UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 
WASHINGTON, D.C. 20549

 
FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

Commission File Number 0-26068

ACACIA RESEARCH CORPORATION
(Exact Name of Registrant as Specified in Its Charter)


Delaware
 
95-4405754
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification No.)


500 Newport Center Drive, Newport Beach, CA
 
92660
(Address of Principal Executive Offices)
 
(Zip Code)


Registrant’s telephone number, including area code:  (949) 480-8300

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.    Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 Large accelerated filer   ¨
  
Accelerated filer  þ
  
Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨  No  þ 
 
As of October 31, 2006, 28,020,042 shares of Acacia Research-Acacia Technologies common stock were issued and outstanding. As of October 31, 2006, 41,507,579 shares of Acacia Research-CombiMatrix common stock were issued and outstanding.


 


 ACACIA RESEARCH CORPORATION
Table of Contents
 
Part I. Financial Information

Item 1.
Financial Statements
 
     
 
Acacia Research Corporation Consolidated Financial Statements
 
     
 
Consolidated Balance Sheets as of September 30, 2006, and
December 31, 2005 (Unaudited)
1
     
 
Consolidated Statements of Operations and Comprehensive Income (Loss) for the
Three Months and Nine Months Ended September 30, 2006 and 2005 (Unaudited)
 
2
     
 
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2006 and 2005 (Unaudited)
 
3
     
 
Notes to Consolidated Financial Statements (Unaudited).
4
     
     
 
*Acacia Technologies Group Financial Statements
 
     
 
Balance Sheets as of September 30, 2006, and December 31, 2005 (Unaudited)  
25
     
 
Statements of Operations for the Three Months and Nine Months Ended
September 30, 2006 and 2005 (Unaudited)
 
26
     
 
Statements of Cash Flows for the Nine Months Ended
September 30, 2006 and 2005 (Unaudited)
 
27
     
 
Notes to Financial Statements (Unaudited)
28
     
     
 
*CombiMatrix Group Financial Statements
 
     
 
Balance Sheets as of September 30, 2006, and December 31, 2005 (Unaudited)
33
     
 
Statements of Operations for the Three Months and Nine Months Ended
September 30, 2006 and 2005 (Unaudited)
 
34
     
 
Statements of Cash Flows for the Nine Months Ended
September 30, 2006 and 2005 (Unaudited)
 
35
     
 
Notes to Financial Statements (Unaudited)
36
     
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
41
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
65
     
Item 4.
Controls and Procedures
65
     
 

 
 
     
     
     
     
     
Part II. Other Information
     
     
Item 1.
Legal Proceedings
66
     
Item 1A.
Risk Factors
66
     
Item 6.
Exhibits
68
     
     
Signatures 
69
   
Exhibit Index 
70


*NOTE: We are presenting the Acacia Research Corporation consolidated unaudited interim financial statements and the separate unaudited interim financial statements for the CombiMatrix group and the Acacia Technologies group. The separate financial statements and accompanying notes of the two groups are being provided as additional disclosure regarding the financial performance of the two divisions and to provide investors with information regarding the potential value and operating results of the respective businesses, which may affect the respective share values. The separate financial statements should be reviewed in conjunction with Acacia Research Corporation’s consolidated financial statements and accompanying notes. The presentation of separate financial statements is not intended to indicate that we have changed the title to any of our assets or changed the responsibility for any of our liabilities, nor is it intended to indicate that the rights of our creditors have been changed. Acacia Research Corporation, and not the individual groups, is the issuer of the securities. Holders of the two securities are stockholders of Acacia Research Corporation and do not have a separate and exclusive interest in the respective groups.





ACACIA RESEARCH CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share information)
(Unaudited)

   
September 30,
 
December 31,
 
   
2006
 
2005
 
ASSETS
         
           
Current assets:
         
Cash and cash equivalents
 
$
27,791
 
$
20,164
 
Short-term investments
   
26,511
   
39,009
 
Accounts receivable
   
2,762
   
5,332
 
Prepaid expenses, inventory, and other assets
   
1,955
   
2,115
 
Total current assets
   
59,019
   
66,620
 
               
Property and equipment, net of accumulated depreciation
   
2,259
   
2,484
 
Patents, net of accumulated amortization
   
26,931
   
31,712
 
Goodwill
   
17,039
   
18,980
 
Other assets
   
2,747
   
1,638
 
   
$
107,995
 
$
121,434
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
               
Current liabilities:
             
Accounts payable and accrued expenses
 
$
5,883
 
$
3,924
 
Royalties and legal fees payable
   
2,343
   
3,758
 
Current portion of deferred revenues
   
930
   
804
 
Total current liabilities
   
9,156
   
8,486
 
               
Deferred income taxes
   
-
   
2,701
 
Deferred revenues, net of current portion
   
1,145
   
1,439
 
Other liabilities
   
736
   
1,464
 
Total liabilities
   
11,037
   
14,090
 
               
Commitments and contingencies (Note 10)
             
               
Minority interests
   
-
   
447
 
               
Redeemable stockholders' equity:
             
Preferred stock
             
Acacia Research Corporation, par value $0.001 per share; 10,000,000 shares authorized; no shares issued or outstanding
   
-
   
-
 
Common stock
             
Acacia Research - Acacia Technologies stock, par value $0.001 per share; 50,000,000 shares authorized; 28,017,459 and 27,722,242 shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively
   
28
   
28
 
Acacia Research - CombiMatrix stock, par value $0.001 per share; 50,000,000 shares authorized; 41,405,798 and 38,992,402 shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively
   
41
   
39
 
Additional paid-in capital
   
321,604
   
315,146
 
Deferred stock compensation
   
-
   
(1,400
)
Accumulated comprehensive income
   
16
   
(2
)
Accumulated deficit
   
(224,731
)
 
(206,914
)
Total stockholders' equity
   
96,958
   
106,897
 
               
   
$
107,995
 
$
121,434
 
 

The accompanying notes are an integral part of these consolidated financial statements.
1

ACACIA RESEARCH CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(In thousands, except share and per share information)
(Unaudited)

   
For the Three Months Ended
 
For the Nine Months Ended
 
   
September 30, 2006
 
September 30, 2005
 
September 30, 2006
 
September 30, 2005
 
Revenues:
                         
License fees
 
$
8,424
 
$
6,783
 
$
27,512
 
$
11,328
 
Government contract
   
725
   
973
   
1,563
   
2,985
 
Products
   
968
   
453
   
3,050
   
1,298
 
Service contracts
   
151
   
37
   
268
   
106
 
Total revenues
   
10,268
   
8,246
   
32,393
   
15,717
 
                           
Operating expenses:
                         
Cost of government contract revenues
   
684
   
920
   
1,476
   
2,820
 
Cost of product sales
   
412
   
282
   
973
   
635
 
Research and development expenses (including non-cash stock compensation expense of $311 and $797 for the three and nine months ended September 30, 2006 and $0 for the three and nine months ended September 30, 2005)
   
2,819
   
1,527
   
7,380
   
4,082
 
Marketing, general and administrative expenses (including non-cash stock compensation expense of $1,262 and $3,881 for the three and nine months ended September 30, 2006 and $88 and ($23) for the three and nine months ended September 30, 2005)
   
6,315
   
4,918
   
20,086
   
12,957
 
Legal expenses - patents
   
2,354
   
1,076
   
3,803
   
2,173
 
Inventor royalties and contingent legal fees expense - patents
   
2,623
   
3,939
   
12,741
   
5,706
 
Inventor royalties - V-chip
   
-
   
225
   
-
   
225
 
Amortization of patents
   
1,596
   
1,607
   
4,813
   
4,407
 
Write-off of patent-related intangible asset
   
-
   
-
   
297
   
-
 
Legal settlement credits
   
-
   
(211
)
 
-
   
(406
)
Loss from equity investments
   
253
   
100
   
786
   
202
 
Total operating expenses
   
17,056
   
14,383
   
52,355
   
32,801
 
Operating loss
   
(6,788
)
 
(6,137
)
 
(19,962
)
 
(17,084
)
                           
Other income (expense):
                         
Interest and investment income
   
501
   
434
   
1,572
   
1,090
 
Loss on sale of interest in subsidiary
   
-
   
-
   
(84
)
 
-
 
Warrant gains (charges)
   
913
   
163
   
663
   
163
 
Total other income, net
   
1,414
   
597
   
2,151
   
1,253
 
                           
Loss from continuing operations before income taxes and minority interests
   
(5,374
)
 
(5,540
)
 
(17,811
)
 
(15,831
)
                           
(Provision) benefit for income taxes
   
(2
)
 
98
   
(6
)
 
232
 
                           
Loss from continuing operations before minority interests
   
(5,376
)
 
(5,442
)
 
(17,817
)
 
(15,599
)
                           
Minority interests
   
-
   
1
   
-
   
1
 
                           
Loss from continuing operations
   
(5,376
)
 
(5,441
)
 
(17,817
)
 
(15,598
)
                           
Discontinued operations:
                         
                           
Estimated loss on disposal of discontinued operations
   
-
   
-
   
-
   
(210
)
                           
Net loss
   
(5,376
)
 
(5,441
)
 
(17,817
)
 
(15,808
)
                           
Unrealized gains (losses) on short-term investments
   
70
   
(5
)
 
73
   
2
 
Unrealized gains on foreign currency translation
   
2
   
14
   
6
   
36
 
Sale of interest in subsidiary's cumulative translation adjustment
   
-
   
-
   
(61
)
 
-
 
                           
Comprehensive loss
 
$
(5,304
)
$
(5,432
)
$
(17,799
)
$
(15,770
)
                           
Earnings (loss) per common share:
                         
Attributable to the Acacia Technologies group:
                         
Loss from continuing operations
 
$
(1,049
)
$
(1,558
)
$
(2,359
)
$
(4,982
)
Basic and diluted loss per share
   
(0.04
)
 
(0.06
)
 
(0.09
)
 
