form424b3_17573.htm

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NETWORK-1 SECURITY SOLUTIONS, INC.

INDEX TO FINANCIAL STATEMENTS

	Page Number
Condensed Balance Sheets as of June 30, 2013 (unaudited) and December 31, 2012	F-2
Condensed Statements of Income and Comprehensive Income for the three months and six months ended June 30, 2013 and 2012 (unaudited)	F-3
Condensed Statements of Cash Flow for the six months ended June 30, 2013 and 2012 (unaudited)	F-4
Notes to Interim (unaudited) Condensed Financial Statements	F-5
Report of independent registered public accounting firm	F-17
Balance Sheets as of December 31, 2012 and 2011	F-18
Statements of Income and Comprehensive Income for the years ended December 31, 2012 and 2011	F-19
Statements of Changes in Stockholders’ Equity for the years ended December 31, 2012 and 2011	F-20
Statements of Cash Flow for the years ended December 31, 2012 and 2011	F-21
Notes to Financial Statements for the years ended December 31, 2012 and 2011	F-22

NETWORK-1 SECURITY SOLUTIONS, INC.

CONDENSED BALANCE SHEETS

UNAUDITED

	JUNE 30, 2013			DECEMBER 31, 2012
	(UNAUDITED)
CURRENT ASSETS:
Cash and cash equivalents	$	18,103,000		$	21,983,000
Marketable securities		533,000			547,000
Royalty receivables		1,867,000			775,000
Other current assets		232,000			222,000

Total Current Assets	$	20,735,000			23,527,000

OTHER ASSETS:
Deferred tax asset	$	5,878,000			6,194,000
Patent, net of accumulated amortization		5,675,000			65,000
Security deposits		19,000			19,000

Total Other Assets		11,572,000			6,278,000

TOTAL ASSETS	$	32,307,000		$	29,805,000

LIABILITIES:

CURRENT LIABILITIES:
Accounts payable	$	160,000		$	232,000
Accrued expenses		651,000			593,000

TOTAL LIABILITIES		811,000			825,000


COMMITMENTS AND CONTINGENCIES		—			—

STOCKHOLDERS' EQUITY


Common stock - $0.01 par value; authorized 50,000,000 shares;
25,597,183 and 25,392,269 shares issued and outstanding at
June 30,2013 and December 31,2012, respectively		256,000			254,000

Additional paid-in capital	$	59,728,000		$	58,046,000
Accumulated deficit		(28,460,000	)		(29,306,000	)
Other comprehensive income(loss)		(28,000	)		(14,000	)

TOTAL STOCKHOLDERS' EQUITY		31,496,000			28,980,000

TOTAL LIABILITIES AND STOCKHOLDERS EQUITY	$	32,307,000		$	29,805,000

See notes to condensed financial statements

F - 2

NETWORK-1 SECURITY SOLUTIONS, INC.

CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

UNAUDITED

	Three Months Ended June 30,					Six Months Ended June 30,
	2013			2012		2013			2012

ROYALTY REVENUE	$	1,907,000		$	1,966,000	$	5,971,000		$	6,391,000
COST OF REVENUE		547,000			562,000		1,772,000			1,948,000
GROSS PROFIT		1,360,000			1,404,000		4,199,000			4,443,000
OPERATING EXPENSES:
General and Administrative		767,000			446,000		1,445,000			1,036,000

Non-Cash compensation		144,000			74,000		256,000			165,000

TOTAL OPERATING EXPENSES		911,000			520,000		1,701,000			1,201,000

OPERATING INCOME		449,000			884,000		2,498,000			3,242,000


OTHER INCOME (EXPENSES):
Interest income, net		12,000			10,000		18,000			19,000


INCOME BEFORE INCOME TAXES		461,000			894,000		2,516,000			3,261,000

INCOME TAXES (BENEFIT)
Current		(22,000	)		9,000		26,000			33,000
Deferred		(299,000	)		148,000		316,000			568,000
Total Income Taxes (Benefits)		(321,000	)		157,000		342,000			601,000
NET INCOME	$	782,000		$	737,000	$	2,174,000		$	2,660,000


Net Income per share - Basic	$	0.03		$	0.03	$	0.09		$	0.10
- Diluted	$	0.03		$	0.02	$	0.08		$	0.09

Weighted average number of common shares outstanding:
- Basic		25,181,736			26,192,920		25,098,074			25,595,913
- Diluted		27,087,061			28,819,929		27,396,414			28,729,256

NET INCOME	$	782,000		$	737,000	$	2,174,000		$	2,660,000

OTHER COMPREHENSIVE INCOME NET OF TAX: Unrealized gain (loss) arising during period		(9,000	)		3,000		(14,000	)		2,000

COMPREHENSIVE INCOME	$	773,000		$	740,000	$	2,160,000		$	2,662,000

See notes to condensed financial statements

F - 3

NETWORK-1 SECURITY SOLUTIONS, INC.

CONDENSED STATEMENTS OF CASH FLOW

UNAUDITED

	Six Months Ended June 30,
	2013			2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income	$	2,174,000		$	2,660,000
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		249,000			5,000
Stock based compensation		256,000			165,000
Source (use) of cash from changes in operating assets and liabilities:
Royalty receivables and other current assets		(1,051,000	)		(1,162,000	)
Accounts payable and accrued expenses		(5,000	)		(1,012,000	)
Income Taxes Payable		(62,000	)		(67,000	)
Deferred tax asset		316,000			568,000
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES		1,877,000			1,157,000

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Patents		(4,420,000	)		—

CASH FLOWS FROM FINANCING ACTIVITIES:
Value of shares delivered to fund withholding taxes		(486,000	)		(487,000	)
Repurchase of treasury stock		(851,000	)		(52,000	)


NET CASH PROVIDED (USED IN) FINANCING ACTIVITIES		(1,337,000	)		(539,000	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(3,880,000	)		618,000

CASH AND CASH EQUIVALENTS, beginning of period		21,983,000			20,661,000

CASH AND CASH EQUIVALENTS, end of period	$	18,103,000		$	21,279,000

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the periods for:
Interest	$	—		$	—
Taxes	$	93,000		$	127,000

NON-CASH INVESTING AND FINANCING ACTIVITIES: Value of shares and warrants issued to purchase patents	$	1,438,000		$	—

See notes to condensed financial statements

F - 4

NOTE A – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

[1] BASIS OF PRESENTATION:

The accompanying condensed financial statements as of June 30, 2013 and for the three and six month periods ended June 30, 2013 and June 30, 2012 are unaudited, but, in the opinion of the management of Network-1 Security Solutions, Inc. (the "Company"), contain all adjustments consisting only of normal recurring items which the Company considers necessary for the fair presentation of the Company's financial position as of June 30, 2013, and the results of its operations for the three and six month periods ended June 30, 2013 and June 30, 2012 and its cash flows for the six month periods then ended. The condensed financial statements included herein have been prepared in accordance with the accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Accordingly, certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations, although management believes that the disclosures are adequate to make the information presented not misleading. These financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2012 included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission. The results of operations for the three and six months ended June 30, 2013 are not necessarily indicative of the results of operations to be expected for the full year.

[2] BUSINESS:

Our principal business is the acquisition, development, licensing and protection of our intellectual property. We presently own nineteen (19) patents issued by the U.S. Patent and Trademark Office that relate to various technologies including patents covering (i) the delivery of power over Ethernet (“PoE”) cables for the purpose of remotely powering network devices, such as wireless access ports, IP phones and network based cameras, over Ethernet networks; (ii) foundational technologies that enable unified search and indexing, displaying and archiving of documents in a computer system; (iii) enabling technology for identifying media content on the Internet, and taking further action to be performed based on such identification including, among others, the insertion of advertising and the facilitation of the purchase of goods and services; and (iv) systems and methods for the transmission of audio, video and data over computer and telephony networks. In addition, we continually review opportunities to acquire or license additional intellectual property. Our strategy is to pursue licensing and strategic alliances with companies in industries that manufacture and sell products that make use of the technologies underlying our intellectual property as well as with other users of the technologies who benefit directly from the technologies including corporate, educational and governmental entities. To date, our licensing efforts have largely focused on licensing our patent (U.S. Patent No. 6,218,930) covering the control of power delivery over Ethernet cables (the “Remote Power Patent”). At June 30, 2013, we had entered into a total of sixteen (16) license agreements with respect to our Remote Power Patent which, among others, include license agreements with Cisco Systems, Inc. and Cisco-Linksys, Microsemi Corporation, Extreme Networks, Inc., Motorola Solutions, Inc., Allied Telesis, Inc., NEC Corporation and several other major data networking equipment manufacturers. We have a pending patent infringement litigation against eleven (11) data network equipment manufacturers for infringement of our Remote Power Patent (See Note D[1] to our financial

F - 5

NOTE A – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

statements included in this quarterly report). As part of our patent acquisition strategy, in February 2013 we acquired four (4) patents and one (1) pending patent application and in May 2013 we acquired nine (9) patents and five (5) pending patent applications (See Note B[2] to our financial statement included in this quarterly report). In May 2013, the Company’s newly formed subsidiary (Mirror Worlds Technologies, LLC) initiated patent litigation against Apple, Inc., Microsoft, Inc. and several other major vendors of operating system software and computer systems for infringement of one of the patents acquired in May 2013 (See Note D[2] hereof).

(b) As reflected in the accompanying financial statements, the Company had revenue of $1,907,000 and $1,966,000 for the three month period ended June 30, 2013 and June 30, 2012, respectively, and revenue of $5,971,000 and $6,391,000 for the six month period ended June 30, 2013 and June 30, 2012, respectively. The Company has been dependent upon royalty revenue from license of its Remote Power Patent to fund its operations. The Company had cash and cash equivalents of $18,103,000 as of June 30, 2013.

[3] STOCK-BASED COMPENSATION:

On June 19, 2013, the Company issued to a director a 5-year option to purchase 300,000 shares of its common stock, at an exercise price of $1.88 per share, for service as the sole member of the Company’s Strategic Development Committee. The shares underlying such option vested 100,000 shares on the date of grant and will vest 100,000 shares on June 19, 2014 and 100,000 shares on June 19, 2015. The Company recorded $75,000 in non-cash compensation in connection with the vested portion of the option for the six month period ended June 30, 2013.

On January 24, 2013, the Company issued stock options to each of its four (4) non-management directors to purchase 25,000 shares of common stock at an exercise price of $1.19 per share. Such options vest over a one year period in equal quarterly amounts, subject to continued service on the Board. The Company recorded $24,000 in non-cash compensation in connection with the vested portion of these options for the six month period ended June 30, 2013.

During the six month periods ended June 30, 2013 and 2012, the Company recorded non-cash compensation expense of $54,000 and $74,000 for the vested portion of options to purchase 500,000 and 750,000 shares issued to the Company’s Chairman and Chief Executive Officer in November 2012 and June 2009, respectively. In addition, during the six month periods ended June 30, 2013 and June 30, 2012, the Company recorded non-cash compensation expense of $101,000 and $54,000, respectively, for the vested portion of options granted to its Chief Financial Officer, directors and consultants in prior years.

On April 11, 2012, the Company issued a 5-year option to purchase 125,000 shares of its common stock to one of its directors, at an exercise price of $1.40 per share, in consideration of serving on a special committee of the Board of Directors, and such option was to vest over a one year period in equal quarterly amounts of 31,250 shares (the vesting was accelerated following the resignation of the director in December 2012). On April 12, 2012, the Company issued to its Chief Financial Officer, in consideration of extension of his consulting

F - 6

NOTE A – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

agreement with the Company (See Note C[4]), a 5-year option to purchase 75,000 shares of its common stock, at an exercise price of $1.40 per share. Such option vests over a one year period in equal installments of 18,750 shares.

