SWK Holdings Corp - Quarter Report: 2001 September (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission File number 000-27163

KANA Software, Inc.
(Exact Name of Registrant as Specified in its Charter)

Registrant's Telephone Number, Including Area Code: (650) 614-8300

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 such filing requirements for the past 90 days. YES x NO o

On October 30, 2001, approximately 182,316,634 shares of the Registrant's Common Stock, $0.001 par value, were outstanding.

KANA Software, Inc.
Form 10-Q
Quarter Ended September 30, 2001

Index

Part I: Financial Information

Item 1: Financial Statements

KANA SOFTWARE, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

KANA SOFTWARE, INC
UNAUDITED CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

KANA SOFTWARE, INC
UNAUDITED CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

KANA SOFTWARE, INC. AND SUBSIDIARIES
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The unaudited condensed consolidated financial statements have been prepared by KANA Software, Inc. ("KANA" or the "Company"), previously KANA Communications, Inc. and reflect all adjustments (all of which are normal and recurring in nature) that, in the opinion of management, are necessary for a fair presentation of the interim financial information. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year ending December 31, 2001. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted under the Securities and Exchange Commission's ("SEC") rules and regulations. These unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with KANA's audited consolidated financial statements and notes included in KANA's annual report on Form 10-K for the year ended December 31, 2000.

The Company's consolidated financial statements have been presented on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred a consolidated net loss of approximately $919 million for the nine months ended September 30, 2001. Included in the aggregate net loss is an impairment charge to reduce goodwill of approximately $603 million recorded in the first quarter of the year.

The Company is evaluating various initiatives to improve its cash position, including raising additional funds to finance its business, implementing further restrictions on spending, negotiating the early release of certain restricted cash, and other cash flow initiatives. Additional financing may not be available on terms that are acceptable to the Company, especially in the uncertain market climate, and the Company may not be successful in implementing or negotiating such other arrangements to improve its cash position. If the Company raises additional funds through the issuance of equity or convertible debt securities, the percentage ownership of its stockholders would be reduced and these securities might have rights, preferences and privileges senior to those of its current stockholders. Any such financing will be dilutive to existing stockholders. If adequate funds are not available on acceptable terms, the Company's ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.

Note 2. Investments

The Company considers all investments with an original maturity greater than three months and less than one year to be short-term investments. All investments with maturities greater than one year are categorized as long-term investments.

Note 3. Net Loss per Share

Basic net loss per share is computed using the weighted–average number of outstanding shares of common stock, excluding common stock subject to repurchase. Diluted net loss per share is computed using the weighted-average number of outstanding shares of common stock and, when dilutive, potential common shares from options and warrants to purchase common stock and common stock subject to repurchase using the treasury stock method. The following table presents the calculation of basic and diluted net loss per share:

All warrants, outstanding stock options and shares subject to repurchase by KANA have been excluded from the calculation of diluted net loss per share because all such securities are anti-dilutive for all periods presented. The total number of shares excluded from the calculation of diluted net loss per share are as follows (in thousands):

The weighted average exercise price of stock options and warrants outstanding was $14.71 and $57.71 as of September 30, 2001 and 2000, respectively.

Note 4. Comprehensive Loss

Comprehensive loss comprises the net loss and foreign currency translation adjustments. Comprehensive loss was $96.3 million and $335.3 million for the three months ended September 30, 2001 and 2000, respectively. Comprehensive loss was $915.9 million and $634.7 million for the nine months ended September 30, 2001 and 2000, respectively.

Note 5. Stock-Based Compensation

In June 2001, the Company entered into an agreement to issue to a customer a fully vested and exercisable warrant to purchase up to 250,000 shares of common stock pursuant to a warrant purchase agreement. The Company has recorded deferred stock-based compensation of $330,000 for the warrant using the Black-Scholes model. This amount is being amortized as service is rendered as a reduction to revenue.

In September 2000, the Company issued to Accenture 400,000 shares of common stock and a warrant to purchase up to 725,000 shares of common stock pursuant to a stock and warrant purchase agreement in connection with its global strategic alliance. The shares of the common stock issued were fully vested and the Company has recorded a charge of approximately $14.8 million which is being amortized over the four-year term of the agreement. The portion of the warrant to purchase 125,000 shares of common stock is fully vested with the remainder becoming vested upon the achievement of certain performance goals. The vested warrants were valued using the Black-Scholes model resulting in a charge of $1.0 million which is being amortized over the four-year term of the agreement. The Company will incur a charge to stock-based compensation for the unvested portion of the warrant when performance goals are achieved. As of September 30, 2001, 430,000 shares of common stock under the warrant which are unvested had a fair value of approximately $18,600 based upon the fair market value of the Company's common stock at such date.

In September, 2001, the Company issued to Accenture a warrant to purchase up to 1,500,000 shares of common stock pursuant to a warrant purchase agreement in connection with its global strategic alliance. The warrant is fully vested and exercisable as of September 2001. The warrants were valued using the Black-Scholes model resulting in a charge of approximately $946,000 which is being amortized over the four-year term of the agreement.

In September 8, 2001, the Company issued to a customer a warrant to purchase up to 50,000 shares of common stock pursuant to a warrant purchase agreement. The warrant fully vests in September 2006 and has a provision for acceleration of vesting 12,500 shares annually over four years if certain marketing criteria are met by the customer. The warrants were valued using the Black-Scholes model resulting in a charge of approximately $29,000 which is being amortized over the five-year term of the agreement.

Note 6. Legal Proceedings

The Company's underwriters, Goldman Sachs & Co., Lehman Bros, Hambrecht & Quist LLC, Wit Capital Corp as well as the Company and certain current and former officers have been named as defendants in federal securities class action lawsuits filed in the United States District Court for the Southern District of New York. The cases allege violations of Section 11, 12(a)(2) and Section 15 of the Securities Act of 1933 and violations of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, on behalf of a class of plaintiffs who purchased the Company's stock between September 21, 1999 and December 6, 2000 in connection with the Company's initial public offering. Specifically, the complaints alleged that the underwriter defendants engaged in a scheme concerning sales of KANA's securities in the initial public offering and in the aftermarket. These cases are stayed pending selection of lead counsel for the plaintiff class. Although the Company is in the early stages of analyzing the claims alleged against KANA and the individual defendants, the Company believes that it has good and valid defenses to these claims. The Company intends to defend the action vigorously.

On April 24, 2001, Office Depot, Inc. ("Office Depot") filed a complaint against KANA in the Circuit Court for the 15th District of the State of Florida claiming that KANA has breached its license agreement with Office Depot. Office Depot is seeking relief in the form of a refund of license fees and maintenance fees paid to KANA, attorneys' fees and costs. The litigation is currently in its early stages and the Company has not received material information or documentation. KANA intends to defend itself from this claim vigorously and does not expect it to materially impact its results from operations.

KANA is not currently a party to any other material legal proceedings.

Note 7. Restructuring costs

For the three and nine months ended September 30, 2001, the Company incurred restructuring charges of approximately $32.1 million and $86.3 million, respectively, related to the reductions in its workforce and costs associated with certain excess leased facilities and asset impairments.

For the three and nine months ended September 30, 2001, the Company recorded charges of $1.9 million and $18.9 million, respectively, for the assets disposed of or removed from operations. Assets disposed of or removed from operations consisted primarily of leasehold improvements, computer equipment and related software, office equipment, and furniture and fixtures.

For the three and nine months ended September 30, 2001, the Company recorded charges of $6.0 million and $23.6 million, respectively, for severance, benefits and related costs due to the reduction in workforce. For the nine months ended September 30, 2001, the Company reduced its workforce by approximately 1,210 people, or 74% of our employee base. All functional areas have been affected by the reductions.

For the three and nine months ended September 30, 2001, the Company recorded charges of $24.2 million and $43.8 million, respectively, due to the Company's decision to exit and reduce some facilities. The estimated facility costs are based on current comparable rates for leases in the respective markets. Should facilities operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease these facilities, the actual loss could exceed this estimate. Future cash outlays are anticipated through February 2011 unless the Company negotiates to exit the leases at an earlier date.

For the nine months ended September 30, 2001, of the $86.3 million charge, $26.2 million relates to non-cash charges, cash payments totaled $29.6 million and $30.5 million in restructuring liabilities remain at September 30, 2001. The restructuring liability is included on the balance sheet in accrued restructuring and merger costs.