(0.19
)
Loss from discontinued operations
 
$
-
 
$
-
 
$
-
 
$
(210
)
Basic and diluted loss per share
   
-
   
-
   
-
   
(0.01
)
Net loss
 
$
(1,049
)
$
(1,558
)
$
(2,359
)
$
(5,192
)
Basic and diluted loss per share
   
(0.04
)
 
(0.06
)
 
(0.09
)
 
(0.20
)
                           
Attributable to the CombiMatrix group:
                         
Net loss
 
$
(4,327
)
$
(3,883
)
$
(15,458
)
$
(10,616
)
Basic and diluted loss per share
   
(0.11
)
 
(0.12
)
 
(0.39
)
 
(0.33
)
                           
Weighted average shares:
                         
Acacia Research - Acacia Technologies stock:
                         
Basic and diluted
   
27,567,848
   
27,302,693
   
27,492,410
   
26,387,562
 
Acacia Research - CombiMatrix stock:
                         
Basic and diluted
   
40,209,640
   
33,239,726
   
39,411,421
   
31,887,872
 

The accompanying notes are an integral part of these consolidated financial statements.
2

ACACIA RESEARCH CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
   
For the Nine Months Ended
 
   
September 30, 2006
 
September 30, 2005
 
Cash flows from operating activities:
             
Net loss
 
$
(17,817
)
$
(15,808
)
Adjustments to reconcile net loss to net cash used in operating activities:
             
Depreciation and amortization
   
5,553
   
5,260
 
Minority interests
   
-
   
3
 
Non-cash stock compensation
   
4,678
   
(23
)
Deferred income taxes
   
(70
)
 
(210
)
Non-cash warrant charges (gains)
   
(663
)
 
(163
)
Non-cash legal settlement charges (credits)
   
-
   
(406
)
Loss on disposal of discontinued operations
   
-
   
210
 
Write-off of patent-related intangible asset
   
297
   
-
 
Loss from equity investments
   
786
   
253
 
Loss on sale of interest in subsidiary
   
84
   
-
 
Stock issued to consultant
   
94
   
-
 
Other
   
42
   
(128
)
Changes in assets and liabilities, excluding effect of business acquisition:
             
Accounts receivable
   
2,553
   
(986
)
Prepaid expenses, inventory and other assets
   
(213
)
 
(576
)
Accounts payable and accrued expenses
   
2,285
   
574
 
Royalties and legal fees payable
   
(1,415
)
 
1,331
 
Deferred revenues
   
(115
)
 
375
 
Net cash used in operating activities from continuing operations
   
(3,921
)
 
(10,294
)
Net cash provided by (used in) operating activities from discontinued operations
   
222
   
(525
)
Net cash used in operating activities
   
(3,699
)
 
(10,819
)
               
Cash flows from investing activities:
             
Purchase of property and equipment
   
(619
)
 
(1,162
)
Purchase of available-for-sale investments
   
(14,927
)
 
(57,309
)
Sale of available-for-sale investments
   
27,485
   
59,260
 
Business acquisition (Note 7)
   
(16
)
 
(5,796
)
Purchase of additional interests in equity method investee
   
(1,400
)
 
(1,100
)
Patent acquisition costs
   
(1,020
)
 
(445
)
Sale of interest in subsidiary (net of cash disposed)
   
(369
)
 
-
 
               
Net cash provided by (used in) investing activities
   
9,134
   
(6,552
)
Net cash used in investing activities from discontinued operations
   
(353
)
 
-
 
Net cash provided by (used in) investing activities
   
8,781
   
(6,552
)
               
Cash flows from financing activities:
             
Proceeds from sale of common stock, net of issuance costs
   
2,640
   
32,354
 
Prepaid Standby Equity Distribution Agreement commitment fees (Note 6)
   
(550
)
 
-
 
Proceeds from the exercise of stock options
   
455
   
187
 
               
Net cash provided by financing activities
   
2,545
   
32,541
 
               
Effect of exchange rate on cash
   
-
   
35
 
               
Increase in cash and cash equivalents
   
7,627
   
15,205
 
               
Cash and cash equivalents, beginning
   
20,164
   
13,910
 
               
Cash and cash equivalents, ending
 
$
27,791
 
$
29,115
 
 

The accompanying notes are an integral part of these consolidated financial statements.
3

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
1.    DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

Description of Business. Acacia Research Corporation (“we,” “us” and “our”) is comprised of two operating groups.

Acacia Technologies Group

The Acacia Technologies group, a division of Acacia Research Corporation, develops, acquires, licenses and enforces patented technologies. The Acacia Technologies group owns and has rights to patent portfolios covering a wide range of technology areas. The Acacia Technologies group is primarily comprised of certain of Acacia Research Corporation’s direct and or indirect wholly owned subsidiaries and limited liability companies including:

· Acacia Global Acquisition Corporation
· Acacia Media Technologies Corporation
· Acacia Patent Acquisition Corporation
· Acacia Technologies Services Corporation
· AV Technologies LLC
· Broadcast Data Retrieval Corporation
· Broadcast Innovation LLC
· Computer Acceleration Corporation
· Computer Cache Coherency Corporation
· Computer Docking Station Corporation
· Credit Card Fraud Control Corporation
· Data Encryption Corporation
· Data Innovation LLC
· Diagnostic Systems Corporation
· Disk Link Corporation
· Financial Systems Innovation LLC
· High Resolution Optics Corporation
· Information Technology Innovation LLC
· InternetAd LLC
· IP Innovation LLC
· KY Data Systems LLC
· Micromesh Technology Corporation
· Microprocessor Enhancement Corporation
· New Medium LLC
· Peer Communications Corporation
· Product Activation Corporation
· Resource Scheduling Corporation
· Software Collaboration Corporation
· Soundview Technologies, Inc.
· Spreadsheet Automation Corporation
· TechSearch LLC
· Telematics Corporation
· VData LLC

The Acacia Technologies group also includes all corporate assets, liabilities, and related transactions of Acacia Research Corporation attributed to Acacia Research Corporation’s intellectual property licensing and enforcement business. Refer to “Business Acquisition” below for information on the Acacia Technologies group’s 2005 business acquisition activity.

Business Acquisition. On January 28, 2005, Acacia Global Acquisition Corporation acquired the assets of Global Patent Holdings, LLC, which owned 11 patent licensing companies (“GPH Acquisition”). The acquisition provided the Acacia Technologies group ownership of companies that control 27 patent portfolios, which include 120 U.S. patents and certain foreign counterparts, and cover technologies used in a wide variety of industries. Refer to Note 7 for a description of the acquisition transaction.

CombiMatrix Group

Our life sciences business, referred to as the “CombiMatrix group,” a division of Acacia Research Corporation, is comprised of our wholly owned subsidiary, CombiMatrix Corporation and CombiMatrix Corporation’s wholly owned subsidiary, CombiMatrix Molecular Diagnostics and includes all corporate assets, liabilities and transactions related to Acacia Research Corporation’s life sciences business.

The CombiMatrix group develops proprietary technologies and products and services in the areas of drug development, genetic analysis, nanotechnology research, defense and homeland security markets, and other markets where its products could be utilized. Among the technologies being developed by the CombiMatrix group is a platform technology to produce customizable arrays, which are semiconductor-based tools for use in identifying and determining the roles of genes, gene mutations and proteins. This technology has potential applications in the areas of genomics, proteomics, biosensors, drug discovery, drug development, diagnostics, combinatorial chemistry, material sciences and nanotechnology. Other technologies include proprietary molecular synthesis and screening methods for the discovery of potential new drugs. CombiMatrix Molecular Diagnostics, Inc., (“CMDX”), a wholly owned subsidiary located in Irvine, California, is exploring opportunities for the CombiMatrix group’s arrays in the field of molecular diagnostics. CombiMatrix K.K., a Japanese corporation located in Tokyo, Japan, has existed for the purpose of exploring opportunities for CombiMatrix Corporation’s array system with pharmaceutical and biotechnology companies in the Asian market. In January 2006, CombiMatrix Corporation sold 67% of its ownership interest in CombiMatrix K.K. to a third party. Refer to Note 12.
 
4

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
Other

In January 2006, Acacia Research Corporation’s board of directors approved a plan for its wholly owned subsidiary, CombiMatrix Corporation, to become an independent public company. The transaction is expected to be completed no sooner than the first quarter of 2007, subject, however, to determination that there are no significant negative tax consequences to Acacia Research Corporation or it’s shareholders and completing the required filings with the Securities and Exchange Commission, or SEC. We have received a private letter ruling from the IRS addressing certain tax implications of the transaction and have requested a tax opinion from counsel. If the conditions are met, Acacia Research Corporation will redeem all of the issued and outstanding shares of AR-CombiMatrix common stock for all of the common stock of CombiMatrix Corporation, which will register its common stock under the Securities and Exchange Act of 1934. Following the redemption, CombiMatrix Corporation will apply to list its shares for trading on a national exchange.

Capital Structure. On December 11, 2002, our stockholders voted in favor of a recapitalization transaction, which became effective on December 13, 2002, whereby we created two new classes of common stock called Acacia Research-CombiMatrix common stock (“AR-CombiMatrix stock”) and Acacia Research-Acacia Technologies common stock (“AR-Acacia Technologies stock”), and divided our existing Acacia Research Corporation common stock into shares of the two new classes of common stock. AR-CombiMatrix stock is intended to reflect separately the performance of Acacia Research Corporation’s CombiMatrix group. AR-Acacia Technologies stock is intended to reflect separately the performance of Acacia Research Corporation’s Acacia Technologies group. Although the AR-CombiMatrix stock and the AR-Acacia Technologies stock are intended to reflect the performance of our different business groups, they are both classes of common stock of Acacia Research Corporation and are not stock issued by the respective groups.

Liquidity and Risks

General. To date, we and our subsidiaries have relied primarily upon selling equity securities and payments from our strategic partners and licensees to generate the funds needed to finance the implementation of our plans of operation for our subsidiaries.

Management believes that the Acacia Technologies group’s cash and cash equivalent balances, anticipated cash flow from operations and other external sources of available credit will be sufficient to meet our cash requirements through at least November 2007.

