a valuation allowance recorded against the majority of our deferred tax assets. The valuation allowance against deferred tax assets as of December 31, 2022 was $83,000, an increase of $18,727 from $64,273 as of December 31, 2021. We continually assess the applicability of a valuation allowance against our deferred tax assets. Based upon the positive and negative evidence available as of December 31, 2022, and largely due to the cumulative loss incurred by us over the preceding three years, which is considered a significant piece of negative evidence when assessing the realizability of deferred tax assets, a valuation allowance is recorded against our deferred tax assets. We will not record tax benefits on any future losses until it is determined that those tax benefits will be realized. All future reversals of the valuation allowance would result in a tax benefit in the period recognized.

For the year ended December 31, 2021, our effective tax rate was 0%, reflecting a full valuation allowance recorded against our deferred tax assets. The valuation allowance against deferred tax assets as of December 31, 2021 was $64,273, an increase of $8,634 from $55,639 as of December 31, 2020.

Non-GAAP Financial Measures

The following discussion and analysis include both financial measures in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) as well as non-GAAP financial measures. Generally, a non-GAAP financial measure is a numerical measure of a company’s performance, financial position or cash flows that excludes amounts that are not normally excluded in the most directly comparable measure calculated and presented in accordance with GAAP. Non-GAAP financial measures should be viewed as supplemental to, and should not be considered as alternatives to, GAAP financial measures. Non-GAAP financial measures may not be indicative of the historical operating results of the Company nor are they intended to be predictive of potential future results. Investors should not consider non-GAAP financial measures in isolation or as substitutes for performance measures calculated in accordance with GAAP. Our management uses and relies on Non-GAAP gross profit, Non-GAAP gross profit margin, Non-GAAP operating expenses, Non-GAAP net loss, and Non-GAAP loss per common share (diluted), which are all non-GAAP financial measures. We believe that both management and shareholders benefit from referring to the following non-GAAP financial measures in planning, forecasting and analyzing future periods.

Our management uses these non-GAAP financial measures in evaluating its financial and operational decision making and as a means to evaluate period-to-period comparisons. Our management recognizes that the non-GAAP financial measures have inherent limitations because of the described excluded items.

We define Non-GAAP gross profit, Non-GAAP gross profit margin, Non-GAAP operating expenses, Non-GAAP net loss, and Non-GAAP loss per common share (diluted) excluding the adjustments in the table below. These non-GAAP financial measures are an important measure of our operating performance because they allow management, investors and analysts to evaluate and assess our core operating results from period-to-period after removing non-cash and non-recurring activities that can affect comparability.

We have included a reconciliation of our financial measures calculated in accordance with GAAP to the most comparable non-GAAP financial measures. We believe that providing the non-GAAP financial measures, together with the reconciliation to GAAP, helps investors make comparisons between us and other companies. In making any comparisons to other companies, investors need to be aware that companies use different non-GAAP measures to evaluate their financial performance. Investors should pay close attention to the specific definition being used and to the reconciliation between such measures and the corresponding GAAP measures provided by each company under applicable SEC rules.

The following table presents a reconciliation of Non-GAAP gross profit, Non-GAAP gross profit margin, Non-GAAP operating expenses, Non-GAAP net loss, and Non-GAAP loss per common share (diluted) for the twelve months ended December 31, 2022 and 2021:

Non-GAAP gross profit increased by $2.2 million primarily due to higher gross profit contribution from higher subscription revenue.

Non-GAAP gross profit margin changed slightly reflecting differences in the mix of subscription revenue, as some subscription products have higher or lower margins than others, and the impact of higher services costs.

Non-GAAP operating expenses increased by $18.6 million primarily as a result of $13.1 million of EVRYTHNG Non-GAAP operating expenses post acquisition, after excluding the EVRYTHNG portion of the adjustments above for amortization expense on acquired intangible assets of $1.1 million and stock-based compensation of $1.5 million. Excluding the impact of EVRYTHNG, Non-GAAP operating expenses increased $5.5 million, primarily reflecting $4.3 million of higher cash compensation costs due to annual compensation adjustments and higher headcount, $0.8 million of cash severance costs incurred for organizational changes we made in the third quarter of 2022, $0.8 million of higher travel and conference costs, $0.6 million of higher facilities and move related costs, $0.3 million of higher legal, accounting and tax costs not included in acquisition-related expenses, $0.3 million of operating taxes, $0.2 million of higher insurance costs, $0.2 million of higher hardware and software costs, and $0.3 million of net other expenses, partially offset by $2.2 million of cash costs associated with the Separation Agreement we entered into with our former chief executive officer, and $0.3 million of cash severance costs incurred for organizational changes we made in the second quarter of 2021.