Note 8. Goodwill impairment

The Company has performed an impairment assessment of the identifiable intangibles and goodwill recorded in connection with the acquisition of Silknet. The assessment was performed primarily due to the significant sustained decline in the Company's stock price since the valuation date of the shares issued in the Silknet acquisition resulting in the Company's net book value of its assets prior to the impairment charge significantly exceeding the Company's market capitalization, the overall decline in the industry growth rates, and the Company's lower than projected operating results. As a result, the Company recorded an impairment charge of approximately $603 million to reduce goodwill in the quarter ended March 31, 2001. The charge was based upon the estimated discounted cash flows over the remaining useful life of the goodwill using a discount rate of 20%. The assumptions supporting the cash flows, including the discount rate, were determined using the Company's best estimates as of such date. The remaining goodwill balance, excluding negative goodwill, of approximately $82.4 million as of September 30, 2001 is being amortized over its remaining useful life.

Note 9. Segment Information

The Company's chief operating decision maker reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single industry segment, specifically the license, implementation and support of its software applications. The Company's long-lived assets are primarily in the United States. Geographic information on revenue for the three months and nine months ended September 30, 2001 and 2000 are as follows (in thousands):

During the three and nine months ended September 30, 2001, no customer represented more than 10% of total revenues.

Note 10. Notes Payable and Commitments

The Company has a line of credit providing for borrowings of up to $5.0 million as of September 30, 2001 to be used for qualified equipment purchases or working capital needs. Borrowings under the line of credit are collateralized by all of the Company's assets and bear interest at the bank's prime rate plus .5% (6.5% of September 30, 2001). Total borrowings as of September 30, 2001 were $1,187,000 and the line of credit also supported letters of credit totaling $1.3 million. The line of credit contains certain financial covenants. As of September 30, 2001, the Company was in compliance with its financial covenants, as amended. This line of credit expires on November 30, 2001. The Company is in discussions with the bank regarding the renewal of this line of credit, and KANA currently believes that it will be available for renewal should the Company so desire. However, there can be no assurance the bank will renew the line of credit and no guarantee the terms will be acceptable to the Company.

In the quarter ended September 30, 2001, the Company issued a letter of credit totaling $5.8 million in connection with a contractual agreement. During the quarter ended September 30, 2001 the Company transferred $5.8 million to support a letter of credit and also transferred $2.0 million of cash into an escrow account to fulfill certain contractual agreements. These amounts are reflected in restricted cash in the accompanying condensed consolidated balance sheet.

Note 11. Discontinued Operation

As of the quarter ended June 30, 2001, the Company adopted a plan to discontinue the KANA Online business. The Company will no longer seek new business but will continue to service all ongoing contractual obligations it has to its existing customers. Accordingly, KANA Online is reported as a discontinued operation for the three and nine months ended September 30,

2001 and 2000. Net assets of the discontinued operation at September 30, 2001, consisted primarily of computers and servers. The estimated loss on the disposal of KANA Online is $3.7 million, consisting of an estimated loss on disposal of the assets of $2.6 million and a provision of $1.1 million for the anticipated operating losses during the phase-out period. This operation has been presented as a discontinued operation for all periods presented. The KANA Online operating results are as follows (in thousands):

Note 12. Acquisition of Broadbase

On June 29, 2001, the Company finalized the acquisition of Broadbase. In connection with the merger, each share of Broadbase common stock outstanding immediately prior to the consummation of the merger was converted into the right to receive 1.05 shares of KANA common stock (the "Exchange Ratio") and KANA assumed Broadbase's outstanding stock options and warrants based on the Exchange Ratio, issuing approximately 86.7 million shares of KANA common stock and assuming options and warrants to acquire approximately 26.6 million shares of KANA common stock. The transaction was accounted for using the purchase method of accounting.

The preliminary allocation of the purchase price at September 30, 2001 to assets acquired and liabilities assumed is as follows (in thousands):

Deferred compensation recorded in connection with the merger will be amortized over a four-year period. Negative goodwill will be amortized over its estimated useful life of three years.

The estimated purchase price was approximately $101.4 million, measured as the average fair market value of KANA's outstanding common stock from April 7 to April 11, 2001, two trading days before and after the merger agreement was announced plus the Black-Scholes calculated value of the options and warrants of Broadbase assumed by KANA in the merger, and other costs directly related to the merger is as follows (in thousands):

In connection with the Broadbase merger, KANA recorded $11.5 million of merger-related integration expenses and transition costs during the nine months ended September 30, 2001. These amounts consisted primarily of transitional personnel of $5.3 million and duplicate facility and insurance costs, redundant assets, and professional fees associated with the merger of $6.2 million.

The following unaudited pro forma net revenues, net loss and net loss per share data for the nine months ended September 30, 2001 and 2000 are based on the respective historical financial statements of the Company and Broadbase. The pro forma data reflects the consolidated results of operations as if the merger with Broadbase occurred at the beginning of each of the periods indicated and includes the amortization of the resulting negative goodwill and deferred compensation. The pro forma results include the results of pre-acquisition periods for companies acquired by Broadbase prior to its acquisition by KANA. The pro forma financial data presented are not necessarily indicative of the Company's results of operations that might have occurred had the transaction been completed at the beginning of the periods specified, and do not purport to represent what the Company's consolidated results of operations might be for any future period.

Note 13. Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 addresses financial accounting and reporting for business combinations and supercedes Accounting Principals Board ("APB") No.16, Business Combinations. The provisions of SFAS No.141 are required to be adopted July 1, 2001. The most significant changes made by SFAS No.141 are: (1) requiring that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, (2) establishing specific criteria for the recognition of intangible assets separately from goodwill, and (3) requiring unallocated negative goodwill to be written off immediately as an extraordinary gain.

SFAS No.142 primarily addresses the accounting for goodwill and intangible assets subsequent to their acquisition and supercedes APB No.17, Intangible Assets. The provisions of SFAS No. 142 are required to be adopted as of January 1, 2002 for calendar year entities. The most significant changes made by SFAS No. 142 are: (1) goodwill and indefinite lived intangible assets will no longer be amortized, (2) goodwill will be tested for impairment at least annually at the reporting unit level, (3) intangible assets deemed to have an indefinite life will be tested for impairment at least annually, and (4) the amortization period of intangible assets with finite lives will no longer be limited to forty years.

The Company adopted SFAS No.141 effective July 1, 2001 which will result in the Company accounting for any business combination consummated on or after that date under the purchase method of accounting. The Company will also apply the non-amortization provisions of SFAS No. 142 for any business combination consummated on or after July 1, 2001. The adoption of SFAS No. 141 will not change the method of accounting used in previous business combinations.

The Company is required upon adoption of SFAS No. 142 effective January 1, 2002, which will result in the Company no longer amortizing its existing goodwill. At September 30, 2001, goodwill was $80.5 million and goodwill amortization expense was $13.6 million and $114.1 million for the three and nine months ended September 30, 2001, respectively. In addition, the Company will be required to measure goodwill for impairment effective January 1, 2002 as part of the transition provisions. Any impairment resulting from the transition provisions will be recorded as of January 1, 2002 and will be recognized as the effect of a change in accounting principle. The Company will not be able to determine if an impairment will be required until completion of such impairment test. In addition, at September 30, 2001, negative goodwill approximated $2.1 million. The Company will be required as part of the adoption of SFAS No. 142 to immediately recognize the unamortized negative goodwill that exists on January 1, 2002. This adjustment will be recognized as the effect of a change in accounting principle.

In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which is required to be applied starting with fiscal years beginning after December 15, 2001. SFAS No. 144 requires, among other things, the application of one accounting model for long-lived assets that are impaired or to be disposed of by sale. The adoption of SFAS No. 144 is not expected to have a significant impact on the Company's financial statements or results of operations.

Note 14. Subsequent Event

In October 2001, the Board of Directors approved a resolution authorizing a one for ten reverse stock split. At a stockholders' meeting to be held in December 2001, the stockholders will vote on this resolution. This one for ten reverse stock split has not been reflected in the accompanying unaudited condensed financial statements or notes thereto.

Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations

This report contains forward-looking statements that are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, our beliefs and assumptions. Words such as "anticipates", "expects", "intends", "plans", "believes", "seeks", "estimates" and variations of these words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks and uncertainties, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. These risks and uncertainties include those described in under the heading "Risk Factors Associated with KANA's Business and Future Operating Results" and elsewhere in this report. Forward-looking statements that were true at the time made may ultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-looking statement, which reflect our management's view only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

Overview

We are a leading provider of enterprise Customer Relationship Management (eCRM) software solutions that deliver integrated communication and business applications built on a Web-architectured platform. We were incorporated in July 1996 in California and were reincorporated in Delaware in September 1999. We had no significant operations until 1997. In February 1998, we released the first commercially available version of the KANA platform. To date, we have derived substantially all of our revenues from licensing our software and related services, and we have sold our products worldwide primarily through our direct sales force.