Management believes that the CombiMatrix group’s cash and cash equivalent balances, anticipated cash flows from operations and other external sources of available credit, including the standby equity distribution agreement (the “SEDA”), discussed at Note 6, will be sufficient to meet its cash requirements for the next six months.

The Acacia Technologies Group. To date, the Acacia Technologies group has relied upon the receipt of license fee payments from the licensing of the Acacia Technologies group’s patented technologies and the selling of Acacia Research Corporation equity securities to generate the funds needed to finance the operations of the Acacia Technologies group. The Acacia Technologies group began to commercially license its DMT® technology in 2003. The GPH Acquisition provided the Acacia Technologies group with ownership of companies that control 27 patent portfolios, which include 120 U.S. patents and certain foreign counterparts, and cover technologies used in a wide variety of industries. Subsequent to the GPH Acquisition, the Acacia Technologies group has acquired or acquired the rights to over 20 additional patent portfolios, covering a wide range of technology areas, which it intends to develop, license and enforce.

There can be no assurance that the Acacia Technologies group will be able to implement its future plans. Failure by management to achieve its plans would have a material adverse effect on the Acacia Technologies group and on Acacia Research Corporation’s ability to achieve its intended business objectives. We may be required to obtain additional financing. There can be no assurance that additional funding will be available on favorable terms, if at all. If we fail to obtain additional funding when needed, we may not be able to execute our business plans and our businesses may suffer.
 
5

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
The timing of the receipt of revenues by the Acacia Technologies group’s business operations are subject to certain risks and uncertainties, including:

 
·
market acceptance of our patented technologies and services;
 
·
business activities and financial results of our licensees;
 
·
technological advances that may make our patented technologies obsolete or less competitive;
 
·
increases in operating costs, including costs for legal services, engineering and research and personnel;
 
·
the availability and cost of capital; and
 
·
governmental regulation that may restrict the Acacia Technologies group’s business.

The Acacia Technologies group’s success also depends on its ability to protect its intellectual property. The Acacia Technologies group relies on its proprietary rights and their protection. Although reasonable efforts will be taken to protect the Acacia Technologies group’s proprietary rights, the complexity of international trade secret, copyright, trademark and patent law, and common law, coupled with limited resources and the demands of quick delivery of technologies to market, create risk that these efforts will prove inadequate. Accordingly, if the Acacia Technologies group is unsuccessful with litigation to protect its intellectual property rights, the future revenues of the Acacia Technologies group could be adversely affected.

The CombiMatrix Group. The CombiMatrix group is deploying new and unproven technologies and continues to develop its commercial products. The CombiMatrix group has several ongoing long-term development projects that involve experimental technology and may require several years and substantial expenditures to complete. Management believes that the CombiMatrix group’s cash and cash equivalent balances, anticipated cash flows from operations and other external sources of available credit including the SEDA will be sufficient to meet its cash requirements for the next six months. In order for the CombiMatrix group to continue as a going concern beyond March 31, 2007, the CombiMatrix group will be required to obtain capital from external sources, including the SEDA. However, based on the recent decline in the market value of AR-CombiMatrix stock, which began trading below $1.00 per share in late September 2006, and due to the limitation of the number of shares of AR-CombiMatrix stock available on the SEDA, the CombiMatrix group may be required to seek additional sources of financing, including the issuance of debt and/or equity securities that may not be available at times and at terms acceptable to the CombiMatrix group. The issuance of equity securities will also cause dilution to the AR-CombiMatrix shareholders. If external financing sources beyond the SEDA are not available or are inadequate to fund the operations of the CombiMatrix group, it will be required to reduce its operating costs including research projects and personnel, which could jeopardize the future strategic initiatives and business plans of the CombiMatrix group. For example, reductions in research and development activities and/or personnel at our Mukilteo, Washington facility could result in the inability to invest the resources necessary to continue to develop next-generation products and improve existing product lines in order to remain competitive in the marketplace, resulting in reduced revenues and cash flows from the sales of our CustomArray products and services. Also, reduction in operating costs at our diagnostics subsidiary in Irvine, California, (CMDX), should they occur, could jeopardize its ability to launch, market and sell additional products and services necessary in order to grow and sustain its operations and eventually achieve profitability.

The ability to meet business objectives is dependent upon the CombiMatrix group’s ability to raise additional financing, substantiate its technology and ultimately to fund itself from continuing operations. There can be no assurance that such funding will be available at acceptable terms or at all. The CombiMatrix group has a history of incurring net losses and net operating cash flow deficits.

The CombiMatrix group’s business operations are also subject to certain risks and uncertainties, including:
 
 
·
market acceptance of products and services;
 
·
technological advances that may make its products and services obsolete or less competitive;
 
·
increases in operating costs, including costs for supplies, personnel and equipment;
 
·
the availability and cost of capital; and
 
·
governmental regulation that may restrict its business.
 
Historically, the CombiMatrix group has been substantially dependent on arrangements with strategic partners and has relied upon payments by its partners for a significant component of its working capital. The CombiMatrix group intends to enter into additional strategic partnerships to develop and commercialize future products. However, there can be no assurance that the CombiMatrix group will be able to implement its future plans. Failure to achieve its plans would have a material adverse effect on the CombiMatrix group’s and on Acacia Research Corporation’s ability to achieve their intended business objectives. The CombiMatrix group also depends on its ability to protect its intellectual property; the loss thereof or the CombiMatrix group’s failure to secure the issuance of additional patents covering elements of its business processes could materially harm its business and financial condition. The patents covering the CombiMatrix group’s core technology begin to expire in 2018.
 
6

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The CombiMatrix group’s products and services are concentrated in a highly competitive market that is characterized by rapid technological advances, frequent changes in customer requirements and evolving regulatory requirements and industry standards. Failure to anticipate or respond adequately to technological advances, changes in customer requirements, changes in regulatory requirements or industry standards, or any significant delays in the development or introduction of planned products or services, could have a material adverse effect on the CombiMatrix group’s business and operating results.

Acacia Research Corporation’s cash and cash equivalent and short term investment balances, cash flows and anticipated cash flows from operations and other sources of external credit, are attributed to the Acacia Technologies group and the CombiMatrix group based on the respective assets of the specific businesses comprising each group. Issuances of AR-Acacia Technologies stock (and the proceeds thereof) are attributed to the Acacia Technologies group and issuances of AR-CombiMatrix stock (and the proceeds thereof) are attributed to the CombiMatrix group. Neither of the groups is obligated to fund the ongoing operations of the other group. Management has no intent to use the cash and cash equivalent balances, anticipated cash flow from operations, and other external sources of available credit of one group to fund the ongoing operations of the other group.

Basis of Presentation. The accompanying unaudited consolidated financial statements include the accounts of Acacia Research Corporation and its wholly owned and majority-owned subsidiaries and investments accounted for under the equity method. Material intercompany transactions and balances have been eliminated in consolidation.

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnotes required by generally accepted accounting principles in annual financial statements have been omitted or condensed in accordance with quarterly reporting requirements of the SEC. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2005, as reported by us in our Annual Report on Form 10-K. The year-end consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America.

The consolidated financial statements of Acacia Research Corporation include all adjustments of a normal recurring nature which, in the opinion of management, are necessary for a fair statement of our financial position as of September 30, 2006, and results of operations and cash flows for the interim periods presented. The results of operations for the three and nine months ended September 30, 2006, are not necessarily indicative of the results to be expected for the entire year.

Separate Group Presentation. AR-CombiMatrix stock and AR-Acacia Technologies stock are intended to reflect the separate performance of the respective division of Acacia Research Corporation. The CombiMatrix group and the Acacia Technologies group are not separate legal entities. Holders of AR-CombiMatrix stock and AR-Acacia Technologies stock are stockholders of Acacia Research Corporation. As a result, holders of AR-CombiMatrix stock and AR-Acacia Technologies stock continue to be subject to all of the risks of an investment in Acacia Research Corporation and all of its businesses, assets and liabilities. The assets of Acacia Research Corporation attributes to one of the groups could be subject to the liabilities of the other group. The group financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America, and taken together, comprise all the accounts included in the corresponding consolidated financial statements of Acacia Research Corporation. The financial statements of the groups reflect the financial position, results of operations, and cash flows of the businesses included therein. The financial statements of the groups include the accounts or assets of Acacia Research Corporation specifically attributed to the groups and were prepared using amounts included in Acacia Research Corporation’s consolidated financial statements.
 
Minority interests represent participation of other stockholders in the net equity and in the division earnings and losses of the groups and are reflected in the caption “Minority interests” in the group financial statements. Minority interests adjust group net results of operations to reflect only the group’s share of the division earnings or losses of non-wholly owned investees.  
 
7

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
Financial effects arising from one group that affect Acacia Research Corporation’s results of operations or financial condition could, if significant, affect the results of operations or financial condition of the other group and the market price of the class of common stock relating to the other group. Any division net losses of the CombiMatrix group or of the Acacia Technologies group, and dividends or distributions on, or repurchases of, AR-CombiMatrix stock or AR-Acacia Technologies stock, will reduce the assets of Acacia Research Corporation legally available for payment of dividends on AR-CombiMatrix stock or AR-Acacia Technologies stock.
 

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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

Revision in the Classification of Certain Securities. In connection with the preparation of the 2005 consolidated financial statements, Acacia Research Corporation concluded that it was appropriate to classify its annuity investments as current investments.  Prior to 2005, such investments had been classified as cash and cash equivalents. Accordingly, we have made adjustments to our consolidated statement of cash flows for the nine months ended September 30, 2005, to reflect the gross purchases of these securities as investing activities rather than as a component of cash and cash equivalents.  This change in classification does not affect previously reported cash flows from operations or from financing activities in our previously reported statements of cash flows, and it does not affect our previously reported statements of operations for any period.

As of September 30, 2005, before this revision in classification, $4,933,000 of these current investments were classified as cash and cash equivalents on our consolidated balance sheet.  There were no material purchases or sales of annuity investments during any of the periods presented, as such, the impact of the revision in classification on consolidated cash flows from investing activities was not material for any of the periods presented.

