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INTERNET PATENTS CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operation.

February 26, 2014

Overview

From its inception through December 21, 2011 (the "Disposition Date"), IPC operated an online insurance marketplace that electronically matched consumers and providers of automobile, property, health, term life, and small business insurance. IPC discontinued this business in connection with the sale of substantially all of its assets related to its lead generation business to Bankrate, Inc. in a transaction that closed on December 21, 2011 (the "Disposition"). As a result of the Disposition, we no longer conduct the insurance lead generation business, and have agreed not to reenter that business for a period of ten years.



Since the Disposition Date, IPC's business consists solely of plans to license or otherwise enforce its portfolio of e-commerce and online insurance distribution patents ("Patent Licensing Business").

Under U.S. law, a patent owner is entitled to exclude others from making, selling or using the patented invention for the life of the patent, generally twenty years from its filing date, with some possible term extensions by statute. The patent holder may grant one or more licenses to the patented invention, typically allowing the licensee to make, use and/or sell the patented invention in return for a royalty paid to the patent owner. A patent owner also may sue and recover damages from unlicensed parties for past patent infringement and sometimes future royalties. Although we intend to attempt to negotiate a reasonable royalty for licenses to the patented technologies, we may not be able to reach a negotiated settlement with the accused infringer. In that case we expect to vigorously litigate our infringement claims. To date, none of the Company's patents has generated direct revenues or been subject to a final adjudication of its validity. Our future revenues are expected to consist of the royalties from licensing the patents and damages for past infringement. We expect significant resistance from entities that we believe infringe one or more of our patents, at least until the validity of the patents can be established. Patent infringement litigation can be expensive and often takes several years to reach the trial stage, and the appeals process could result in further delays in receiving royalties or damage awards. For these reasons, IPC cannot estimate what revenues, if any, it will receive in 2014. In addition to general and administrative expenses, including salaries and benefits, rent and utilities, we will incur expenses associated with patent infringement litigation and being a public company. We cannot predict if we will generate revenues or be profitable in 2014. During 2012 IPC filed patent infringement lawsuits against six companies. Two of the companies are alleged to infringe the Event Log patent; four companies are alleged to infringe the Dynamic Tabs patent. Each of the lawsuits was filed in the U.S. District Court for the Northern District of California and trial dates for the lawsuits have not been set. 10 --------------------------------------------------------------------------------

Results of Operations



Fiscal 2013 compared to Fiscal 2012

The following table sets forth selected statement of operations data with the respective percentage change from the prior year (dollars in thousands):

% Change from % Change from the Prior Year the Prior Year 2013 2012 2013 2012 Revenues $ - $ - N/A * Operating expenses: General and administrative 2,688 2,959 -9 % -7 % Total operating expenses 2,688 2,959 -9 % -10 % Loss from operations (2,688 ) (2,959 ) -9 % -10 % Other income 25 172 -85 % 1,047 % Net loss before income taxes (2,663 ) (2,787 ) -4 % -15 % Income tax benefit - (61 ) N/A N/A Net loss (2,663 ) (2,726 ) -2 % -17 % Comprehensive loss $ (2,663 )$ (2,726 ) -2 % 1,977 % General and Administrative. General and administrative expenses consist primarily of payroll and related expenses, including employee benefits, facility costs, accounting and legal services and insurance for our general management, administrative and accounting personnel, as well as other general corporate expenses. General and administrative expenses decreased 9% to $2.7 million in 2013 from $3.0 million in 2012. The decrease was primarily due to a reduction in administrative headcount, reduced rent, accounting services, consulting services, insurance, board of director fees and business taxes. The decrease was offset by a $606,000 one-time charge to record an accrual for lease obligations related to the sublease of the Rancho Cordova facility and also due to increases in litigation and general legal expenses and share-based compensation expense for the options granted on July 1, 2013 to the non-employee directors. We expect general and administrative expenses for fiscal year 2014 to be approximately $2.0 million. Other Income. Other income was $25,000 in 2013, compared to $172,000, in 2012. In 2012, other income included a one-time payment of $99,000 received by IPC following the settlement of commercial litigation and a supplemental payment from Bankrate of $67,000 related to the collection of outstanding accounts receivable subsequent to the Disposition Date. In addition, $25,000 and $6,000 was recognized in 2013 and 2012, respectively, for interest earned on IPC's investment portfolio of cash, cash equivalents and short-term investments. IPC expects that other income will consist entirely of returns received from its investment portfolio in the near future, which will be negligible given the current interest rate environment in the United States. Income Taxes. IPC recognized federal and state income tax benefits of $61,000 in 2012, due to the difference between the income tax expense recognized for the year ended December 31, 2011 and the actual tax liability incurred when the income tax returns were filed during the quarter ended September 30, 2012.



Off-Balance Sheet Arrangements. The Company had no off-balance sheet arrangements in 2013 or 2012.