On June 29, 2001, we completed a merger with Broadbase under which Broadbase became our wholly–owned subsidiary. Broadbase is a leading provider of software solutions that enable companies to conduct highly effective, intelligent customer interactions through the Internet and traditional business channels, thereby providing the basis for businesses to improve their customer acquisition, retention and profitability. Broadbase's web-based product suite combines operational marketing and service applications with customer analytics.

In connection with the merger, each share of Broadbase common stock outstanding immediately prior to the consummation of the merger was converted into the right to receive 1.05 shares of KANA common stock (the "Exchange Ratio") and KANA assumed Broadbase's outstanding stock options and warrants based on the Exchange Ratio, issuing approximately 86.7 million shares of KANA common stock and assuming options and warrants to acquire approximately 26.6 million shares of KANA common stock. The transaction was accounted for using the purchase method of accounting.

In April 2000, we acquired Silknet Software, Inc. and the transaction was accounted for using the purchase method of accounting.

In the third quarter of 1999, we initiated our KANA Online business. Our KANA Online business provided a hosted environment of our software to customers. Our servers for this business are maintained by third-party service providers. In the second quarter of 2001, we adopted a plan to discontinue the KANA Online business. We have accounted for our KANA Online business as a discontinued operation.

We derive our revenues from the sale of software product licenses and from professional services including implementation, consulting, and maintenance. License revenue is recognized when persuasive evidence of an agreement exists, the product has been delivered, the arrangement does not involve significant customization of the software, the license fee is fixed or determinable and collection of the fee is probable. If the arrangement involves significant customization of the software, the fee, excluding the portion attributable to maintenance, is recognized using the percentage-of-completion method. Service revenue includes revenues from maintenance contracts, implementation, consulting and hosting services. Revenue from maintenance contracts is recognized ratably over the term of the contract. Revenue from implementation, consulting and hosting services is recognized as the

services are provided. Revenue under arrangements where multiple products or services are sold together is allocated to each element based on their relative fair values.

Our cost of license revenue includes royalties due to third parties for technology integrated into some of our products, the cost of product documentation, the cost of the media used to deliver our products and shipping costs. Cost of service revenue consists primarily of personnel–related expenses, subcontracted consultants, travel costs, equipment costs and overhead associated with delivering professional services to our customers.

Our operating expenses are classified into three general categories: sales and marketing, research and development, and general and administrative. We classify all charges to these operating expense categories based on the nature of the expenditures. Although each category includes expenses that are unique to the category, some expenditures, such as compensation, employee benefits, recruiting costs, equipment costs, travel and entertainment costs, facilities costs and third–party professional services fees, occur in each of these categories.

Since 1997, we have incurred substantial operating costs and expenses, as well as noncash charges. As a result, we have incurred substantial losses since inception. For the nine months ended September 30, 2001, we have incurred a consolidated net loss of approximately $919 million and an accumulated deficit of approximately $4.1 billion. We believe our future success is contingent upon providing superior customer service, increasing our customer base and revenues, controlling our costs, and developing our products.

In order to streamline operations, reduce costs and bring our staffing and structure in line with industry standards, we restructured our organization in each quarter of 2001 with workforce reductions totaling approximately 1,210 employees. With the acquisition of Broadbase, we added approximately 400 employees. As of September 30, 2001, we had approximately 425 employees.

We believe that our prospects must be considered in light of the risks, expenses and difficulties frequently experienced by companies in early stages of development, particularly companies in new and rapidly evolving markets like ours. Although we have experienced revenue growth in the past, our revenues has declined in recent periods, and we may not be able achieve revenue growth in the future, particularly in light of increasing competition in our markets, the weak economy, and declines in expenditures on enterprise software products. Furthermore, we may not achieve or maintain profitability in the future.

Selected Results of Operations Data

The following table sets forth selected data for periods indicated expressed as a percentage of total revenues.

Three and Nine Months Ended September 30, 2001 and 2000

Revenues

License revenue decreased 88% for the three months ended September 30, 2001 compared to the same period in the prior year due primarily to a decrease in the number of license transactions. We believe this is due to the overall weakness in the economy and external market factors, particularly the uncertainty in the market subsequent to the events of September 11, 2001. For the nine months ended September 30, 2001 compared to the same period in the prior year, license revenue decreased by 48%. This year-to-date decrease is primarily due to the overall weakness in the economy in 2001. As a percentage of total revenue, license revenue comprised 17% and 39% of total revenues during the three and nine months ended September 30, of 2001, respectively, compared to 61% and 64%, respectively, for the same periods last year. The decrease is due to the overall decrease in our license business, which is more susceptible to rapid market changes than our service revenue. We anticipate license revenue will increase as a percentage of total revenue in the future due to our shift to leverage third party integrators for providing implementation services to our customers.

Service revenue decreased by 5% for the three months ended September 30, 2001 compared to the same period in the prior year. This primarily results from the reduction in license revenue from the second quarter of 2001 compared to the second quarter of 2000. For the nine months ended September 30, 2001 compared to the same period in the prior year, service revenue increased by 44%. This was a result of the increased revenue from customer implementations, system integration projects and maintenance contracts during the first six months of 2001. We anticipate that service revenue will decrease in absolute dollars in the future due to our shift to leverage third party integrators for providing implementation services to our customers.

Revenues from international sales were $2.5 million and $5.5 million in the three months ended September 30, 2001 and 2000 and $9.2 million and $9.5 million for the nine months ended September 30, 2001 and 2000. The decrease during the third quarter of 2001 in international revenues is related to the same economic factors impacting our total revenues. Our international revenues were derived from sales in Europe, Canada, Asia Pacific and Latin America.

Cost of Revenues

Cost of license revenue consists primarily of third party software royalties, product packaging, documentation, and production and delivery costs for shipments to customers. Cost of license revenue as a percentage of license revenue was higher than usual at 17% for the three months ended September 30, 2001 compared to 4% in the same period in the prior year. For the nine months ended September 30, 2001 compared to the same period in the prior year, cost of license revenue increased as a percentage of license revenue to 7% from 4%. The increases in 2001 are due to the reduced license revenue and fixed nature of some of the license costs, as well as an increase in royalties from the prior year periods.

Cost of service revenue consists primarily of salaries and related expenses for our customer support, implementation and training services organization and allocation of facility costs and system costs incurred in providing customer support. Cost of service revenue increased to 139% of service revenue for the three months ended September 30, 2001 compared to 97% for the same period in the prior year. This is primarily due to a change in the estimated costs to complete recorded in the third quarter of 2001. Cost of service revenue increased to 114% of service revenues for the nine months ended September 30, 2001 compared to 106% the same period in the prior year. This is primarily due to the change in the estimated costs to complete recorded in the third quarter of 2001.

We anticipate that cost of service revenue will decrease in absolute dollars in the future due to reductions in services personnel in preparation for our shift to leverage third party integrators for providing implementation services to our customers.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related costs for sales and marketing personnel and promotional expenditures, including public relations, advertising, trade shows, and marketing collateral materials. Sales and marketing expenses decreased by $6.5 million for the three months ended September 30, 2001 compared to the same period in the prior year primarily as a result of reduction of sales and marketing personnel, and to a lesser extent, decreases in sales commissions associated with decreased revenues and decreases in marketing costs, primarily in advertising and promotional activities. Sales and marketing expenses increased by $1.2 million for the nine months ended September 30, 2001 compared to the same period in the prior year due to higher personnel and operating costs in the first three months of 2001 to support the growth in that period.

We anticipate that sales and marketing expenses will decrease in absolute dollars in the fourth quarter of 2001 and thereafter may increase or decrease, depending primarily on the volume of future revenues and our assessment of market opportunities and sales channels.

Research and Development. Research and development expenses consist primarily of compensation and related costs for research and development employees and contractors and enhancement of existing products and quality assurance activities. Research and development expenses decreased $2.8 million for the three months ended September 30, 2001 compared to the same period in the prior year primarily due to the reduction of personnel and related benefits and facility costs. Research and development expenses were slightly higher by $0.2 million for the nine months ended September 30, 2001 compared to the same period in the prior year due to higher personnel and operating costs in the first three months of 2001 to support the growth in that period.

We anticipate that research and development expenses will decrease in absolute dollars in the fourth quarter of 2001 and thereafter may increase or decrease, depending primarily on the volume of future revenues, customer needs, and our assessment of market demand.

General and Administrative. General and administrative expenses consist primarily of compensation and related costs for administrative personnel, and of legal, accounting and other general corporate expenses. General and administrative expenses increased for the three months ended September 30, 2001 compared with the same period in the prior year primarily due to an increase in bad debt expense. General and administrative expenses were higher for the nine months ended September 30, 2001 compared to the same period in the prior year due to higher personnel and operating costs in the first three months of 2001 to support the growth in that period.

