Sum Zero AWRE Memo Feb2012

AWARE, INC. (NASDAQ: AWRE)

FEBRUARY 2012

PRIVET FUND MANAGEMENT 3280 PEACHTREE ROAD NE, SUITE 2670

ATLANTA, GA 30305

PRIVET FUND MANAGEMENT FEBRUARY 2012

Summary

Aware, Inc. is a Massachusetts-based company focused upon signal processing and communications

technology. At $3.20, we believe the company is currently priced at a steep discount to its intrinsic value

and offers significant upside to $7.33, which could generate a return of ~130%, while having negligible

downside risk. This value is derived as follows:

Furthermore, there are reasonable scenarios under which Aware equity could be worth $10/share or more,

producing upside of well over 200%. Of note, neither of these valuations includes over $2/share of

deferred tax assets. In short, we believe Aware offers dramatic return asymmetry with pricing at a slight

premium to liquidation value and upside of 2x to over 3x.

History

Aware has its origins in the late-1980s when the company began as an IP-focused firm whose revenue

was primarily derived from government research grants. Aware’s research led to a steadily-increasing

patent trove and efforts to commercialize the company’s technology. This strategy resulted in Aware

housing several different operating businesses over the past two decades as it refined its approach to

commercializing its technology.

Ultimately, through a process of business and asset dispositions, Aware settled on two core operating

segments: (1) biometrics software and services and (2) DSL test and diagnostics software and hardware.1

These two businesses produce the bulk of annual revenue, and each has value in its own right. In addition

to the value of the operating entities, Aware offers several other components of value. The first is an IP

portfolio comprised of approximately 185 U.S. and foreign patents and 271 patent applications. These

patents cover a wide swath of technology including audio processing, image compression, video

compression and seismic data compression. Second, Aware enjoys a continued royalty stream accruing

from DSL chipset sales related to a business line it sold in 2009. Thirdly, we believe, but have been

unable to confirm, that the company also likely holds an interest in the outcome of a pending patent

lawsuit. Aware also owns its corporate headquarters.

In sum, Aware is a technology-focused firm with seven separate components of value:

(1) Biometrics software and services business

(2) DSL test and diagnostics business

1 In January 2012, Aware announced the shuttering of its DSL hardware business, which will continue to fill

previously-made orders through June 2012.

AWRE - Valuation

Value Value/Share

Biometrics business $39 $1.89

DSL business $6 $0.28

DSL royalties $8 $0.39

IP portfolio $32 $1.55

Hybrid Audio $15 $0.73

Real estate $6 $0.28

Cash $46 $2.21

Total asset value $151 $7.33

Debt $0 $0

Estimated equity value $151 $7.33

Market price $66 $3.20

Percentage upside 129%


(3) DSL chipset royalty stream

(4) IP portfolio

(5) Patent litigation

(6) Real estate

As developed in this Report, these value-drivers aggregate to approximately $151mm of equity value

versus a current market cap of around $66mm.

Biometrics

Markets – Aware’s biometrics business has historically centered on selling software component parts to

OEMs and government clients for inclusion in end-use biometric systems. The primary markets within

which Aware biometrics operates are:

Border control – immigration, passports, national ID cards

National defense – handheld ID devices for use in the field

Secure credentialing – personal identity verification cards

Law enforcement – FBI systems

Access control – building access

Strategy – from its past focus on component software sales to OEMs, Aware has more recently begun to

develop a services business that consults and assists with the development and construction of biometric

enrollment and analytic systems for governments and other users. This strategy has the double benefit of

creating a separate, profitable revenue source while also putting Aware in the advantageous position of

consulting on projects for which its software solutions serve as component parts (thus increasing the

chance of Aware products being used in the systems). Further, as a result, the services side of the

business serves as a leading indicator of software demand. Aware’s biometric services business targets

small projects that larger industry players do not seek based on scale.

Within the biometric systems product chain, Aware sells component and application software for

enrollment and server-based transaction management systems. Beyond the development of a

services/consulting business, Aware has also extended the software business toward providing fully-

developed applications rather than simply producing component parts for applications created by other

companies. This migration led Aware to create BioSP, its server-based transaction management system,

and other like products that represent more complete application solutions.

