Edgar Filing: NETWORK 1 SECURITY SOLUTIONS INC

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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-QSB

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______ TO _______

COMMISSION FILE NUMBER 1-14896

NETWORK-1 SECURITY SOLUTIONS, INC.

(EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)

DELAWARE 11-3027591
--------------------------------------------------------------------------------
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)

445 Park Avenue, Suite 1028, New York, New York 10022
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

212-829-5770
(Issuer's Telephone Number)

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes [X] No [_]

The number of shares of Common Stock, $.01 par value per share, outstanding as
of May 10, 2005 was 17,697,572.

Transitional Small Business Disclosure Format (check one): Yes [_] No [X]
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NETWORK-1 SECURITY SOLUTIONS, INC.

INDEX

Page No.

PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS
Condensed Balance Sheets as of March 31, 2005 (unaudited)
and December 31, 2004............................................... 3

Condensed Statements of Operations for the three months
ended March 31, 2005 and 2004 (unaudited)........................... 4

Condensed Statements of Cash Flows for the three months
ended March 31, 2005 and 2004 (unaudited)........................... 5

Notes to Condensed Financial Statements............................. 6

Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION........... 13

Item 3. CONTROLS AND PROCEDURES............................................. 20

PART II. OTHER INFORMATION

Item 1. Legal Proceedings................................................... 20

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds......... 21

Item 3. Defaults Upon Senior Securities..................................... 21

Item 4. Submission of Matters to a Vote of Security Holders................. 21

Item 5. Other Information................................................... 22

Item 6. Exhibits and Reports on Form 8-K.................................... 22

SIGNATURES................................................................... 23

NETWORK-1 SECURITY SOLUTIONS, INC.
CONDENSED BALANCE SHEETS
(UNAUDITED)

NETWORK-1 SECURITY SOLUTIONS, INC.

CONDENSED BALANCE SHEETS

MARCH 31, DECEMBER 31,
2005 2004
------------ ------------
(UNAUDITED)

ASSETS
------
Current assets:
Cash and cash equivalents $ 1,725,000 $ 2,177,000
Prepaid expenses and other current assets 76,000 100,000
------------ ------------

Total current assets 1,801,000 2,277,000

Patents 91,000 92,000
------------ ------------
$ 1,892,000 $ 2,369,000
============ ============

LIABILITIES
-----------
Current liabilities:
Accounts payable $ 120,000 $ 437,000
Accrued expenses and other current liabilities 505,000 505,000
------------ ------------

Total current liabilities 625,000 942,000
------------ ------------

Liability to be settled with equity instrument 265,000 294,000
------------ ------------

Commitments and contingencies

STOCKHOLDERS' EQUITY
--------------------

Common stock - $0.01 par value ; authorized
50,000,000 shares; 17,697,572 shares issued
and outstanding at March 31, 2005 and
17,097,572 at December 31, 2004 177,000 171,000

Additional paid-in capital 44,545,000 43,951,000
Accumulated deficit (43,720,000) 42,989,000
------------ ------------

1,002,000 1,133,000
------------ ------------
$ 1,892,000 $ 2,369,000
============ ============

See notes to condensed financial statements

NETWORK-1 SECURITY SOLUTIONS, INC.
CONDENSED STATEMENTS OF OPERATIONS

THREE MONTHS ENDED MARCH 31,
------------------------------
2005 2004
------------ ------------

Operating expenses:
General and administrative $ 238,000 $ 364,000
Patent Cost 500,000 --
------------ ------------

LOSS BEFORE INTEREST INCOME (738,000) (364,000)
Interest income - net 7,000 1,000
------------ ------------

Net Loss (731,000) (363,000)

Deemed dividend on additional warrant antidilution
adjustment (6,000) --
------------ ------------

Net loss attributable to common stockholders $ (737,000) $ (363,000)
============ ============

LOSS PER COMMON SHARE - BASIC AND DILUTED $ (0.04) $ (0.04)
============ ============

WEIGHTED AVERAGE COMMON SHARES - BASIC AND DILUTED 17,617,572 8,314,458
============ ============

See notes to condensed financial statements

NETWORK-1 SECURITY SOLUTIONS, INC.
CONDENSED STATEMENTS OF CASH FLOW

THREE MONTHS ENDED MARCH 31,
------------------------------
2005 2004
------------ ------------

Cash flows from operating activities:
Net loss $ (731,000) $ (363,000)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 1,000 2,000
Valuation adjustment for outstanding stock options (29,000)
Issuance of options and warrants for services
rendered -- 57,000

Changes in:
Prepaid expenses and other current assets 24,000 24,000
Accounts payable, accrued expenses and other
current liabilities (317,000) (44,000)
------------ ------------

Net cash used in operating activities (1,052,000) (324,000)
------------ ------------
Cash Flows from Investing Activities
-- --
------------ ------------
Cash Flows from Financing Activities
Issuance of Common Stock 600,000 --
------------ -----------

NET DECREASE IN CASH AND CASH EQUIVALENTS (452,000) (324,000)
Cash and cash equivalents, beginning of period 2,177,000 984,000
------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,725,000 $ 660,000
============ ============

See notes to condensed financial statements

NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

[1] BASIS OF PRESENTATION:

The accompanying condensed financial statements as of March 31, 2005 and for the
three month periods ended March 31, 2005 and March 31, 2004, 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 March 31, 2005, the results of its operations and its
cash flows for the three month periods ended March 31, 2005 and March 31, 2004.
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-QSB. 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, 2004 included in the Company's Annual
Report on Form 10-KSB filed with the Securities and Exchange Commission. The
results of operations for the three months ended March 31, 2005 and 2004 are not
necessarily indicative of the results of operations to be expected for the full
year.