We anticipate that general and administrative expenses will decrease in absolute dollars in the fourth quarter of 2001 and thereafter may increase or decrease, depending primarily on the volume of future revenues and corporate infrastructure requirements including insurance, professional services, bad debt expense and other administrative costs.

Restructuring Costs. For the three and six months ended September 30, 2001, we incurred restructuring charges of approximately $32.1 million and $86.3 million, respectively, related to the reduction in workforce and costs associated with certain excess leased facilities and asset impairments.

For the three and nine months ended September 30, 2001, we recorded charges of $1.9 million and $18.9 million, respectively, for the assets disposed of or removed from operations. Assets disposed of or removed from operations consisted primarily of leasehold improvements, computer equipment and related software, office equipment, furniture and fixtures.

For the three and nine months ended September 30, 2001, we recorded charges of $6.0 million and $23.6 million, respectively, for severance, benefits and related costs due to the reduction in workforce. For the nine months ended September 30, 2001, we reduced our workforce by approximately 1,210 people, or 74% of our employee base. All functional areas have been affected by the reductions.

For the three and nine months ended September 30, 2001, we recorded charges of $24.2 million and $43.8 million, respectively, due to the Company's decision to exit and reduce some facilities. The estimated facility costs are based on the Company's contractual obligations, net of assumed sublease income based on current comparable rates for leases in the respective markets. Should facilities operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease these facilities, the actual loss could exceed this estimate. Future cash outlays are anticipated through February 2011 unless we negotiate to exit the leases at an earlier date.

For the nine months ended September 30, 2001, of the $86.3 million charge, $26.2 million relates to non-cash charges, cash payments totaled $29.6 million and $30.5 million in restructuring liabilities remain at September 30, 2001. The restructuring liability is included on the balance sheet in accrued restructuring and merger costs.

Merger and Transition Related Costs. In connection with the Broadbase merger, for the three and nine months ended September 30, 2001, we recorded $4.8 million and $11.5 million, respectively, of transition costs and merger–related integration expenses. For the three and nine months ended September 30, 2001, the estimated costs include transitional personnel costs of $3.1 million and $5.3 million, respectively. For the three and nine months ended September 30, 2001, the estimated costs include duplicate facility and insurance costs, redundant assets, and professional fees associated with the merger of $1.7 million and $6.2 million, respectively.

In connection with the Silknet merger, we recorded $6.6 million of merger–related integration expenses in the second quarter of 2000. These amounts consisted primarily of merger–related advertising and announcements of $4.5 million and duplicate facility costs of $1.0 million.

Amortization of Deferred Stock–Based Compensation. We are amortizing deferred stock-based compensation on an accelerated basis by charges to operations over the vesting period of the options, consistent with the method described in FASB Interpretation No. 28.

As of September 30, 2001, there was approximately $24.9 million of total unearned deferred stock-based compensation remaining to be amortized.

The amortization of stock–based compensation by operating expense is detailed as follows (in thousands):

Amortization of Goodwill and Identifiable Intangibles. Amortization of goodwill and identifiable intangibles for the three months ended September 30, 2001 was $13.6 million compared to $312.9 million in the same period in the prior year. Amortization for the nine months ended September 30, 2001 was $114.1 million compared to $559.9 million in the same period in the prior year. This decrease is primarily related to the impairment charges to goodwill in the fourth quarter of 2000 and first quarter of 2001.

Goodwill Impairment. We performed an impairment assessment of the identifiable intangibles and goodwill recorded in connection with the acquisition of Silknet. The assessment was performed primarily due to the significant sustained decline in our stock price since the valuation date of the shares issued in the Silknet acquisition resulting in our net book value of our assets prior to the impairment charge significantly exceeding our market capitalization, the overall decline in the industry growth rates, and our lower than projected operating results. As a result,

we recorded an impairment charge of approximately $603 million to reduce goodwill in the first quarter of 2001. The charge was based upon the estimated discounted cash flows over the remaining useful life of the goodwill using a discount rate of 20%. The assumptions supporting the cash flows, including the discount rate, were determined using our best estimates. The remaining goodwill balance, excluding negative goodwill, of approximately $82.4 million is being amortized over its remaining useful life.

In Process Research and Development. In connection with the merger of Silknet, net intangibles of $6.9 million were allocated to in process research and development in the second quarter of 2000.

Other Income, Net. Other income, net during the three and nine months ended September 30, 2001 and 2000 consists primarily of interest income earned on cash and investments, offset by interest expense relating to operating and capital leases.

Provision for Income Taxes. We have incurred operating losses for all periods from inception through September 30, 2001, and therefore have not recorded a provision for income taxes. We have recorded a valuation allowance for the full amount of our gross deferred tax assets, as the future realization of the tax benefit is not currently likely.

Discontinued Operation. During the second quarter of 2001, we adopted a plan to discontinue the KANA Online business. We will no longer seek new business but will continue to service all ongoing contractual obligations we have to our existing customers. Accordingly, KANA Online is reported as a discontinued operation for the three and nine months ended September 30, 2001 and 2000. Net assets of the discontinued operation at September 30, 2001, consisted primarily of computers and servers. The estimated loss on the disposal of KANA Online recorded during the second quarter of 2001 was $3.7 million, consisting of an estimated loss on disposal of the business of $2.6 million and a provision of $1.1 million for the anticipated operating losses during the phase-out period.

Revenues from our discontinued operation for the three months ended September 30, 2001, were $208,000 compared to $1.6 million in the same period in the prior year. Revenues for the nine months ended September 30, 2001 were $3.2 million compared to $4.1 million in the same period in the prior year.

Net Loss. Our net loss was approximately $96.1 million for the three months ended September 30, 2001 and approximately $4.1 billion since inception. In the past, we have experienced substantial increases in our expenditures consistent with growth in our operations and personnel through the first quarter of 2001. In addition, goodwill impairment, amortization of goodwill and identifiable intangibles, restructuring costs and stock-based compensation charges have contributed to the significant increase in net loss during 2001. We anticipate that our expenditures will decrease due to the recent cost reduction initiatives.

Liquidity and Capital Resources

Our operating activities used $97.1 million of cash for the nine months ended September 30, 2001, primarily due to the $918.7 million net loss experienced during the period offset by $763.9 million in non-cash charges and $57.8 million increase in operating assets and liabilities, primarily accounts receivable and accrued restructuring and merger costs.

Our investing activities provided $39.4 million of cash for the nine months ended September 30, 2001, resulting from a net of $46.7 million of acquired cash from the acquisition of Broadbase offset by Silknet acquisition related payments of $13.1 million, and net maturities of short-term investments of $24.8 million, offset by $11.1 million in purchases of property and equipment and $7.8 million in restricted cash.

Our financing activities provided $3.9 million in cash for the nine months ended September 30, 2001, primarily due to proceeds from payments on stockholders' notes receivable and issuance of common stock in connection with employee option exercises and employee stock purchase plans.

At September 30, 2001, we had cash and cash equivalents aggregating $21.4 million and short–term investments totaling $30.5 million.

We have a line of credit totaling $5.0 million, which is secured by all of our assets, bears interest at the bank's prime rate plus .5% (6.5% as of September 30, 2001). Total borrowings as of September 30, 2001 were $1,187,000 and the line of credit supported letters of credit totaling $1.3 million. The line of credit contains certain financial covenants. As of September 30, 2001, we were in compliance with the covenants, as amended. This line of credit expires on

November 30, 2001. We are in discussions with the bank regarding the renewal of this line of credit, and we currently believe that it will be available for renewal should we so desire. However, there can be no assurance the bank will renew the line of credit and no guarantee the terms will be acceptable to us. In the quarter ended September 30, 2001, we issued a letter of credit totaling $5.8 million in connection with a contractual agreement. During the quarter ended September 30, 2001 we transferred $5.8 million to support a letter of credit and also transferred $2.0 million of cash into an escrow account to fulfill certain contractual agreements. These amounts are reflected in restricted cash in the accompanying condensed consolidated balance sheet.