With this background in mind, Aware’s current biometrics strategy is premised upon continued growth

via (a) professional services and (b) sales of more complete product offerings, both of which provide

larger and more profitable market opportunities than a purely OEM-based sales model. As discussed

further below, we believe the biometrics business is very profitable, a fact that has thus far been masked

by the remainder of Aware’s businesses. Management views 20%-30% annual top-line growth as a

reasonable goal for the segment with the possibility of landing a larger project that would drive 100%

revenue growth over 2010 numbers.

Industry/Competition – the biometrics industry is in the midst of a significant growth cycle, with ~20%

annualized growth expected to carry the industry sales from ~$4.5bn in 2011 to over $10bn by 2017.

Primary market participants within software and hardware for enrollment stations include Lockheed

Martin, Cross Match Technologies, Unisys, Science Applications International, L-1 Identity Solutions

(Safran), Northrop Grumman, Hewlett-Packard Electronic Data Systems and NEC. On the transaction

management side of the business, competitors include Safran, Avalon Biometrics, NEC and 3M Cogent.

As is evident, competition within biometrics is comprised of firms significantly larger than Aware.

Aware’s competitive advantage in this context stems from a combination of offering higher quality


software and having a lower cost structure. Beyond the obvious benefit of a high quality product, the

lower cost structure enables Aware to competitively bid for government contracts and ensures it is more

cost efficient for larger OEMs to buy software from Aware rather than develop it internally.

The biometrics industry has seen an uptick in consolidation as larger players have acquired smaller firms,

enabling the acquirers to complement and integrate their businesses with new technologies and

capabilities. In this vein, French defense contractor Safran SA recently closed the July 2011 acquisition

of L-1 Identity Solutions, while in October 2010 3M acquired Cogent.

Valuation – Aware biometrics has demonstrated steady topline performance over the trailing three years

and is gaining steam as the company develops the services component of its business and continues to

prove itself within the government bidding process, a contracting process in which success builds upon

itself.

Although Aware does not report biometrics results as a separate operating segment, we were able to back

into topline numbers based upon earnings call commentary and 10-K footnotes (management generally

confirmed the accuracy of our estimates). From a 2007 revenue base of $7.5mm, biometrics produced

$10mm in revenue in both 2009 and 2010. Furthermore, with the development and growth of its

biometrics services work the segment has produced, through 3Q11, incremental revenue of ~$2.7mm over

the first three quarters of 2010. On full-year 2010 revenue base of $10mm, this represents annualized

growth of well over 30%, consistent with management’s target.

Based on our analysis, we believe the biometrics business is on track for ~$13mm in 2011 revenue.

While determining the margins on the biometrics business is not possible given Aware’s failure to report

biometrics as an operating segment, the company’s overall blended gross margin for hardware and

software sales is around 75% and management has repeatedly indicated biometrics is a highly profitable

business relative to the DSL T&D business, thus suggesting gross margins over 90%.

Given the lack of margin transparency and recent precedent transactions accruing from industry

consolidation, valuing the biometrics business on a multiple of revenue is a reasonable approach. The

detail on recent acquisitions follows:

With a revenue multiple of 3.0x – significantly below both recent transaction comps – Aware’s

biometrics business is worth $39mm on 2011 estimated revenue of $13mm.

DSL Test & Diagnostics Markets – Aware’s DSL T&D business sells software and hardware products used by telephone

companies in monitoring, optimizing, diagnosing and servicing their DSL infrastructures. The hardware

business supplies modem modules to OEMs for inclusion in testing devices for diagnosing line-based

service problems. As noted above, the Company recently announced its intention to close the DSL

hardware business with shipments ceasing during summer 2012. We view this as a positive as we believe

the hardware business is unprofitable at the EBIT level and represents a drain on cash.

AWRE - Biometrics - Precedent Transactions

Date Target Buyer Value ($mm) Revenue

Jul-11 L-1 Safran $1,582 3.5x

Oct-10 Cogent 3M $662 5.7x

Mar-08 Bioscrypt L-1 $41 2.2x

Aug-06 Identix L-1 $608 8.5x

Jul-02 AIT Advanced 3M $41 3.0x

Jun-02 Visionics Identix $265 11.3x


The remaining DSL software business is the better of the two businesses, and provides telephone

companies with the ability to test, diagnose and optimize DSL performance from company mainframe

computers without the need for technician engagement in the field or other hardware-based solutions.