On January 27, 2012, the Company issued a 5-year option to purchase 50,000 shares of its common stock, at an exercise price of $1.21 per share, to a director for joining the Board of Directors, which option vests in equal quarterly installments over a one year period. On January 31, 2012 and February 24, 2012, the Company issued 5-year options to purchase an aggregate of 25,000 shares to each of its three non-management directors, at exercise prices of $1.21 and $1.35 per share. These options vest over a one year period in equal quarterly installments.

During the three month period ended June 30, 2013, the Company’s Chairman and Chief Executive Officer and an employee exercised options to purchase an aggregate of 1,125,000 and 52,500 shares, respectively, of the Company’s common stock at an exercise price of $0.68 per share. All such options were exercised on a cashless basis by delivery of an aggregate of 396,373 and 18,497 shares of common stock, respectively, and 241,540 and 10,201 shares of common stock were delivered with an aggregate value of $466,617 and $19,688 to fund payroll withholding taxes on exercise, resulting in aggregate net shares of 487,087 and 23,802 issued to the Chairman and Chief Executive Officer and the employee, respectively, with respect to such option exercises.

During the six month period ended June 30, 2012, the Company's Chairman and Chief Executive Officer and an affiliate exercised options and warrants to purchase an aggregate of 2,623,070 shares of the Company's common stock at an exercise price of $0.68 per share. All such options were exercised on a cashless basis by delivery of 1,306,979 shares of common stock and 350,160 shares of common stock were delivered with an aggregate value of $486,951 to fund payroll withholding taxes on exercise, resulting in aggregate net shares of 965,933 issued to the Chairman and Chief Executive Officer with respect to such option and warrant exercises.

The fair value of each option grant on the date of grant is estimated using the Black-Scholes option-pricing utilizing the following weighted average assumptions:

	SIX MONTHS ENDED JUNE 30,
	2013	2012
Risk-free interest rates Expected option life in years Expected stock price volatility Expected dividend yield	0.78-1.24% 5 years 43.54%-44.31% -0-	0.71-0.89% 5 years 45.86% - 0 -

F - 7

NOTE A – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

[4] REVENUE RECOGNITION:

The Company recognizes revenue received from the licensing of its intellectual property in accordance with Staff Accounting Bulletin No. 104, "Revenue Recognition" ("SAB No. 104") and related authoritative pronouncements. Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) all obligations have been performed pursuant to the terms of the license agreement, (iii) amounts are fixed or determinable, and (iv) collectibility of amounts is reasonably assured. One licensee (Cisco Systems) constituted approximately 84% and 81% of the Company’s revenue, respectively, for the six month periods ended June 30, 2013 and June 30, 2012.

[5] INCOME TAXES:

At June 30, 2013, the Company had net operating loss carryforwards (NOLs) totaling approximately $23,954,000 expiring 2029, with a future tax benefit of approximately $8,144,000. During the second quarter of 2011, as a result of the Company's financial results and projected future operating results, management determined that a portion of the NOL was more likely than not to be utilized resulting in the recording of a one-time, non-cash income tax benefit of $7,000,000 (income) or $0.29 per share (basic) for the three and six month periods ended June 30, 2011. At June 30, 2013 and December 31, 2012, $5,878,000 and $6,194,000, respectively, were recorded as a deferred tax asset on the Company's balance sheet. During the six month period ended June 30, 2013 as a result of income (before taxes) for the period of $2,516,000, $342,000 was recorded as income tax expense and the deferred tax asset was reduced by $316,000 to $5,878,000. To the extent that the Company earns income in the future, it will report income tax expense and such expense attributable to federal income taxes will reduce the recorded income tax benefit asset reflected on the balance sheet. Management will continue to evaluate the recoverability of the NOL and adjust the deferred tax asset appropriately. Utilization of NOL credit carryforwards can be subject to a substantial annual limitation due to ownership change limitations that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended, as well as similar state provisions.

F - 8

NOTE A – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

[6] EARNINGS (LOSS) PER SHARE:

Basic Earnings (loss) per share is calculated by dividing the net income (loss) by the weighted average number of outstanding common shares during the period. Diluted per share data includes the dilutive effects of options, warrants and convertible securities. Potential shares of 7,587,500 and 5,460,000 at June 30, 2013 and 2012, respectively, consisted of options and warrants. Computations of basic and diluted weighted average common shares outstanding are as follows:

	Six Months Ended June 30,				Three Months Ended June 30,
	2013		2012		2013		2012

Weighted-average common shares outstanding – basic		25,098,074		25,595,913		25,181,736		26,192,920
Dilutive effect of options and warrants		2,298,340		3,133,343		1,905,325		2,627,009
Weighted-average common shares outstanding – diluted		27,396,414		28,729,256		27,087,061		28,819,929
Options and Warrants excluded from the computation of diluted income (loss) per share because the effect of inclusion would have been anti-dilutive		5,289,160		2,326,657		5,682,175		2,832,991

[7] CASH EQUIVALENTS:

The Company places cash investments in high quality financial institutions insured by the Federal Deposit Insurance Corporation ("FDIC"). At June 30, 2013, the Company maintained cash balance of $17,583,000 in excess of FDIC limits.

The Company considers all highly liquid short-term investments purchased with an original maturity of three months or less to be cash equivalents.

Cash and cash equivalents as of June 30, 2013 and December 31, 2012 are composed of:

	June 30, 2013		December 31, 2012

Cash	$	1,456,000	$	1,346,000
Money market fund		16,647,000		20,637,000
Total	$	18,103,000	$	21,983,000

[8] MARKETABLE SECURITIES

Marketable securities are classified as available-for-sale and are recorded as fair market value. Unrealized gain and losses are reported as other comprehensive income. Realized gains and losses are included in income in the period they are realized. The Company's marketable securities consist of a corporate bond (face value $500,000) with a 5% coupon and a maturity date of June 2015.

F - 9

Note B - COMMITMENTS AND CONTINGENCIES

[1] Legal Fees:

Dovel & Luner, LLP provides legal services to us with respect to our patent litigation commenced in May 2013 against Apple, Inc., Microsoft, Inc. and other major vendors of document system software and computer systems in the United States District Court of Texas, Tyler Division for infringement of U.S. Patent No. 6,006,227. The terms of our agreement with Dovel & Luner LLP provide for legal fees on a contingency basis ranging from 25% to 40% of the net recovery (after deduction of expenses) depending upon the stage of proceeding in which a result (settlement or judgment) is achieved, subject to certain agreed upon contingency fee caps depending upon the amount of the net recovery. The Company is responsible for a certain portion of the expenses incurred with respect to the litigation.

Dovel & Luner, LLP provides legal services to the Company with respect to the Company’s pending patent litigation filed in September 2011 against eleven (11) data networking equipment manufacturers in the United States District Court for the Eastern District of Texas, Tyler (See Note D[1]). The terms of the Company’s agreement with Dovel & Luner LLP essentially provides for legal fees on a full contingency basis ranging from 12.5% to 35% (with certain exceptions) of the net recovery (after deduction for expenses) depending on the stage of the preceding in which a result (settlement or judgment) is achieved. For the six month period ended June 30, 2013 and June 30, 2012, the Company accrued aggregate legal fees with respect to the litigation of $155,000 and $268,000, respectively, to Dovel & Luner. The Company is responsible for a certain portion of the expenses incurred with respect to the litigation.

Dovel & Luner, LLP provided legal services to the Company with respect to the litigation settled in July 2010 against several major data networking equipment manufacturers (See Note D[2]). The terms of the Company’s agreement with Dovel & Luner, LLP with respect to this litigation provided for legal fees of a maximum aggregate cash payment of $1.5 million plus a contingency fee of 24% (based on the settlement being achieved at the trial stage). Because of the royalty payments payable quarterly by Cisco in accordance with the Company’s settlement and license agreement with Cisco (See Note D[3]), the Company has an obligation to pay Dovel & Luner 24% of such royalties received. During the six months ended June 30, 2013 and 2012, the Company incurred aggregate legal fees to Dovel & Luner, LLP of approximately $1,264,000 and $1,296,000, respectively, with respect to the aforementioned litigation.

With respect to the Company’s litigation against D-Link, which was settled in May 2007, the Company utilized the services of Blank Rome, LLP on a full contingency basis. In accordance with the Company’s contingency fee agreement with Blank Rome LLP, once the Company recovers its expenses related to the litigation (which have not yet been recovered), the Company is obligated to pay legal fees to Blank Rome LLP equal to 25% of the royalty revenue received by the Company from its license agreement with D-Link. During the first quarter of 2013 the Company recovered its expenses related to the litigation and accrued legal fees to Blank Rome of $6,000 for the six months ended June 30, 2013.

F - 10

Note B - COMMITMENTS AND CONTINGENCIES (continued)

[2] Patent Acquisitions:

On February 28, 2013, the Company completed the acquisition of four (4) patents (as well as a pending patent application) from Dr. Ingemar Cox, a technology leader in digital watermarking content identification, digital rights management and related technologies, for a purchase price of $1,000,000 in cash and 403,226 shares of the Company’s common stock. In addition, the Company is obligated to pay Dr. Cox 12.5% of the net proceeds (after deduction of expenses) generated by the Company from licensing, sale or enforcement of the patents. Since the acquisition the Company has filed seven (7) additional related patent applications with the United States Patent and Trademark Office seeking patent protection based upon the original patent application filed in 2000.

On May 21, 2013, the Company’s newly formed subsidiary, Mirror Worlds Technologies, LLC, acquired all of the patents previously owned by Mirror Worlds, LLC (which subsequently changed its name to Looking Glass LLC), consisting of nine (9) issued United States patents and five (5) pending applications covering foundational technologies that enable unified search and indexing, displaying and archiving of documents in a computer system. As consideration for the patent acquisition, the Company paid Looking Glass LLC $3,000,000 in cash, and issued 5-year warrants to purchase an aggregate of 1,750,000 shares of our common stock (875,000 shares of common stock at an exercise price of $1.40 per share and 875,000 shares of our common stock at an exercise price of $2.10 per share). As part of the acquisition, the Company also entered into an agreement with Recognition Interface, LLC (“Recognition”), an entity that financed the commercialization of the patent portfolio prior to its sale to Mirror Worlds, LLC and also retained an interest in the licensing proceeds of the patent portfolio held by Mirror Worlds, LLC. Pursuant to the terms of the Company’s agreement with Recognition, Recognition received (i) 5-year warrants to purchase 250,000 shares of the Company’s common stock at $1.40 per share, and (ii) 5-year warrants to purchase 250,000 shares of common stock at $2.10 per share. Recognition also received from the Company an interest in the net proceeds realized from the monetization of the patent portfolio as follows: (i) 10% of the first $125 million of net proceeds, (ii) 15% of the next $125 million of net proceeds, (iii) and 20% of any portion of the net proceeds in excess of $250 million. In addition, Abacus and Associates, Inc., an investment entity affiliated with Recognition, received a 60-day warrant to purchase 500,000 shares of the Company’s common stock at $2.05 per share. In accordance with the Company’s agreement with Recognition, if Abacus exercises the 60-day warrant an additional warrant to purchase an aggregate of 250,000 shares of the Company will be issued to Recognition.

[3] Services Agreement:

Pursuant to an agreement, dated November 30, 2004, between the Company and ThinkFire Services USA, Ltd. (“ThinkFire”), the Company is obligated to pay ThinkFire fees from royalty payments received from certain licensees in consideration for services performed on behalf of the Company. During the six month periods ended June 30, 2013 and 2012, the Company accrued fees of approximately $50,000 and $47,000, respectively, with respect to its obligation to ThinkFire.