In the past, we have experienced substantial increases in expenditures consistent with growth in our operations and personnel. Our independent accountants have included a paragraph in their report for the year ended December 31, 2000, indicating that substantial doubt exists as to our ability to continue as a going concern. To reduce our expenditures, we restructured in several areas, including reduced staffing, expense management and capital spending. For the first nine months, we reduced our workforce by approximately 74%, in order to streamline operations, reduce costs and bring our staffing and structure in line with industry standards. Our most recent reduction in force was announced to employees on September 28, 2001, which reduced staff by approximately 365 positions across all departments. We expect our cash and cash equivalents and short-term investments on hand will be sufficient to meet our working capital and capital expenditure needs for the next 12 months. We expect to continue to experience negative cash flows through the first quarter of 2002. Significant expected cash flows through the second quarter of 2002 include approximately $20 million in payments relating to accrued merger and restructuring costs, as well as approximately $7 million of expenditures on certain corporate infrastructure. We are evaluating various initiatives to improve our cash position, including raising additional funds to finance our business, implementing further restrictions on spending, negotiating the early release of certain restricted cash and other cash flow initiatives. Additional financing may not be available on terms that are acceptable to us, especially in the uncertain market climate, and we may not be successful in implementing or negotiating such other arrangements to improve our cash position. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and these securities might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds were not available on acceptable terms, our ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.

Our expectations as to when we can achieve positive cash flows, and as to our future cash balances, are subject to a number of assumptions, including assumptions regarding anticipated increases in our revenue, improvements in general economic conditions and customer purchasing and payment patterns, many of which are beyond our control.

     RISKS ASSOCIATED WITH KANA'S BUSINESS AND FUTURE OPERATING RESULTS

Our future operating results may vary substantially from period to period. The price of our common stock will fluctuate in the future, and an investment in our common stock is subject to a variety of risks, including but not limited to the specific risks identified below. The risks described below are not the only ones facing our company. Additional risks not presently known to us, or that we currently deem immaterial, may become important factors that impair our business operations. Inevitably, some investors in our securities will experience gains while others will experience losses depending on the prices at which they purchase and sell securities. Prospective and existing investors are strongly urged to carefully consider the various cautionary statements and risks set forth in this report and our other public filings. In particular, this "Risk Factors Associated with KANA's Business and Future Operating Results" contains cautionary statements that identify important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements in this report.

Because we have a limited operating history, there is limited information upon which you can evaluate our business.

We are still in the early stages of our development, and our limited operating history makes it difficult to evaluate our business and prospects. Any evaluation of our business and prospects must be made in light of the risks and uncertainties often encountered by early-stage companies in Internet-related markets. We were incorporated in July 1996 and first recorded revenue in February 1998. Thus, we have a limited operating history upon which you can evaluate our business and prospects. Due to our limited operating history, it is difficult or impossible to predict future results of operations. For example, we cannot forecast operating expenses based on our historical results because they are limited, and we are required to forecast expenses in part on future revenue projections. Moreover, due to our limited operating history and evolving product offerings, our insights into trends that may emerge and affect our business are limited. In addition, in June 2001, we completed our acquisition of Broadbase. Because we have limited experience operating as a combined company, our business is even more difficult to evaluate. Many of these risks are discussed in the subheadings below, and include our ability to:

Our quarterly revenues and operating results may fluctuate in future periods and we may fail to meet expectations, which could cause the price of our common stock to decline.

Our quarterly revenues and operating results are difficult to predict and may fluctuate significantly from quarter to quarter particularly because our products and services are relatively new and our prospects are uncertain. We believe that period-to-period comparisons of our operating results may not be meaningful and you should not rely on these comparisons as an indication of our future performance. If quarterly revenues or operating results fall below the expectations of investors or public market analysts, the price of our common stock could decline

substantially. Factors that might cause quarterly fluctuations in our operating results include the factors described in the subheadings below as well as:

We also often offer volume-based pricing, which may affect operating margins. Broadbase, which we recently acquired, has experienced seasonality in its revenues, with the fourth quarter of the year typically having the highest revenue for the year. We believe that this seasonality results primarily from customer budgeting cycles. We expect that this seasonality will continue, and could increase. In addition, the average size of our license transactions has increased in recent periods as we have focused on larger enterprise customers and on licensing our more comprehensive integrated products, and as our revenues become dependent on fewer transactions, they become less predictable. Customers' decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. Due to the continuing slowdown in the general economy and the uncertainties resulting from recent acts of terrorism, we believe that many existing and potential customers are reassessing or reducing their planned technology and internet-related investments and deferring purchasing decisions. As a result, there is increased uncertainty with respect to our expected revenues in the remainder of 2001 and in 2002, and further delays or reductions in business spending for information technology could have a material adverse effect on our revenues and operating results.

Our expenses are generally fixed and we will not be able to reduce these expenses quickly if we fail to meet our revenue forecasts.

Most of our expenses, such as employee compensation and rent, are relatively fixed in the short term. Moreover, our expense levels are based, in part, on our expectations regarding future revenue levels. As a result, if total revenues for a particular quarter are below expectations, we

could not proportionately reduce operating expenses for that quarter. Therefore, this revenue shortfall would have a disproportionate effect on our expected operating results for that quarter.

We have a history of losses and may not be profitable in the future and may not be able to generate sufficient revenue or funding to continue as a going concern.

Since we began operations in 1997, our revenues have not been sufficient to support our operations, and we have incurred substantial operating losses in every quarter. As of September 30, 2001, our accumulated deficit was approximately $4.1 billion. Our history of losses has caused some of our potential customers to question our viability, which has in turn hampered our ability to sell some of our products. Although our revenues grew significantly in 2000, we have experienced a significant decline in sales over the nine months ended September 30, 2001. Our revenue has been affected by the increasingly uncertain economic conditions both generally and in our market and our revenue may decline, or fail to grow, in future periods. Although we have restructured our operations to reduce operating expenses, we will need to significantly increase our revenue to achieve profitability and positive cash flows. Our expectations as to when we can achieve positive cash flows, and as to our future cash balances, are subject to a number of assumptions, including assumptions regarding improvements in general economic conditions and customer purchasing and payment patterns, many of which are beyond our control. In addition we may require additional financing, which might not be available on acceptable terms, if at all. Our independent accountants have included a paragraph in their report for the year ended December 31, 2000 indicating that substantial doubt exists as to our ability to continue as a going concern.

As a result of uncertainties in our business, we have experienced and expect to continue to experience difficulties in collecting outstanding receivables from our customers and attracting new customers. As a result, we may continue to experience losses, even if sales of our products and services grow.

We recently reduced the size of our professional services team and, as a result, expect to rely more on independent third-party providers for customer services such as product installations and support. However, if third parties do not provide the support our customers need, we may be required to hire subcontractors to provide these professional services. Increased use of subcontractors would harm our revenues and margins because it costs us more to hire subcontractors to perform these services than to provide the services ourselves.

Our failure to complete our expected sales in any given quarter could dramatically harm our operating results because of the large size of typical orders.

Our sales cycle is subject to a number of significant risks, including customers' budgetary constraints and internal acceptance reviews, over which we have little or no control. Consequently, if sales expected from a specific customer in a particular quarter are not realized in that quarter, we are unlikely to be able to generate revenue from alternate sources in time to compensate for the shortfall. As a result, and due to the relatively large size of a typical order, a lost or delayed sale could result in revenues that are lower than expected. Moreover, to the extent that significant sales occur earlier than anticipated, revenues for subsequent quarters may be lower than expected. Consequently, we face difficulty predicting the quarter in which sales to expected customers will occur. This contributes to the uncertainty of our future operating results.

We may not be able to forecast our revenues accurately because our products have a long and variable sales cycle.

The long sales cycle for our products may cause license revenue and operating results to vary significantly from period to period. To date, the sales cycle for our products has taken 3 to 12 months in the United States and longer in foreign countries. Consequently, we face difficulty predicting the quarter in which sales to expected customers will occur. This contributes to fluctuations in our future operating results. Our sales cycle has required pre-purchase evaluation by a significant number of individuals in our customers' organizations. Along with third parties that often jointly market our software with us, we invest significant amounts of time and resources educating and providing information to prospective customers regarding the use and benefits of our products. Many of our customers evaluate our software slowly and deliberately, depending on the specific technical capabilities of the customer, the size of the deployment, the complexity of the customer's network environment, and the quantity of hardware and the degree of hardware

configuration necessary to deploy our products. In the event that the current economic downturn were to continue, the sales cycle for our products may become longer and we may require more resources to complete sales.

Difficulties in implementing our products could harm our revenues and margins.

We generally recognize revenue from a customer sale when persuasive evidence of an agreement exists, the product has been delivered, the arrangement does not involve significant customization of the software, the license fee is fixed or determinable and collection of the fee is probable. If an arrangement requires significant customization or implementation services from KANA, recognition of the associated license and service revenue could be delayed. The timing of the commencement and completion of the these services is subject to factors that may be beyond our control, as this process requires access to the customer's facilities and coordination with the customer's personnel after delivery of the software. In addition, customers could delay product implementations. Implementation typically involves working with sophisticated software, computing and communications systems. If we experience difficulties with implementation or do not meet project milestones in a timely manner, we could be obligated to devote more customer support, engineering and other resources to a particular project. Some customers may also require us to develop customized features or capabilities. If new or existing customers have difficulty deploying our products or require significant amounts of our professional services support or customized features, our revenue recognition could be further delayed and our costs could increase, causing increased variability in our operating results.