[2] BUSINESS:

(a) The principal business of the Company is the acquisition, development,
licensing and protection of its intellectual property. The Company presently
owns six patents (the "Patent Portfolio") covering various telecommunications
and data networking technologies including, among others, patents covering the
delivery of power over Ethernet cable for the purpose of remotely powering
network devices, and the transmission of audio, video and data over computer and
telephony networks. The Company's strategy is to pursue licensing and strategic
business alliances with companies in the industries that manufacture and sell
products that make use of the technologies underlying its patents as well as
with other users of the technology who benefit directly from the technology
including corporate, educational and governmental entities.

On November 18, 2003, the Company acquired the Patent Portfolio from Merlot
Communications, Inc., a broadband communications solutions provider. In February
2004, the Company initiated licensing efforts relating to one of its patents
(U.S. Patent No. 6,218,930) covering the remote delivery of power over Ethernet
cables (the "Remote Power Patent"). As of March 31, 2005, the Company
transmitted letters to approximately 85 companies offering licenses to the
Remote Power Patent. To date the Company has not entered into any license
agreements with third parties with respect to its Remote Power Patent.

NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

[2] BUSINESS: (CONTINUED)

(b) As reflected in the accompanying financial statements, the Company has
incurred substantial losses and has experienced net cash outflows from
operations for 2004 and the three month period ended March 31, 2005. For the
year ended December 31, 2004 and the three month period ended March 31, 2005,
the Company had no revenue from operations. The Company will continue to have
operating losses for the foreseeable future until it is successful in licensing
its patented technologies. The Company is dependent upon debt and equity
financing until it generates cash flows from operations. In December 2004 and
January 2005, the Company completed a private placement of its securities. As a
result of such private placement, the Company has cash and cash equivalents of
$2,177,000 as of December 31, 2004 and $1,725,000 as of March 31, 2005. The
Company believes its current cash position will more likely than not be
sufficient to satisfy the Company's operations and capital requirements until
September 2006, although there can be no assurance that such funds will not be
expended prior thereto. If necessary, the Company will take further action which
it believes is required to sustain its operations for the next twelve months.

[3] STOCK-BASED COMPENSATION:

The Company accounts for stock-based employee compensation under Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees", and related interpretations. The Company has adopted the
disclosure-only provisions of Statement of Financial Accounting Standards
("SFAS") No. 123, "Accounting for Stock-Based Compensation" and SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure", which was
released in December 2002 as an amendment of SFAS No. 123. The following table
illustrates the effect on net loss and net loss per share attributable to common
stockholders as if the fair value-based method had been applied to all awards.

NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

[3] STOCK-BASED COMPENSATION: (continued)

THREE MONTHS ENDED MARCH 31,
------------------------------
2005 2004
------------ ------------

Reported net loss attributable to common stockholders $ (731,000) $ (363,000)
Stock-based employee compensation expense included in the
reported net loss, net of related tax effects -- --
Stock-based employee compensation determined under the
fair value-based method, net of related tax effects (433,000) (11,000)
------------ ------------

Pro forma net loss $ (1,164,000) $ (374,000)
============ ============

Loss per common share (basic and diluted):
As reported $ (0.04) $ (0.04)
============ ============

Pro forma $ (0.07) $ (0.03)
============ ============

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:

THREE MONTHS ENDED MARCH 31,
----------------------------
2005 2004
--------- ---------
Risk-free interest rates 3.95% 2.79%
Expected option life in years 3.00-7.00 3.00
Expected stock price volatility 220.65% 220.90%
Expected dividend yield 0.00% 0.00%

NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

[4] REVENUE RECOGNITION:

The Company plans on recognizing revenue received from the licensing of its
intellectual property portfolio 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.

[5] LOSS PER SHARE:

Basic net loss per share is calculated by dividing the net 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 11,017,244 and 12,814,078 at March 31, 2005 and
2004 respectively, are anti-dilutive, and are not included in the calculation of
diluted loss per share. Such potential common shares reflect options and
warrants.

[6] CASH EQUIVALENTS:

The Company places cash investments in high quality financial institutions
insured by the Federal Deposit Insurance Corporation ("FDIC"). At March 31,
2005, the Company maintained cash balance of approximately $1,610,000 in excess
of FDIC limits.