This offering drives significant cost savings for telcos, which is an increasing area of focus throughout

their operations given continued migration from landlines and associated deteriorating profitability.

Aware’s DSL software business also benefits from industry tailwinds deriving from increased

international DSL adoption driving demand for service assurance infrastructure and testing products.

DSL has 70% of the total broadband market with ~400mm customers. Further, there are more new DSL

subs each month than new subs for all other broadband alternatives combined. Although some are

inclined to pan the DSL technology relative to fiber, wireless and other mediums, the reality is that DSL

is the most cost efficient broadband alternative and will continue to dominate the landscape for the

foreseeable future. Optimizing DSL transmission will become increasingly important, which is precisely

the function of Aware’s line diagnostic platform software.

Strategy – the software business represents the future of Aware’s DSL operations, and the company is

working to grow this business. International telcos were at first hesitant to adopt a software-based

diagnostic and optimization approach, but over the past several years product acceptance has accelerated

and the growth trend is appealing. Accordingly, Aware has been aggressively targeting this business,

which has significantly higher margins than the DSL hardware business the Company is abandoning.

Aware has demonstrated increasing success on this front with customer wins from two different European

telcos during 2H10. Further, the company is engaged in product trials with multiple other international

telcos.

Industry/Competition – competitors within the DSL T&D business include Alcatel-Lucent, Spirent

Communications, Tollgrade Communications, JDS Uniphase, Sunrise Corporation, Fluke Corporation,

Kurth Electronic and Assia. Within the software assurance and optimization Aware’s management has

highlighted Alcatel and Assia, particularly. Assia is a VC-backed firm focused solely on this niche

market. Assia’s investors include industry backers Telefonica, AT&T, Swisscom Ventures and T-

Ventures. Alcatel’s Network Analyzer is that company’s competing product within the software

optimization market. Aware and Assia represent the only “hardware-neutral” competitors within line

diagnostics and optimization.

Value – Aware’s DSL T&D business has shown strong top-line performance. From a 2008 nadir of

$5.2mm in segment revenue and $1.6mm of DSL software sales, 2010 segment revenue grew to $10.6mm

with $4.1mm of software sales, cumulative growth of 104% and 156%, respectively. Through 3Q11,

YTD DSL software sales have increased $200k over the same year-earlier period, which implies 2011

estimated DSL software revenue of approximately $4.4mm. With the Company’s recent decision to

jettison the DSL hardware business, Aware is dropping a business that is likely to produce roughly $6mm

of 2011 revenue. Importantly, software revenue carries much higher margins than hardware, with the

latter generating 35% to 40% gross margins, according to management. We believe the DSL hardware

business was unprofitable at the EBIT level, and this business closure should have a positive cash flow

benefit over time.

While divining the margins for Aware’s remaining DSL software business is not possible, with continued

sales growth within the business, we believe the DSL software business clearly has value. Our

conversations with industry participants indicate that each of Aware’s, Assia’s and Alcatel’s competitive

software offerings have unique attributes that distinguish them from one another – one firm’s software is

best suited for different telcos depending on the customer’s systems and needs. This dynamic indicates

differentiated technology amongst the competition, and a likely market for Aware’s DSL business. Given


the lack of margin clarity and ability to determine segment profitability, we believe it is appropriate to

look to recent precedent transactions to determine an appropriate revenue multiple.

Tollgrade is a very applicable comp as the company designs and markets DSL test and diagnostics

software, the same business as Aware’s DSL segment. Similarly, Digital Lightwave sells fiber-optic

diagnostic and optimization products to telcos. While the latter is a relevant comp, Tollgrade is the closer

analogue as the company is focused on DSL rather than fiber-optic lines. Aware’s DSL business should

drive 2011 revenue of approximately $4.4mm, utilizing the Tollgrade multiple results in a $5.7mm

valuation of Aware’s DSL business.

DSL Chipset Royalties

In 2009, Aware exited its DSL chipset and home networking business whose associated expenses

exceeded revenues annually. To this end, the company sold all related assets (chip designs, 41

engineering employees, two patents, one patent application) for $6.75mm booking a gain of $6.2mm.

The transaction represented a favorable outcome for a business that garnered $500k to $1mm in quarterly

revenue against $1.7mm to $1.9mm in quarterly expenses. Further, as a data point for valuing Aware’s

DSL T&D business, Lantiq paid $6.75mm for the DSL chipset business which eliminated around $3mm

in annual revenue from Lantiq to Aware, an approximate 2.3x revenue multiple.

