ITEM 1:    BUSINESS

Overview

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

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Foster large-scale adoption of media identification and management solutions licensed under Digimarc's intellectual property; and



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

        We issue more than 60 million identification documents ("IDs") annually and are the leading supplier of government-issued citizen IDs in North America, including supplying systems that produce more than two-thirds of all driver licenses issued in the United States. We are also a pioneer and leading owner of intellectual property in a signal processing technology innovation known as "digital watermarking" which allows imperceptible digital information to be embedded in all forms of digitally designed, produced or distributed media content, including personal identification documents, financial instruments, photographs, movies, music, television, and product packages. The embedded data within various types of media content can be detected and read by software or hardware detectors in personal computers and other digital devices.

        Digital watermarking is a strategic component of nearly all of our product offerings. We provide media identification and management solutions based on this and related technologies directly and

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through our licensees. Digital watermarking has already proven to be a powerful element of document security, giving rise to our long-term relationship with a consortium of Central Banks and many leading companies in the information technology industry. We are working to achieve a similar success in secure identity management systems. We anticipate that by the middle of 2008 more than one out of two driver licenses being produced in the U.S. will carry digital watermarks as a means to provide cross-jurisdictional machine authentication. In addition, Digimarc and its licensees have successfully propagated digital watermarking in music, movies, television broadcasts, images and printed materials. Digital watermarks have been used in these applications to provide improved media rights and asset management, reduce piracy and counterfeiting losses, improve marketing programs, permit more efficient and effective distribution of valuable media content, and enhance consumer experiences.

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

        Our ID systems revenue is primarily generated pursuant to long-term contracts with government ID issuers—primarily U.S. State government agencies responsible for driver license issuance and national governments of a number of countries. These customers rely on our systems design, integration and materials science expertise, and proprietary technologies such as digital watermarking, to implement issuance systems and processes that improve the security of identity documents and banknotes.

        Our media identification and management revenue is generated through commercial and government applications of our digital watermarking and related media identification and management technologies, primarily from patent and technology license fees paid by business partners and our contracts with a consortium of Central Banks and with The Nielsen Company. Our licensing program, which is a core part of our media identification and management business, is built upon our extensive patent portfolio, which contains 360 issued U.S. patents, and numerous foreign patents, as of December 31, 2007. Private sector media and entertainment industry customers use secure media identification and management solutions from our business partners and us to identify, track, manage and protect content as it is distributed and consumed—either digitally or physically—and to enable new consumer applications to improve access to networks and information from personal computers and mobile devices. We expect that patent and technology licensing will continue to contribute most of our revenues from non-government customers for the foreseeable future.

        Financial information about geographic areas is incorporated by reference to Note 4 of our consolidated financial statements.

History

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

        Banknote counterfeit deterrence was the first commercially successful use of digital watermarking. Digimarc, in cooperation with an international consortium of Central Banks, developed a system to deter the use of digital technologies in the unauthorized reproduction of banknotes. More recently, innovations based on our digital watermarking technology and experience have been leveraged to create new products to deter counterfeiting and tampering of driver licenses and other government-issued

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secure credentials. In parallel, Digimarc's business partners, under patent or technology license from Digimarc, are delivering digital watermarking solutions to track and monitor the distribution of music, images, television and movies to consumers.

        Following the events of September 11, 2001, we realized that our expertise in security printing and digital imaging technologies and systems placed us in a position to address both the digital threats to identity management credentials and the environment and concerns of the issuers of these credentials. In late 2001, we acquired the Large Government Programs business unit of Polaroid Corporation ("Polaroid"). The primary focus of this business is the production of driver licenses and other IDs issued by government agencies. The acquired assets included all relevant software, hardware, services, materials science and distribution assets of Polaroid's government-issued photo identification business.