Concentrations. Two and three licensee(s) individually accounted for greater than 10% of the Acacia Technologies group’s license fee revenues recognized during the three and nine months ended September 30, 2006, as compared to one licensee during the three and nine months ended September 30, 2005, respectively.  Three and two licensees represented approximately 82% and 95% of the Acacia Technologies group’s accounts receivable at September 30, 2006 and December 31, 2005, respectively.  

Two and no customer(s) individually accounted for greater than 10% of the CombiMatrix group’s product sales recognized during the three and nine months ended September 30, 2006, as compared to one and no customer(s) during the three and nine months ended September 30, 2005, respectively. Five and two customers represented approximately 89% and 84% of the CombiMatrix group’s accounts receivable at September 30, 2006 and December 31, 2005, respectively.

Stock-Based Compensation. Effective January 1, 2006, Acacia Research Corporation adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), which sets forth the accounting requirements for “share-based” compensation payments to employees and non-employee directors and requires that compensation cost relating to share-based payment transactions be recognized in the statement of operations. In March 2005, the SEC published Staff Accounting Bulletin No. 107 (“SAB 107”), which requires stock-based compensation to be classified in the same expense line items as cash compensation (i.e. marketing, general and administrative and research and development expenses). The compensation cost for all stock-based awards is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity award).

In addition, SFAS No. 123R requires stock-based compensation expense to be recorded only for those awards expected to vest using an estimated forfeiture rate. As such, SFAS No. 123R requires Acacia Research Corporation to estimate pre-vesting option forfeitures at the time of grant and reflect the impact of estimated pre-vesting option forfeitures on compensation expense recognized. Acacia Research Corporation considers several factors in connection with our estimates of pre-vesting forfeitures including types of awards, employee classification, and historical pre-vesting forfeiture data. Estimates of pre-vesting forfeitures must be periodically revised in subsequent periods if actual forfeitures differ from those estimates. To the extent that actual results differ from our estimates, such amounts will be recorded as cumulative adjustments in the period the estimates are revised. Prior to the adoption of SFAS No. 123R, Acacia Research Corporation accounted for forfeitures as they occurred under the pro forma disclosure provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.” All references to stock-based compensation expense in these notes, upon adoption of SFAS No. 123R, refers to stock-based compensation net of estimated forfeitures, as required by SFAS No. 123R.
 
8

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
We adopted SFAS No. 123R using the modified prospective transition method. Under this transition method, compensation cost recognized for the nine months ended September 30, 2006 includes: (i) compensation cost for all stock-based awards granted prior to, but not yet vested as of January 1, 2006 (based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123 and previously presented in the pro forma footnote disclosures), and (ii) compensation cost for all stock-based awards granted subsequent to January 1, 2006 (based on the grant-date fair value estimated in accordance with the new provisions of SFAS No. 123R). The cumulative effect of applying an estimated forfeiture percentage to stock-based payments granted prior to, but not yet vested as of, January 1, 2006 was not material.

Prior to January 1, 2006, Acacia Research Corporation accounted for share-based compensation to employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and related interpretations. Acacia Research Corporation also followed the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” Because Acacia Research Corporation previously adopted only the pro forma disclosure provisions of SFAS No. 123, we will recognize compensation cost relating to the unvested portion of awards granted prior to the date of adoption using the same estimate of the grant-date fair value and the same attribution method used to determine the pro forma disclosures under SFAS No. 123, except that forfeiture rates will be estimated for all awards, as required by SFAS No. 123R. In accordance with the requirements of the modified prospective transition method of adoption of SFAS No. 123R, the financial statement amounts for prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of recognizing compensation cost relating to stock-based awards.
 
The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the table below. Expected volatility is based on the separate historical volatility of the market prices of the AR-CombiMatrix stock and AR-Acacia Technologies stock. Volatilities of peer companies were also considered, when applicable, to address the lack of extensive historical volatility data for Acacia Research Corporation’s classes of common stock. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term assumption was determined in accordance with guidance set forth in SAB 107, which provides a “simplified method” for estimating the expected term for stock options, granted prior to December 31, 2007, that 1) are granted at-the-money, 2) have exercisability conditioned only on completion of a service condition through the vesting date, 3) require that employees who terminate their service prior to vesting must forfeit the options, 4) provide that employees who terminate their service after vesting are granted limited time to exercise their stock options (typically 30-90 days), and 5) are nontransferable and nonhedgeable. The simplified method is based on the vesting period and the contractual term for each grant, or for each vesting-tranche for awards with graded vesting. The mid-point between the vesting commencement date and the expiration date is used as the expected term under this method. For awards with multiple vesting-tranches, the times from grant until these mid-points for each of the tranches were averaged to provide an overall expected term.
 
The fair value of restricted stock awards is determined by the product of the number of shares granted and the grant date market price of the AR-Acacia Technologies stock or AR-CombiMatrix stock.
 
The fair value of share-based awards is expensed on a straight-line basis over the requisite service period (generally the vesting period of the award), which is generally two to four years.
 
The fair value of stock options was estimated using the Black-Scholes option-pricing model based on the following weighted average assumptions:
 
9

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 

 
   
Risk Free Interest Rate
 
Term
 
Volatility
 
Dividends
 
                   
For the Three Months Ended September 30, 2006 (1)
                 
AR-CombiMatrix stock
   
5.10%
 
 
6 years
   
82%
 
 
0%
 
CMDX stock 
   
5.00%
 
 
6.25 years
   
82%
 
 
0%
 
                           
For the Nine Months Ended September 30, 2006
                         
AR-CombiMatrix stock
   
5.06%
 
 
6 years
   
82%
 
 
0%
 
AR-Acacia Technologies stock
   
4.30%
 
 
6 years
   
75%
 
 
0%
 
CMDX stock 
   
5.07%
 
 
6.25 years
   
82%
 
 
0%
 

 ___________________________________
(1) No AR - Acacia Technologies stock options were granted during the three months ended September 30, 2006.
 
The following table illustrates the impact of share-based compensation expense on reported amounts (in thousands, except for per share data):
 
   
For the Three Months Ended
September 30, 2006
 
For the Nine Months Ended
September 30, 2006
 
       
Impact of Stock
     
Impact of Stock
 
   
As Reported
 
Based Compensation
 
As Reported
 
Based Compensation
 
                   
Loss from continuing operations before income taxes
 
$
(5,374
)
$
(1,310
)
$
(17,811
)
$
(3,789
)
Net loss
   
(5,376
)
 
(1,310
)
 
(17,817
)
 
(3,789
)
                           
Loss per share:
                         
AR-Acacia Technologies stock:
                         
Stock-based compensation
 
$
-
 
$
(702
)
$
-
 
$
(2,072
)
Basic and diluted
 
$
(0.04
)
$
(0.03
)
$
(0.09
)
$
(0.08
)
                           
AR-CombiMatrix stock:
                         
Stock-based compensation
 
$
-
 
$
(608
)
$
-
 
$
(1,717
)
Basic and diluted
 
$
(0.11
)
$
(0.02
)
$
(0.39
)
$
(0.04
)

 
Stock-based compensation expense for the three and nine months ended September 30, 2006 and 2005 is included in research and development expenses and marketing, general and administrative expenses, as disclosed in the accompanying consolidated statement of operations and comprehensive income (loss).
 
Awards granted prior to Acacia Research Corporation’s implementation of SFAS No. 123R were accounted for under the recognition and measurement principles of APB No. 25 and related interpretations. Accordingly, no stock-based employee compensation cost was reflected in the accompanying unaudited consolidated statements of operations for the three and nine months ended September 30, 2005, because all options granted under Acacia Research Corporation’s plans had exercise prices equal to the market value of the underlying common stock on the date of grant.
 
The following table illustrates the pro forma effect on net loss and loss per share, if Acacia Research Corporation had applied the fair value recognition provisions of SFAS No. 123 (in thousands, except per share data):
 
   
AR-Acacia Technologies Stock
 
AR-Acacia CombiMatrix Stock
 
   
Three Months Ended
 
Nine Months Ended
 
Three Months Ended
 
Nine Months Ended
 
   
September 30, 2005
 
September 30, 2005
 
September 30, 2005
 
September 30, 2005
 
                   
Loss from continuing operations, as reported
 
$
(1,558
)
$
(5,192
)
$
(3,883
)
$
(10,616
)
Add: Stock-based compensation, intrinsic value method reported in net loss, net of tax(3)
    -    
123
    -     -  
Deduct: Pro forma stock-based compensation fair value method (2)
   
(726
)
 
(1,945
)
 
(870
)
 
(2,549
)
Loss from continuing operations, pro forma
 
$
(2,284
)
$
(7,014
)
$
(4,753
)
$
(13,165
)
                           
Basic and diluted loss per share from operations, as reported
 
$
(0.06
)
$
(0.20
)
$
(0.12
)
$
(0.33
)
Basic and diluted loss per share from operations, pro forma
 
$
(0.08
)
$
(0.27
)
$
(0.14
)
$
(0.41
)
                           
Weighted Average Assumptions used (1)
                         
Risk free interest rate
   
3.96%
 
 
3.76%
 
 
3.97%
 
 
3.83%
 
Volatility
   
94%
 
 
94%
 
 
88%
 
 
88%
 
Expected term
   
5 years
   
5 years
   
5 years
   
5 years
 
___________________________  
(1)
The fair value of stock options was determined using the Black-Scholes option-pricing model. The fair value calculations assume no expected dividends.
(2)
The previously reported 2005 pro forma income (loss) from operations and related pro forma earnings (loss) per share amounts have been revised for a computational error in the amortization of stock compensation expense and to reflect amounts with a 0% effective tax rate due to the full valuation allowance recoded by Acacia Research Corporation for all periods presented and to exclude stock compensation expense related to non-employees.
(3)
Includes the impact of non-cash stock compensation expense related to restricted stock grants. The pro forma impact on net income (loss) and earnings (loss) per share of options outstanding under the CombiMatrix Molecular Diagnostics, Inc. Plan was not material.
 