Liquidity and Capital Resources

The $10,924 increase in cash, cash equivalents and marketable securities at December 31, 2022, from December 31, 2021, resulted primarily from:

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, marketable securities, and trade accounts receivable. We place our cash and cash equivalents with major banks and financial institutions and at times deposits may exceed insured limits. Marketable securities include commercial paper, corporate notes, federal agency notes and pre-refunded municipals. Our investment policy requires our portfolio to be invested to ensure that the greater of $3,000 or 7% of the invested funds will be available within 30 days’ notice.

Other than cash used for operating needs, which may include short-term marketable securities, our investment policy limits our credit exposure to any one financial institution or type of financial instrument by limiting the maximum of 5% of our cash and cash equivalents and marketable securities or $1,000, whichever is greater, to be invested in any one issuer except for the U.S. government, U.S. federal agencies and U.S.-backed securities, which have no limits, at the time of purchase. Our investment policy also limits our credit exposure by limiting to a maximum of 40% of our cash and cash equivalents and marketable securities, or $15,000, whichever is greater, to be invested in any one industry category, (e.g., financial or energy industries), at the time of purchase. As a result, we believe our credit risk associated with cash and investments to be minimal. A decline in the market value of any security that is deemed to be other-than-temporary is charged to earnings. To determine whether an impairment is other-than-temporary, we consider whether we have the ability and intent to hold the investment until a market price recovery and evidence indicating that the cost of the investment is recoverable outweighs evidence to the contrary. There have been no other-than-temporary impairments identified or recorded by us in the years ended December 31, 2022 and 2021.

Cash flows from operating activities

Cash flows used in operating activities in 2022 compared to 2021 increased by $18,292, primarily as a result of a larger net loss and changes in operating assets and liabilities, partially offset by an increase in non-cash items included in net loss. Non-cash items increased primarily due to $5,503 of higher amortization of acquired intangible assets, the $5,032 gain on forgiveness of our PPP loan in 2021, and the $915 impairment on lease right of use assets and leasehold improvements, partially offset by $647 lower stock-based compensation. Changes in operating assets and liabilities primarily reflect changes in the timing and amounts of vendor payments reflected in accounts payable.

Cash flows from investing activities

Cash flows provided by investing activities in 2022 compared to 2021 decreased by $22,224, from $25,981 to $3,757, primarily as a result of $20,817 lower net maturities of marketable securities and $3,512 of net cash paid for the acquisition of EVRYTHNG, partially offset by a $2,000 related-party loan made to EVRYTHNG in 2021.

Cash flows from financing activities

Cash flows from financing activities in 2022 compared to 2021 improved by $66,271, from $5,772 of cash used to $60,499 of cash provided, primarily as a result of net proceeds of $62,890 from the issuance of stock during 2022 and $3,416 of lower repurchases of shares of common stock in satisfaction of required withholding tax liability on employee stock awards.

Future cash expectations

Under the rules of ASC Subtopic 205-40 “Presentation of Financial Statements-Going Concern” (“ASC 205-40”), companies are required to evaluate whether conditions and/or events raise substantial doubt about their ability to meet their future financial obligations as they become due within one year after the date that the financial statements are issued. This evaluation takes into account a company’s current available cash and projected cash needs over the one-year evaluation period but may not consider things beyond its control. We have incurred operating losses and negative cash flows from operating activities during the last several years, and depending on future results, may continue to incur such losses and negative cash flows in the future. We believe our cash and marketable securities of $52,542 at December 31, 2022, will satisfy our projected working capital and capital expenditure requirements for at least the next 12 months. We continuously review our liquidity and anticipated capital requirements in light of the uncertainty created by the COVID-19 pandemic.

Registered Direct Offering

On April 5, 2022, we entered into purchase agreements with certain investors providing for the issuance and sale by us of 2,250 common shares in a registered direct offering. The common shares were offered at a price of $25.90 per share, and the gross cash proceeds to us were $58,275. We incurred $55 of legal costs related to the offering. The closing of the registered direct offering occurred on April 7, 2022.