        In this strategic acquisition, we saw a unique opportunity to assist in efforts to deter identity theft and fraud and thereby enhance transportation safety and Homeland Security through the combination of a new layer of security using our digital watermarking technology and Polaroid's expertise in secure ID solutions. Based on Polaroid's history with secured ID issuance systems, the resulting business has over 50 years of experience in the delivery and operation of secure ID issuance systems, has produced more than 2 billion issued IDs, and has guided customers through numerous major upgrades and technology migrations in ID security. We are the leader in deploying new solutions to meet driver license security and related service challenges. This includes being first to:

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produce driver licenses with digital portraits,



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



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



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produce driver licenses in secure, networked central issuance factories,



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offer driver license renewal by Internet,



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offer comprehensive and modular secure driver license solutions to address recently enacted Federal legislation, such as the Federal legislation passed in May 2005 known as the REAL ID Act (the "REAL ID Act"). The Real ID Act imposes certain Federal requirements for State-issued driver licenses. These requirements are intended to increase the security of driver licenses, require validation of applicants prior to issuance, and mandate certain changes in business processes relating to security and the sharing and storage of data, and



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offer an Enhanced Driver License (EDL) solution in response to a recently enacted Federal law called the Western Hemisphere Travel Initiative, which imposes new security requirements on North American land and sea border crossings. We supplied production of the first high security licenses in a pilot program in Washington State.

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

Customers and Business Partners

        Our ID systems revenue is derived from long-term contracts with government ID issuers, primarily State driver license issuers and governments of various foreign countries and provinces.

        Our media identification and management revenue is generated through commercial and government applications of our digital watermarking, including a long-term contract with a consortium

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of Central Banks. Our contract with the Central Bank consortium is in its tenth year in 2008. The contract is in the final year of a 5-year extension and provides for two additional 3-year extensions. The Central Bank consortium has agreed to the first 3-year extension. Other digital watermarking-related revenue is generated primarily from patent and technology license fees paid by business partners providing media identification and management solutions to movie studios and music labels, television broadcasters, creative professionals and other customers around the world. Patent and technology licensing is expected to continue to contribute most of the revenues from non-government customers for the foreseeable future.

        We must comply with and are affected by laws and regulations relating to the award, administration and performance of government contracts. Government contract laws and regulations affect how we do business with our customers and, in some instances, impose added costs on our business.

        In some instances, these laws and regulations impose terms or rights that are more favorable to the government than those typically available to commercial parties in negotiated transactions. For example, the government agency may terminate any of our contracts and, in general, subcontracts, at its convenience, as well as for default based on performance. Upon termination for convenience of a fixed-price type contract, we normally are entitled to receive the purchase price for delivered items, reimbursement for allowable costs for work-in-process and an allowance for profit on the contract or adjustment for loss if completion of performance would have resulted in a loss. Upon termination for convenience of a cost reimbursement contract, we normally are entitled to reimbursement of allowable costs plus a portion of the fee.

        In addition, our government contracts typically span one or more base years and multiple option years. The government agency generally has the right to not exercise option periods and may not exercise an option period if the agency is not satisfied with our performance on the contract.

Products and Services

        We provide secure ID solutions to government agencies and media identification and management solutions to commercial entities and government customers.

Secure ID Systems

        We issue more than 60 million IDs annually and are the leading supplier of government-issued citizen IDs in North America, producing more than two-thirds of all driver licenses issued in the U.S. We have also provided secure ID solutions to approximately 25 foreign governments.

        In North America, we generate most of our revenue through the issuance of State driver licenses and other IDs on a fixed price per credential issued basis. In North America, we are generally a prime contractor, providing full issuance systems to Federal, State, and provincial departments of motor vehicles or other government issuing authorities. These systems typically include hardware (including specialized cameras, printers, personal computers and servers), software, consumable supplies (such as ribbons, blank or preprinted card materials and laminated and related consumables) and ongoing support services. These systems may also involve software and/or hardware development, integration services, and implementation services. When we provide a full issuance system to a customer, we generally retain title to all equipment, software and consumables associated with the system and are responsible for maintaining the system over the contractual period.