10

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
SFAS No. 123R does not require the recording of deferred stock compensation charges in stockholder’s equity on the grant date of a stock based award. As such, in accordance with SFAS No. 123R, all deferred stock compensation charges recorded under APB No. 25, totaling $1,400,000 at December 31, 2005, have been reversed upon adoption of SFAS No. 123R, with a corresponding reduction being recorded in consolidated additional paid-in capital.


3.    EARNINGS (LOSS) PER SHARE

Earnings (Loss) Per Share. Basic earnings per share for each class of common stock is computed by dividing the income or loss allocated to each class of common stock by the weighted average number of outstanding shares of that class of common stock. Diluted earnings per share is computed by dividing the income allocated to each class of common stock by the weighted average number of outstanding shares of that class of common stock including the dilutive effect of potential common shares, computed using the treasury method. Potential common shares primarily consist of employee stock options and unvested restricted stock grants.

The earnings or losses allocated to each class of common stock are determined by Acacia Research Corporation’s board of directors. This determination is generally based on the net income or loss amounts of the corresponding group determined in accordance with accounting principles generally accepted in the United States of America. Acacia Research Corporation believes this method of allocation is systematic and reasonable. The Acacia Research Corporation board of directors can, at its discretion, change the method of allocating earnings or losses to each class of common stock at any time.
 
Weighted average share information for the periods presented was as follows:

   
For the Three Months Ended
 
For the Nine Months Ended
 
   
September 30, 2006
 
September 30, 2005
 
September 30, 2006
 
September 30, 2005
 
Acacia Research - Acacia Technologies stock
                 
                   
Basic and diluted weighted average number of common shares outstanding
   
27,567,848
   
27,302,693
   
27,492,410
   
26,387,562
 
All outstanding stock awards excluded from the computation of diluted loss per share because the effect of inclusion would have been anti-dilutive
   
6,520,052
   
6,201,869
   
6,520,052
   
6,201,869
 
                           
Acacia Research - CombiMatrix stock
                         
Basic and diluted weighted average number of common shares outstanding
   
40,209,640
   
33,239,726
   
39,411,421
   
31,887,872
 
All outstanding stock options excluded from the computation of diluted loss per share because the effect of inclusion would have been anti-dilutive
   
8,557,557
   
6,981,677
   
8,557,557
   
6,981,677
 
 

Outstanding stock options under the CombiMatrix Molecular Diagnostics 2005 Stock Award Plan, as disclosed at Note 9, have also been excluded from the computation of diluted loss per share because the effect of inclusion would have been anti-dilutive.


4.    GOODWILL AND INTANGIBLES

The Acacia Technologies group had $121,000 of goodwill at September 30, 2006, and December 31, 2005. The CombiMatrix group had $16,918,000 and $18,859,000 of goodwill at September 30, 2006, and December 31, 2005, respectively.
 
Acacia Research Corporation’s identifiable intangible assets at September 30, 2006, and December 31, 2005, are comprised of patents and patent rights. The gross carrying amounts and accumulated amortization as of September 30, 2006, and December 31, 2005, related to patents and patent rights, by segment, are as follows (in thousands):

   
Acacia Technologies Group
 
CombiMatrix Group
 
Consolidated
 
   
September 30,
 
December 31,
 
September 30,
 
December 31,
 
September 30,
 
December 31,
 
   
2006
 
2005
 
2006
 
2005
 
2006
 
2005
 
                           
Gross carrying amount - patents
 
$
30,307
 
$
30,392
 
$
12,095
 
$
12,095
 
$
42,402
 
$
42,487
 
Accumulated amortization
   
(10,480
)
 
(6,606
)
 
(4,991
)
 
(4,169
)
 
(15,471
)
 
(10,775
)
Patents, net
 
$
19,827
 
$
23,786
 
$
7,104
 
$
7,926
 
$
26,931
 
$
31,712
 
 

 
11

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
The Acacia Technologies group and the CombiMatrix group’s patents have remaining estimated economic useful lives up to 2013 and 2020, respectively. The weighted average remaining estimated economic useful life of the Acacia Technologies group’s patents is 5 years. The weighted average remaining estimated economic useful life of the CombiMatrix group’s patents is 9 years. Annual aggregate amortization expense for each of the five fiscal years through December 31, 2010 is estimated to be $5,272,000 in 2006, $5,235,000 in 2007, $3,912,000 in 2008, $3,461,000 in 2009 and $3,270,000 in 2010 for the Acacia Technologies group and $1,095,000 per year for the CombiMatrix group. At September 30, 2006, and December 31, 2005, all of our acquired intangible assets other than goodwill were subject to amortization.

For the nine months ended September 30, 2006, the Acacia Technologies group incurred patent acquisition costs totaling $1,020,000 in connection with the acquisition of the rights to several additional patent portfolios. The acquired patents and patent rights have estimated economic useful lives ranging from five to seven years. Refer to Note 7 for additions to patent related intangibles during the nine months ended September 30, 2005.

In June 2006, the Acacia Technologies group recorded a non-cash charge of $297,000, related to the write-off of a patent-related intangible asset. We review long-lived assets and intangible assets for potential impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. In the event the sum of the expected undiscounted future cash flows resulting from the use of the asset is less than the carrying amount of the asset, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded. During the second quarter of 2006, pursuant to the terms of the respective license agreement, management elected to terminate its rights to exclusively license and enforce the patent, resulting in the write-off of the remaining carrying value of the patent-related intangible asset as of June 30, 2006.

As of March 31, 2006, the CombiMatrix group reduced its goodwill and deferred tax liability balances by $1,941,000, which were initially recorded in fiscal 2000, to properly reflect the reduction in its income tax valuation allowance after consideration of the deferred tax liability. As of March 31, 2006, the Acacia Technologies group reduced its patents and deferred tax liability by $691,000, which were initially recorded in fiscal 2002, to properly reflect the reduction in its income tax valuation allowance after consideration of the deferred tax liability.


5.    RECENT ACCOUNTING PRONOUNCEMENTS

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of this standard, if any, on our consolidated and separate group financial position, results of operations and cash flows.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 is effective for fiscal years ending on or after November 15, 2006 and addresses how financial statement errors should be considered from a materiality perspective and corrected. The literature provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Historically there have been two common approaches used to quantify such errors: (i) the “rollover” approach, which quantifies the error as the amount by which the current year income statement is misstated, and (ii) the “iron curtain” approach, which quantifies the error as the cumulative amount by which the current year balance sheet is misstated. The SEC Staff believes that companies should quantify errors using both approaches and evaluate whether either of these approaches results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. Historically, we have evaluated uncorrected differences utilizing the “rollover” approach, and we are currently evaluating the impact, if any, of adopting the provisions of SAB 108 on our consolidated and separate group financial position, results of operations and cash flows.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a common definition for fair value to be applied to US GAAP guidance requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact, if any, of adopting SFAS No. 157 on our consolidated and separate group financial position, results of operations and cash flows.

12

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

6.    EQUITY FINANCING

On June 14, 2006, Acacia Research Corporation entered into a standby equity distribution agreement (the “SEDA”) with Cornell Capital Partners, LP (“Cornell”). Under the terms of the SEDA, Acacia Research Corporation can require Cornell to purchase up to $50.0 million of AR-CombiMatrix common stock, or up to 13,024,924 shares, over a two-year period following the effective date of the SEDA. Such shares will be in the form of registered securities drawn from Acacia Research Corporation’s current shelf registration statement. All proceeds from each advance will be contributed to the CombiMatrix group. Acacia Research Corporation can request advances under the SEDA in up to $5.0 million increments. At the closing of each advance, which will take place six days after the initial notification to Cornell, Acacia Research Corporation will issue to Cornell a number of shares of AR-CombiMatrix common stock equal to the amount of the advance divided by the lowest daily volume weighted average price (“VWAP”) of AR-CombiMatrix common stock during the five trading days following the advance notice to Cornell, which will purchase the shares at 97.5% of the VWAP. Management can also specify a floor price whereby shares that trade below this price during the five-day trading period will be excluded from determining the VWAP. At each closing, Acacia Research Corporation will pay an underwriting fee of 4% of the gross amount of each advance on the first $20.0 million and 5% of the gross proceeds of each advance on the remaining $30.0 million of the SEDA to Cornell. Acacia Research Corporation is not obligated to request any advances under the agreement and will not pay any additional fees to Cornell so long as no advances are requested. The SEDA is also cancelable by Acacia Research Corporation at any time, without penalty. Acacia Research Corporation may not request advances if the shares to be issued in connection with such advances would result in Cornell owning more than 9.9% of the outstanding AR-CombiMatrix common stock. A total of 13,024,924 shares of AR-CombiMatrix common stock are authorized to be issued under the SEDA.

Upon closing of the SEDA, the CombiMatrix group paid Cornell a one-time commitment fee of $550,000 and an additional $20,000 in due diligence and other closing-related costs. The $550,000 fee was recorded as a long-term asset and will be amortized against future advances as costs of equity issuances. On June 23 2006, Cornell purchased 343,750 shares of AR-CombiMatrix common stock at $1.60 per share (which was not an advance under the SEDA), based on the fair value of AR-CombiMatrix stock on June 12, 2006. The shares of AR-CombiMatrix stock were offered pursuant to an effective registration statement previously filed with the Securities and Exchange Commission. Since executing the SEDA through September 30, 2006, Acacia Research Corporation has requested three advances from Cornell to purchase a total of 2,019,646 shares of AR-CombiMatrix stock at prices ranging from $1.16 to $1.13 per share, resulting in net proceeds of $2,207,000 contributed to the CombiMatrix group. Subsequent to September 30, 2006 through November 2, 2006, an additional 1,191,699 shares of AR-CombiMatrix stock at prices ranging from $0.98 to $0.73 per share have been sold to Cornell, generating net proceeds of $863,000 contributed to the CombiMatrix group. As of November 2, 2006, 9,813,579 shares of AR-CombiMatrix common stock remain available under the SEDA.