In conjunction with the sale, Aware maintained the right to licensing revenue based upon DSL chipset

sales from Lantiq (the acquirer in the DSL chipset transaction) and Ikanos Communications (Aware’s

other major chipset licensing customer). Over the 4 trailing calendar years, this licensing stream has

averaged $2.3mm/year with relatively consistent numbers of $2.6mm/$1.8mm/$2.1mm/$2.7mm in

2007/2008/2009/2010. This revenue flow represents pure margin to Aware.

Aware’s DSL chipset annuity is a free cash flow claim on Lantiq’s and Ikanos’ sales. While Aware does

not control the long-term sustainability of these businesses, there is material value in these 100% margin

cash flows. As previously noted, the royalty stream has remained relatively stable over the past four

years with an average annual cash flow of $2.3mm. Capitalizing a $2mm annual cash flow with a 4x

multiple values the royalty at $8mm, which is conservative from a multiple perspective. From a DCF

vantage, assuming a 10% discount rate and that the $2mm royalty decreases on a 10-year straight-line

basis results in a $7.7mm valuation. In any event, an $8mm royalty value appears reasonable.

IP Portfolio

Background – from its inception in the late-1980s, Aware has dedicated significant resources to

developing a robust IP portfolio that totals 456 patents and applications. Much of this work has centered

on developing and evolving technology that drives its biometrics and DSL businesses, but the portfolio

also contains additional assets of value that are unrelated to its core businesses and are essentially not

valued by the market. The first category of non-core IP assets relates to DSL chipsets, LAN wireless and

home networking technology that is no longer applicable to Aware’s business following the Lantiq

transaction which disposed of these business lines. The second category of excess IP has been described

by company management as “other,” essentially a catchall for the remainder of the portfolio. Thus,

Aware’s IP can be categorized as follows:

(1) Biometrics IP

(2) DSL T&D IP

AWRE - DSL - Precedent Transactions

Date Target Buyer Value ($mm) Revenue

May-11 Tollgrade Golden Gate Capital $61 1.3x

Feb-10 Digital Lightwave Optel Capital $53 6.1x


(3) DSL chipsets, wireless and home networking IP

(4) Other

Portfolio Detail – determining the exact composition of an IP portfolio is not a simple or precise task. In

combing a portfolio, a helpful starting point for categorization of the various patents is the International

Patent Classification codes used to classify each issued patent.

As the adjacent table indicates, 54% of Aware’s

issued patents and applications fall within IPCs H04B

and H04L and with the inclusion of H04K, H03M and

H04J the total increases to 74% of the portfolio. The

H04B and H04L classifications relate to transmission

and transmission of digital information, while HO4K,

H03M and HO4J relate to secret communication;

coding, decoding or code conversion; and multiplex

communication, respectively. Each of these categories

is associated with communications transmission and

associated technologies.

Making a determination of the specific uses of a given

technology by simply reading the text of a patent is

not always possible. To this end, it is helpful to

analyze patent classifications across companies to

determine the general areas of technological

applicability. The table below compares the IPCs of

Aware’s patents with those of Nortel, Motorola

Mobility and Interdigital, three large firms who are

viewed as having extremely valuable patent portfolios

involving mobile communications technology. In July

2011, a consortium of technology firms acquired Nortel’s portfolio for $4.5bn, and on the heels of the

Nortel transaction, Google agreed to acquire Motorola Mobility for $12.5bn with many commentators

speculating the bulk of Google’s interest was founded upon Motorola’s patents. Likewise, during this

same time period, Interdigital’s stock catapulted from $40 to $70 based on reports multiple technology

firms were eyeballing the company’s intellectual property for acquisition. While much of this interest and

pricing action was driven by wireless technology which has not been a core Aware focus, the transactions

nevertheless demonstrate the increasing importance and value of intellectual property.