        Our strategy regarding the anticipated opportunities relating to the REAL ID Act is to provide solutions that address the requirements of the REAL ID Act: identity verification; document scanning and archiving; individual background checking; data and image sharing; and migration to and production of REAL ID Act compliant driver license documents. These solutions are available to

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customers as upgrades or complete issuance systems. Digimarc is currently offering the States program management assistance to safely migrate to REAL ID Act compliance.

        In markets outside of North America, we generally provide driver license, national identification and voter identification systems, services, and components in partnership with local card producers, security printers, system integrators and others. In these markets, we may serve as prime contractor or sub-contractor, depending on the circumstances. As a sub-contractor, we generally are responsible for delivering hardware, software, or consumables, and some degree of integration services to the prime contractor; whereas as a prime contractor, we are responsible for integrating all components of the system to the customer's specifications.

        Outside of North America, our revenues are typically generated from sales of equipment, software and/or consumables to government agencies or their prime contractors. These sales may occur at irregular intervals, can carry relatively low margins and cause variations in quarterly revenue and gross profit trends. We enter into low margin contracts and transactions from time to time to maintain market presence and build relationships with customers and business partners, and often transition to more profitable digital technologies over time. Due to the nature of such international programs and customers, the timing of these sales is less predictable than our service revenues provided by domestic customers and, consequently, international sales can occur unevenly during the course of a year.

Media Identification and Management

        We license our technology and patents and otherwise foster development of the market for media identification and management solutions through our participation in industry activities and events, including our digital watermarking technologies, for commercial as well as governmental uses. Our licenses primarily involve use of our technology and patents in the media and entertainment area, but also support industrial and commercial enterprise applications as well as applications supporting Federal programs. We also have a multi-year contract with an international consortium of Central Banks in which we have been, since 1997, developing, deploying, supporting and continuing to enhance a system to deter digital counterfeiting of currency using personal computers and digital reprographics.

        Commercial customers use secure media solutions from our business partners and us to identify, track, manage and protect content as it is distributed and consumed—either digitally or physically—and to enable new consumer applications to access networks and information from personal computers and mobile devices. Many movie studios, record labels, broadcasters, creative professionals and other customers rely on digital watermarking as a cost-effective means to:

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



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protect entertainment content from copyright infringement;



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



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



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enhance information access, search and marketing capabilities related to media content; and



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enable fair and legitimate use of content by consumers.

        Our business partners and customers include AquaMobile, Cinea, Inc., a subsidiary of Dolby Laboratories, Inc., GCS Research LLC, MediaGrid, Microsoft Corporation, Mobile Data Systems, Inc., The Nielsen Company, Royal Philips, Signum Technologies Limited, Thomson Multimedia, S.A., USA Video, Verance Corporation, Verimatrix, Inc. and VCP (an affiliate of VEIL Interactive Technologies). Although each partner or customer addresses particular needs, as a whole these partners and customers are propagating digital watermarking in music, movies, images and television as a means to improve

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media rights and asset management, reduce piracy losses, improve marketing programs, and provide more efficient and effective distribution of valuable media content.

Technology and Intellectual Property

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

        Most of our patents relate to various methods for embedding digital information in video, audio, and images, whether the content is rendered in analog or digital formats. The digital information is generally embedded by making subtle modifications to the fundamental elements of the content itself, generally at a signal processing level. The changes necessary to embed this information are so subtle that they are generally not noticeable by people during normal use. Because the message is carried by the content itself, it is file-format independent. The message generally survives most normal compression, edits, rotation, scaling, re-sampling, file-format transformations, copying, scanning and printing. Our media identification and management patent portfolio includes not only digital watermarking but innovations in pattern recognition (sometimes referred to as "fingerprinting") and digital rights management (DRM) applications.