F - 11

Note B - COMMITMENTS AND CONTINGENCIES (continued)

[4] Lease Agreement:

The Company currently leases office space in New York City at a cost of $3,300 which lease expires on November 30, 2013.

On June 16, 2011, the Company entered into a four-year lease agreement commencing July 18, 2011 to rent office space, consisting of approximately 2,400 square feet, for offices in New Canaan, Connecticut. In accordance with the lease, the Company will pay a base rent of $6,400 per month for the first two years, $6,800 per month for the third year and $7,000 per month for the fourth year. The base rent is subject to annual adjustments to reflect increases in real estate taxes and operating expenses. The Company also entered into a one year sublease (expiring July 2012) at a base rent of $3,700 per month to sublet approximately 50% of the space to a third party.

Note C - EMPLOYMENT ARRANGEMENTS AND OTHER AGREEMENTS

[1] On November 1, 2012, the Company entered into a new employment agreement (the “Agreement”) with its Chairman and Chief Executive Officer for a one year term (which shall automatically be extended for two successive one year periods unless terminated by the Company) at an annual base salary of $415,000. The Agreement established an annual target bonus of $150,000 for the Chairman and Chief Executive Officer based on performance criteria to be established on an annual basis by the Board of Directors (or compensation committee). For the year ended December 31, 2012, the Chairman and Chief Executive Officer received the target bonus of $150,000. In connection with the Agreement, the Chairman and Chief Executive Officer was issued a ten year option to purchase 500,000 shares of the Company’s common stock at an exercise price of $1.19 per share, which vests in equal quarterly amounts of 41,667 shares beginning November 1, 2012 through August 31, 2015, subject to acceleration upon a change of control. The Chairman and Chief Executive Officer shall forfeit the balance of unvested shares if his employment has been terminated “For Cause” (as defined) by the Company or by him without "Good Reason" (as defined). Under the terms of the Agreement, the Chairman and Chief Executive Officer also receives incentive compensation in an amount equal to 5% of the Company’s gross royalties or other payments or proceeds (without deduction of legal fees or any other expenses) with respect to its Remote Power Patent and a 10% net interest (gross royalties and other payments or proceeds after deduction of all legal fees and litigation expenses related to licensing, enforcement and sale activities, but in no event shall he receive less than 6.25% of the gross recovery) of the Company’s royalties and other payments with respect to its other patents besides the Remote Power Patent (the “Additional Patents”) (the “Incentive Compensation”). During the six months ended June 30, 2013 and June 30, 2012 the Chairman and Chief Executive Officer earned Incentive Compensation of $299,000 and $320,000, respectively. The Incentive Compensation shall continue to be paid to the Chairman and Chief Executive Officer for the life of each of the Company’s patents with respect to licenses entered into with third parties during the term of his employment or at anytime thereafter, whether he is employed by the Company or not; provided, that, the Chairman and Chief Executive Officer’s employment has not been terminated by the Company “For Cause” (as defined) or terminated by him without “Good Reason” (as defined). In the event of a merger or sale of substantially all of the assets of the Company, the Company has the option to extinguish the right of Chairman and Chief Executive Officer to receive future Incentive Compensation by payment to him of a lump sum payment, in an amount equal to the fair market value of such

F - 12

Note C - EMPLOYMENT ARRANGEMENTS AND OTHER AGREEMENTS (continued)

future interest as determined by an independent third party expert if the parties do not reach agreement as to such value. In the event that the Chairman and Chief Executive Officer’s employment is terminated by the Company “Other Than For Cause” (as defined) or by him for “Good Reason” (as defined), the Chairman and Chief Executive Officer shall also be entitled to (i) a lump sum severance payment of 12 months base salary, (ii) a pro-rated portion of the $150,000 target bonus provided bonus criteria have been satisfied on a pro-rated basis through the calendar quarter in which the termination occurs and (iii) accelerated vesting of all unvested options and warrants.

In connection with the Agreement, the Chairman and Chief Executive Officer has also agreed not to compete with the Company as follows: (i) during the term of the Agreement and for a period of 12 months thereafter if his employment is terminated “Other Than For Cause” (as defined) provided he is paid his 12 month base salary severance amount and (ii) for a period of two years from the termination date, if terminated “For Cause” by the Company or “Without Good Reason” by the Chairman and Chief Executive Officer.

[2] On June 8, 2009, the Company entered into an Employment Agreement (the “Agreement”) with the Chairman and Chief Executive Officer for a three year term (which expired in June 2012) at an annual base salary of $375,000 (retroactive to April 1, 2009) for the first year and increasing 5% on each of April 1, 2010 and April 1, 2011. During the term of the Agreement, the Chairman and Chief Executive Officer received a cash bonus in an amount no less than $150,000 on an annual basis. In connection with the Agreement, the Chairman and Chief Executive Officer was issued a ten year option to purchase 750,000 shares of common stock at an exercise price of $0.83 per share, which vested in equal quarterly amounts of 62,500 shares beginning June 30, 2010 through March 31, 2012. In addition to the aforementioned option grant, the Company extended for an additional 5 years the expiration dates of all options (an aggregate of 417,500 shares) expiring in the calendar year 2009 owned by the Chairman and Chief Executive Officer. Under the terms of the Agreement, the Chairman and Chief Executive Officer also received additional bonus compensation in an amount equal to 5% of the Company’s royalties or other payments with respect to the Company’s Remote Power Patent (before deduction of payments to third parties including, but not limited to, legal fees and expenses and third party license fees).

[3] On February 3, 2011, the Company entered into an agreement with its Chief Financial Officer for his continued service through December 31, 2012. In consideration for his services, the Chief Financial Officer was compensated at the rate of $9,000 per month for the year ending December 31, 2011 and was to be compensated at the rate of $9,450 per month for the year ending December 31, 2012. In connection with the agreement, the Chief Financial Officer was also issued a five year option to purchase 100,000 shares of the Company’s common stock at an exercise price of $1.59 per share. The option vested 50,000 shares on the date of grant and the balance of the shares (50,000) vested on the one year anniversary date (February 3, 2012) from the date of grant.

[4] On April 12, 2012, the Company entered into an agreement, with its Chief Financial Officer which amended the agreement, dated February 3, 2011 (See Note C[3] above), pursuant to which he continued to serve the Company. The amendment (the "Amendment") provided as follows: (i) the term of service of the Chief Financial Officer shall be extended until December 31, 2013; (ii) monthly compensation shall be increased to $11,000 per month; and (iii) the Chief Financial Officer was granted a five year option to purchase 75,000

F - 13

Note C - EMPLOYMENT ARRANGEMENTS AND OTHER AGREEMENTS (continued)

shares of the Company’s common stock at an exercise price of $1.40 per share, which option vests over a one year period in equal quarterly amounts of 18,750 shares. Except as provided in the Amendment, all other terms of the Agreement, dated February 3, 2011, remain in full force and effect.

NOTE D - LITIGATION

[1] In September 2011, the Company initiated patent litigation against sixteen (16) data networking equipment manufacturers in the United States District Court for the Eastern District of Texas, Tyler Division, for infringement of its Remote Power Patent. Named as defendants in the lawsuit, excluding related parties, were Alcatel-Lucent USA, Inc., Allied Telesis, Inc., Avaya Inc., AXIS Communications Inc., Dell, Inc., GarrettCom, Inc., Hewlett-Packard Company, Huawei Technologies USA, Juniper Networks, Inc., Motorola Solutions, Inc., NEC Corporation, Polycom Inc., Samsung Electronics Co., Ltd., ShoreTel, Inc., Sony Electronics, Inc., and Transition Networks, Inc. The Company seeks monetary damages based upon reasonable royalties. During the year ended December 31, 2012, the Company reached settlement agreements with defendants Motorola Solutions, Inc. ("Motorola"), Transition Networks, Inc. ("Transition Networks") and GarretCom, Inc. (“GarretCom”). In February 2013, the Company reached settlement agreements with Allied Telesis, Inc. (“Allied Telesis”) and NEC Corporation (“NEC”). As part of the settlements, Motorola, Transition Networks, GarretCom, Allied Telesis and NEC each entered into a non-exclusive license agreement for the Company’s Remote Power Patent pursuant to which each such defendant agreed to license the Remote Power Patent for its full term (which expires in March 2020) and pay a license initiation fee and quarterly or annual royalties based on their sales of PoE products. On January 25, 2013, certain defendants filed a motion to stay the litigation pending completion or termination of the Inter Partes review proceedings pending at the United States Patent and Trademark Office (see Note D(5) below). On March 5, 2013, the Court granted defendants’ motion and stayed the litigation pending the disposition of the Inter Partes review proceedings.

[2] On May 23, 2013, the Company’s newly formed subsidiary (Mirror Worlds Technologies, LLC) initiated patent litigation in the United States District Court for the Eastern District of Texas, Tyler Division, against Apple, Inc., Microsoft, Inc., Hewlett-Packard Company, Lenovo Group Ltd., Lenovo (United States), Inc., Dell, Inc., Best Buy Co., Inc., Samsung Electronics America, Inc. and Samsung Telecommunications America L.L.C., for infringement of the ‘227 Patent (one of the patents the Company acquired as part of the Mirror Worlds patent portfolio – See Note B[2] to our financial statements included in this quarterly report). The Company seeks, among other things, monetary damages based upon reasonable royalties. The lawsuit alleges that the Defendants have infringed and continue to infringe the claims of the ‘227 Patent by making, selling, offering to sell and using infringing products including Mac OS and Windows operating systems and personal computers and tablets that include versions of those operating systems, and by encouraging others to make, sell, and use these products.

[3] In July 2010, the Company settled its patent litigation pending in the United States District Court for the Eastern District of Texas, Tyler Division, against Adtran, Inc, Cisco Systems, Inc. and Cisco-Linksys, LLC, (collectively, “Cisco”), Enterasys Networks, Inc., Extreme Networks, Inc., Foundry Networks, Inc., and 3Com Corporation, Inc. As part of the settlement, Adtran, Cisco, Enterasys, Extreme Networks and Foundry Networks each entered

F - 14

NOTE D - LITIGATION (continued)

into a settlement agreement with the Company and entered into non-exclusive licenses for our Remote Power Patent (the “Licensed Defendants”). Under the terms of the licenses, the Licensed Defendants paid the Company aggregate upfront payments of approximately $32 million and also agreed to license the Remote Power Patent for its full term, which expires in March 2020. In accordance with the Settlement and License Agreement, dated May 25, 2011, which expanded upon the July 2010 agreement, Cisco is obliged to pay the Company royalties (which began in the first quarter of 2011) based on its sales of PoE products up to maximum royalty payments per year of $8 million through 2015 and $9 million per year thereafter for the remaining term of the patent. The royalty payments are subject to certain conditions including the continued validity of the Company’s Remote Power Patent, and the actual royalty amounts received may be less than the caps stated above, as was the case in 2012 and 2011. Under the terms of the Agreement, if the Company grants other licenses with lower royalty rates to third parties (as defined in the Agreement), Cisco shall be entitled to the benefit of the lower royalty rates provided it agrees to the material terms of such other license. Under the terms of the Agreement, the Company has certain obligations to Cisco and if it materially breaches such terms, Cisco will be entitled to stop paying royalties to the Company. This would have a material adverse effect on the Company’s business, financial condition and results of operations.