[Memorandum continues on next page]

AWRE Issued U.S. Patents & Apps by IPC Code

Total Patents Applications

H04B 93 H04L 38 H04B 61

H04L 92 H04B 32 H04L 54

H04K 27 H04J 11 H04K 20

H03M 22 H03M 8 G06F 15

H04J 21 G06K 7 H03M 14

G06F 19 H04K 7 H04J 10

G06K 13 H03H 5 H04M 7

H04M 11 G01R 4 G06K 6

G01R 9 H04M 4 G01R 5

H03H 8 H03D 4 H03H 3

H03D 4 G06F 4 G06T 2

H04N 4 H04N 4 G06Q 2

H04L 3 H04L 3 H04J 1

G10L 3 G10L 3 G11C 1

H04J 2 G09G 1 G08C 1

G08C 2 H04J 1 H04Q 1

H03K 2 G02B 1 H03K 1

G06Q 2 G08C 1 H04W 1

G06T 2 H03K 1

G09G 1 H03C 1

G02B 1

H03C 1

H04W 1

H04Q 1

G11C 1


As the table demonstrates, there is tremendous crossover amongst Aware and the comparable companies’

portfolios. H04B, the largest component of Aware’s portfolio is the first, first and third largest

components of Motorola’s, Interdigital’s and Nortel’s portfolios, respectively. Further, HO4L, the second

largest component of Aware’s portfolio is the first, third and third largest components of Nortel’s,

Motorola’s and Interdigital’s portfolios, respectively. Similarly, there is a tremendous amount of overlap

amongst the remainder of the portfolios.

Portfolio Growth & Relevance – Aware’s consistent and escalating dedication to IP creation is evident

from the trend in the number of patents issued annually.

Furthermore, from the perspective of IP relevance, Aware’s citation-to-patent ratio is very compelling

relative to other IP-focused firms that derive significant value from the sale and licensing of their assets.

[Memorandum continues on next page]

AWRE - Patent Subject Matter Comparison

Aware Patents % Total Nortel Patents % Total

H04B Transmission 63 28.9% H04L Transmission digital info 1,200 23.9%

H04L Transmission digital info 58 26.6% G06F Electric digital data processing 863 17.2%

G06F Electric digital data processing 19 8.7% H04B Transmission 643 12.8%

H03M Coding, decoding or code conversion 17 7.8% H04M Telephonic communicaiton 611 12.2%

H04K Secret communication 13 6.0% H04J Multiplex communication 581 11.6%

G06K Recognition of data 12 5.5% H04Q Selecting 569 11.3%

H04M Telephonic communicaiton 10 4.6% G02B Optical elements, systems, apparatus 220 4.4%

G01R Measuring electric variables 9 4.1% G01R Measuring electric variables 119 2.4%

H04J Multiplex communication 9 4.1% H04W Wireless communication networks 115 2.3%

H03H Impedance networks 8 3.7% HO5K Printed circuits 100 2.0%

Interdigital Patents % Total Motorola Mobility Patents % Total

H04B Transmission 985 37.3% H04B Transmission 1,198 23.3%

H04Q Selecting 470 17.8% H04Q Selecting 999 19.4%

H04L Transmission digital info 438 16.6% H04L Transmission digital info 736 14.3%

H04J Multiplex communication 244 9.2% G06F Electric digital data processing 665 12.9%

H04W Wirelesss communication 147 5.6% H04M Telephonic communicaiton 584 11.3%

G06F Electric digital data processing 121 4.6% H04J Multiplex communication 354 6.9%

H04M Telephonic communicaiton 111 4.2% H04W Wirelesss communication 233 4.5%

H04K Secret communication 82 3.1% H01Q Aerials 192 3.7%

H03M Coding, decoding or code conversion 40 1.5% G10L Speech analysis or synthesis 191 3.7%

Source: PatentBuddy.com

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AWRE - U.S. Patents Issued per Year

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AWRE - Total U.S. Patents Issued


Monetization – in September 2010, Aware management announced it was considering the spin-off of its

IP licensing assets. In reaction, two members of the Stafford family (which in aggregate owns 36% of

Aware and holds voting proxies for another 10%) rejoined the board of directors in January 2011,

appearing to slow the spin-off process and assess the best means of monetizing Aware’s excess IP assets.

We view the Staffords’ reengagement as a positive given maximizing shareholder value is likely their

sole concern.

Following the Staffords joining the board, Aware’s CEO and two tenured board members resigned in

spring 2011. Subsequently, in October 2011, John Stafford, Jr. was elevated to chairman of the board,

and the executive chairman – Michael Tzannes – resigned from the board to focus on heading Aware’s

patent monetization efforts. In our conversations with management, a debate amongst the board has

become apparent concerning the best means by which to monetize the excess-IP portfolio with some

favoring spin-off and others preferring alternative routes.