NOTE B - AMENDED PATENT PURCHASE AGREEMENT:

In November 2003, the Company acquired a portfolio of telecommunications and
data networking patents (six patents) from Merlot Communications, Inc.
("Merlot"). The purchase price for the Patent Portfolio was $100,000, paid in
cash. The cash price paid has been capitalized and is being amortized over the
remaining useful life of each patent. In addition, the Company has granted
Merlot 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 Company had agreed to pay Merlot 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 Merlot amended the Patent Purchase Agreement
(the "Amendment") pursuant to which the Company paid additional purchase price
of $500,000 to Merlot in consideration for the restructuring of future
contingent payments to Merlot from the licensing or sale of the Patents. The
Amendment provides for future contingent payments by the Company to Merlot 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 Merlot. Certain principal

NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE B - AMENDED PATENT PURCHASE AGREEMENT: (continued)

stockholders of the Company and related parties are also principal stockholders
of Merlot and were also directors of Merlot at the time of the original
agreement in November 2003 and the Amendment. The Company has treated this
expenditure as an expense called Patent Cost for the three months ended March
31, 2005.

NOTE C - PRIVATE PLACEMENT

[1] On December 21, 2004, the Company completed the first closing of a private
placement of 2,085,000 shares of common stock and three-year warrants to
purchase 1,563,750 shares of common stock (warrants to purchase 1,042,500 shares
of common stock at an exercise price of $1.25 and warrants to purchase 521,250
shares of common stock at an exercise price of $1.75) for an aggregate purchase
price of $2,035,000, net of $50,000 issuance costs. On January 13, 2005, the
Company completed a second closing with respect to the private placement of
securities, which consisted of an additional 600,000 shares of common stock and
warrants to purchase an additional 450,000 shares of common stock for an
aggregate purchase price of $600,000. In connection with the private placement,
the Company issued to a finder, warrants to purchase 50,000 shares of common
stock at an exercise price of $1.00 expiring in December 2009. As part of the
private placement, the Company also agreed to file a registration statement on
or before June 21, 2005, to register the common stock and the shares issuable
upon exercise of the warrants.

[2] In connection with the private placement and anti-dilutive provisions for
the warrants previously issued to Falconstor Software, Inc., the Company issued
warrants to purchase an aggregate of 135,000 additional shares of common stock
at an exercise price of $1.00 per share expiring in October 2006. The associated
expense, which is treated as an imputed dividend, is based on the fair value of
these warrants using the Black-Scholes model utilizing the risk-free interest
rate of 3.01%, life of 2 years, volatility of 270% and dividend yield of 0%.
Such expenses were $147,000 and $6,000 and are included in the accompanying
statement of operations for the year ended December 31, 2004 and March 31, 2005,
respectively.

NOTE D - LIABILITY TO BE SETTLED WITH EQUITY INSTRUMENTS

On April 18, 2002, in consideration of additional consulting and financial
advisory services, the Company issued to CMH Capital Management Corp., an entity
solely owned by Corey M. Horowitz, Chairman and Chief Executive Officer of the
Company, an option to purchase 750,000 shares of the common stock at an exercise
price of $1.20 per share, which was the market price of the Company's common
stock on the date of issuance. The options vest over a three-year period in
equal amounts of 250,000 per year beginning April 18, 2003. In addition, the
options shall vest in full in the event of a "change of control" or in the event
that the closing

NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE D - LIABILITY TO BE SETTLED WITH EQUITY INSTRUMENTS:(CONTINUED)

price of the Company's common stock reaches a minimum of $3.50 per share for 20
consecutive trading days. These options are treated as contingent options and
were originally priced in the quarter ended June 30, 2002 at $416,000.
Subsequently, they are revalued at each balance sheet date. On April 18, 2003,
250,000 of these options vested, having a fair value of $5,000. Accordingly,
$5,000 was reallocated to additional paid-in capital with a corresponding
reduction to the liability. On April 18, 2004, 250,000 of these options vested
having a fair value of $51,000. Accordingly, $51,000 was reallocated to
additional paid-in-capital with a corresponding reduction to the liability. The
options to purchase the remaining 250,000 shares continue to be treated as
contingent options and are valued utilizing the Black-Scholes option-pricing
model at each balance sheet date. At March 31, 2005, these unvested options were
revalued from $294,000 at December 31, 2004 to $265,000 at March 31, 2005. Any
increase or decrease in the valuation has been reflected as an addition or
reduction of general and administrative expenses at each balance sheet date.

NOTE E - COMMITMENTS AND CONTINGENCIES

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 has agreed to pay ThinkFire a fee not to
exceed 20% of the royalty payments received from license agreements consummated
by ThinkFire on its behalf.

NOTE F - EMPLOYMENT ARRANGEMENTS AND OTHER AGREEMENTS

On November 26, 2004, the Company entered into an employment agreement with
Corey M. Horowitz pursuant to which he agreed to continue to serve as Chairman
and Chief Executive Officer of the Company for a two-year term at an annual base
salary of $250,000 for the first year and $275,000 for the second year. Mr.
Horowitz was also issued options to purchase an aggregate of 1,500,000 shares of
the Company's common stock consisting of (i) a ten (10) year fully vested option
to purchase 1,100,000 shares at an exercise price of $0.25 per share, and (ii) a
five-year option to purchase 400,000 shares at an exercise price of $0.68 per
share which vest 50% on the date of grant and 50% one year thereafter, subject
to acceleration upon a change of control. In addition, Mr. Horowitz will receive
a bonus of 5% of the Company's royalties or other payments received from
licensing its patents. This bonus will continue to be paid to Mr. Horowitz for a
period of five (5) years following the term of the employment agreement with
respect to licenses entered into by the Company during the term of the
employment agreement, provided that he has not been terminated by the Company
"for cause" or by Mr. Horowitz himself without "good reason". Mr. Horowitz shall
receive severance equal to 12 months base salary in the event his employment is
terminated "without cause" or by

NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE F - EMPLOYMENT ARRANGEMENTS AND OTHER AGREEMENTS: (CON'T)

Mr. Horowitz for "good reason".