Equity Distribution Agreement

On May 16, 2019, we entered into an Equity Distribution Agreement, whereby we may sell from time to time through Wells Fargo Securities, LLC, as our sales agent, our common stock having an aggregate offering price of up to $30,000. Wells Fargo Securities, LLC will receive from us a commission equal to 2.50% of the gross sales price per share of common stock for shares having an aggregate offering price of up to $10,000, and a commission of 2.25% of the gross sales price per share of common stock thereafter, for shares sold under the Equity Distribution Agreement. During 2022, we sold 222 shares at an average price of $22.42 under this Equity Distribution Agreement, totaling $4,984 of cash proceeds, less $112 of commissions and $202 of stock issuance costs. We did not sell any shares under this Equity Distribution Agreement during 2021. As of December 31, 2022, we have sold a total of 720 shares at an average price of $38.97 under this Equity Distribution Agreement, totaling $28,052 of cash proceeds. As of December 31, 2022, $1,948 remains available for future issuance under the Equity Distribution Agreement.

Shelf Registration

On June 5, 2020, we filed a new shelf registration statement on Form S-3 that included $49,265 of unsold securities from our prior shelf registration statement filed on May 26, 2017 that expired in June 2020. Under the new shelf registration statement, we may sell securities in one or more offerings up to $100,000. As of December 31, 2022, $34,633 remains available under the shelf registration. The new shelf registration statement will expire in July 2023.

We may sell shares under the shelf registration and/or use similar or other financing means to raise working capital in the future, if necessary, to support continued investment in our growth initiatives. We may also raise capital in the future to fund acquisitions and/or investments in complementary businesses, technologies or product lines. If it becomes necessary to obtain additional financing, we may not be able to do so, or if these funds are available, they may not be available on satisfactory terms. These factors may inhibit our near-term ability to obtain financing.

Forward-Looking Statements

This Annual Report on Form 10-K includes “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Words such as “may,” “might,” “plan,” “should,” “could,” “expect,” “anticipate,” “intend,” “believe,” “project,” “forecast,” “estimate,” “continue,” and variations of such terms or similar expressions are intended to identify such forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements, or other statements made by us, are made based on our expectations and beliefs concerning future events impacting us, and are subject to uncertainties and factors (including those specified below), which are difficult to predict and, in many instances, are beyond our control. As a result, our actual results could differ materially from those expressed in or implied by any such forward-looking statements, and investors are cautioned not to place undue reliance on such statements. We believe that the following factors, among others (including those described in Item 1A. “Risk Factors”), could affect our future performance and the liquidity and value of our securities and cause our actual results to differ materially from those expressed or implied by forward-looking statements made by us. Forward-looking statements include but are not limited to statements relating to:

We believe that the risk factors specified above and the risk factors contained in Item 1A, “Risk Factors,” among others, could affect our future performance and the liquidity and value of our securities and cause our actual results to differ materially from those expressed or implied by forward-looking statements made by us or on our behalf. Investors should understand that it is not possible to predict or identify all risk factors and that there may be other factors that may cause our actual results to differ materially from the forward-looking statements. All forward-looking statements made by us or by persons acting on our behalf apply only as of the date of this Annual Report on Form 10-K. We do not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of the filing of this Annual Report on Form 10-K.

ITEM 8:         FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Our Consolidated Financial Statements and the accompanying Notes that are filed as part of this Annual Report are listed under Part III, Item 15, Exhibits and Financial Statement Schedules and are set forth beginning on page F-1 immediately following the signature page of this Form 10-K.

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

None

ITEM 9A:         CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, have carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered by this Form 10-K. These disclosure controls and procedures are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (ii) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Based on our evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures, as of the end of the period covered by this Form 10-K, were effective.

Management’s Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP.

Because of inherent limitations, any control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Management is committed to continue monitoring our internal controls over financial reporting and will modify or implement additional controls and procedures that may be required to ensure the ongoing integrity of our consolidated financial statements.

With the participation of our Chief Executive Officer and Chief Financial Officer, management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, (“COSO”). Based on this evaluation, management has concluded that internal control over financial reporting was effective as of the end of the period covered by this Form 10-K based on those criteria.