[4] On July 20, 2012, an unknown third party filed with the United States Patent and Trademark Office (USPTO) a request for an Ex Parte Reexamination, requesting that our Remote Power Patent be reexamined by the USPTO. The request for reexamination was stayed on December 21, 2012 pending the termination or completion of the Inter Partes Review proceedings described in Note D[4] below. The initial grant of the reexamination by USPTO is not unusual as the majority of such applications are initially granted by USPTO. While the Company believes that the reexamination proceeding will further validate and strengthen the Remote Power Patent, should the USPTO reach a final determination that the Remote Power Patent is invalid (unless overturned by the Board of Patent Appeals and Interference or the United States Court of Appeals for the Federal Circuit), such a determination would have a material adverse effect on the Company as its entire current revenue stream is dependent upon the continued validity of our Remote Power Patent.

[5] There have been four Inter Partes Review petitions filed in the USPTO pertaining to our Remote Power Patent. On December 5, 2012, Avaya Inc. filed a petition to institute an Inter Partes Review of the Remote Power Patent. On December 19, 2012, Sony Corporation of America (“Sony”), Axis Communications AB, and Axis Communications, Inc. filed a separate petition to also institute an Inter Partes Review of the Remote Power Patent. On May 24, 2013, the Patent Trial and Appeal Board (“Patent Board”) determined to institute an Inter Partes Review of the ‘930 Patent on two of the five grounds requested in the proceeding initiated by Avaya, Inc. (IPR2013-0071). Also on May 24, 2013, the Patent Board determined not to institute an Inter Partes Review of the ‘930 Patent in the Inter Partes Review proceeding initiated by Sony Corporation and Axis Communications, Inc. (IPR 2013-0092). On July 2, 2013, the Board denied Sony and Axis’s Request for Rehearing. On June 24, 2013, Dell, Inc. filed a Petition for Inter Partes Review of the ‘930 Patent (IPR 2013-00385). On July 12, 2013, the Company filed a Preliminary Response to Dell’s Petition. On July 29, 2013, the Patent Board instituted this Inter Partes Review proceeding (based on the same grounds as the Avaya proceeding) and joined it with the Avaya proceeding (IPR 2013-0071). On June 24, 2013, Sony, Axis and Hewlett-Packard filed a Petition for Inter Partes Review of the ‘930 Patent (IPR 2013-000386). Petitioners in each

F - 15

NOTE D - LITIGATION (continued)

Inter Partes review seek to cancel certain claims of the Remote Power Patent as unpatentable. In the event that the USPTO reaches a final determination in any of the Inter Partes Review proceedings or the ex parte reexamination that certain of our claims related to the Remote Power Patent are unpatentable, such a determination (unless overturned) would have a material adverse effect on the Company’s business, financial condition and results of operations as our entire revenue stream is dependent upon the continued validity of the Company’s Remote Power Patent.

NOTE E – STOCK REPURCHASE

On August 22, 2011, the Company announced that its Board of Directors approved a share repurchase program to repurchase up to $2,000,000 of shares of its common stock over the next 12 months ("Share Repurchase Program"). The common stock may be repurchased from time to time in open market transactions or privately negotiated transactions in the Company’s discretion. The timing and amount of the shares repurchased is determined by management based on its evaluation of market conditions and other factors. The Share Repurchase Program may be increased, suspended or discontinued at any time. On January 31, 2012, the Board of Directors increased the Share Repurchase Program to purchase up to an additional $2,000,000 (or an aggregate of $4,000,000) of the Company's common stock for the next 12 months. On January 24, 2013, the Board of Directors increased the Share Repurchase Program to purchase up to an additional $1,000,000 (or an aggregate of $5,000,000) of the Company’s common stock over the next 12 months. During the three month period ended June 30, 2013, the Company did not repurchase any of its shares of common stock as part of its Share Repurchase Program.

NOTE F – SUBSEQUENT EVENTS

[1] On July 22, 2013, Abacus & Associates, Inc. (“Abacus”) exercised a warrant to purchase 500,000 shares of the Company’s common stock at an exercise price of $2.05 per share resulting in proceeds to the Company of $1,025,000. In accordance with the Agreement, dated May 21, 2013, between the Company and Recognition Interface, LLC (“Recognition”), an affiliate of Abacus, entered into in connection with the Company’s acquisition of patents from Mirror Worlds, LLC, as a result of the warrant exercised by Abacus the Company issued to Recognition on July 26, 2013 additional five (5) year warrants to purchase an aggregate of 250,000 shares of the Company’s common stock consisting of (i) warrants to purchase 125,000 shares at an exercise price of $2.10 per share and (ii) warrants to purchase 125,000 shares at an exercise price of $1.40 per share (See Note B[2] hereof].

[2] On July 29, 2013, the Patent Trial and Appeal Board (United States Patent and Trademark Office) determined not to institute an Inter Partes review of the ‘930 Patent in the proceeding filed by Sony Corporation of America, Axis Communications and Hewlett-Packard (IPR 2013-000386) (See Note D[4] hereof). On August 7, 2013, Sony and Hewlett-Packard filed another Petition for Inter Partes Review of the ‘930 Patent (Case IPR to be assigned). The grounds in this Petition are the same as the grounds in the Avaya IPR (IPR 2013-0071) and Sony and HP moved to join this potential Inter Partes review with the IPR filed by Avaya Inc. (IPR 2013-0071) (See Note D(5) hereof). On August 13, 2013, the Company filed its opposition to joinder with respect to the additional filing by Sony and HP.

F - 16

NETWORK-1 SECURITY SOLUTIONS, INC.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

Network-1 Security Solutions, Inc.

We have audited the accompanying balance sheets of Network-1 Security Solutions, Inc. as of December 31, 2012 and 2011 and the related statements of income and comprehensive income, changes in stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Network-1 Security Solutions, Inc. as of December 31, 2012 and 2011, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

/s/ Radin, Glass & Co., LLP

New York, New York

March 22, 2013

F - 17

NETWORK-1 SECURITY SOLUTIONS, INC.

Balance Sheets

	December 31,
	2012			2011

CURRENT ASSETS:
Cash and cash equivalents	$	21,983,000		$	20,661,000
Marketable securities		547,000			556,000
Royalty receivables		775,000			760,000
Other current assets		222,000			156,000

Total Current Assets		23,527,000			22,133,000

OTHER ASSETS:
Deferred tax asset		6,194,000			6,903,000
Patent, net of accumulated amortization		65,000			74,000
Security deposits		19,000			19,000
Total Other Assets		6,278,000			6,996,000
TOTAL ASSETS	$	29,805,000		$	29,129,000


LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable	$	232,000		$	180,000
Accrued expenses		593,000			1,551,000

TOTAL LIABILITIES		825,000			1,731,000


COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY

Common stock, $0.01 par value; authorized 50,000,000 shares; 25,392,269 and 25,037,518 issued and outstanding at December 31, 2012 and December 31, 2011, respectively		254,000			250,000
Additional paid-in capital		58,046,000			57,728,000
Accumulated deficit		( 29,306,000	)		(30,575,000	)
Other comprehensive income (loss)		(14,000	)		(5,000	)

TOTAL STOCKHOLDERS’ EQUITY		28,980,000			27,398,000

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	29,805,000		$	29,129,000

See notes to financial statements

F - 18

NETWORK-1 SECURITY SOLUTIONS, INC.

Statements of Income and Comprehensive Income

	Years Ended December 31,
	2012			2011
ROYALTY REVENUE	$	8,698,000		$	7,398,000
COST OF REVENUE		2,602,000			2,106,000
GROSS PROFIT		6,096,000			5,292,000

OPERATING EXPENSES:
General and administrative		2,447,000			2,456,000
Additional patent expense		—			1,000,000
Non-cash compensation		316,000			303,000
TOTAL OPERATING EXPENSES		2,763,000			3,759,000

OPERATING INCOME		3,333,000			1,533,000
OTHER INCOME (EXPENSES):
Interest income, net		39,000			48,000

INCOME BEFORE INCOME TAXES		3,372,000		$	1,581,000


INCOME TAXES (BENEFIT):
Current		37,000			(9,000	)
Deferred		709,000			(6,903,000	)
Total Income Taxes (Benefits)		746,000			(6,912,000	)

NET INCOME	$	2,626,000		$	8,493,000

Net Income Per Share
Basic	$	.10		$	0.33
Diluted	$	.09		$	0.27

Weighted average common shares outstanding Basic		25,744,330			25,813,038
Diluted		28,472,753			30,930,483

NET INCOME	$	2,626,000		$	8,493,000

OTHER COMPREHENSIVE INCOME, NET OF TAX:
Unrealized gain (loss) arising during the period		( 9,000	)		(5,000	)

COMPREHENSIVE INCOME	$	2,617,000		$	8,488,000

See notes to financial statements

F - 19

NETWORK-1 SECURITY SOLUTIONS, INC.

Statement of Changes in Stockholders' Equity

For the Years Ended December 31, 2012 and 2011

	Common Stock Shares Amount						Additional Paid-in Capital			Accumulated Deficit			Accumulated Other Comprehensive Income		Total Stockholders' Equity

Balance – December 31, 2010		25,931,879		$	259,000		$	57,266,000		$	(36,830,000	)	$	—	$	20,695,000
Granting of options		—			—			268,000			—			—		268,000
Proceeds from exercise of options and warrants		875,972			9,000			154,000			—			—		163,000
Extensions of expiration dates of options and warrants		—			—			59,000			—			—		59,000
Cancellation of options and warrants extensions		—			—			(19,000	)		—			—		(19,000	)
Value of shares delivered to fund withholding taxes		(230,234	)		(2,000	)		—			(281,000	)		—		(283,000	)
Treasury stock purchased and retired		(1,540,099	)		(16,000	)		—			(1,957,000	)		—		(1,973,000	)
Unrealized gain (loss) on bonds		—			—			—			—			(5,000)		(5,000	)
Net income		—			—			—			8,493,000			—		8,493,000
Balance – December 31, 2011		25,037,518			250,000			57,728,000			(30,575,000	)		5,000		27,398,000
Granting of options		—			—			316,000			—			—		298,000
Proceeds from exercise of options and warrants		1, 441,268			14,000			2,000			—			—		16,000
Value of shares delivered to fund withholding taxes		(350,160	)		(3,000	)		—			(484,000	)		—		(487,000	)
Treasury stock purchased and retired		(736,357	)		(7,000	)		—			(873,000	)		—		(880,000	)
Unrealized gain (loss) on bonds		—			—			—			—			(9,000)		(9,000	)
Net income		—			—			—			2,626,000			—		2,626,000
Balance – December 31, 2012		25,392,269		$	254,000		$	58,046,000		$	(29,306,000	)	$	(14,000)	$	28,980,000

See notes to financial statements

F - 20

NETWORK-1 SECURITY SOLUTIONS, INC.

Statements of Cash Flows

	Years Ended December 31,
	2012			2011

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	2,626,000		$	8,493,000
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		9,000			9,000
Stock-based compensation		316,000			303,000
Non-cash consulting fee		—			5,000
Source (use) of cash from changes in operating assets and liabilities:
Royalty receivables		(15,000	)		579,000
Other current assets		(16,000	)		21,000
Security deposits		—			(13,000	)
Deferred tax asset		709,000			(6,903,000	)
Accounts payable and accrued expenses		(956,000	)		(527,000	)

NET CASH PROVIDED BY OPERATING ACTIVITIES		2,673,000			1,967,000

CASH FLOWS USED IN INVESTING ACTIVITIES:		—			(561,000	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Value of shares delivered to fund withholding taxes		(487,000	)		(283,000	)
Repurchase of treasury stock		(880,000	)		(1,973,000	)
Proceeds from exercises of options and warrants		16,000			163,000

NET CASH (USED IN) FINANCING ACTIVITIES		(1,351,000	)		(2,093,000	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		1,322,000			(687,000	)

CASH AND CASH EQUIVALENTS, Beginning		20,661,000			21,348,000

CASH AND CASH EQUIVALENTS, Ending	$	21,983,000		$	20,661,000

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the years for:
Interest		—			—
Taxes	$	266,000		$	123,000

See notes to financial statements

F - 21

NETWORK-1 SECURITY SOLUTIONS, INC.