Mr. Horowitz was also granted certain anti-dilution rights which provide that if
at any time during the period ending December 31, 2005, in the event that the
Company completes an offering of its common stock or any securities convertible
or exercisable into common stock, he will receive, at the same price as the
securities issued in the financing, such number of additional stock options so
that he maintains the derivative ownership percentage (20.11%) of the Company
based upon options and warrants owned by him and CMH (exclusive of his ownership
of shares of common stock) as he owned as of the date of his employment
agreement (November 26, 2004). As a result of the closings of the private
placement on December 31, 2004 and January 13, 2005 and in accordance with the
anti-dilution protection afforded to Mr. Horowitz in his employment agreement,
Mr. Horowitz earned seven year options to purchase an aggregate of 1,195,361
shares at an exercise price of $1.18 per share. The Company did not recognize
any compensation expense as the exercise price for these options exceeded the
market price.

NOTE G - LITIGATION

In March 2004, PowerDsine Inc. ("PowerDsine") commenced an action against the
Company in the United District Court, Southern District of New York, seeking a
declaratory judgment that the Company's patent (U.S. Patent No. 6,218,930)
covering the remote delivery of power over Ethernet (the "Remote Power Patent")
is not infringed by PowerDsine and/or its customers. PowerDsine further seeks an
order permanently enjoining the Company (i) from making any claims to any person
or entity that PowerDsine's products infringe the Remote Power Patent or
contribute to infringement of the patent, (ii) from interfering with or
threatening to interfere with the importation, sale, license or use of
PowerDsine's power over Ethernet components or products, and (iii) from
instituting or prosecuting any lawsuit or proceeding placing at issue the right
of PowerDsine, its customers, licensees, successors, or assigns to import, use
or sell PowerDsine's power over Ethernet components or products. The Company
believes its Remote Power Patent is valid and has meritorious defenses to the
action. On December 1, 2004, the Company moved to dismiss the declaratory
judgment action asserting, among other things, that there is no actual case or
controversy because PowerDsine did not have reasonable apprehension of suit at
the time the case was filed, and therefore the court lacks jurisdiction over the
matter. On January 21, 2005, the Company's motion to dismiss was denied. The
Company has engaged in settlement discussion with PowerDsign in an effort to
resolve the litigation. In the event the Company is unable to settle the
litigation, the Company intends to vigorously defend the action and take
whatever actions are necessary to protect its intellectual property. In the
event, however, that the Court grants the declaratory judgment and the Company's
patent is determined to be invalid, such a determination would have a material
adverse effect on the Company.

ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

THIS QUARTERLY REPORT ON FORM 10-QSB CONTAINS FORWARD-LOOKING STATEMENTS WITHIN
THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE
"SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS
AMENDED (THE "EXCHANGE ACT"). ACTUAL RESULTS, EVENTS AND CIRCUMSTANCES
(INCLUDING FUTURE PERFORMANCE, RESULTS AND TRENDS) COULD DIFFER MATERIALLY FROM
THOSE SET FORTH IN SUCH STATEMENTS DUE TO VARIOUS RISKS AND UNCERTAINTIES,
INCLUDING, BUT NOT LIMITED TO, THOSE DISCUSSED BEGINNING ON PAGES 15-20 OF THIS
QUARTERLY REPORT ON 10-QSB FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005.

PLAN OF OPERATION

The principal business of the Company is the acquisition, development,
licensing and protection of its intellectual property. The Company presently
owns six patents covering various telecommunications and data networking
technologies (the "Patent Portfolio") including, among others, patents covering
the delivery of power over Ethernet for the purpose of remotely powering network
devices, and the transmission of audio, video and data over computer and
telephony networks. The Company's strategy is to pursue licensing and strategic
business alliances with companies in the industries that manufacture and sell
products that make use of the technologies underlying its patents as well as
with other users of the technology who benefit directly from the technology
including corporate, educational and governmental entities.

On November 18, 2003, the Company acquired the Patent Portfolio from Merlot
Communications, Inc., a broadband communications solutions provider. In February
2004, following its review of applicable markets, the Company initiated
licensing efforts relating to one of its patents (U.S. Patent No. 6,218,930)
covering the remote delivery of power over Ethernet cable (the "Remote Power
Patent"). The Company has focused, and will continue to focus, its efforts on
licensing its Remote Power Patent. As of the date of this Report, the Company
has not entered into any license arrangement with respect to the Remote Power
Patent, although it is pursing such arrangements with third parties. During the
next 12 months, management does not anticipate licensing efforts for its other
patents besides the Remote Power Patent.