        To protect our significant efforts in creating these technologies, we have implemented an extensive intellectual property protection program that relies on a combination of patent, copyright, trademark and trade secret laws, and nondisclosure agreements and other contracts. As a result, we believe we have one of the world's most extensive patent portfolios in the field of digital watermarking, with 360 U.S. and over 80 foreign issued patents and more than 500 U.S. and foreign patent applications on file as of December 31, 2007 in the areas of digital watermarking, secure identity management and related technologies. Separately, we own registered trademarks in both the U.S. and other countries and have applied for other trademarks. We continue to develop and broaden our portfolio of patented technologies, including digital watermarking and related applications and systems, and other technologies related to secure ID systems. For ID systems-related technologies, the focus of patent development has been in the areas of imaging and printing systems, card architecture and materials, and security features. Some patents relate to future product offerings or related technologies like smart cards, laser engraving and alternative card systems.

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

Markets

Identification

        We believe that the U.S. driver license market will continue to grow as a result of (i) broadening use of the driver license as a secure credential beyond its traditional role as evidence of competence to drive a motor vehicle; (ii) technological innovation; (iii) desire among issuers to improve security and efficiency; and (iv) new governmental regulations such as the REAL ID Act. We anticipate that these regulations may result in substantial system upgrades by our customers. Final rules under the REAL ID Act were published on January 11, 2008. According to a February 8, 2008 report published by CNET Networks, Inc., 30 States have stated they intend to comply with REAL ID or have applied for and already received extensions. Five States, representing 5% of the U.S. population, have passed anti-REAL ID laws; and 15 States believe they will possibly comply.

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        We believe that many aspects of our driver license issuance solutions have value in other forms of credentials and secure personal identification systems. As the global market for secure personal identification solutions develops, we believe that our position as the leading supplier of government-issued citizen IDs in North America and our extensive investments in research and development provide a good foundation for participation in the global market for government programs establishing the identities of citizens and issuing associated credentials.

        An example of such a potential opportunity is in the market for smart cards. The Western Hemisphere Travel Initiative requires that all U.S. citizens returning from outside the U.S. present either a passport, a new border PASS Card or EDL, approved by the Department of Homeland Security. The Federal government is requiring a Radio-frequency identification (RFID) chip in each PASS Card or EDL. In other applications, the Federal government has been advancing worker identification using smart cards. In response to these moves, in 2006 we announced a smart card option for our secure driver license solution. We began production of the first high security licenses in a pilot program in Washington State. Interest in these new high tech licenses is spreading. The US Secretary of Homeland Security is strongly encouraging Canadian provincial governments to consider producing such licenses, which could be used in lieu of a passport at the border. In parallel, a growing number of U.S. States, including Arizona, New York, Texas, and Vermont, have expressed interest in producing an EDL. In addition, we will continue to look for opportunities to participate in smart card ID programs in Europe and other parts of the world where smart cards are more widely used.

Media Identification and Management

        Digital watermarking and related technologies are used in various media identification and management products and solutions supporting a variety of media objects, from movies and music, to banknotes and secure credentials. Each media object enabled by our technology creates the potential for several applications, such as:

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counterfeiting and piracy deterrence,



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media management,



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authentication and monitoring,



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linking to networks and providing access to information,



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and enhanced services in support of mobile commerce.

        We believe the market for such applications is in the early stages of development and that existing solutions represent only a small portion of the potential market for our products, services, and technologies.

Competition

        Digimarc competes for government business with system integrators, biometrics suppliers, security printers, card manufacturers, and smart card and other security technology suppliers, including companies like L-1 Identity Solutions, Inc. (formerly Viisage Technology, Inc.) (biometrics), Unisys Corporation (system integration) and De La Rue plc (security printer). Each of these companies is a supplier to U.S. driver license issuers. As U.S. driver licenses gain utility as general credentials and the Federal government is demanding higher security and a certain amount of standardization, competition may increase. For instance, certain aspects of the REAL ID Act may expedite an existing trend toward central issuance of driver licenses. Although we are proficient at central issuance, the possible acceleration of this trend could draw new competition from classic security printers such as Canadian Banknote Company, Limited and Giesecke & Devrient GmbH.