There are essentially 4 likely routes to IP monetization:

(1) Licensing/litigation – Aware directly pursues licenses from and/or litigates against other

companies. This route raises two primary issues: (a) Aware already houses two different

operating entities and adding a third would present increased complexity for investors and (b)

there could potentially be legal blowback risk for Aware’s operations should it pursue litigation

against other technology firms.

(2) Spin-off new entity with excess IP assets and cash – this is the route former management began to

pursue in late-2010. Typically, a spin-off would offer the benefit of tax efficiency, but given

Aware’s $41.8mm deferred tax asset this consideration is not as relevant. Further, there is a very

real question of whether it makes economic sense to split into two separate publicly-traded

entities given Aware’s market cap and lack of scale.

(3) Assign IP and retain residual interest – Aware assigns patents to other companies who then

pursue licensing and/or litigation with Aware retaining an interest in the ultimate revenues. As

noted above, in this structure, the assignor’s retained interest (net of associated expenses) is often

around 50%.

(4) Sell the patents

In terms of monetizing the current excess IP portfolio, the preferred route is likely asset sale(s) of the

patents given the significant deferred tax asset that can be used to offset gains from the transaction, a tax

asset that may otherwise be squandered by the tepid profitability of the operating businesses.

AWRE - Comparable Analysis - IP-Focused Firms

U.S. Patents Apps. Cites Cites/Patent

Aware 101 167 1,809 17.9x

Interdigital 1,339 1,193 10,409 7.8x

Nortel 4,465 1,281 73,735 16.5x

Motorola Mobility 5,353 1,569 82,558 15.4x

Eastman Kodak 16,922 3,339 171,166 10.1x

Apple 4,073 4,197 63,856 15.7x

Google 2,115 1,627 30,726 14.5x

Digimarc 632 511 29,017 45.9x

Intellectual Ventures 1,677 540 19,974 11.9x

Wi-Lan 468 166 9,209 19.7x

Rambus 1,013 558 16,155 15.9x

MOSAID 1,088 473 11,851 10.9x

Source: USPTO & PatentBuddy.com


Valuation – patent valuation is far from a precise science as patent beauty is truly in the eye of the

beholder. Nevertheless, there are several means by which to inform a view of value.

The first valuation approach is a “by the pound” method – assessing the total value of Aware’s patent

portfolio based on recent transactions involving similar IP. The above-referenced Nortel and Motorola

transactions provide useful data in this analysis. Nortel was a pure-play sale of Nortel’s IP. Although

Motorola involved the sale of operations and IP, the consensus view is Google assigned the vast majority

of value to Motorola’s IP for defensive and offensive use in patent litigation against Microsoft and Apple.

This is consistent with the fact that Motorola generated only $76mm in 2010 operating income on

$11.5bn in revenues, following operating losses of $1.2bn and $2.0bn in 2009 and 2008, respectively.

Nevertheless, for purposes of patent transaction comps we assume the Motorola’s operating business was

worth book value of $1.8bn, reducing the patent transaction value to $10.7bn.

As the table indicates, Nortel’s portfolio sold for

$750,000 per patent and Motorola’s for roughly

$446,000 per patent. Utilizing a $500,000 per patent

assumption, results in a $228mm value for Aware’s IP,

over 11x the current enterprise value. Even reducing

the assumption by half to $250,000 per patent, equates

to $114mm in IP value, over 5x enterprise value.

One further example of strategic patent value is offered by the recent HTC-S3 Graphics deal. In July

2011, just days after the International Trade Commission found Apple had infringed two of S3 Graphics

patents, HTC agreed to purchase S3 for $300mm, or $1.3mm per patent. While S3 is reevaluating the

deal in light of a subsequent reversal of the ITC ruling, the events demonstrate the tactical and monetary

value of well-positioned technology IP.

Finally, we note the insider purchases of Michael Tzannes, a long-time Aware employee and former

Aware CEO and executive chairman. Tzannes is also a prodigious inventor named on the majority of

Aware’s patents – if anyone knows the value of the IP portfolio, it is Tzannes. For several years prior to

the announcement of the IP spin-off in September 2010, Tzannes consistently owned 91,033 shares.