To date the Company has incurred significant losses and at March 31, 2005
had an accumulated deficit of $(43,720,000). For the year ended December 31,
2004, the Company incurred a net loss of $(1,953,000) and incurred a net loss of
$(731,000) for the three months ended March 31, 2005. Management anticipates
that the Company will continue to incur losses until it enters into material
license agreements with respect to its patented technologies. The Company has
not achieved any revenue from its technology licensing business. To date the
Company has not entered any licensing agreements with third parties with respect
to its Remote Power Patent or the Company's other patented technologies. The
Company's inability to consummate license agreements and achieve revenue from
its patented technologies would have a material adverse effect on its operations
and its ability to continue business.

The Company does not currently have any revenue from operations. The
success of the Company and its ability to generate revenue is largely dependent
on its ability to consummate licensing arrangements with third parties. In
November 2004, the Company entered into an agreement with ThinkFire Services
USA, Ltd. ("ThinkFire") pursuant to which ThinkFire has been granted the
exclusive worldwide rights to negotiate license agreements for the Remote Power
Patent with certain agreed-upon potential licensees. The Company has agreed to
pay ThinkFire a fee not to exceed 20% of the royalty payments received from
license agreements consummated by ThinkFire on its behalf.

The Company's success depends on its ability to protect its intellectual
property rights. In the future, it may be necessary for the Company to commence
patent litigation against third parties whom it believes require a license to
its patents. In addition, the Company may be subject to third-party claims
seeking to invalidate its patents, as is the case with the action commenced by
PowerDsine against the Company relating to the Remote Power Patent as discussed
below. These types of claims, with or without merit, may subject the Company to
costly litigation and diversion of management's focus. In addition, based on the
Company's limited financial resources, it may not be able to pursue litigation
as aggressively as competitors with substantially greater financial resources.
Based on the Company's limited financial resources, it may be necessary to
engage third party professionals on a contingency basis pursuant to which such
parties would be entitled to share in the proceeds of any successful enforcement
of its intellectual property rights. If third parties making claims against the
Company seeking to invalidate its patent are successful, they may be able to
obtain injunctive or other equitable relief, which effectively could block its
ability to license or otherwise capitalize on its proprietary technologies.
Successful litigation against the Company resulting in a determination that its
patents are invalid would have a material adverse effect on the Company.

The Company faces uncertainty as to the outcome of its litigation with
PowerDsine (See Note G). Although the Company is currently involved in
discussions with PowerDsine in an effort to resolve the litigation, the Company
may not be able to achieve a satisfactory settlement. In the event that the
Company is unable to settle the litigation, the Company intends to vigorously
defend the lawsuit and take whatever actions are necessary to protect its
intellectual property.

On December 21, 2004 and January 13, 2005, the Company completed a private
offering of its equity securities resulting in gross proceeds of $2,685,000. At
March 31, 2005, the Company had $1,725,000 of cash and cash equivalents and
working capital of $1,176,000. The Company anticipates, based on currently
proposed plans and assumptions, relating to its operations, that its cash and
cash equivalents of approximately $1,722,000 as of March 31, 2005 will more
likely than not be sufficient to satisfy the Company's operations and capital
requirements until September 2006. There can be no assurance, however, that such
funds will not be expended prior thereto. In the event the Company's plans
change, or its assumptions change, or prove to be inaccurate (due to
unanticipated expenses, difficulties, delays or otherwise), the Company may have
insufficient funds to support its operations prior to September 2006. The
Company's inability to consummate licensing arrangements with respect to its
Remote Power

Patent and generate revenues therefrom on a timely basis or obtain additional
financing when needed would have a material adverse effect on the Company,
requiring it to curtail or cease operations. In addition, any equity financing
may involve substantial dilution to the current stockholders of the Company.

RISK FACTORS THAT MAY AFFECT FUTURE RESULTS

The Company operates in a highly competitive environment that involves a number
of risks, some of which are beyond the Company's control. The following
discussion highlights the most material of the risks.

WE HAVE A HISTORY OF LOSSES AND NO REVENUE FROM CURRENT OPERATIONS.

We have incurred substantial operating losses since our inception, which has
resulted in an accumulated deficit of $(43,720,000) as of March 31, 2005. For
the years ended December 31, 2004 and 2003, we incurred net losses of
$(1,953,000) and $(614,000), respectively. For the three months ended March 31,
2005, we incurred a net loss of $(731,000). We have financed our operations
primarily by sales of equity securities as well as the sale of our CyberWall
PLUS security software technology in May 2003. Since December 2002, when we
discontinued our security software products and following the commencement of
our new technology licensing business in November 2003, we have not had material
revenue from operations and for the year ended December 31, 2004 and the three
months ended March 31, 2005 we had no revenue from operations. Our ability to
achieve revenue and generate positive cash flow from operations is dependent
upon consummating licensing agreements with respect to our patented technology.
We may not be successful in achieving licensing agreements with third parties
and our failure to do so would have a material adverse effect on our business,
financial condition and results of operations. We may not be able to achieve
revenue or generate positive cash flow from operations from our new licensing
business.