In February 2005, Acacia Research Corporation raised gross proceeds of $19,600,000 through the sale of 3,500,000 shares of AR-Acacia Technologies stock at a price of $5.60 per share in a registered direct offering. Net proceeds raised of approximately $19,532,000, which are net of related issuance costs, were attributed to the Acacia Technologies group. The shares of AR-Acacia Technologies stock were offered pursuant to an effective registration statement previously filed with the Securities and Exchange Commission.


7.    ACQUISITION

On January 28, 2005, Acacia Global Acquisition Corporation, a wholly owned subsidiary of Acacia Research Corporation, acquired substantially all of the assets of Global Patent Holdings, LLC, a privately held patent holding company based in Northbrook, Illinois, which owned 11 patent licensing companies. The acquisition provided the Acacia Technologies group 100% ownership of companies that control 27 patent portfolios, which include 120 U.S. patents and certain foreign counterparts, and cover technologies used in a wide variety of industries. As a result of the acquisition, we have expanded and diversified the Acacia Technologies group’s potential revenue generating activities.
 
13

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
The acquisition was accounted for in accordance with the purchase method of accounting. Under the purchase method of accounting, the purchase consideration is allocated to the assets acquired, including tangible assets, patents and other identifiable intangibles and liabilities assumed, based on their estimated fair values at the date of acquisition. The consolidated statement of operations includes the results of the acquired companies beginning on January 28, 2005, the date of acquisition. The aggregate purchase consideration was approximately $25,105,000, including $5.0 million of cash, the issuance of 3,938,832 shares of AR-Acacia Technologies stock valued at $19,293,000 (net of estimated common stock registration costs of $228,000) and acquisition costs, including registration costs, of $812,000. The value of the common shares issued was determined based on the average market price of AR-Acacia Technologies stock, as reported on NASDAQ, over the 5-day period (December 13 - December 17, 2004) before and after the terms of the acquisition were agreed to and announced.

The following table summarizes the total purchase consideration and the allocation of the consideration paid to the estimated fair value of the assets acquired and liabilities assumed (in thousands):
       
Purchase Consideration:
       
Cash paid
 
$
5,000
 
Fair value of AR-Acacia Technologies stock issued(1)
   
19,293
 
Acquisition and registration costs
   
812
 
Total purchase consideration
 
$
25,105
 
 
Purchase Price Allocation:
       
Estimated fair value of net tangible assets acquired at January 28, 2005
 
$
(26
)
Intangible assets acquired - patents and patent rights(1)
   
25,131
 
Total
 
$
25,105
 
____________________________________________
(1) Reflects non-cash investing activity.

Management was primarily responsible for determining the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed at the date of acquisition. Management considered a number of factors in estimating the fair value of the intangible assets acquired, including reference to an independent valuation. The patents and patent rights acquired were valued using a discounted cash flow model on a patent portfolio by portfolio basis, which estimated the future net cash flows expected to result from the licensing of each portfolio, taking into account potential infringers of the patents, usage of the underlying technologies, estimated license fee revenues, contingent legal fee arrangements, royalties due to former patent holders, other estimated costs, tax implications and other factors. A discount rate consistent with the risks associated with achieving the estimated net cash flows was used to estimate the present value of future estimated net cash flows. Management’s valuation resulted in an estimated fair value of patent related assets acquired of approximately $27,000,000, resulting in approximately $1,900,000 of excess fair value over the cost of net assets acquired, which has been allocated as a pro rata reduction to the amounts that otherwise would have been assigned to the assets acquired, in accordance with the purchase method of accounting.

Amounts attributable to patents and patent rights acquired are amortized using the straight-line method over the estimated economic useful lives of the underlying patents which range from two to seven years. At the date of acquisition, the estimated weighted average useful life of amortizable patent related intangibles acquired was approximately 6 years.

In connection with the acquisition described above, Acacia Global Acquisition Corporation entered into a consulting agreement with the former CEO of Global Patent Holdings, LLC who, as a result of the acquisition transaction, is also a shareholder of Acacia Research Corporation. The agreement requires the payment of $2,000,000 in consulting fees over a two-year period, and certain reimbursable consulting related expenses, commencing on the date of acquisition. Marketing, general and administrative expenses for the three and nine months ended September 30, 2006 include $272,000 and $816,000, respectively, in expenses related to the consulting agreement. Marketing, general and administrative expenses for the three and nine months ended September 30, 2005 include $274,000 and $738,000, respectively, in expenses related to the consulting agreement. Consulting services to be performed consist primarily of consultation on intellectual property matters associated with the patents and patent rights acquired in the transaction. The consulting fees are being expensed in the consolidated statement of operations as the consulting services are rendered during the two-year term of the consulting agreement. Acacia Global Acquisition Corporation may terminate the consulting agreement for cause as provided for in the agreement. The consulting agreement also contains certain automatic termination provisions, including; the failure by Acacia Global Acquisition Corporation to make timely consulting payments in accordance with the agreement; a significant decrease in working capital of Acacia Research Corporation, as defined in the agreement; material breach of the agreement by Acacia Global Acquisition Corporation; and the death of the consultant. Any occurrence of these conditions may require the payment of all remaining consulting fees outstanding under the agreement within thirty days of the occurrence of the termination event. Acacia Research Corporation also executed an agreement guaranteeing Acacia Global Acquisition Corporation’s performance of its obligations under the consulting agreement.
 
14

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The acquisition was treated for tax purposes as a taxable asset acquisition and, as such, Acacia Research Corporation did not record any book/tax basis differences and thus, no deferred income taxes were recorded in connection with the application of the purchase method of accounting. Differences between the book and tax amortization period for amounts allocated to patented related intangibles give rise to deferred tax assets.


8.    COMMON STOCK PURCHASE WARRANT LIABILITY
 
Acacia Research Corporation’s classes of common stock are subject to certain redemption provisions in the event that Acacia Research Corporation sells, transfers, assigns or otherwise disposes of, in one transaction or a series of related transactions, all or substantially all of the properties and assets attributed to either group.

Acacia Research Corporation adopted FASB Staff Position No. 150-5 (“FSP No. 150-5”), effective July 1, 2005, which requires that warrants for shares that are redeemable be classified as liabilities, based on the fair values of the warrants, which are required to be marked to market at each balance sheet date. The fair value of contingently redeemable AR-CombiMatrix stock purchase warrants outstanding at September 30, 2006 and December 31, 2005 was $719,000 and $1,381,000, respectively. Net warrant gains for the three and nine months ended September 30, 2006, reflected in other income (expense), related to changes in the fair value of the warrant liability totaled $913,000 and $663,000, respectively. Net warrant gains for the three and nine months ended September 30, 2005 totaled $163,000.

The fair value of AR-CombiMatrix stock purchase warrants was determined using the Black-Scholes option-pricing model, assuming weighted average risk free interest rates over the remaining term of the warrants of approximately 4.35% in December 2005 and 4.71% (two-year) and 4.62% (four year) in September 2006, volatility over the remaining term of the warrants of 84% in December 2005 and 79% and 82% in September 2006, and remaining terms of two to four years.


9.    STOCK BASED COMPENSATION PLANS
 
The 2002 Acacia Technologies Stock Incentive Plan (the “AR-Acacia Technologies Group Plan”) and the 2002 CombiMatrix Stock Incentive Plan (the “AR-CombiMatrix Group Plan”) were approved by the stockholders of Acacia Research Corporation in December 2002. The AR-Acacia Technologies Group Plan authorizes grants of stock options, stock awards and performance shares with respect to AR-Acacia Technologies stock. The AR-CombiMatrix Group Plan authorizes grants of stock options, stock awards and performance shares with respect to AR-CombiMatrix stock. Directors and certain officers and key employees with responsibilities involving both the Acacia Technologies group and the CombiMatrix group may be granted awards under both incentive plans in a manner which reflects their responsibilities. The board of directors believes that granting participants awards tied to performance of the group in which the participants work and, in certain cases the other group, is in the best interest of the Acacia Research Corporation and its stockholders. The terms of the AR-Acacia Technologies Group Plan and the AR-CombiMatrix Group Plan are identical except that AR-Acacia Technologies stock may be issued only under the AR-Acacia Technologies Group Plan and AR-CombiMatrix stock may be issued only under the AR-CombiMatrix Group Plan.
 
Acacia Research Corporation’s compensation committee administers the discretionary option grant and stock issuance programs. This committee determines which eligible individuals are to receive option grants or stock issuances under those programs, the time or times when the grants or issuances are to be made, the number of shares subject to each grant or issuance, the status of any granted option as either an incentive stock option or a non-statutory stock option under the federal tax laws, the vesting schedule to be in effect for the option grant or stock issuance and the maximum term for which any granted option is to remain outstanding. The exercise price of options is generally equal to the fair market value of the AR-CombiMatrix stock or AR-Acacia Technologies stock on the date of grant. Options generally begin to be exercisable six months to one year after grant and generally expire ten years after grant. Stock options generally vest over three to four years and restricted shares generally vest in full after two years (represents the requisite service period under SFAS No. 123R).
 
15

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
The authorized number of shares of common stock subject to the AR-Acacia Technologies Group Plan is 7,208,000 shares. The authorized number of shares of common stock subject to the AR-CombiMatrix Group Plan is 10,910,000 shares. The number of shares of common stock available for issuance under the AR-Acacia Technologies Group Plan and the AR-CombiMatrix Group Plan automatically increases on the first trading day of January each calendar year during the term of the Plan by an amount equal to three percent (3%) of the total number of shares of common stock outstanding on the last trading day in December of the immediately preceding calendar year, but in no event shall any such annual increase exceed 500,000 shares for the AR-Acacia Technologies Group Plan and 600,000 shares for the AR-CombiMatrix Group Plan. The aggregate number of shares of common stock available for issuance under either Plan shall not exceed 20,000,000 shares. At September 30, 2006, shares available for grant are 53,427 and 1,038,872 under the AR-Acacia Technologies Group Plan and the AR-CombiMatrix Group Plan, respectively.  The AR-Acacia Technologies Group Plan and the AR-CombiMatrix Group Plan do not segregate the number of securities remaining available for future issuance among stock options and other awards. The shares authorized for future issuance represents the total number of shares available through any combination of stock options or other awards. Upon the exercise of stock options or the granting of restricted stock, it is Acacia Research Corporation’s policy to issue new shares of the respective class of common stock.