Following the spin-off announcement, in April and May 2011, Tzannes invested $1.02mm to purchase

321,000 additional shares. Tzannes’ investment was effected through the exercise of essentially at-the-

money options ($3.18 average basis) that were not scheduled to expire until October 2013; thus, the

option exercises were the effective equivalent of open market purchases. In the nine months following

Aware’s decision to pursue IP monetization, Tzannes – who developed and heads Aware’s IP efforts –

invested cash to increase his share ownership by 4.5x. We believe this is a bullish indicator of value.

IP Spin-Off Announced

Patent Transaction Comps

Total Patents & Price per

Seller Price Apps. Patent

Nortel $4.5bn 6,000 $750k

Motorola $10.7bn 24,000 $446k


Nevertheless, for purposes of assigning value to the IP portfolio, we take a conservative approach and

capitalize Aware’s R&D on trailing five-year basis. Assuming straight-line depreciation of R&D

investment from 2006 to 2010 results in IP asset value of $32mm. However, utilizing a twenty-year

capitalization/depreciation schedule – consistent with the time length of patents – produces an IP asset of

$85mm or over $2.50/share of incremental value (additional upside of 78%). The reasonableness of using

a twenty-year capitalization/depreciation schedule is highlighted by the fact that several of the patents

transferred to Hybrid Audio were filed in the early 1990s, demonstrating the long-term potential value of

technology patents.

Patent Litigation – Hybrid Audio

A final, option-like Aware value driver relates to patent infringement litigation surrounding several

Aware patents. In December 2010, Aware assigned four patents to Hybrid Audio, LLC. Hybrid Audio is

a Texas-based entity whose management is associated with Technology, Patents & Licensing, Inc., a

Pennsylvania firm focused on developing, acquiring, managing and monetizing patent assets.

Three of the four assigned patents fall under IPC code G10L, which covers audio analysis and

processing. These were the only G10L patents within Aware’s portfolio. Although Aware has provided

little disclosure relating to the patent transfer or Hybrid Audio, our diligence leads us to believe Aware

conveyed the patents for $300,0002 and retained ~50% interest in any future net proceeds from litigation

or licensing. Our discussions with IP attorneys indicate patent assignors often retain a percentage of

future proceeds. Further, subsequent conversations with Aware’s management confirmed – although they

would not address Hybrid Audio specifically – that in patent assignments geared toward monetization by

the assignee Aware would typically retain 50%+/- interest in future net proceeds.

The belief that Aware structured a deal with Hybrid Audio for the latter to pursue patent infringement

claims is bolstered by the fact that simultaneous with the assignment Hybrid Audio filed federal suit in

the Eastern District of Texas against HTC, Apple, Dell, Motorola Mobility, Nokia, RIM and Samsung.

The claimed infringement involves one of the four assigned patents and relates to the processing of audio

information under MP3 on products including iPod, iPhone 4, iPad, iTunes, XOOM and DROID.3

While handicapping the value of patent litigation is difficult, the Hybrid Audio suit certainly appears to

involve a colorable claim and significant potential value. Plaintiff’s counsel is McKool Smith, a national

trial law firm with a patent litigation focus. McKool secured several recent victories in infringement suits

against Microsoft, including a $290mm claim in favor of i4i Limited Partnership that was upheld by the

U.S. Supreme Court in June 2011. In short, McKool is a very

successful law firm, having secured more of the 100 largest U.S.

courtroom verdicts than any other firm in the country during

2008 and 2009.4 Importantly, McKool takes IP infringement

cases on a contingency fee basis, which means the firm has

significant economic risk should the lawsuit prove unsuccessful,

and must therefore diligence and select its clients carefully. This

suggests McKool sees merit and material value in the Hybrid

Audio suit.

A second positive aspect of the case is its venue in the U.S. District Court for the Eastern District of

Texas, site of the above-referenced Microsoft suit and a great venue for patent suits. The judges within

2 The only patent revenue recognized during 2010 occurred in Q4, the same period as the Hybrid Audio assignment.

3 The other 3 patents not part of the lawsuit may serve as defense in the litigation or constitute fuel for future suits.

4 McKool was also named by Managing Intellectual Property magazine as one of the four top patent firms in the

United States.