WE COULD BE REQUIRED TO STOP OPERATIONS IF WE ARE UNABLE TO DEVELOP OUR
TECHNOLOGY LICENSING BUSINESS OR RAISE CAPITAL WHEN NEEDED.

We anticipate, based on our currently proposed plans and assumptions relating to
our operations (including the timetable of, costs and expenses associated with
our continued operations), that our current cash position will more likely than
not be sufficient to satisfy our operations and capital requirements until
September 2006. However, we may expend our funds prior thereto. In the event our
plans change, or our assumptions change or prove to be inaccurate (due to
unanticipated expenses, difficulties, delays or otherwise), we could have
insufficient funds to support our operations prior to September 2006. Our
inability to obtain additional financing when needed, absent generating
sufficient cash from licensing arrangements, would have a material adverse
effect on the Company, requiring us to curtail or possibly cease our operations.
In addition, any additional equity financing may involve substantial dilution to
the interests of our then existing stockholders.

OUR NEW LICENSING BUSINESS MAY NOT BE SUCCESSFUL.

In November 2003, we entered the technology licensing business as a result of
our acquisition of six patents relating to various telecommunications and data
networking technologies including, among others, patents covering the
transmission of audio, video and data over computer and telephony networks and
the delivery of remote power over Ethernet. Accordingly, we have a very limited
history in the technology licensing business upon which an evaluation of our
prospects and future performance can be made. Our prospects must be considered
in light of the risks, expenses and difficulties frequently encountered in the
development, operation and expansion of a new business based on patented
technologies in a highly specialized and competitive market. We may not be able
to generate revenue or profitable operations from our new licensing business.

OUR FUTURE SOURCE OF LICENSING REVENUE IS UNCERTAIN.

In February 2004, we initiated our first licensing efforts relating to the
technologies in our remote power patent (U.S. Patent No. 6,218,930) (the "Remote
Power Patent"). To date, we have not entered into any licensing agreements with
third parties with respect to our Remote Power Patent or our other patented
technologies. Our inability to consummate licensing agreements and achieve
revenue from our patented technologies would have a material adverse effect on
our operations and our ability to continue our business. In addition, in the
event we consummate license arrangements with third parties, such arrangements
are not likely to produce a stable or predictable stream of revenue in the
foreseeable future. Furthermore, the success of our licensing efforts depends
upon the strength of our intellectual property rights.

WE ARE CURRENTLY RELYING UPON THE EFFORTS OF THINKFIRE TO CONSUMMATE LICENSING
AGREEMENTS FOR OUR REMOTE POWER PATENT WITH CERTAIN SELECT POTENTIAL LICENSEES.

On November 30, 2004, we entered into a Master Services Agreement (the
"Agreement") with ThinkFire Services USA, Ltd. ("ThinkFire") pursuant to which
ThinkFire has been granted the exclusive (except for us and related companies)
worldwide rights to negotiate license agreements for the Remote Power Patent
with respect to certain potential licensees agreed between the parties. Either
we 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. We have agreed to pay
ThinkFire a fee not to exceed 20% of the royalty payments received from license
agreements consummated by ThinkFire on our behalf. There is no assurance that
ThinkFire will be successful in consummating license agreements on our behalf or
that such agreements will result in significant royalty payments to us.

OUR SUCCESS IS DEPENDENT UPON OUR ABILITY TO PROTECT OUR PROPRIETARY
TECHNOLOGIES.

Our success is substantially dependent upon our proprietary technologies and our
ability to protect our intellectual property rights. We currently hold 6 patents
issued by the U.S. Patent Office that relate to various telecommunications and
data networking technologies and include among other things, patents covering
the transmission of audio, voice and data over computer and

telephony networks and the delivery of remote PoE networks. We rely upon our
patents and trade secret laws, non-disclosure agreements with our employees,
consultants and third parties to protect our intellectual property rights. The
complexity of patent and common law, combined with our limited resources, create
risk that our efforts to protect our proprietary technologies may not be
successful. We cannot assure you that our patents will be upheld or that third
parties will not invalidate our patent rights. In the event our intellectual
property rights are not upheld, such an event would have a material adverse
effect on our company. In addition, there is a risk that third parties may
independently develop substantially equivalent or superior technologies.

ANY LITIGATION TO PROTECT OUR INTELLECTUAL PROPERTY OR ANY THIRD PARTY CLAIMS TO
INVALIDATE OUR PATENTS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS.

Our success depends on our ability to protect our intellectual property rights.
In the future, it may be necessary for us to commence patent litigation against
third parties whom we believe require a license to our patents. In addition, we
may be subject to third-party claims seeking to invalidate our patents, as is
the case with the action commenced by PowerDsine relating to our Remote Power
Patent as discussed below. These types of claims, with or without merit, may
subject us to costly litigation and diversion of management's focus. In
addition, based on our limited financial resources, we may not be able to pursue
litigation as aggressively as competitors with substantially greater financial
resources. Based on our limited financial resources, it may be necessary to
engage third party professionals on a contingency basis pursuant to which such
parties would be entitled to share in the proceeds of any successful enforcement
of our intellectual property rights. If third parties making claims against us
seeking to invalidate our patent are successful, they may be able to obtain
injunctive or other equitable relief, which effectively could block our ability
to license or otherwise capitalize on our proprietary technologies. Successful
litigation against us resulting in a determination that our patents are invalid
would have a material adverse effect on our company.