Notes to Financial Statements

December 31, 2012 and 2011

Note A - The Company

Network-1 Security Solutions, Inc. (the “Company”) is engaged in the acquisition, development, licensing and protection of its intellectual property. The Company presently owns ten patents that relate to various telecommunications, data networking and Internet technologies as well as the [identification of media content] and include, among other things, patents covering (i) the delivery of power over Ethernet ("PoE") cables for the purpose of remotely powering network devices, such as wireless access ports, IP phones and network based cameras, over PoE networks, (ii) enabling technology for identifying media content on the Internet such as audio and video (purchased in 2013 see Note L[3]) and (iii) systems and methods of transmission of audio, video and data over computer and telephony networks. The Company’s strategy is to pursue licensing and strategic alliances with companies in industries that manufacture and sell products that make use of the technologies underlying the Company’s intellectual property as well as with other users of the technologies who benefit directly from the technologies including corporate, educational and governmental entities. To date, the Company’s licensing efforts have focused on its remote power patent (U.S. Patent No. 6,218,930) covering the control of power delivery over Ethernet cables (the “Remote Power Patent”). The Company has entered into sixteen (16) license agreements with respect to its Remote Power Patent. The Company’s current strategy includes continuing to pursue licensing opportunities for its Remote Power Patent from vendors of PoE equipment in order to resolve possible infringement of its Remote Patent by such vendors. In addition, the Company seeks to acquire, develop and license additional intellectual property assets to develop, commercialize, license or otherwise monetize such intellectual property. The Company continually reviews opportunities to acquire or license additional intellectual property. In addition, the Company may enter into strategic relationships with third parties to develop, commercialize, license or otherwise monetize their intellectual property.

Note B –Summary of Significant Accounting Policies

[1]	Cash and cash equivalents:

The Company considers all highly liquid short-term investments purchased with an original maturity of three months or less to be cash equivalents.

Cash and cash equivalents as of December 31 are composed of:

	2012		2011
Cash	$	1,444,000	$	1,134,974
Money market fund		20,539,000		19,525,868
Total	$	21,983,000	$	20,660,842

[2]	Marketable securities

[3]	Revenue recognition:

The Company recognizes revenue received from the licensing of its intellectual property in accordance with Staff Accounting Bulletin No. 104, "Revenue Recognition" ("SAB No. 104") and related authoritative pronouncements. Under this guidance, revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) all obligations have been performed pursuant to the terms of the license agreement, (iii) amounts are fixed or determinable and (iv) collectability of amounts is reasonably assured.

[4]

Patents:

The Company owns patents that relate to various telecommunications and data networking technologies as well as the identification of media content. The Company capitalizes the costs associated with acquisition, registration and maintenance of the patents and amortizes these assets over their remaining useful lives on a straight-line basis.

F - 22

NETWORK-1 SECURITY SOLUTIONS, INC.

Note B – Summary of Significant Accounting Policies (continued)

[5]	Impairment of long-lived assets:

Intangible assets with finite lives are tested for impairment whenever events or circumstances indicate that the carrying amount may not be recoverable. Accordingly, the Company records impairment losses on long-lived assets used in operations or expected to be disposed of when indicators of impairment exist and the undiscounted cash flows expected to be derived from those assets are less than carrying amounts of those assets. During the years ended December 31, 2012 and 2011, there was no impairment to the Company's patents.

[6]	Income taxes:

The Company utilizes the liability method of accounting for income taxes. Under such method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect at the balance sheet date. The resulting asset or liability is adjusted to reflect enacted changes in tax law. Deferred tax assets are reduced, if necessary, by a valuation allowance when the likelihood of realization is not assured.

[7]	Earnings (Loss) Per Share

Basic Earnings (loss) per share is calculated by dividing the net income (loss) by the weighted average number of outstanding common shares during the period. Diluted per share data included the dilutive effects of options, warrants and convertible securities. Potential shares of 5,832,500 and 9,779,697 at December 31, 2012 and 2011, respectively, consisted of options and warrants. Computations of basic and diluted weighted average common shares outstanding are as follows:

	2012		2011

Weighted-average common shares outstanding - basic		25,744,330		25,813,038

Dilutive effect of options and warrants	2,728,423			5,117,445

Weighted-average common shares outstanding - diluted		28,472,753		30,930,483

Options and Warrants excluded from the computation of diluted income (loss) per share because the effect of inclusion would have been anti-dilutive		3,104,077		4,662,252

[8]	Use of estimates:

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

F - 23

NETWORK-1 SECURITY SOLUTIONS, INC.

Note B – Summary of Significant Accounting Policies (continued)

[9]	Financial instruments:

The carrying amounts of cash and cash equivalents, accounts payable and accrued expenses approximate their fair value due to the short period to maturity of these instruments. The investment in a corporate bond is reported at the closing price reported on the active market on which the bond is traded.

[10]	Stock-based compensation:

The Company accounts for its stock-based compensation at fair value estimated on the grant date using the Black-Scholes option pricing model. See Note D[1] for further discussion of the Company’s stock-based compensation.

[11]	Allowance for Doubtful Accounts:

The Company uses estimates to determine the amount of the allowance for doubtful accounts necessary to reduce accounts receivable to their expected net realizable value. There was no allowance for doubtful accounts at December 31, 2012 and 2011.

[12]	Fair Value Measurements:

Accounting Standard Codification (“ASC”) Topic 820 (“ASC 820”) utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

●

Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.

●

Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.

●

Level 3: Unobservable inputs that reflect the reporting entity’s own assumptions.

The Company’s financial assets subject to fair value measurements and the necessary disclosures are as follows:

	Fair Value as of		Fair Value Measurements at December 31, 2012 Using Fair Value Hierarchy
	December 31, 2012			Level 1		Level 2		Level 3
Cash and cash equivalents	$	21,983,000	$	21,983,000	$	—	$	—
Corporate bond		547,000		—		547,000		—
Total	$	22,530,000	$	21,983,000	$	547,000	$	—

	Fair Value as of		Fair Value Measurements at December 31, 2011 Using Fair Value Hierarchy
	December 31, 2011			Level 1		Level 2		Level 3
Cash and cash equivalents	$	20,660,842	$	20,660,842	$	—	$	—
Corporate bond		556,376		—		556,376		—
Total	$	21,217,218	$	20,660,842	$	556,376	$	—

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note B – Summary of Significant Accounting Policies (continued)

[13]	Subsequent event evaluation:

The Company has evaluated subsequent events from the balance sheet date through the issuance date of the financial statements and has determined that there are no such events that would have a material impact on the financial statements (See Note L).

[14]	Recently issued accounting standards:

In February 2013, the FASB issued updated guidance that amends the reporting of amounts reclassified out of accumulated other comprehensive income (“AOCI”). These amendments do not change the current requirements for reporting net income or other comprehensive income in the financial statements. However, the guidance requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component, either on the face of the financial statement where net income is presented or in the notes to the financial statements. This guidance is effective for fiscal periods beginning after December 15, 2012, and is to be applied prospectively. We will comply with this guidance as of January 1, 2013, and the adoption of the guidance will not have a material impact on our financial statements.

In October 2012, the FASB issued updated guidance on technical corrections and other revisions to various FASB codification topics. The guidance represents changes to clarify the codification, correct unintended application of the guidance or make minor improvements to the codification. The guidance also amends various codification topics to reflect the measurement and disclosure requirements of Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures. Certain amendments in this guidance are effective for fiscal periods beginning after December 15, 2012, while the remainder of the amendments is effective immediately. We previously adopted the guidance that was effective immediately and it did not have a material impact on our financial statements. We will comply with the remainder of the guidance as of January 1, 2013, and it will not have a material impact on our financial statements.

In August 2012, the FASB issued updated guidance on technical corrections to the U.S. Securities and Exchange Commission (“SEC”) guidance in the U.S. GAAP hierarchy. The SEC guidance was updated to make it more consistent with U.S. GAAP issued by the FASB. The principal changes of the guidance involve revision or removal of accounting guidance references and other conforming changes to ensure consistent referencing throughout the SEC’s Staff Accounting Bulletins. This guidance was effective immediately and it did not have a material impact on our financial statements.

In July 2012, the FASB issued updated guidance on the annual testing of indefinite-lived intangible assets for impairment. The amendments allow an entity to first assess qualitative factors to determine whether it is more likely than not that the indefinite-lived intangible asset is impaired. If, based on its qualitative assessment, an entity concludes it is more likely than not that the fair value of the indefinite-lived intangible asset is less than its carrying amount, quantitative impairment testing is required. However, if an entity concludes otherwise, quantitative impairment testing is not required. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. We will comply with this guidance as of January 1, 2013, and it will not have a material impact on our financial statements.

In December 2011, the FASB issued updated guidance which amends the disclosure requirements regarding the nature of an entity’s rights of offset and related arrangements associated with its financial instruments and derivative instruments. Under the guidance, an entity must disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. In January 2013, the FASB issued updated guidance which clarified that the 2011 amendment to the balance sheet offsetting standard does not cover transactions that are not considered part of the guidance for derivatives and hedge accounting. This guidance is effective for fiscal periods beginning on or after January 1, 2013.

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note B - Summary of Significant Accounting Policies (continued)

We will comply with this guidance as of January 1, 2013, and it will not have a material impact on our financial statements.

Note C - Patents

In November 2003, the Company acquired a portfolio of telecommunications and data networking patents (six patents) from Merlot Communications, Inc., the successor of which is BAXL Technologies, Inc. (the "Seller"). The purchase price for the patent portfolio was $100,000. As additional consideration for the purchase, the Company granted the Seller a nonexclusive, royalty free, perpetual license for the term of each patent to use the patents for the development, manufacture or sale of its own branded products to end users. The cash price has been capitalized and is being amortized over the remaining useful life of each patent. The Company had agreed to pay the Seller 20% of the net income, as defined, after the first $4,000,000 of net income realized by the Company on a per patent basis from the sale or licensing of the patents. On January 18, 2005, the Company and Seller amended the Patent Purchase Agreement "Amendment") pursuant to which the Company paid additional purchase price of $500,000 to Seller in consideration for the restructuring of future contingent payments to Seller from the licensing or sale of the Patents. Such $500,000 has been recorded as an expense in 2005. The Amendment provides for future contingent payments by the Company to Seller of $1.0 million upon achievement of $25 million of Net Royalties (as defined), an additional $1.0 million upon achievement of $50 million of Net Royalties and an additional $500,000 upon achievement of $62.5 million of Net Royalties from licensing or sale of the patents acquired from the Seller. Amortization expense amounted to $9,000 for both years ended December 31, 2012 and 2011. At December 31, 2011, a payment of $1.0 million was payable to Seller since Net Royalties of $25 million was achieved. This amount has been recorded as additional patent expense for the year ended December 31, 2011 and has been paid to Seller.

Note D - Stockholders' Equity

[1]	Stock options:

During 1996, the Board of Directors and stockholders approved the adoption of the 1996 Stock Option Plan (the "1996 Plan"). The 1996 Plan, as amended, provided for the granting of both incentive and non-qualified options to purchase common stock of the Company. A total of 4,000,000 were eligible to be issued under the 1996 Plan. As of March 2006, in accordance with the terms of the plan, no further options were eligible to be issued under the Plan.