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Critical Accounting Policies

IPC's discussion and analysis of its financial condition and results of operations are based on IPC's consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires IPC to make estimates and judgments that affect the reported amounts of assets and liabilities and the 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. IPC bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. IPC believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. Revenue Recognition. The Company has not yet determined the methodology it will use for recognizing revenues from royalties for licensing its patents or from damages for past infringement, as no agreements or judgments related to these types of revenue streams had been entered into or paid, respectively, as of December 31, 2013. Share-Based Compensation. IPC accounts for share-based compensation in accordance with ASC 718 "Compensation - Stock Compensation." Under the provisions of ASC 718, share-based compensation cost is generally estimated at the grant date based on the award's fair value as calculated by the Black-Scholes-Merton (BSM) option-pricing model. The BSM option-pricing model requires various highly judgmental assumptions including expected option life, volatility, and forfeiture rates. If any of the assumptions used in the BSM option-pricing model change significantly, share-based compensation expense may differ materially in the future from that recorded in the current period. Generally, compensation cost is recognized over the requisite service period. However, to the extent performance conditions affect the vesting of an award, compensation cost will be recognized only if the performance condition is satisfied. Compensation cost will not be recognized, and any previously recognized compensation cost will be reversed, if the performance condition is not satisfied. Income Taxes. Under the asset and liability method prescribed under ASC 740, "Income Taxes", IPC recognizes deferred tax assets and liabilities for the future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. At December 31, 2013 and December 31, 2012, IPC had unrecognized tax benefits of approximately $0.3 million and $0.3 million, respectively ($0.1 million of which, if recognized, would affect IPC's effective tax rate). IPC does not believe there will be any material changes in its unrecognized tax positions over the next twelve months. For tax return purposes, IPC had net operating loss carry forwards at December 31, 2013 of approximately $142.9 million and $64.4 million for federal income tax and state income tax purposes, respectively. Included in these amounts are unrealized federal and state net operating loss deductions resulting from stock option exercises of approximately $10.2 million each. The benefit of these unrealized stock option-related deductions has not been included in deferred tax assets and will be recognized as a credit to additional paid-in capital when realized. Federal and state net operating loss carry forwards begin expiring in 2019 and 2014, respectively. The carrying value of our deferred tax assets, which was approximately $49.5 million at December 31, 2013, is dependent upon our ability to generate sufficient future taxable income. We have established a full valuation allowance against our net deferred tax assets to reflect the uncertainty of realizing the deferred tax benefits, given historical losses. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. This assessment requires a review and consideration of all available positive and negative evidence, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, and the length of carryforward periods and evaluation of potential tax planning strategies. We expect to continue to maintain a full valuation allowance until an appropriate level of profitability is sustained or we are able to develop tax strategies that would enable us to conclude that it is more likely than not that a portion of our deferred tax assets would be realizable. 12

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Liquidity and Capital Resources

Summarized cash flow information is as follows (in thousands):

Years Ended December 31, Cash Flows provided by (used in) 2013 2012 Operating activities $ (2,203 )$ (4,485 ) Investing activities 1,248 (1,288 ) Financing activities - (33,485 )



Decrease in cash and cash equivalents $ (955 )$ (39,258 )

At December 31, 2013, IPC's principal source of liquidity was $30.1 million in cash and cash equivalents and $0.2 million in short-term investments. IPC adheres to an investment policy with minimal market or settlement risk with its current holdings. There are no restrictions or limitations regarding access to the $30.1 million in cash and cash equivalents and $0.2 million in short-term investments. Since inception, IPC has financed its operations primarily through the sale of preferred and common stock and, until the Disposition, cash flow from operations. In 2013, net cash used in operating activities was $2.2 million, primarily consisting of our net loss adjusted for share-based compensation, depreciation and amortization of property and equipment, impairment of long-lived assets and accrual for lease obligations of $2.0 million and cash used of $0.3 million, primarily due to a decrease in accrued expenses and accounts payable. This was partially offset by increases in other liabilities and a decrease in prepaid expenses of $0.1 million. In 2012, net cash used by operations was $4.5 million. This primarily consisted of IPC's net loss of $2.7 million and cash used of $4.0 million, primarily due to payment of accounts payable, income taxes, accrued expenses and other liabilities. This was partially offset by a decrease in prepaid expenses and other current assets of $1.2 million and other assets of $1.0 million.



In 2013, net cash provided by investing activities was $1.2 million representing $1.5 million relating to the purchases of short-term investments and $1.0 million relating to purchases of restricted cash equivalents, offset by redemptions of short-term investments of $2.7 million and redemptions of restricted short-term investments of $1.0 million.

In 2012, net cash used in investing activities was $1.3 million. This consisted of cash used by continuing operations in 2012 of $1.3 million, representing $2.2 million relating to the purchases of short-term investments and $1.0 million relating to purchases of restricted short-term investments, offset by redemptions of short-term investments of $1.9 million. Net cash used in financing activities in 2012 was $33.5 million. This consisted of an aggregate $38.6 million cash distribution paid to shareholders on March 9, 2012, offset by proceeds from employee stock option exercises of $5.1 million. IPC currently anticipates that its cash and cash equivalents will be sufficient to meet its anticipated cash needs to fund operations and capital expenditures for at least the next 12 months. Although IPC does not anticipate the need for additional financing to meet its operating needs or to expand its business, IPC cannot be certain that additional financing will be available when required, on favorable terms or at all. If IPC is not successful in raising additional capital as required, its business could be materially harmed. If additional funds were raised through the issuance of equity securities, the percentage ownership of IPC's then-current stockholders would be reduced. 13



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