WE FACE UNCERTAINTY AS TO THE OUTCOME OF LITIGATION WITH POWERDSINE.

On March 31, 2004, PowerDsine Inc. ("PowerDsine") commenced an action against us
in the United District Court, Southern District of New York (Civil Action No. 04
CV 2502) seeking a declaratory judgment that our Remote Power Patent is invalid
and is not infringed by PowerDsine and/or its customers. PowerDsine further
seeks an order permanently enjoining us (i) from making any claims to any person
or entity that PowerDsine's products infringe the Remote Power Patent or
contribute to infringement of the patent, (ii) from interfering with or
threatening to interfere with the importation, sale, license or use of
PowerDsine's PoE components or products, and (iii) from instituting or
prosecuting any lawsuit or proceeding placing at issue the right of PowerDsine,
its customers, licensees, successors, or assigns to import, use or sell
PowerDsine's PoE components or products. We believe our Remote Power Patent is
valid and that we have meritorious defenses to the action. On December 1, 2004,
we moved to dismiss the declaratory judgment action asserting, among other
things, that there is no actual case or controversy because PowerDsine did not
have reasonable apprehension of suit at the time the case was filed, and
therefore, the court lacks jurisdiction over the matter. On January 21, 2005 our
motion to dismiss was denied. We have engaged in settlement discussions

with PowerDsine in an effort to resolve the litigation. In the event that we are
unable to settle the litigation, we intend to vigorously defend the lawsuit and
take whatever actions are necessary to protect our intellectual property. In the
event, however, that the Court granted the declaratory judgment and our Remote
Power Patent was determined to be invalid, such a determination would have a
material adverse effect on us. Regardless of the outcome, this litigation may
subject us to significant costs and diversion of management time.

MATERIAL LICENSING REVENUES FROM OUR REMOTE POWER PATENT MAY BE DEPENDENT UPON
THE APPLICABILITY OF THE IEEE STANDARD.

The Institute of Electrical and Electronic Engineers (IEEE) is a non-profit,
technical professional association of more than 360,000 individual members in
approximately 175 countries. The Standards Association of the IEEE is
responsible for the creation of global industry standards for a broad range of
technology industries. In 1999, at the urging of several industry venders, the
IEEE formed a task force to facilitate the adoption of a standardized
methodology for the delivery of remote power over Ethernet networks which would
insure interoperability among vendors of switches and terminal devices. In June
2003, the IEEE Standards Association approved the 802.3af Power Over Ethernet
standard (the "Standard"), which covers technologies deployed in delivering
power over Ethernet cables including whether deployed in switches or as
standalone midspan hubs both of which provide power to remote devices including
wireless access points, IP phones and network based cameras. The technology is
commonly referred to as Power Over Ethernet ("PoE"). We believe our Remote Power
Patent covers several of the key technologies covered by the Standard. However,
there is a risk that as a result of litigation a court may determine otherwise
and such a determination would have a material adverse effect on our ability to
enter into license agreements and achieve revenue and profits from our Remote
Power Patent.

WE FACE INTENSE COMPETITION AND WE MAY NOT BE ABLE TO SUCCESSFULLY COMPETE.
The telecommunications and data networking market is characterized by intense
competition and rapidly changing business conditions, customer requirements and
technologies. Our current and potential competitors have longer operating
histories, greater name recognition and possess substantially greater financial,
technical, marketing and other competitive resources than us. Although we
believe that we have rights to enforceable patents relating to
telecommunications and data networking, there can be no assurance that third
parties will not invalidate any or all of our patents. In addition, the
telecommunications and data networking industries may develop technologies that
may be more effective than our proprietary technologies or that render our
technologies less marketable or obsolete.

OUR MARKETS ARE SUBJECT TO RAPID TECHNOLOGICAL CHANGE AND OUR TECHNOLOGIES FACE
POTENTIAL TECHNOLOGY OBSOLESCENCE.

The telecommunications and data networking technology market including,
transmission of audio, video and data over computer and telephony networks and
the delivery of remote power over Ethernet markets, are characterized by rapid
technological changes, changing customer

requirements, frequent new product introductions and enhancements, and evolving
industry standards. The introduction of products embodying new technologies and
the emergence of new industry standards may render our technologies obsolete or
less marketable. To the extent we are able to achieve revenue in the future,
such revenue will be derived from licensing our technologies based on existing
and evolving industry standards.

DEPENDENCE UPON CEO AND CHAIRMAN.

Our success will largely be dependent upon the personal efforts of Corey M.
Horowitz, Chairman and Chief Executive Officer and Chairman of the Board of
Directors. On November 26, 2004, we entered into a two (2) year employment
agreement with Mr. Horowitz pursuant to which he will continue to serve as our
Chairman and Chief Executive Officer. We do not maintain key man life insurance
on the life of Mr. Horowitz. The loss of the services of Mr. Horowitz would have
a material adverse effect on our business and prospects.