The term of options granted under the 1996 Plan may not exceed ten years (five years in the case of an incentive stock option granted to an employee/director owning more than 10% of the voting stock of the Company) ("10% stockholder"). The option price for incentive stock options cannot be less than 100% of the fair market value of the shares of common stock at the time the option is granted (110% for a 10% stockholder). Option terms and vesting periods were set by the Compensation Committee (or the Board of Directors) in its discretion.

The fair value of options on the date of grant is estimated using the Black-Scholes option-pricing model utilizing the following weighted average assumptions:

	Year Ended
	December 31,
	2012	2011

Risk-free interest rates	0.71% - 1.75%	2.05% - 2.18%
Expected option life in years	5 years – 10 years	5 years
Expected stock price volatility	43.54% - 45.86%	42.04%
Expected dividend yield	0.00%	0.00%

The weighted average fair value on the option grant date during the years ended December 31, 2012 and 2011 was $0.59 and $0.63 per option, respectively.

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note D - Stockholders' Equity (continued)

The following table summarizes stock option activity for the years ended December 31:

	2012					2011
				Weighted					Weighted
				Average					Average
	Options			Exercise		Options			Exercise
	Outstanding			Price		Outstanding			Price

Options outstanding at beginning of year		7,208,070		$	0.69		7,947,613		$	0.62
Granted		925,000		$	1.24		430,000		$	1.60
Cancelled/expired/exercised		(2,550,570	)	$	0.66		(1,169,531	)	$	0.55

Options outstanding at end of year		5,582,500		$	0.78		7,208,070		$	0.69

Options exercisable at end of year		4,826,250		$	0.71		6,853,903		$	0.65

During the years ended December 31, 2012 and 2011, the Company granted an aggregate of 925,000 and 430,000 options to its officers, directors and consultants, respectively. The fair value of these options based on the Black-Scholes option-pricing model amounted to $549,000 and $271,000, respectively, for the 2012 and 2011 grants. The Company recorded non-cash compensation of $141,000 and $104,000 for the vesting portion of these options for the years ended December 31, 2012 and 2011, respectively. The Company also recognized non-cash compensation of $157,000 and $164,000 in 2012 and 2011, respectively, for the options that were granted in prior years but vested in 2012 and 2011.

During the year ended December 31, 2012, options to purchase an aggregate of 2,478,070 shares of the Company’s common stock were exercised at prices ranging from $0.14 per share to $0.68 per share, resulting in proceeds of $16,000. As certain of these options were exercised on a cashless basis, 962,537 shares of common stock were issued. In addition, an aggregate of 350,160 shares were delivered with a value of $487,000 to fund payroll withholding taxes on exercise.

On February 2, 2011, the Company extended for three years the expiration dates of certain outstanding options issued to a consultant to purchase an aggregate of 75,000 shares of common stock at $0.68 per share. The Company incurred non-cash compensation charges of $5,000 with respect to this option extension.

On May 20, 2011, the Company extended the expiration dates of options (expiring in 2011) for three years to purchase an aggregate of 745,218 shares of common stock held by officers, directors and a third party. The extensions of the expiration dates for an aggregate of 690,218 shares of such options were subsequently cancelled in December 2011 and the Company recorded non-cash compensation of $5,000 with respect to the option extensions which were not cancelled. (See Note H[3]).

During the year ended December 31, 2011, options to purchase an aggregate of 1,031,467 shares of the Company's common stock were exercised at prices of between $0.13 and $0.70 per share, for total proceeds to the Company of $163,028. As certain of these options were exercised on a cashless basis, 851,157 shares of common stock were issued. In addition, 230,234 shares were delivered with a value of $283,000 to fund payroll withholding taxes on exercise.

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note D- Stockholders’ equity (continued)

The following table presents information relating to all stock options outstanding and exercisable at December 31, 2012:

			Weighted
		Weighted	Average		Weighted
Range of		Average	Remaining		Average
Exercise	Options	Exercise	Life in	Options	Exercise
Price	Outstanding	Price	Years	Exercisable	Price

$0.21 - $1.60	5,582,500	$0.78	3.05	4,826,250	$ 0.71

[2]

Warrants:

As of December 31, 2012, the following are the outstanding warrants to purchase shares of the Company's common stock:

Number of	Exercise
Warrants	Price	Expiration Date

250,000	$0.68	October 8, 2013

On January 4, 2012, warrants to purchase 300,000 shares of the Company’s common stock were exercised (on a cashless basis) by an affiliated entity of the Company’s Chairman and Chief Executive Officer which resulted in the issuance of net shares of common stock of 128,572 shares.

During the year ended December 31, 2011, warrants to purchase an aggregate of 50,000 shares of the Company's common stock were exercised at a price of $0.68 per share, on a cashless basis resulting in the issuance of 24,815 shares.

On May 20, 2011, the Company extended for three years the expiration dates of warrants (expiring in 2011) to purchase an aggregate of 350,000 shares of common stock held by the Chief Executive Officer and a Director and the Company recorded non-cash compensation of $300,000 with respect to such extensions.

Note E - Commitments and Contingencies

[1]	Legal fees:

Dovel & Luner, LLP provides legal services to the Company with respect to the Company’s pending patent litigation filed in September 2011 against sixteen (16) data networking equipment manufacturers in the United States District Court for the Eastern District of Texas, Tyler (See Note J[1]). The terms of the Company’s agreement with Dovel & Luner LLP essentially provides for legal fees on a full contingency basis ranging from 12.5% to 35% (with certain exceptions) of the net recovery (after deduction for expenses) depending on the stage of the preceding in which a result (settlement or judgment) is achieved. For the year ended December 31, 2012, the Company incurred legal fees and expenses of $344,000 with respect to the litigation.

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note E - Commitments and Contingencies (continued)

Dovel & Luner, LLP provided legal services to the Company with respect to the Company’s patent litigation settled in July 2010 against several major data networking equipment manufacturers. (See Note J[2]). The terms of the Company’s agreement with Dovel & Luner, LLP provided for legal fees of a maximum aggregate cash payment of $1.5 million plus a contingency fee of up to 24% (based on the settlement being achieved at the trial stage) including legal fees of local counsel in Texas. With respect to royalty payments payable quarterly by Cisco in accordance with the Company’s settlement and license agreement with Cisco (See Note J[2]),the Company has an obligation to pay Dovel & Luner 24% of such royalties received after expenses). During the years ended December 31, 2012 and 2011, total contingency fees incurred to Dovel & Luner, LLP (including local counsel) approximated $1,726,000 and $1,651,000, respectively.

With respect to the Company’s litigation against D-Link, which was settled in May 2007, the Company utilized the services of Blank Rome, LLP, on a full contingency basis. In accordance with the Company’s contingency fee agreement with Blank Rome LLP, once the Company recovers its expenses related to the litigation (which has not been achieved yet), the Company is obligated to pay legal fees to Blank Rome LLP equal to 25% of the royalty revenue received by the Company from its license agreement with D-Link.

[2]	Services agreement:

On November 30, 2004, the Company entered into a master services agreement (the "Agreement") with ThinkFire Services USA, Ltd. ("ThinkFire") pursuant to which ThinkFire has been granted the exclusive worldwide rights (except for direct efforts by the Company and related companies) to negotiate license agreements for the Remote Power Patent with respect to certain potential licensees agreed to between the parties. Either the Company or ThinkFire can terminate the Agreement upon 60 days' notice for any reason or upon 30 days' notice in the event of a material breach. The Company agreed to pay ThinkFire a fee not to exceed 20% of the royalty payments received from license agreements consummated by ThinkFire on its behalf after the Company recovers its expenses. For the years ended December 31, 2012 and December 31, 2011, fees incurred to ThinkFire amounted to $97,000 and $85,000, respectively.

[3]	Operating leases:

The Company leases its principal office space in New York City at a monthly base rent of approximately $3,500 which lease expires in November 2013.

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note E - Commitments and Contingencies (continued)

On June 16, 2011, the Company entered into a four-year lease agreement commencing July 18, 2011 to rent office space, consisting of approximately 2,400 square feet, for offices in New Canaan, Connecticut. In accordance with the lease, the Company pays a base rent of $6,400 per month for the first two years, $6,800 per month for the third year and $7,000 per month for the fourth year. The base rent is subject to annual adjustments to reflect increases in real estate taxes and operating expenses. The Company also entered into a one year sublease (which expired July 2012) at a base rent of $3,700 per month to sublet approximately 50% of the space to a third party.

Rental expense for the years ended December 31, 2012 and 2011 aggregated $99,000 and $72,000, respectively, net of sublease income of $26,000 and $18,000.

[4]	Savings and investment plan:

The Company has a Savings and Investment Plan which allows participants to make contributions by salary reduction pursuant to Section 401(k) of the Internal Revenue Code of 1986. The Company also may make discretionary annual matching contributions in amounts determined by the Board of Directors, subject to statutory limits. The 401(k) Plan expense for the years ended December 31, 2012 and 2011 was $33,000 and $32,500, respectively.

Note F – Income Taxes

At December 31, 2012, the Company had net operating loss carryforwards (NOLs) totaling approximately $25,255,000 expiring through 2029, with a future tax benefit of approximately $8,840,000. During 2011, as a result of the Company’s recent results and projected future operating results, management determined that a portion of the NOL was more likely than not to be utilized resulting in the recording of a one-time, non-cash tax benefit of $7,000,000 (income) or $0.29 per share (basic) for the three and six month periods ended June 30,2011. At December 31, 2011, $6,903,000 has been recorded as a deferred tax asset on the Company’s balance sheet and $6,903,000 (or $0.22 per share on a diluted basis) has also been recorded as deferred tax benefit on the Company’s statement of income for the year ended December 31, 2011. At December 31, 2012, $6,194,000 has been recorded as a deferred tax asset on the Company’s balance sheet. During the year ended December 31, 2012 as a result of income (before taxes) for the period of $3,372,000, $37,000 was recorded as income tax expense and the deferred tax asset was reduced by $709,000 to $6,194,000. To the extent that the Company earns income in the future, it will report income tax expense and such expense attributable to federal income taxes will reduce the recorded income tax benefit asset reflected on the balance sheet. Management will continue to evaluate the recoverability of the NOL and adjust the deferred tax asset appropriately. Utilization of NOL credit carryforwards can be subject to a substantial annual limitation due to ownership change limitations that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended, as well as similar state provisions.

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note F – Income Taxes (continued)

The principal components of the net deferred tax assets are as follows:

	Year Ended
	December 31,
	2012			2011
Deferred tax assets:
Net operating loss carryforwards	$	8,840,000		$	9,450,000
Options and warrants not yet deducted, for tax purposes		420,000			990,000

		9,250,000			10,440,000
Valuation allowance		(3,066,000	)		(3,537,000	)

Net deferred tax assets	$	6,194,000		$	6,903,000

The reconciliation between the taxes as shown and the amount that would be computed by applying the statutory federal income tax rate to the income before income taxes is as follows:

	Year Ended
	December 31,
	2012	2011

Income tax - statutory rate	34.0%	34.0%
State and local, net	0.0%	0.0%
Valuation allowance on deferred tax assets	(12.0)%	(461.3)%
(Utilization of NOL)

While only the tax returns for the four years ended December 31, 2012 are open for examination for taxes payable for those years, tax authorities could challenge returns for earlier years to the extent that they generated loss carry forwards that are available for those or future years.