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        The possibility of including smart card technologies in driver licenses is generating a great deal of public debate. The smart card industry is generally driven by European chip manufacturers such as Infineon Technologies AG and Gemalto NV. While successful in bank cards, mobile phone SIMs and phone cards, smart cards have only recently begun to gain distribution as government-issued credentials. The U.S. government is a strong advocate. Federal identity standards are embracing smart cards for the military, transportation workers, and government employees and contractors, and new "ePassports" will carry a portrait in an on-book chip. Despite considerable investment by the Federal government, we believe no States have attempted or even piloted smart card driver licenses, except for the EDL card we recently deployed in Washington State. We understand that in recent years, at least two States have expressly considered and rejected smart card driver licenses. Emerging border control and Federal traveler programs are considering smart card concepts, but have not gained traction and face privacy issues. We anticipate we will be prepared to support requirements from customers for smart card technology if, and when, such requirements arise.

        We are seeing increased interest in the U.S. ID market from large systems integrators such as Electronic Data Systems Corporation, IBM Global Services, Accenture, and Bearing Point, as well as other ID and security suppliers such as Canadian Banknote and DataCard Corporation. Smaller application providers are also emerging as point-product competition, including Saber and Archon. In 2007, we implemented our first EDL pilot approved by the Department of Homeland Security in the State of Washington for land and sea border crossing. While to date there are no other known companies offering complete EDL solutions, we anticipate the primary competition for the EDL will be the PASS Card, which General Dynamics Corporation is contracted to provide.

        Internationally, we supply credentialing systems, components or supplies to numerous foreign governments, including four Canadian provinces, Latvia, Mexico, Ghana and Russia. Competition in international markets, like in the U.S., comes from security printers, card producers, biometric companies and systems integrators, such as Sagem Telecommunications, S.A., De La Rue plc, Gemalto NV, Fujitsu Siemens Computers, Wincor Nixdorf International GmbH, Unisys Corporation, and Hewlett Packard Company.

        In media identification and management, our business partners and we generally compete with application-specific alternative technologies for the security budget of the producers and distributors of the media objects. These alternatives include technologies and solutions based on encryption or on pattern recognition. We anticipate that our competitive position within certain markets may be affected by factors such as reluctance to adopt new technologies and, positively or negatively, by changes in government regulations.

Seasonality

        We have observed seasonality in our U.S. driver license issuance revenues, with larger revenues in the second and third quarter of the year, and generally lower revenues in the first and fourth quarters. The fourth quarter is usually the seasonally lowest quarter each year. We use the straight line method of depreciation and amortization for program-related assets. The combination of the seasonality of our revenues and straight line depreciation and amortization can cause significant variations in quarterly gross margin trends, generally increasing margins in the second and third quarters when our issuance revenues are higher and decreasing margins in the first and fourth quarters when our issuance revenues are typically lower, while having a neutral effect on a yearly basis.

Backlog

        Backlog as of December 31, 2007 was approximately $225 million. We expect more than $90 million of this amount to be recognized as revenue during 2008. This amount includes production volumes reasonably expected to be achieved under currently effective contracts, government orders that

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are firm but not yet funded, and government contracts awarded but not yet signed. Backlog as of December 31, 2006 was approximately $250 million.

        There is no assurance that our backlog will 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 such recognition may change.

Employees

        At December 31, 2007, we had 424 full-time employees, including 60 in sales, marketing, technical support and customer support; 89 in research, development and engineering; 84 in finance, administration, information technology and legal; and 191 in field operations, manufacturing and supply chain. We also had 38 contract workers, primarily utilized in our international manufacturing operations at December 31, 2007. Our future success will depend, in part, on our ability to continue to attract, retain and motivate highly qualified technical and management personnel, for whom competition is intense. Our employees are not covered by any collective bargaining agreement, and we have never experienced a work stoppage. We believe that our relations with our employees are good.

Available Information

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