RISKS RELATED TO LOW PRICED STOCKS.

Our common stock currently trades on the OTC Bulletin Board under the symbol
NSSI.OB. Since the trading price of our common stock is below $5.00 per share,
our common stock is considered a penny stock. SEC regulations generally define a
penny stock to be an equity security that is not listed on Nasdaq or a national
securities exchange and that has a market value of less than $5.00 per share,
subject to certain exceptions. SEC regulations require broker-dealers to deliver
to a purchaser of our common stock a disclosure schedule explaining the penny
stock market and the risks associated with it. Various sales practice
requirements are also imposed on broker-dealers who sell penny stocks to persons
other than established customers and accredited investors (generally
institutions). Broker-dealers must also provide the customer with current bid
and offer quotations for the penny stock, the compensation of the broker-dealer
and monthly account statements disclosing recent price information for the penny
stock held in the customer's account.

THE SIGNIFICANT NUMBER OF OPTIONS AND WARRANTS OUTSTANDING MAY ADVERSELY EFFECT
THE MARKET PRICE FOR OUR COMMON STOCK.

As of March 31, 2005, there are outstanding (i) options and warrants to purchase
an aggregate of 11,017,244 shares of our common stock at exercise prices ranging
from $.12 to $10.13, and (ii) 207,630 additional shares of our common stock
which may be issued in the future under our stock option plan. To the extent
that outstanding options and warrants are exercised, stockholder percentage
ownership will be diluted and any sales in the public market of the common stock
underlying such options may adversely affect prevailing market prices for our
common stock.

WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.

Our Board of Directors has the authority, without further action by the
stockholders, to issue 10,000,000 shares of preferred stock on such terms and
with such rights, preferences and designations as our Board of Directors may
determine. Such terms may include restricting dividends on our common stock,
dilution of the voting power of our common stock or impairing the liquidation
rights of the holders of our common stock. Issuance of such preferred stock,
depending on the rights, preferences and designations thereof, may have the
effect of delaying, deterring or preventing a change in control. In addition,
certain "anti-takeover" provisions in Delaware law may restrict the ability of
our stockholders to authorize a merger, business combination or change of
control.

ITEM 3. CONTROLS AND PROCEDURES.

(a) Evaluation of Disclosure Controls and Procedures.

The Company's Chief Executive Officer and Chief Financial Officer have reviewed
the disclosure controls and procedures of the Company as of the end of the
period covered by this Quarterly Report on Form 10-QSB. Based upon this review,
these officers concluded that, as of the end of the period covered by this
Quarterly Report on Form 10-QSB, the Company's disclosure controls and
procedures are adequately designed to ensure that information required to be
disclosed by the Company in the reports it files or submits under Securities and
Exchange Act of 1934 is recorded, processed, summarized and reported, within the
time periods specified in applicable rules and forms.

(b) Changes in Internal Controls.

There were no significant changes in the Company's internal controls or in other
factors that could significantly affect these controls during the last fiscal
quarter included in this report or from the end of the reporting period to the
date of this Quarterly Report on Form 10-QSB.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

PowerDsine's power over Ethernet components or products. The Company believes
its Remote Power Patent is valid and has meritorious defenses to the action. On
December 1, 2004, the Company moved to dismiss the declaratory judgment action
asserting, among other things, that there is no actual case or controversy
because PowerDsine did not have reasonable apprehension of suit at the time the
case was filed, and therefore the court lacks jurisdiction over the matter. On
January 21, 2005, the Company's motion to dismiss was denied. The Company has
engaged in settlement discussions with PowerDsign in an effort to resolve the
litigation. In the event the Company is unable to settle the litigation, the
Company intends to vigorously defend the action and take whatever actions are
necessary to protect its intellectual property. In the event, however, that the
Court grants the declaratory judgment and the Company's patent is determined to
be invalid, such a determination would have a material adverse effect on the
Company.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

No such issuances except as disclosed in the Company`s Current Report on Form
8-K filed on January 20, 2005 relating to the second closing of the Company's
private placement of $600,000 of securities on January 13, 2005.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None.

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

None.

ITEM 5. OTHER INFORMATION.

None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits

31.1 Controls and Procedure Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Controls and Procedure Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certification of Chief Executive Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.

32.2 Certification of Chief Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.

(b) Reports of Form 8-K

On January 20, 2005 the Company filed a Current Report on Form 8-K relating to
the second closing of its private placement of securities completed on January
13, 2005.

On January 24, 2005 the Company filed a Current Report on Form 8-KA with respect
to an Amendment, dated January 18, 2005, of its Patent Purchase, Assignment and
License Agreement, dated November 13, 2003 between the Company and Merlot
Communications, Inc.

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

NETWORK-1 SECURITY SOLUTIONS, INC.

BY: /S/ COREY M. HOROWITZ
------------------------------------
COREY M. HOROWITZ
CHAIRMAN AND CHIEF EXECUTIVE OFFICER

DATDATE: MAY 13, 2005