Note G - Concentrations

The Company places its cash investments in high quality financial institutions which at December 31, 2012 exceed the Federal Insurance Deposit Corporation $250,000 limit. At December 31, 2012, the Company invested $21,733,000 in a money market fund.

Note H - Related Party Transactions

[1]	On April 25, 2012, the Company repurchased 27,757 shares of its common stock from its Chief Financial Officer at a purchase price of $1.35 per share or aggregate consideration of $37,472.

[2]

On March 16, 2011, the Company's employment agreement, dated June 8, 2009, with its Chairman and Chief Executive Officer, was amended pursuant to which, in consideration of a payment of $250,000, the Chairman and Chief Executive Officer agreed to reduce Additional Bonus Compensation and Royalty Bonus Compensation (as such terms are defined in Section 5(b)(ii) of the agreement) payable to him from the proceeds of patents other than the Remote Power Patent from 12.5% to 10%.

[3]

On May 20, 2011, the Company's Board of Directors approved three year extensions of the expiration dates (which were to expire in 2011) for certain outstanding options and warrants to purchase an aggregate of 1,095,218 shares of common stock, exercisable at $0.13 and $0.68 per share, which included options and warrants held by the Chairman and Chief Executive Officer, and an affiliated entity (aggregate of 835,218 shares), Chief Financial Officer (75,000 shares), and two directors (aggregate 150,000 shares). The extensions of the expiration dates for the Chairman and CEO (515,218 shares), Chief Financial Officer (75,000 shares), and two directors (aggregate 100,000 shares) were subsequently cancelled in December

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note H - Related Party Transactions (continued)

2011 as the holders exercised such options prior to the original expiration dates of such options.

[4]

On October 15 and October 17, 2011, the Company repurchased 114,815 and 24,434 shares of its common stock from a director and a consultant, respectively, at an aggregate purchase price of $187,986 or $1.35 per share (the fair market value at the date of purchase). The repurchase was part of the Company's stock repurchase program to repurchase up to $4,000,000 of its common stock (See Note K).

Note I - Employment Arrangements and Other Agreements

[1]

On November 1, 2012, the Company entered into a new employment agreement (the “Agreement”) with its Chairman and Chief Executive Officer for a one year term (which shall automatically be extended for two successive one year periods unless terminated by the Company) at an annual base salary of $415,000. The Agreement established an annual target bonus of $150,000 for the Chairman and Chief Executive Officer based on performance criteria to be established on an annual basis by the Board of Directors (or compensation committee). For the year ended December 31, 2012, the Chairman and Chief Executive Officer received the target bonus of $150,000. In connection with the Agreement, the Chairman and Chief Executive Officer was issued a ten year option to purchase 500,000 shares of the Company’s common stock at an exercise price of $1.19 per share, which vests in equal quarterly amounts of 41,667 shares beginning November 1, 2012 through August 31, 2015, subject to acceleration upon a change of control. The Chairman and Chief Executive Officer shall forfeit the balance of unvested shares if his employment has been terminated “For Cause” (as defined) by the Company or by him without "Good Reason" (as defined).

Under the terms of the Agreement, the Chairman and Chief Executive Officer also receives incentive compensation in an amount equal to 5% of the Company’s gross royalties or other payments or proceeds (without deduction of legal fees or any other expenses) with respect to its Remote Power Patent and a 10% net interest (gross royalties and other payments or proceeds after deduction of all legal fees and litigation expenses related to licensing, enforcement and sale activities, but in no event shall he receive less than 6.25% of the gross recovery) of the Company’s royalties and other payments with respect to its other patents besides the Remote Power Patent (the “Additional Patents”) (the “Incentive Compensation”). For the years ended December 31, 2012 and December 31, 2011, the Chairman and Chief Executive Officer earned Incentive Compensation of $434,891 and $369,922, respectively. The Incentive Compensation shall continue to be paid to Chairman and Chief Executive Officer for the life of each of the Company’s patents with respect to licenses entered into with third parties during the term of his employment or at anytime thereafter, whether he is employed by the Company or not; provided, that, the Chairman and Chief Executive Officer’s employment has not been terminated by the Company “For Cause” (as defined) or terminated by him without “Good Reason” (as defined). In the event of a merger or sale of substantially of the assets of the Company, the Company has the option to extinguish the right of Chairman and Chief Executive Officer to receive future Incentive Compensation by payment to him of a lump sum payment, in an amount equal to the fair market value of such future interest as determined by an independent third party expert if the parties do not reach agreement as to such value. In the event that Chairman and Chief Executive Officer’s employment is terminated by the Company “Other Than For Cause” (as defined) or by him for “Good Reason” (as defined), the Chairman and Chief Executive Officer shall also be entitled to (i) a lump sum severance payment of 12 months base salary, (ii) a pro-rated portion of the $150,000 target bonus provided bonus criteria have been satisfied on a pro-rated basis through the calendar quarter in which the termination occurs and (iii) accelerated vesting of all unvested options and warrants.

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note I - Employment Arrangements and Other Agreements (continued)

[2]

On June 8, 2009, the Company entered into an Employment Agreement (the “Agreement”) with the Chairman and Chief Executive Officer for a three year term (which expired in June 2012) at an annual base salary of $375,000 (retroactive to April 1, 2009) for the first year and increasing 5% on each of April 1, 2010 and April 1, 2011. During the term of the Agreement, the Chairman and Chief Executive Officer received a cash bonus in an amount no less than $150,000 on an annual basis. In connection with the Agreement, the Chairman and Chief Executive Officer was issued a ten year option to purchase 750,000 shares of common stock at an exercise price of $0.83 per share, which vested in equal quarterly amounts of 62,500 shares beginning June 30, 2010 through March 31, 2012. In addition to the aforementioned option grant, the Company extended for an additional 5 years the expiration dates of all options (an aggregate of 417,500 shares) expiring in the calendar year 2009 owned by the Chairman and Chief Executive Officer. Under the terms of the Agreement, the Chairman and Chief Executive Officer also received additional bonus compensation in an amount equal to 5% of the Company’s royalties or other payments with respect to the Company’s Remote Power Patent (before deduction of payments to third parties including, but not limited to, legal fees and expenses and third party license fees).

[3]

On February 3, 2011, the Company entered into an agreement with its Chief Financial Officer for his continued service through December 31, 2012. In consideration for his services, the Chief Financial Officer was compensated at the rate of $9,000 per month for the year ending December 31, 2011 and was to be compensated at the rate of $9,450 per month for the year ending December 31, 2012. In connection with the agreement, the Chief Financial Officer was also issued a five year option to purchase 100,000 shares of the Company’s common stock at an exercise price of $1.59 per share. The option vested 50,000 shares on the date of grant and the balance of the shares (50,000) vested on the one year anniversary date (February 3, 2012) from the date of grant.

[4]

On April 12, 2012, the Company entered into an agreement, with its Chief Financial Officer which amended the agreement, dated February 3, 2011 (See Note I[3] above), pursuant to which he continued to serve the Company. The amendment (the "Amendment") provided as follows: (i) the term of service of the Chief Financial Officer shall be extended until December 31, 2013; (ii) monthly compensation shall be increased to $11,000 per month; and (iii) the Chief Financial Officer was granted a five year option to purchase 75,000 shares of the Company’s common stock at an exercise price of $1.40 per share, which option vests over a one year period in equal quarterly amounts of 18,750 shares. Except as provided in the Amendment, all other terms of the Agreement, dated February 3, 2011, remain in full force and effect.

Note J – Litigation

[1]

In September 2011, the Company initiated patent litigation against 16 data networking equipment manufacturers in the United States District Court for the Eastern District of Texas, Tyler Division, for infringement of its Remote Power Patent. Named as defendants in the lawsuit, excluding related parties, were Alcatel-Lucent USA, Inc., Allied Telesis, Inc., Avaya Inc., AXIS Communications Inc., Dell, Inc., GarrettCom, Inc., Hewlett-Packard Company, Huawei Technologies USA, Juniper Networks, Inx., Motorola Solutions, Inc., NEC Corporation, Polycom Inc., Samsung Electronics Co., Ltd., ShoreTel, Inc., Sony Electronics, Inc., and Transitions Networks, Inc. Network-1 seeks monetary damages based upon reasonable royalties. During the year ended December 31, 2012, the Company reached settlement agreements with defendants Motorola Solutions, Inc. ("Motorola"), Transition Networks, Inc. ("Transition Networks") and GarretCom, Inc. (“GarretCom”). In February 2013, the Company reached settlement agreements with Allied Telesis, Inc. (“Allied Telesis”) and NEC Corporation (“NEC”). As part of the settlements, Motorola, Transition Networks, GarretCom, Allied Telesis and NEC each entered into a non-exclusive license agreement for the Company’s Remote Power Patent pursuant to which each such defendant agreed to license the Remote Power Patent for its full term (which expires in March 2020) and pay a license initiation fee and quarterly or annual royalties based on their sales of PoE products.

[2]

In July 2010, the Company settled its patent litigation pending in the United States District Court for the Eastern District of Texas, Tyler Division, against Adtran, Inc, Cisco Systems, Inc. and Cisco-Linksys, LLC, (collectively, “Cisco”), Enterasys Networks, Inc., Extreme Networks, Inc., Foundry Networks, Inc., and 3Com Corporation, Inc. As part of the settlement, Adtran, Cisco, Enterasys, Extreme Networks and Foundry Networks each entered into a settlement agreement with the Company and entered into non-exclusive licenses for our Remote Power Patent (the “Licensed Defendants”). Under the terms of the licenses, the Licensed Defendants paid the Company aggregate upfront payments of approximately $32 million and also

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NETWORK-1 SECURITY SOLUTIONS, INC.

Note J – Litigation (continued)

agreed to license the Remote Power Patent for its full term, which expires in March 2020. In accordance with the Settlement and License Agreement, dated May 25, 2011, which expanded upon the July 2010 agreement, Cisco is obliged to pay the Company royalties (which began in the first quarter of 2011) based on its sales of PoE products up to maximum royalty payments per year of $8 million through 2015 and $9 million per year thereafter for the remaining term of the patent. The royalty payments are subject to certain conditions including the continued validity of the Company’s Remote Power Patent, and the actual royalty amounts received may be less than the caps stated above, as was the case in 2012 and 2011. Under the terms of the Agreement, if the Company grants other licenses with lower royalty rates to third parties (as defined in the Agreement), Cisco shall be entitled to the benefit of the lower royalty rates provided it agrees to the material terms of such other license. Under the terms of the Agreement, the Company has certain obligations to Cisco and if it materially breaches such terms, Cisco will be entitled to stop paying royalties to the Company. This would have a material adverse effect on the Company’s business, financial condition and results of operations.

In May 2009, the Company achieved a settlement with Netgear, Inc. (“Netgear”), also a defendant in the above referenced litigation in Tyler, Texas which was settled with the other defendants in July 2010. As part of the settlement and under its special licensing program, Netgear entered into a license agreement with the Company for the Remote Power Patent effective April 1, 2009. Under the terms of the license, Netgear licenses the Remote Power Patent from the Company for its full term (which expires in March 2020), and pays quarterly royalties (which began as of April 1, 2009) based on its sales of Power over Ethernet products, including those Power over Ethernet products which comply with the Institute of Electrical and Electronic Engineers 802.3af and 802.3at Standards. Licensed products include Netgear’s Power over Ethernet enabled switches and wireless access points. The royalty rates included in the license are 1.7% of the sales price of Power Sourcing Equipment, which includes Ethernet switches, and 2% of the sales price of Powered Devices, which includes wireless access points. The royalty rates are subject to adjustment, under certain circumstances, if the Company grants a license to other licensees with lower royalty rates and Netgear is able to and agrees to assume all material terms and conditions of such other license. In addition, Netgear made a payment of $350,000 to the Company with respect to the settlement.