We may incur non-cash charges resulting from acquisitions and equity issuances, which could harm our operating results.

In connection with outstanding stock options and warrants to purchase shares of our common stock, as well as other equity rights we may issue, we are incurring and may incur substantial charges for stock-based compensation. Accordingly, significant increases in our stock price could result in substantial non-cash accounting charges and variations in our results of operations. Furthermore, we will continue to incur charges to reflect amortization and any impairment of goodwill and other intangible assets acquired in connection with our acquisition of Silknet in April 2000, and we may make other acquisitions or issue additional stock or other securities in the future that could result in further accounting charges. In particular, a new standard for accounting for goodwill acquired in a business combination has recently been adopted. This new standard, which we will adopt for 2002, requires recognition of goodwill as an asset but does not permit amortization of goodwill. Instead goodwill must be separately tested for impairment. As a result, our goodwill amortization charges will cease in 2002. However, it is possible that in the future, we would incur less frequent, but larger, impairment charges related to the goodwill already recorded, as well as goodwill arising out of any future acquisitions. Current and future accounting charges like these could delay our achievement of net income.

We have appointed an entirely new executive team, and the integration of these officers may interfere with our operations.

As a result of the merger, most of Broadbase's executives have been appointed to corresponding positions with us, replacing most of our executive team. We appointed Chuck Bay as Chief Executive Officer and President, replacing James C. Wood and David B. Fowler, respectively, both of whom were appointed to their respective positions in January 2001. We also appointed Brett White as Chief Financial officer, replacing Art M. Rodriguez who was appointed on an interim basis in February 2001. In addition to Chuck Bay and Brett White, our current management team consists of Tom Doyle as Chief Operating Officer and Executive Vice President, Worldwide Sales, Services, Bud Michael as Executive Vice President, Products, Chris Maeda as Chief Technology Officer and Vicki Amon-Higa as Vice President, Integration, and all of whom were employees and officers of Broadbase. The transitions of Mssrs. Bay, White and the other executive team members have resulted and will continue to result in disruption to our ongoing operations. These transitions may materially harm the way that the market perceives us, which could cause a decline in the price of our common stock.

Our workforce reduction and financial performance may adversely affect the morale and performance of our personnel and our ability to hire new personnel.

In connection with our effort to streamline operations, reduce costs and bring our staffing and structure in line with industry standards, KANA and Broadbase restructured their organizations in the first nine months of 2001 with substantial reductions in their collective workforce. KANA has continued to restructure operations subsequent to the merger of KANA and Broadbase, during the third quarter of 2001. There have been and may continue to be substantial costs associated with the workforce reduction related to severance and other employee-related costs, and our restructuring plan may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce. As a result of these reductions, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. In addition, many of the employees who were terminated possessed specific knowledge or expertise that may prove to have been important to our operations. In that case, their absence may create significant difficulties. This personnel reduction may also subject us to the risk of litigation which may adversely impact our ability to conduct our operations and may cause us to incur significant expense.

We may be unable to hire and retain the skilled personnel necessary to develop and grow our business.

Recently, we restructured our organization and terminated a significant number of employees in the process. This reduction in force may reduce employee morale and may create concern among existing employees about job security, which may lead to increased turnover and reduce our ability to meet the needs of our current and future customers. As a result of the reduction in force, we may also need to increase our staff to support new customers and the expanding needs of our existing customers, without compromising the quality of our customer service. Although a number of technology companies have recently implemented lay-offs, there remains substantial competition for experienced personnel, particularly in the San Francisco Bay Area, where we are headquartered, due to the limited number of people available with the necessary technical skills. Because our stock price has recently suffered a significant decline, stock-based compensation, including options to purchase our common stock, may have diminished effectiveness as employee hiring and retention devices. Further, our ability to hire and retain qualified personnel might be diminished as a result of the acquisition of Broadbase. Employees may experience uncertainty about their future role with us until post-merger personnel strategies are executed. KANA and Broadbase have different corporate cultures, and employees of either company may not want to work for us as a combined company. In addition, competitors may recruit employees during our integration of Broadbase, as is common in high technology mergers. If we are unable to retain personnel that are critical to the successful integration of the companies, we could face disruptions to operations, loss of key information, expertise or know-how and unanticipated additional recruitment and training costs. If employee turnover increases, our ability to provide client service and execute our strategy would be negatively affected.

We may face difficulties in hiring and retaining qualified sales personnel to sell our products and services, which could impair our revenue growth.

Our ability to increase revenues in the future depends considerably upon our success in recruiting, training and retaining additional direct sales personnel and the success of the direct sales force. We might not be successful in these efforts. Our products and services require sophisticated sales efforts. There is a shortage of sales personnel with the qualifications, and competition for qualified personnel is intense in our industry. Also, it may take a new salesperson a number of months to become a productive member of our sales force. Our business will be harmed if we fail to hire or retain qualified sales personnel, or if newly hired salespeople fail to develop the necessary sales skills or develop these skills more slowly than anticipated.

We rely on marketing, technology and distribution relationships for the sale of our products that may generally be terminated at any time, and if our current and future relationships are not successful, our growth might be limited.

We rely on marketing and technology relationships with a variety of companies that, in part, generate leads for the sale of our products. These marketing and technology relationships include relationships with:

If we cannot maintain successful marketing and technology relationships or if we fail to enter into additional marketing and technology relationships, we could have difficulty expanding the sales of our products and our growth might be limited. While some of these companies do not resell or distribute our products, we believe that many of our direct sales are the result of leads generated by vendors of e-business and enterprise and we expect to continue relying heavily on sales from these relationships in future periods. Our marketing and technology relationships are generally not documented in writing, or are governed by agreements that can be terminated by either party with little or no prior notice. In addition, companies with which we have marketing, technology or distribution relationships may promote products of several different companies including those of our competitors. If these companies choose not to promote our products or if they develop, market or recommend software applications that compete with our products, our business will be harmed.

In addition, we rely on distributors, value-added resellers, systems integrators, consultants and other third-party resellers to recommend our products and to install and support these products. Our recent reduction in the size of our professional services team increases our reliance on third parties for product installations and support. If the companies providing these services fail to implement our products successfully for our customers, we might be unable to complete implementation on the schedule required by the customers and we may have increased customer dissatisfaction or difficulty making future sales as a result. We might not be able to maintain these relationships and enter into additional relationships that will provide timely and cost-effective customer support and service. If we cannot maintain successful relationships with our indirect sales channel partners around the world, we might have difficulty expanding the sales of our products and our international growth could be limited.

We face substantial competition and may not be able to compete effectively.

The market for our products and services is intensely competitive, evolving and subject to rapid technological change. In recent periods, some of our competitors reduced the prices of their products and services (substantially in certain cases) in order to obtain new customers. Competitive pressures could make it difficult for us to acquire and retain customers and could require us to reduce the price of our products. Our customers' requirements and the technology available to satisfy those requirements are continually changing. Therefore, we must be able to respond to these changes in order to remain competitive. Changes in our products may also impact the ability of our sales force to sell effectively. In addition, changes in the perceived needs of customers for specific products, features and services may result in our products becoming uncompetitive. We expect the intensity of competition to increase in the future. Increased competition may result in price reductions, reduced gross margins and loss of market share. We may not be able to compete successfully against current and future competitors, and competitive pressures may seriously harm our business.

Our competitors vary in size and in the scope and breadth of products and services offered. We currently face competition for our products from systems designed by in-house and third-party development efforts. We expect that these systems will continue to be a principal source of competition for the foreseeable future. Our competitors include a number of companies offering one or more products for the e-business communications and relationship management market, some of which compete directly with our products. For example, our competitors include companies providing stand-alone point solutions, including Accrue, Inc., Annuncio, Inc., AskJeeves, Inc., Avaya, Inc., Brightware, Inc., Digital Impact, Inc., eGain Communications Corp., E.piphany, Inc., Inference

Corp., Live Person, Inc., Marketfirst, Inc., and Responsys.com. In addition, we compete with companies providing traditional, client-server based customer management and communications solutions, such as Clarify Inc. (which was acquired by Northern Telecom), Alcatel, Cisco Systems, Inc., Lucent Technologies, Inc., Message Media, Inc., Oracle Corporation, Pivotal Corporation, Siebel Systems, Inc. and Vantive Corporation (which was acquired by PeopleSoft, Inc.).