A summary of option activity under our stock option plans for the nine months ended September 30, 2006 is as follows:
 
 
 
AR-CombiMatrix Stock: 
 
 
Options
 
Weighted
Average
Exercise Price
 
Weighted Average
Remaining
Contractual Term
 
Aggregate Intrinsic
Value
               
Outstanding at December 31, 2005
6,925,000
 
$6.82
       
Granted
1,834,000
 
$1.41
       
Exercised
-
 
-
       
Forfeited
(95,000)
 
$3.11
       
Expired
(106,000)
 
$6.72
       
Outstanding at September 30, 2006
8,558,000
 
$5.70
 
6.5 years
 
-
Vested and Exercisable at September 30, 2006
6,185,000
 
$7.13
 
5.4 years
 
-
 
The weighted average grant date fair value of stock options granted during the three and nine months ended September 30, 2006 was $1.02, and during the three and nine months ended September, 30, 2005 was $1.38 and $2.09, respectively. No AR-CombiMatrix options were exercised during the three and nine months ended September 30, 2006. The total intrinsic value of options exercised during the three and nine months ended September 30, 2005 was not material. The fair value of options vested during the three and nine months ended September 30, 2006 was $486,000 and $2,138,000, respectively, and during the three and nine months ended September 30, 2005 was $686,000 and $2,327,000, respectively. As of September 30, 2006, the total unrecognized compensation expense related to nonvested stock option awards was $2,932,000, which is expected to be recognized over a weighted average term of approximately one year.
 
 
 
AR-Acacia Technologies Stock:
 
 
Options
 
Weighted
Average
Exercise Price
 
Weighted Average
Remaining
Contractual Term
 
Aggregate Intrinsic
Value
               
Outstanding at December 31, 2005 
5,977,000 
 
$7.64
       
Granted 
465,000 
 
$7.75
 
     
Exercised 
(216,000)
 
$2.11
       
Forfeited 
(94,000)
 
$6.12
       
Outstanding at September 30, 2006 
6,132,000 
 
$7.87
 
5.9 years
 
$31,224,000
Vested and Exercisable at September 30, 2006 
4,866,000 
 
$8.43
 
5.3 years
 
$24,069,000
 
The weighted average grant date fair value of stock options granted during the nine months ended September 30, 2006 was $5.35 (no AR-Acacia Technologies stock options were granted during the three months ended September 30, 2006) and for the three and nine months ended September, 30, 2005 was $3.73 and $4.04, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $583,000 and $1,980,000, respectively, and during the three and nine months ended September 30, 2005 was $141,000 and $231,000, respectively. The fair value of options vested during the three and nine months ended September 30, 2006 was $950,000 and $2,825,000, respectively, and during the three and nine months ended September 30, 2005 was $399,000 and $1,156,000, respectively. As of September 30, 2006, the total unrecognized compensation expense related to nonvested stock option awards was $3,444,000, which is expected to be recognized over a weighted average term of approximately two years.
 
16

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
A summary of the status of AR-Acacia Technologies nonvested restricted shares as of September 30, 2006, and changes during the nine months ended September 30, 2006, is as follows:
 
 
AR-Acacia Technologies Stock:
Nonvested Restricted Shares
 
Weighted
Average Grant
Date Fair Value
       
Nonvested restricted stock at December 31, 2005
338,000
 
$5.07
Granted
102,000
 
$10.82
Vested
(30,000)
 
$7.16
Forfeited
(23,000)
 
$6.75
Nonvested restricted stock at September 30, 2006
387,000
 
$6.33
 
As of September 30, 2006, the total unrecognized compensation expense related to nonvested restricted stock awards was $1,405,000, which is expected to be recognized over a weighted average period of approximately one year. The total fair value of shares vested during the three and nine months ended September 30, 2006 was $0 and $215,000, respectively. There are no restricted share grants outstanding under the AR-CombiMatrix Group Plan.
 
At September 30, 2006, Acacia Research Corporation and its separate operating groups continue to record a full valuation allowance against its deferred tax assets due to management’s determination that the criteria for recognition have not been met. As such, the implementation and subsequent accounting for stock based awards under SFAS No. 123R did not have an impact on Acacia Research Corporation’s or the separate group’s deferred taxes or related tax provisions for the periods presented.

CombiMatrix Molecular Diagnostics 2005 Stock Award Plan

CombiMatrix Corporation’s wholly owned subsidiary, CMDX, executed the CombiMatrix Molecular Diagnostics 2005 Stock Award Plan (the "CMDX Plan") with plan provisions and terms similar to that of the AR-CombiMatrix Group Plan, as described above. The authorized number of shares of common stock subject to the CMDX Plan is 4,000,000 shares. At September 30, 2006, shares available for grant under the CMDX Plan are 2,150,000. A summary of option activity under CMDX Plan for the nine months ended September 30, 2006 is as follows:

 
 
CMDX Stock:
 
 
Options
 
Weighted
Average
Exercise Price
 
Weighted Average Remaining
Contractual Term
 
Aggregate Intrinsic Value
               
Outstanding at December 31, 2005
1,692,000
 
$0.10
       
Granted
910,000
 
$0.50
       
Exercised
-
 
-
       
Forfeited
(752,000)
 
$0.10
       
Outstanding at September 30, 2006
1,850,000
 
$0.30
 
8.8 years
 
$557,000
Vested and Exercisable at September 30, 2006
171,000
 
$0.12
 
5 years
 
$20,000

The weighted average grant date fair value of stock options granted during the three and nine months ended September 30, 2006 was $0.37, and during the three and nine months ended September 30, 2005 was $0.07. As of September 30, 2006, the total unrecognized compensation expense related to nonvested stock option awards was $244,000, which is expected to be recognized over a weighted average term of approximately 2.7 years. Total stock compensation expense recognized and the fair value of options vested for the three and nine months ended September 30, 2006 were not material.


17

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
10.    COMMITMENTS AND CONTINGENCIES

Collaborative and Research Agreements

On February 8, 2006, the CombiMatrix group executed a one-year, $2.1 million contract with the Department of Defense (“DoD”) to further the development of the CombiMatrix group's array technology for the electrochemical detection of biological and chemical threat agents. Under the terms of this contract, the CombiMatrix group will perform research and development activities, as described under the contract, and will be reimbursed on a periodic basis for actual costs incurred to perform its obligations, plus a fixed fee, of up to $2.1 million. As of September 30, 2006, the CombiMatrix group had incurred $1.1 million in actual contract costs for the electrochemical detection contract. In March 2004, the CombiMatrix group was awarded a two-year, $5.9 million contract with the DoD to further the development of the CombiMatrix group’s array technology for the detection of biological and chemical threat agents. This contract was completed in December 2005.

On August 9, 2006, the CombiMatrix group executed a two-year, $1.9 million contract with the DoD, focusing on the integration of its electrochemical detection technology currently under development with the CombiMatrix group’s microfluidics “lab-on-a-chip” technology to be used for military and homeland security applications. Under the terms of this contract, the CombiMatrix group will perform research and development activities, as described under the contract, and will be reimbursed on a periodic basis for actual costs incurred to perform its obligations, plus a fixed fee, of up to $1.9 million. As of September 30, 2006, the CombiMatrix group had incurred $61,000 in actual contract costs for the microfluidics contract.

In October 2004, the CombiMatrix group entered into an agreement to acquire up to a one-third ownership interest in Leuchemix, Inc. (“Leuchemix”), a private drug development firm, which is developing several compounds for the treatment of leukemia and other cancers. In accordance with the terms of the purchase agreement, the CombiMatrix group will purchase 3,137,500 shares of Series A Preferred Stock of Leuchemix for a total purchase price of $4,000,000. The ownership interest will be acquired and paid for quarterly over the two-year period commencing with the fourth quarter of 2004. In accordance with the terms of the purchase agreement, the CombiMatrix group made an additional $1,400,000 investment in Leuchemix during the nine months ended September 30, 2006, resulting in an ownership interest of approximately 29% as of September 30, 2006. The CombiMatrix group will make a final contractual investment in Leuchemix of $750,000 in the fourth quarter of 2006 in accordance with the terms of the agreement. The CombiMatrix group’s investment is being accounted for under the equity method.

Litigation and Patent Enforcement
 
Acacia Research Corporation is subject to claims, counterclaims and legal actions that arise in the ordinary course of business. Management believes that the ultimate liability with respect to these claims and legal actions, if any, will not have a material effect on our financial position, results of operations or cash flows. Companies comprising the Acacia Technologies group are often required to engage in litigation to enforce their patents and patent rights.

On September 30, 2002, CombiMatrix Corporation and Dr. Donald Montgomery entered into a settlement agreement with Nanogen, Inc. to settle all pending litigation between the parties. During the nine months ended September 30, 2005, the CombiMatrix group recorded a net non-cash credit totaling $406,000 in connection with certain anti-dilution provisions of the settlement agreement. The related liability reflected management’s estimate, as of each balance sheet date, of the fair value of AR-CombiMatrix stock potentially issuable to Nanogen, Inc. as a result of certain options and warrants exercised during the period, if any, and the fair value of AR-CombiMatrix stock potentially issuable to Nanogen, Inc. as of each balance sheet date pursuant to the anti-dilution terms of the agreement. The liability was adjusted at each balance sheet date for changes in the market value of the AR-CombiMatrix stock and was reflected as long-term until settled in equity. The anti-dilution provisions of the settlement agreement expired in September 2005 and thus, there is no liability recorded as of September 30, 2005, or in any future periods, and there were no charges or credits recognized during the three and nine months ended September 30, 2006.