[3]

On July 20, 2012, an unknown third party filed with the United States Patent and Trademark Office (USPTO) a request for an Ex Parte Reexamination, requesting that our Remote Power Patent be reexamined by the USPTO. The request for reexamination was stayed on December 21, 2012 pending the termination or completion of the Inter Partes Review proceedings described in Note J[4] below. The initial grant of the reexamination by USPTO is not unusual as the majority of such applications are initially granted by USPTO. While the Company believes that the reexamination proceeding will further validate and strengthen the Remote Power Patent, should the USPTO reach a final determination that the Remote Power Patent is invalid (unless overturned by the Board of Patent Appeals and Interference or the United States Court of Appeals for the Federal Circuit), such a determination would have a material adverse effect on the Company as its entire current revenue stream is dependent upon the continued validity of our Remote Power Patent.

[4]

There have been two Inter Partes Review petitions filed in the USPTO pertaining to the Company’s Remote Power Patent. On December 5, 2012, Avaya Inc. filed a petition to institute an Inter Partes Review of the Remote Power Patent. On December 19, 2012, Sony Corporation of America, Axis Communications AB, and Axis Communications, Inc. filed a separate petition to also institute an Inter Partes Review of the Remote Power Patent. Petitioners in each inter-partes review seek to cancel certain claims of the Remote Power Patent as unpatentable. The USPTO has not yet made a determination of whether a trial will proceed in either Inter Partes Review proceeding. In the event that the USPTO reaches a final determination in the Inter Partes Review proceedings that certain of our claims related to the Remote Power Patent are unpatentable such a determination would have a material adverse effect on our business, financial condition and results of operations.

F - 34

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE K – STOCK REPURCHASE PROGRAM

On August 22, 2011, the Company announced that the Board of Directors approved a share repurchase program to repurchase up to $2,000,000 of shares of its common stock over the next 12 months (“Share Repurchase Program”). The common stock may be repurchased from time to time in open market transactions or privately negotiated transactions in the Company’s discretion. The timing and amount of the shares repurchased will be determined by management based on its evaluation of market conditions and other factors. The repurchase program may be increased, suspended or discontinued at any time. On January 31, 2012, the Board of Directors increased the Share Repurchase Program to repurchase up to an additional $2,000,000 (or an aggregate of $4,000,000) of the Company's common stock. During the year ended December 31, 2012, the Company repurchased an aggregate of 736,357 shares of common stock pursuant to its Share Repurchase Program at a cost of $880,329 or an average price per share of $1.19.

NOTE L – SUBSEQUENT EVENTS

[1]	On January 24, 2013, the Board of Directors of the Company further increased the Company’s Share Repurchase Program (See Note [K] hereof) to repurchase up to an additional $1,000,000 (or an aggregate of $5,000,000) of the Company’s common stock over the next 12 months.

[2]	On January 24, 2013, the Company issued annual option grants to each of its four non-management directors to purchase 25,000 shares of common stock, at an exercise price of $1.19 per share, which options vest on a quarterly basis over one year period.

[3]

On February 28, 2013, the Company completed the acquisition of 4 patents (as well as a pending patent application) pertaining to enabling technology for identification of media content for a purchase price of $1,000,000 in cash and 403,226 shares of the Company’s common stock. In addition, the Company is obligated to pay the seller 12.5% of the net proceeds generated by the Company from licensing, sale or enforcement of the patents.

F - 35

YEAR ENDING DECEMBER 31, 2013	HIGH	LOW

Second Quarter	$1.90	$1.23
First Quarter	$1.50	$1.12

YEAR ENDED DECEMBER 31, 2012	HIGH	LOW

Fourth Quarter	$1.28	$1.10
Third Quarter	$1.32	$1.16
Second Quarter	$1.37	$1.18
First Quarter	$1.35	$1.13

YEAR ENDED DECEMBER 31, 2011	HIGH	LOW

Fourth Quarter	$1.30	$1.01
Third Quarter	$1.45	$0.01
Second Quarter	$0.65	$0.00
First Quarter	$1.65	$0.01

	Number of securities to be issued upon exercise of outstanding options, warrants and rights (a)		Weighted-average exercise price of outstanding options, warrants and rights (b)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column) (a) (c)
Equity compensation plans approved by security holders (1)		1,400,000	$	0.66		0(1)
Equity compensation plans not approved by security holders(2)		4,432,500	$	0.81		—
Total		5,832,500	$	0.78		0(1)

● Cisco Systems, Inc. and Cisco Linksys	● Motorola Solutions, Inc.
● Microsemi Corporation	● NEC Corporation
● Extreme Networks, Inc.	● Adtran, Inc.
● Netgear, Inc.	● Allied Telesis, Inc.
● Transition Networks, Inc.	● Enterasys Networks, Inc.
● GarretCom, Inc.	● Foundry Networks, Inc.
● D-Link Corporation and D-Link Systems, Inc.	● SEH Technology, Inc.
● BRG Precision Products, Inc.	● Buffalo Technology (USA), Inc.

Name	Number of Shares Beneficially Owned Prior to Offering(1)	Number of Shares Being Offered	Number of Shares Beneficially Owned After Offering(1)(2)	Percentage of Outstanding Common Stock After Offering(1)
Looking Glass LLC	1,750,000(3)	1,750,000(3)	0	0%
Recognition Interface, LLC	750,000(4)	750,000(4)	0	0%
Sucaba LLC	440,000(5)	440,000(5)	0	0%
Sucaba CRUT, LLC	60,000(6)	60,000(6)	0	0%
Corey M. Horowitz	7,987,818(7)	761,027(8)	4,663,157	16.4%
CMH Capital Management Corp.	2,171,372(9)	2,171,372(9)	0	0%
Donna Slavitt	67,471	67,471	0	0%
Logan Zev Horowitz 1999 Trust	107,500(10)	107,500(10)	0	0%
Dylan Max Horowitz 1999 Trust	107,500(10)	107,500(10)	0	0%
Corey M. Horowitz Custodian for Zachary Jordon Horowitz	107,500(10)	107,500(10)	0	0%
Horowitz Partners	2,291(11)	2,291(11)	0	0%

NAME	AGE	POSITION
Corey M. Horowitz	58	Chairman, Chief Executive Officer and Chairman of the Board of Directors
David C. Kahn	61	Chief Financial Officer, Secretary and a Director
Jonathan Greene	51	Executive Vice President
Emanuel Pearlman	53	Director
Niv Harizman	49	Director
Allison Hoffman	42	Director

PROSPECTUS SUMMARY	2
RISK FACTORS	7
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS	17
PRICE RANGE OF OUR COMMON STOCK	18
DIVIDEND POLICY	18
EQUITY COMPENSATION PLAN INFORMATION	19
BUSINESS	20
LEGAL PROCEEDINGS	29
USE OF PROCEEDS	31
SELLING STOCKHOLDERS	32
PLAN OF DISTRIBUTION	34
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION	36
MANAGEMENT	46
EXECUTIVE COMPENSATION	49
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT	54
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE	57
DESCRIPTION OF SECURITIES	57
LEGAL MATTERS	59
EXPERTS	59
DISCLOSURE OF COMMISSION POSITION ON INDEMNIFICATION FOR SECURITIES ACT LIABILITIES	60
WHERE YOU CAN FIND MORE INFORMATION	60
FINANCIAL INFORMATION	F-1

	Year Ended December 31,				Six Months Ended June 30,
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:	2012		2011		2013		2012
Royalty Revenue	$	8,698,000	$	7,398,000	$	5,971,000	$	6,391,000
Operating expenses(1)	$	2,763,000	$	3,759,000	$	1,701,000	$	1,201,000
Net income (2)	$	2,626,000	$	8,493,000	$	2,174,000	$	2,660,000

Net income (loss) per share
Basic	$	0.10	$	0.33	$	0.09	$	0.10
Diluted	$	0.09	$	0.27	$	0.08	$	0.09

Weighted-average common shares outstanding
Basic		25,744,330		25,813,038		25,098,074		25,595,913
Diluted		28,472,753		30,930,483		27,396,414		28,729,256

CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents	$	21,983,000	$	20,661,000	$	18,103,000	$	21,279,000
Working capital	$	22,702,000	$	20,402,000	$	19,924,000	$	23,263,000
Total assets	$	29,805,000	$	29,129,000	$	32,307,000	$	30,392,000
Total shareholders’ equity	$	28,980,000	$	27,398,000	$	31,496,000	$	29,686,000

		Annual Compensation			Long Term Compensation Awards
Name and Principal Position	Year	Salary ($)	Bonus ($)	Option Awards($)(3)	All Other Compensation($)(1)	Total($)
Corey M. Horowitz Chairman and Chief Executive Officer	2012 2011	$414,000 $409,000	$ 585,000(2) $ 520,000(2)	$328,000 $176,000	— $ 250,000(4)	$1,327,000 $1,355,000
David C. Kahn Chief Financial Officer	2012 2011	$126,000(5) $108,000(5)	$ 30,000 $ 30,000	$43,000 $32,000	$ 5,000(6) $ 5,000(6)	$204,000 $175,000

Name	Option Awards(2) (3) ($)	Fees Earned or Paid in Cash ($)(1)	Total ($)
Emanuel Pearlman	$38,000	$40,000	$ 78,000(1)
Laurent Ohana	$13,000	$40,000	$ 53,000(1)
Robert Pons	$84,000	$40,000	$124,000
Niv Harizman	$22,000	$ 1,538	$ 23,538
Allison Hoffman	$22,000	$ 1,538	$ 23,538

	Number of Securities Underlying Unexercised Options
Name	Exercisable	Unexercisable	Option Exercise Price ($)	Option Expiration Date
Corey M. Horowitz Chairman and CEO	41,667 750,000	458,333(1) —	$ 1.19 $ 0.83	11/1/22 6/08/19
	400,000	—	$ 0.68	11/26/14
	1,100,000	—	$ 0.25	11/26/14
	750,000	—	$ 0.68	4/18/13
	250,000	—	$ 0.68	10/08/13
	10,000	—	$ 0.68	6/22/14
	7,500	—	$ 0.68	10/25/14
	5,000	—	$ 0.68	9/19/13
	375,000	—	$ 0.68	2/28/13
David Kahn Chief Financial Officer	56,250(2) 100,000	18,750(2) —	$ 1.40 $ 1.59	4/12/17 2/03/16
	75,000	—	$ 0.68	08/04/13
	100,000(3)	—	$ 0.54	12/18/13

NAME AND ADDRESS OF BENEFICIAL OWNER	AMOUNT AND NATURE OF BENEFICIAL OWNERSHIP(1)		PERCENTAGE OF COMMON STOCK BENEFICIALLY OWNED(2)

Corey M. Horowitz(3)		7,987,819		27.8%
MH Capital Management Corp(4)		2,171,372		8.3%
Steven D. Heinemann (5)		2,578,835		9.9%
Barry Rubenstein(6)		2,041,396		7.8%
Woodland Services Corp.(7)		1,376,209		5.3%
Looking Glass LLC(8)		1,750,000		6.7%
Jonathan Auerbach(9)		1,503,813		5.8%
Hound Partners Offshore Fund, L.P.(10)		1,366,230		5.2%
Emigrant Capital Corporation (11)		1,312,500		5.0%
David C. Kahn(12)		348,118		1.3%
Emanuel Pearlman(13)		87,500		*
Niv Harizman(14)		155,043		*
Allison Hoffman(15)		50,000		*
All officers and directors as a group (5 Persons)		8,628,480		29.4%