Changes in Internal Control Over Financial Reporting

       We acquired EVRYTHNG on January 3, 2022, and are currently integrating EVRYTHNG into our operations, compliance programs and internal control processes. EVRYTHNG constituted approximately 6% of our current assets and approximately 17% of our net sales in the year ended December 31, 2022. As permitted under existing SEC interpretive guidance for newly acquired businesses, our management excluded EVRYTHNG from its assessment of the effectiveness of our internal control over financial reporting as of December 31, 2022.

There was no change in our internal control over financial reporting that occurred during the quarter ended December 31, 2022, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

ITEM 9B:         OTHER INFORMATION 

On February 27, 2023, the Company entered into an amendment (the “Amendment”) to its employment agreement dated April 12, 2021 (the “2021 Agreement”), with Riley McCormack, the Company’s President and Chief Executive Officer. The Amendment reflects that Mr. McCormack’s compensation is set annually by the Compensation and Talent Management Committee (the “Committee”) of the Company’s Board of Directors (the “Board”).  The 2021 Agreement established Mr. McCormack’s compensation for 2021.  Since the 2021 Agreement, the Committee updated Mr. McCormack’s compensation for 2022 and 2023.  Mr. McCormack’s 2022 compensation will be reported in the Company’s proxy statement for its 2023 annual meeting of shareholders.  For 2023, Mr. McCormack’s compensation plan is comprised of an annual base salary of $375,000 in cash, $300,000 in cash bonus opportunity in the Company’s executive one-year, short term incentive plan, and $1,050,000 in long term equity incentive, in 3-year cliff-vested performance-based restricted stock units.  Both the short term and long term incentives are subject to performance goals.  Mr. McCormack’s compensation may be increased or decreased in the future by the Committee or Board, in their sole discretion. Except as described in the foregoing, Mr. McCormack’s existing employment agreement remains in effect pursuant to its existing terms and conditions. A copy of the Agreement Amendment is filed herewith as Exhibit 10.25.

ITEM 9C:         DISCLOSURE REGARDING FOREIGN JURISDICTIONS THAT PREVENT INSPECTIONS

Not applicable

PART III

Certain information required by Part III of this Annual Report on Form 10-K is incorporated herein by reference to the Proxy Statement for our 2023 annual meeting of shareholders, which we intend to file no later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.

ITEM 10:         DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Code of Ethics

We have adopted a Code of Business Conduct that applies to our principal executive officer, principal financial officer and controller, as well as a Code of Ethics for Financial Professionals that applies to our principal financial officer and controller. We have made these codes available in the Corporate Governance section of our website at http://www.digimarc.com/about/company/corporate-governance. If we waive, or implicitly waive, any material provision of the codes, or substantively amend the codes, we will disclose that fact on our website within four business days.

The other information required by this item is incorporated herein by reference to the information in the Proxy Statement, which we intend to file with the SEC no later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K under the captions “Election of Directors,” “Management,” “Report of the Governance, Nominating, and Sustainability Committee of the Board of Directors—Audit Committee,” and “Other Matters—Delinquent Section 16(a) Reports.”

ITEM 11:         EXECUTIVE COMPENSATION

The information required by this item is incorporated herein by reference to the information in the Proxy Statement, which we intend to file with the SEC no later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, under the captions “Director Compensation” and “Executive Compensation.”

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

The information required by this item is incorporated herein by reference to the information in the Proxy Statement, which we intend to file with the SEC no later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information.”

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

The information required by this item is incorporated herein by reference to the information in the Proxy Statement, which we intend to file with the SEC no later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K under the captions “Determinations of Board Member Independence” and “Related Party Transactions.”

ITEM 14:         PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item is incorporated herein by reference to the information in the Proxy Statement, which we intend to file with the SEC no later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, under the captions “Audit and Other Fees Paid to KPMG LLP” and “Approval of Audit Fees and Pre-Approval Policy.”

ITEM 15:         EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)(1) Financial Statements

The following documents are filed as part of this Annual Report on Form 10-K:

Consolidated Balance Sheets as of December 31, 2022 and 2021

Consolidated Statements of Operations and Comprehensive Loss for the years ended December 31, 2022 and 2021

Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2022 and 2021

Consolidated Statements of Cash Flows for the years ended December 31, 2022 and 2021

(a)(2) Financial Statement Schedules

All schedules have been omitted since they are not required or are not applicable or the required information is shown in the consolidated financial statements or related notes.