In addition to other terms of the settlement agreement, CombiMatrix Corporation is also required to make quarterly payments to Nanogen, Inc. equal to 12.5% of payments to CombiMatrix Corporation from sales of products developed by CombiMatrix Corporation and its affiliates and based on the patents that had been in dispute in the litigation, up to an annual maximum of $1,500,000. The minimum quarterly payments under the settlement agreement are $25,000 per quarter until the patents expire in 2018. Royalty expenses recognized under the agreement during the nine months ended September 30, 2006, and 2005, were $338,000 and $130,000, respectively.
 
18

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
Inventor Royalties and Contingent Legal Expenses

In connection with the acquisition of certain patents and patent rights, certain companies included in the Acacia Technologies group executed related agreements which grant to the former owners of the respective patents or patent rights, the right to receive inventor royalties based on future net license fee revenues (as defined in the respective agreements) generated by the Acacia Technologies group as a result of licensing the respective patents or patent portfolios.

In connection with the Acacia Technologies group’s licensing and enforcement activities, the Acacia Technologies group may retain the services of law firms that specialize in intellectual property licensing and enforcement and patent law. These law firms may be retained on a contingent fee basis in which the law firms are paid on a scaled percentage of any negotiated license fees, settlements or judgments awarded based on how and when the license fees, settlements or judgments are obtained by the Acacia Technologies group. In instances where the Acacia Technologies group does not recover license fees from potential infringers, no contingent legal fees are paid; however, the Acacia Technologies group is generally liable for certain out of pocket legal costs incurred pursuant to the underlying legal services agreement, which are expensed as incurred.

Inventor royalties and contingent legal fees paid are expensed in the consolidated statement of operations and comprehensive loss in the period that the related license fee revenues are recognized.

Guarantees and Indemnifications

Acacia Research Corporation has made guarantees and indemnities under which it may be required to make payments to a guaranteed or indemnified party, in relation to certain transactions, including revenue transactions in the ordinary course of business. In connection with certain facility leases Acacia Research Corporation has indemnified its lessors for certain claims arising from the facility or the lease. Acacia Research Corporation indemnifies its directors and officers to the maximum extent permitted under the laws of the State of Delaware. However, Acacia Research Corporation has a directors and officers insurance policy that may reduce its exposure in certain circumstances and may enable it to recover a portion of future amounts that may be payable, if any. The duration of the guarantees and indemnities varies and, in many cases is indefinite but subject to statute of limitations. The majority of guarantees and indemnities do not provide any limitations of the maximum potential future payments Acacia Research Corporation could be obligated to make. To date, we have made no payments related to these guarantees and indemnities. Acacia Research Corporation estimates the fair value of its indemnification obligations as insignificant based on this history and has therefore, not recorded any liability for these guarantees and indemnities in the accompanying consolidated balance sheets.


11.    DISCONTINUED OPERATIONS

Results for the nine months ended September 30, 2005, include a $210,000 charge, net of minority interests, related to estimated additional costs to be incurred in connection with the discontinued operations of Soundbreak.com (originally ceased operations in February 2001), related primarily to certain noncancellable lease obligations and a reduction in estimated amounts recoverable from existing sublease arrangements. The related lease obligations, which were guaranteed by Acacia Research Corporation, expired in August 2005. At September 30, 2006, assets consisted of cash and cash equivalents. At December 31, 2005, assets consisted of cash and cash equivalents and lease deposits. At September 30, 2006, liabilities related to miscellaneous accounts payable. At December 31, 2005, liabilities related primarily to miscellaneous payables and accrued lease termination costs. In April 2006, a final distribution to Soundbreak.com’s minority shareholders was paid totaling $353,000. Refer to Note 13 for additional information on assets and liabilities related to discontinued operations for the periods presented.


12.    SALE OF INTEREST IN SUBSIDIARY

In January 2006, the CombiMatrix group expanded its relationship with one of its existing distributors, InBio, for the Asia Pacific region. Major components of the expanded relationship included the transfer of day-to-day operational responsibility and majority ownership of CombiMatrix K.K. to InBio, along with an expanded distribution agreement that encompasses Japan. InBio obtained 67% of the voting interests in CombiMatrix K.K. for a nominal amount of consideration. As a result, InBio assumed all operational and financial responsibilities of CombiMatrix K.K. The net loss on the sale of 67% of the voting interest in CombiMatrix K.K. recorded in the statement of operations in the first quarter of 2006 was $84,000. CombiMatrix Corporation continues to own a 33% interest in CombiMatrix K.K. Subsequent to the sale, the CombiMatrix group’s investment in CombiMatrix K.K. was accounted for under the equity method. The deconsolidation of CombiMatrix K.K. did not have a material impact on the consolidated balance sheets as of September 30, 2006.

19

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

13.    CONSOLIDATING SEGMENT INFORMATION

Acacia Research Corporation has adopted the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” Our chief operating decision maker is considered to be Acacia Research Corporation’s Chief Executive Officer (“CEO”). The CEO reviews and evaluates financial information presented on a group basis as described below. Management evaluates performance based on the profit or loss from continuing operations and financial position of its segments. Acacia Research Corporation has two reportable segments as described earlier in Note 1.

Material intercompany transactions and transfers have been eliminated in consolidation. The accounting policies of the segments are the same as those described in the summary of significant accounting policies.

Presented below is consolidating financial information for our reportable segments reflecting the businesses of the CombiMatrix group and the Acacia Technologies group. Earnings attributable to each group has been determined in accordance with accounting principles generally accepted in the United States.


 
20

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Consolidating Balance Sheets
(In thousands)
(Unaudited)

   
At September 30, 2006
 
At December 31, 2005
 
   
Acacia
             
Acacia
             
   
Technologies
 
CombiMatrix
         
Technologies
 
CombiMatrix
         
   
Group
 
Group
 
Eliminations
 
Consolidated
 
Group
 
Group
 
Eliminations
 
Consolidated
 
                                   
ASSETS
                                 
                                   
Current assets:
                                                 
Cash and cash equivalents
 
$
25,487
 
$
2,304
 
$
-
 
$
27,791
 
$
14,498
 
$
5,666
 
$
-
 
$
20,164
 
Short-term investments
   
20,484
   
6,027
   
-
   
26,511
   
24,462
   
14,547
   
-
   
39,009
 
Accounts receivable
   
1,475
   
1,287
   
-
   
2,762
   
4,421
   
911
   
-
   
5,332
 
Prepaid expenses, inventory and other assets
   
1,333
   
622
   
-
   
1,955
   
1,406
   
709
   
-
   
2,115
 
 Total current assets
   
48,779
   
10,240
   
-
   
59,019
   
44,787
   
21,833
   
-
   
66,620
 
                                                   
Property and equipment, net of accumulated depreciation
   
189
   
2,070
   
-
   
2,259
   
121
   
2,363
   
-
   
2,484
 
Patents, net of accumulated amortization
   
19,827
   
7,104
   
-
   
26,931
   
23,786
   
7,926
   
-
   
31,712
 
Goodwill
   
121
   
16,918
   
-
   
17,039
   
121
   
18,859
   
-
   
18,980
 
Other assets
   
79
   
2,668
   
-
   
2,747
   
78
   
1,560
   
-
   
1,638
 
   
$
68,995
 
$
39,000
 
$
-
 
$
107,995
 
$
68,893
 
$
52,541
 
$
-
 
$
121,434
 
                                                   
LIABILITIES AND STOCKHOLDERS' EQUITY
                                                 
                                                   
Current liabilities:
                                                 
Accounts payable and accrued expenses
 
$
3,374
 
$
2,509
 
$
-
 
$
5,883
 
$
1,441
 
$
2,483
 
$
-
 
$
3,924
 
Royalties and legal fees payable
   
2,343
   
-
   
-
   
2,343
   
3,758
   
-
   
-
   
3,758
 
Current portion of deferred revenues
   
523
   
407
   
-
   
930
   
639
   
165
   
-
   
804
 
 Total current liabilities
   
6,240
   
2,916
   
-
   
9,156
   
5,838
   
2,648
   
-
   
8,486
 
                                                   
Deferred income taxes
   
-
   
-
   
-
   
-
   
726
   
1,975
   
-
   
2,701
 
Deferred revenues, net of current portion
   
-
   
1,145
   
-
   
1,145
   
-
   
1,439
   
-
   
1,439
 
Other liabilities
   
17
   
719
   
-
   
736
   
83
   
1,381
   
-
   
1,464
 
 Total liabilities
   
6,257
   
4,780
   
-
   
11,037
   
6,647
   
7,443
   
-
   
14,090
 
                                                   
Minority interests
   
-
   
-
   
-
   
-
   
443
   
4
   
-
   
447
 
                                                   
Redeemable stockholders' equity:
                                                 
AR - Acacia Technologies stock
   
62,738
   
-
   
-
   
62,738
   
61,803
   
-
   
-
   
61,803
 
AR - CombiMatrix stock
   
-
   
34,220
   
-
   
34,220
   
-
   
45,094
   
-
   
45,094
 
 Total stockholders' equity
   
62,738
   
34,220
   
-
   
96,958
   
61,803
   
45,094
   
-
   
106,897
 
                                                   
   
$
68,995
 
$
39,000
 
$
-
 
$
107,995
 
$
68,893
 
$
52,541
 
$
-
 
$
121,434
 
 
___________________________________________
NOTE: Segment information for the Acacia Technologies group includes discontinued operations related to Soundbreak.com. Total assets related to discontinued operations totaled $37,000 and $741,000 at September 30, 2006, and December 31, 2005, respectively. Total liabilities related to discontinued operations totaled $44,000 and $144,000 at September 30, 2006, and December 31, 2005, respectively.

21

ACACIA RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
Consolidating Statements of Operations
(In thousands)
(Unaudited)

   
For the Three Months Ended September 30, 2006
 
For the Nine Months Ended September 30, 2006
 
   
Acacia
         
Acacia
         
   
Technologies
 
CombiMatrix
     
Technologies
 
CombiMatrix
     
   
Group
 
Group
 
Consolidated
 
Group
 
Group
 
Consolidated
 
Revenues:
                                     
Government contract
 
$
-
 
$
725
 
$
725