The level of competition we encounter has increased as a result of our acquisition of Broadbase. As we have combined and enhance the KANA and Broadbase product lines to offer a more comprehensive e-Business software solution, we are increasingly competing with large, established providers of customer management and communication solutions such as Siebel Systems, Inc. as well as other competitors. Our combined product line may not be sufficient to successfully compete with the product offerings available from these companies, which could slow our growth and harm our business.

Many of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we have. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. We may lose potential customers to competitors for various reasons, including the ability or willingness of competitors to offer lower prices and other incentives that we cannot match. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of recent industry consolidations, as well as future consolidations.

Our stock price has been highly volatile and has experienced a significant decline, and may continue to be volatile and decline.

The trading price of our common stock has fluctuated widely in the past and is expected to continue to do so in the future, as a result of a number of factors, many of which are outside our control, such as:

The trading price of our common stock may decline as a result of our acquisition of Broadbase if, for example, we do not achieve the perceived benefits of the merger as rapidly or to the extent anticipated by financial or industry analysts or investors; or the effect of the merger on our financial results is not consistent with the expectations of financial or industry analysts or investors

In addition, the stock market, particularly the Nasdaq National Market, has experienced extreme price and volume fluctuations that have affected the market prices of many technology and computer software companies, particularly Internet-related companies, and that have often been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could adversely affect the market price of our common stock. In the past, following periods of volatility in the market price of a particular company's securities, securities class action litigation has often been brought against that company. Securities class action litigation could result in substantial costs and a diversion of our management's attention and resources. Since our common stock began trading publicly in September 1999, our common stock reached a high of $175.50 per share and traded as low as $0.36 per share through November 13, 2001. The last reported sales price of our shares on November 13, 2001 was $1.40 per share.

Our business depends on the acceptance of our products and services, and it is uncertain whether the market will accept our products and services.

Our ability to achieve increased revenue depends on overall demand for e-Business software and related services, and in particular for customer-focused applications. We expect that our future growth will depend significantly on revenue from licenses of our e-business applications and related services. There are significant risks inherent in introducing Internet-based systems applications. Market acceptance of these products will depend on the growth of the market for e-business solutions. This growth might not occur. Moreover, our target customers might not widely adopt and deploy our products and services. Our future financial performance will depend on the successful development, introduction and customer acceptance of new and enhanced versions of our products and services. In the future, we may not be successful in marketing our products and services, including any new or enhanced products.

The effectiveness of our products depends in part on the widespread adoption and use of these products by customer support personnel. Some of our customers who have made initial purchases of this software have deferred or suspended implementation of these products due to slower than expected rates of internal adoption by customer support personnel. If more customers decide to defer or suspend implementation of these products in the future, our ability to increase our revenue from these customers through additional licenses or maintenance agreements will also be impaired, and our financial position could be seriously harmed.

A failure to manage our internal operating and financial functions could lead to inefficiencies in conducting our business and subject us to increased expenses.

Our ability to offer our products and services successfully in a rapidly evolving market requires an effective planning and management process. We have limited experience in managing rapid growth. We have experienced a period of growth in connection with the mergers we have completed that has placed a significant strain on our managerial, financial and personnel resources. For example, as a result of our merger with Broadbase in June 2001, we increased our total number of full-time employees by approximately 400 people. In September 2001, we reduced our workforce by approximately 365 people. Our business will suffer if we fail to manage these changes successfully or to assimilate substantially all of Broadbase's operations into our operations. Any additional growth will further strain our management, financial, personnel, internal training and other resources. To manage any future growth effectively, we must improve our financial and accounting systems, controls, reporting systems and procedures, integrate new personnel and manage expanded operations. Any failure to do so could negatively affect the quality of our products, our ability to respond to our customers and retain key personnel, and our business in general.

We depend on increased business from new customers, and if we fail to grow our customer base or generate repeat business, our operating results could be harmed.

Our business model generally depends on the sale of our products to new customers as well as on expanded use of our products within our customers' organizations. If we fail to grow our customer base or generate repeat and expanded business from our current and future customers, our business and operating results will be seriously harmed. In some cases, our customers initially make a limited purchase of our products and services for pilot programs. These customers may not purchase additional licenses to expand their use of our products. If these customers do not successfully develop and deploy initial applications based on our products, they may choose not to purchase deployment licenses or additional development licenses.

In addition, as we introduce new versions of our products or new products, our current customers might not require the functionality of our new products and might not ultimately license these products. Because the total amount of maintenance and support fees we receive in any period depends in large part on the size and number of licenses that we have previously sold, any downturn in our software license revenue would negatively affect our future services revenue. In addition, if customers elect not to renew their maintenance agreements, our services revenue could decline significantly. Further, some of our customers are Internet- based companies, which have been forced to significantly reduce their operations in light of limited access to sources of

financing and the current economic slowdown. If customers were unable to pay for their current products or are unwilling to purchase additional products, our revenues would decline.

If we fail to respond to changing customer preferences in our market, demand for our products and our ability to enhance our revenues will suffer.

If we do not continue to improve our products and develop new products that keep pace with competitive product introductions and technological developments, satisfy diverse and rapidly evolving customer requirements and achieve market acceptance, we might be unable to attract new customers. The development of proprietary technology and necessary service enhancements entails significant technical and business risks and requires substantial expenditures and lead-time. We might not be successful in marketing and supporting recently released versions of our products, or developing and marketing other product enhancements and new products that respond to technological advances and market changes, on a timely or cost-effective basis. In addition, even if these products are developed and released, they might not achieve market acceptance. We have in the past experienced delays in releasing new products and product enhancements and could experience similar delays in the future. These delays or problems in the installation or implementation of our new releases could cause customers to forego purchases of our products.

Our failure to manage multiple technologies and technological change could reduce demand for our products.

Rapidly changing technology and operating systems, changes in customer requirements, and evolving industry standards might impede market acceptance of our products. Our products are designed based upon currently prevailing technology to work on a variety of hardware and software platforms used by our customers. However, our software may not operate correctly on evolving versions of hardware and software platforms, programming languages, database environments and other systems that our customers use. If new technologies emerge that are incompatible with our products, or if competing products emerge that are based on new technologies or new industry standards and that perform better or cost less than our products, our key products could become obsolete and our existing and potential customers could seek alternatives to our products. We must constantly modify and improve our products to keep pace with changes made to these platforms and to database systems and other back-office applications and Internet-related applications. For example, our analytics products were designed to work with databases such as Oracle and Microsoft SQL Server. Any changes to those databases, or increasing popularity of other databases, could require us to modify our analytics products, and could cause us to delay releasing future products and enhancements. Furthermore, software adapters are necessary to integrate our analytics products with other systems and data sources used by our customers. We must develop and update these adapters to reflect changes to these systems and data sources in order to maintain the functionality provided by our products. As a result, uncertainties related to the timing and nature of new product announcements, introductions or modifications by vendors of operating systems, databases, customer relationship management software, web servers and other enterprise and Internet-based applications could delay our product development, increase our product development expense or cause customers to delay evaluation, purchase and deployment of our analytics products. If we fail to modify or improve our products in response to evolving industry standards, our products could rapidly become obsolete.

Failure to successfully develop versions and updates of our products that run on the operating systems used by our current and prospective customers could reduce our sales.

Many of our products currently run only on the Windows NT operating system. Any change to our customers' operating systems could require us to modify our products and could cause us to delay product releases. In addition, any decline in the market acceptance of the Windows NT operating system may force us to ensure that all of our products and services are compatible with other operating systems to meet the demands of our customers. If potential customers do not want to use the Windows NT operating system, we will need to develop more products that run on other operating systems such as Windows 2000, the successor to Windows NT, or any of the UNIX based systems. If we cannot successfully develop these products in response to customer demands, our business could suffer. The development of new products in response to these

risks would require us to commit a substantial investment of resources, and we might not be able to develop or introduce new products on a timely or cost-effective basis, or at all, which could lead potential customers to choose alternative products.

Failure to license necessary third party software incorporated in our products could cause delays or reductions in our sales.

We license third party software that we incorporate into our products. These licenses may not continue to be available on commercially reasonable terms or at all. Some of this technology would be difficult to replace. The loss of any such license could result in delays or reductions of our applications until we identify, license and integrate or develop equivalent software. If we are required to enter into license agreements with third parties for replacement technology, we could be subject to higher royalty payments and a loss of product differentiation. In the future, we might need to license other software to enhance our products and meet evolving customer needs. If we are unable to do this, we could experience reduced demand for our products.

Delays in the development of new products or enhancements to existing products would hurt our sales and damage our reputation.