(a)(3) Exhibits

EXHIBIT INDEX

The agreements included or incorporated by reference as exhibits to this report may contain representations and warranties by each of the parties to the applicable agreement. These representations and warranties have been made solely for the benefit of the other party or parties to the applicable agreement and:

Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. Additional information about Digimarc may be found elsewhere in this Annual Report on Form 10-K and in Digimarc’s other public filings, which are available without charge through the SEC’s website at http://www.sec.gov.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors
Digimarc Corporation:

Opinion on the Consolidated Financial Statements

We have audited the accompanying consolidated balance sheets of Digimarc Corporation and subsidiaries (the Company) as of December 31, 2022 and 2021, the related consolidated statements of operations and comprehensive loss, shareholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2022, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2022 and 2021, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2022, in conformity with U.S. generally accepted accounting principles.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

Critical Audit Matters

The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.

Revenue recognition for new contracts

As discussed in Note 2 to the consolidated financial statements, the Company recorded $30,197 thousand of total revenue for the year ended December 31, 2022, of which $14,978 thousand was service revenue and $15,219 thousand was subscription revenue. Customer arrangements may contain multiple performance obligations such as software development services, software products, and maintenance and support fees. The Company accounts for individual products and services separately if they are distinct. The Company derives its revenue primarily from software development services and software subscriptions with a wide range of service and software offerings.

We identified the evaluation of the Company’s revenue recognition related to new contracts entered during the year as a critical audit matter. Challenging auditor judgment was required to evaluate the potential impact of specific contract terms on revenue recognition due to the unique nature of new revenue contracts within each service and software offering. 

The following are the primary procedures we performed to address this critical audit matter. We evaluated the design of certain internal controls related to the Company’s revenue recognition process, including a control over the Company’s assessment of the contract terms and applicable revenue recognition requirements for new contracts. For a selection of new contracts, we read the contract and evaluated the Company’s assessment of the contract terms and revenue recognition. For certain contracts, we confirmed the relevant contract terms directly with the Company’s customers and compared them to the terms utilized by the Company to record revenue. We assessed the recorded revenue by selecting a sample of transactions and comparing the revenue recognized for consistency with the terms of the underlying documentation, including contracts with customers. For a selection of revenue contracts entered during the year, we interviewed personnel outside of the accounting function to consider other relevant facts and circumstances and their impact on revenue recognition.

Acquisition of EVRYTHNG – Valuation of certain acquired intangible assets

As discussed in Note 8 to the consolidated financial statements, the Company acquired all outstanding shares of EVRYTHNG’s share capital for total consideration of $37,934 thousand on January 3, 2022. As a result of the transaction, the Company acquired certain intangible assets, including developed technology and customer relationships. Management valued the developed technology by applying the cost method and valued the customer relationships using an income approach. The significant assumption used by management in valuing the developed technology was the development costs.  The significant assumptions used by management in valuing the customer relationships were the future expected cash flows from customer contracts, customer attrition rate, and discount rate. The acquisition date fair value of the developed technology and customer relationships was $24,170 thousand and $11,550 thousand, respectively.

We identified the assessment of the fair value of the developed technology and customer relationships acquired in the EVRYTHNG acquisition as a critical audit matter. Complex auditor judgment was required to assess the number of hours in the development costs estimate used to value the developed technology and the future revenue from customer contracts, customer attrition rate, and discount rate used to value the customer relationships.  Specifically, these significant assumptions were sensitive to changes. Additionally, evaluating the customer attrition rate and discount rate required valuation professionals with specialized skills and knowledge.

The following are the primary procedures we performed to address this critical audit matter. We evaluated the design of certain internal controls over the Company’s acquisition-date valuation process, including controls over the development of the significant assumptions noted above. We evaluated the number of hours in the cost estimate used to value the developed technology by comparing it to actual hours for comparable projects completed by the Company. We assessed the future revenue used to value the customer relationships by comparing it to market data for comparable peer companies and industry publications. We evaluated the Company’s ability to estimate future revenue by comparing estimated future revenue to actual results subsequent to the date of acquisition. In addition, we involved valuation professionals with specialized skills and knowledge, who assisted in evaluating the Company’s customer attrition rate and discount rate assumptions by comparing them against publicly available market data for comparable peer companies. 

/s/ KPMG LLP

We have served as the Company’s auditor since 2010.

Portland, Oregon

March 2, 2023

DIGIMARC CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)