Recent McKool Infringement Verdicts

Defendant Verdict ($mm)

SAP 345

Microsoft 106

Microsoft 290

Boston Scientific 250

AT&T 156


the District have developed an interest in patent litigation and ensure speedy process and case resolution.

Additionally, the judge assigned to the Hybrid Audio suit, Judge Leonard Davis, is experienced in IP

litigation and technologically knowledgeable having worked as a computer programmer prior to law

school.

An attempt to put a definitive dollar estimate on the value of the Hybrid Audio litigation would be foolish

– there are simply too many variables and unknowns. However, in light of McKool’s past successes and

contingency fee structure, we believe it is reasonable to assume McKool sees litigation value greater than

$100MM. The firm has multiple $100MM+ IP infringement verdicts over the past several years, and

given the incentives and risks inherent in contingency fee representation and the expense of IP suits,

McKool’s business model is predicated upon only pursuing cases with significant value potential.

Assuming McKool sees at least $100mm in infringement value, the Hybrid Audio litigation would

represent $30mm in value to Aware net of a 40% contingency fee and 50% profit share with Hybrid

Audio. While any value realization from Hybrid Audio is admittedly speculative, we believe there

appears to be real potential for significant value associated with the relationship, and further the suit

represents purely incremental value on what is an already undervalued business. For valuation purposes,

we apply a 50% discount to the valuation above to arrive at $15mm of litigation value. Without the

discount, Hybrid Audio would represent an additional $0.75/share of value (additional upside 23%).

Real Estate Value

Aware owns its 72,000 square foot headquarters in

Bedford, Massachusetts. The structure was

constructed in 1982 and sits on 4.03 acres of property.

Aware acquired the property in 1997 for $6.7mm, and

it is currently assessed at $5.7mm. This equates to an

appraised value of $79 per square foot. Given recent

Bedford office comp transactions in the $85 to $150

per square foot range, the assessed value of $5.7mm /

$78 per square foot passes the reasonableness test.

In any event, at $5.7mm, Aware’s real estate

represents 28% of Aware’s enterprise value.

Conclusion & Other Value Considerations

In sum, based on our analysis, we believe Aware

currently trades at 44% of a sum of its conservatively

valued parts with a newly reconfigured board and

management that is working to actively catalyze value

recognition through asset monetization.

Moreover, there are components of value that this analysis has not considered. We have assigned no

value to Aware’s $64.5mm of federal NOLs/credits and $18.6mm of state NOLs/credits, which comprise

a total DTA of $41.8mm. There is currently a valuation allowance taken against the entirety of the DTA,

but this asset may represent real value of $2/share as the company considers asset sales the gains from

which the DTA can offset.

Finally, the limited downside risk of an Aware investment bears noting. Taking only cash and accounts

receivable and assuming $5.7mm in real estate value against total liabilities of $3.2mm results in $2.51 of

AWRE - Headquarters Comps

Comp Year

Date SqFt Value $/SqFt Built

2010 25,000 $2,750,000 $110 1971

2007 50,000 $4,250,000 $85 1979

2007 40,000 $3,750,000 $94 1975

2006 40,000 $6,250,000 $156 1984


per share liquidation value. Accordingly, Aware trades for only a 28% premium to liquidation value,

which is all the more meaningful for a company generating positive free cash flow. This 28% downside

to liquidation value contrasts with upside of 129%, a roughly 5x upside-downside ratio. Moreover,

conceivable scenarios exist in which Aware’s IP and litigation value offer additional upside of

$3.25/share for a potential total return of over 230%. Most importantly, a buyer of Aware is paying

nothing for this IP optionality as the Company trades at only a slight premium to true liquidation value

and the biometrics business has clear value. We believe the asymmetry of return is compelling.

Information, opinions or recommendations contained herein are solely for informational purposes. The

information used and statements made have been obtained from sources considered reliable but Privet

Fund Management LLC neither guarantees nor represents its completeness or accuracy. Such

information and the opinions expressed herein are subject to change without notice. As of the date

hereof, Privet Fund Management LLC and its affiliates own securities of Aware, Inc. For further

information, see Privet Fund Management LLC’s Schedule 13D filed with the SEC. Privet Fund

Management LLC and its affiliates may either increase or decrease their positions in Aware, Inc. without

notice. This document is not intended as an offering or a solicitation of an offer to buy or sell the

securities mentioned or discussed.

Sum Zero AWRE Memo Feb2012

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