To be competitive, we must develop and introduce on a timely basis new products and product enhancements for companies with significant e-business customer interactions needs. Our ability to deliver competitive products may be impacted by the resources we have to devote to the suite of products, the rate of change of competitive products and required company responses to changes in the demands of our customers. Any failure to do so could harm our business. If we experience product delays in the future, we may face:

In the future, our efforts to remedy this situation may not be successful and we may lose customers as a result. Delays in bringing to market new products or their enhancements, or the existence of defects in new products or their enhancements, could be exploited by our competitors. If we were to lose market share as a result of lapses in our product management, our business would suffer.

We may face increased costs or customer disputes as a result of our recent decision to eliminate our KANA Online service.

We recently eliminated our KANA Online service and as a result, we may face customer dissatisfaction, negative publicity, and legal action by customers resulting from the lack of availability of the KANA Online service. KANA Online customer agreements generally contain provisions designed to limit our exposure to potential claims, such as disclaimers of warranties and limitations on liability for special, consequential and incidental damages. In addition, KANA Online customer agreements generally cap the amounts recoverable for damages to the amounts paid by the licensee to us for the product or service giving rise to the damages. However, any claim by a KANA Online customer, whether or not successful, could harm our business by increasing our costs, damaging our reputation and distracting our management. In addition, we may face additional costs resulting from the termination of the KANA Online service including costs related to the termination of employees, the disposition of hardware and the termination of our service contracts related to the KANA Online service.

Our pending patents may never be issued and, even if issued, may provide little protection.

Our success and ability to compete depend to a significant degree upon the protection of our software and other proprietary technology rights. We regard the protection of patentable inventions as important to our future opportunities. We currently have one issued U.S. patent and multiple U.S. patent applications pending relating to our software. Although we have filed international patent applications corresponding to some of our U.S. patent applications, none of our technology is patented outside of the United States. It is possible that:

We rely upon trademarks, copyrights and trade secrets to protect our proprietary rights, which may not be sufficient to protect our intellectual property.

We also rely on a combination of laws, such as copyright, trademark and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. In the United States, we currently have a registered trademark, "KANA," and several pending trademark applications. Outside of the United States, we have trademark registrations and pending applications in the European Union, Australia, Canada, India, Japan, South Korea and Taiwan. However, despite the precautions that we have taken:

Also, the laws of other countries in which we market our products may offer little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third parties to benefit from our technology without paying us for it, which would significantly harm our business.

We may become involved in litigation over proprietary rights, which could be costly and time consuming.

Substantial litigation regarding intellectual property rights exists in our industry. We expect that software in our industry may be increasingly subject to third-party infringement claims as the number of competitors grows and the functionality of products in different industry segments overlaps. Third parties may currently have, or may eventually be issued, patents upon which our

products or technology infringe. Any of these third parties might make a claim of infringement against us. Many of our software license agreements require us to indemnify our customers from any claim or finding of intellectual property infringement. Any litigation, brought by others, or us could result in the expenditure of significant financial resources and the diversion of management's time and efforts. In addition, litigation in which we are accused of infringement might cause product shipment delays, require us to develop non-infringing technology or require us to enter into royalty or license agreements, which might not be available on acceptable terms, or at all. If a successful claim of infringement were made against us and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, our business could be significantly harmed.

We may face higher costs and lost sales if our software contains errors.

We face the possibility of higher costs as a result of the complexity of our products and the potential for undetected errors. Due to the mission- critical nature of our products and services, errors are of particular concern. In the past, we have discovered software errors in some of our products after their introduction. We have only a few "beta" customers that test new features and functionality of our software before we make these features and functionalities generally available to our customers. If we are not able to detect and correct errors in our products or releases before commencing commercial shipments, KANA could divert the attention of management and key personnel, could be expensive to defend and could result in adverse settlements and judgments.

We may face liability claims that could result in unexpected costs and damages to our reputation.

Our licenses with customers generally contain provisions designed to limit our exposure to potential product liability claims, such as disclaimers of warranties and limitations on liability for special, consequential and incidental damages. In addition, our license agreements generally cap the amounts recoverable for damages to the amounts paid by the licensee to us for the product or service giving rise to the damages. However, all domestic and international jurisdictions may not enforce these contractual limitations on liability. We may be subject to claims based on errors in our software or mistakes in performing our services including claims relating to damages to our customers' internal systems. A product liability claim could divert the attention of management and key personnel, could be expensive to defend and could result in adverse settlements and judgments.

In April 2001, Office Depot, Inc. filed a complaint against KANA claiming that KANA has breached its license agreement with Office Depot. Office Depot is seeking relief in the form of a refund of license fees and maintenance fees paid to KANA, attorneys' fees and costs. The litigation is currently in its early stages and we have not received material information or documentation. We intend to defend this claim vigorously and do not expect it to materially impact our results from operations. However, the ultimate outcome of any litigation is uncertain, and

either unfavorable or favorable outcomes could have a material negative impact due to defense costs, diversion of management resources and other factors.

Our international operations could divert management attention and present financial issues.

Our international operations are located throughout Europe, Australia, and Asia, and, to date, have been limited. We may expand our existing international operations and establish additional facilities in other parts of the world. We may face difficulties in accomplishing this expansion, including finding adequate staffing and management resources for our international operations. The expansion of our existing international operations and entry into additional international markets will require significant management attention and financial resources. In addition, in order to expand our international sales operations, we will need to, among other things:

Our investments in establishing facilities in other countries may not produce desired levels of revenues. Even if we are able to expand our international operations successfully, we may not be able to maintain or increase international market demand for our products. In addition, we have only licensed our products internationally since January 1999 and have limited experience in developing localized versions of our software and marketing and distributing them internationally. Localizing our products may take longer than we anticipate due to difficulties in translation and delays we may experience in recruiting and training international staff.

Our growth could be limited if we fail to execute our plan to expand internationally.

Sales outside North America represented 16% of our total revenues in 2000 and 15% of our total revenues in the first nine months of 2001. As a result of our acquisition of Broadbase, we expect sales outside North America to increase as a percentage of total revenues. We have established offices in the United Kingdom, Australia, Germany, Japan, Holland, France, Spain, Sweden, Singapore and South Korea. As a result, we face risks from doing business on an international basis, any of which could impair our international revenues. Our products must be localized, or customized to meet the needs of local users, before they can be sold in particular foreign countries. Developing localized versions of our products for foreign markets is difficult and can take longer than we anticipate. We have limited experience in localizing our products and in testing whether these localized products will be accepted in the targeted countries. Our localization efforts may not be successful. In addition, we could, in the future, encounter greater difficulty with collecting accounts receivable, longer sales cycles and collection periods or seasonal reductions in business activity. In addition, our international operations could cause our average tax rate to increase. Any of these events could harm our international sales and results of operations.

International laws and regulations may expose us to potential costs and litigation.

Our international operations increase our exposure to international laws and regulations. If we cannot comply with foreign laws and regulations, which are often complex and subject to variation and unexpected changes, we could incur unexpected costs and potential litigation. For example, the governments of foreign countries might attempt to regulate our products and services or levy sales or other taxes relating to our activities. In addition, foreign countries may impose tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers, any of which could make it more difficult for us to conduct our business. The European Union has enacted our own privacy regulations that may result in limits on the collection and use of certain user information, which, if applied to the sale of our products and services, could negatively impact our results of operations.

We may suffer foreign exchange rate losses.

Our international revenues and expenses are denominated in local currency. Therefore, a weakening of other currencies compared to the U.S. dollar could make our products less competitive in foreign markets and could negatively affect our operating results and cash flows. We do not currently engage in currency hedging activities. We have not yet, but may in the future, experience significant foreign currency transaction losses, especially to the extent that we do not engage in currency hedging.

Our prospects for obtaining additional financing, if required, are uncertain and failure to obtain needed financing could affect our ability to maintain current operations and pursue future growth.

We expect our cash and cash equivalents and short term investments on hand will be sufficient to meet our working capital and capital expenditure needs for the next 12 months. To reduce our expenditures, we restructured in several areas, including reduced staffing, expense management and capital spending. For the first nine months, we reduced our workforce by approximately 74%, in order to streamline operations, reduce costs and bring our staffing and structure in line with industry standards. Our most recent reduction in force was announced to employees on September 28, 2001, which reduced staff by approximately 365 positions across all departments. We expect our cash and cash equivalents and short-term investments on hand will be sufficient to meet our working capital and capital expenditure needs for the next 12 months. We expect to continue to experience negative cash flows through the first quarter of 2002. Significant expected cash flows through the second quarter of 2002 include approximately $20 million in payments relating to accrued merger and restructuring costs, as well as approximately $7 million of expenditures on certain corporate infrastructure. We are evaluating various initiatives to improve our cash position, including raising additional funds to finance our business, implementing further restrictions on spending, negotiating the early release of certain restricted cash and other cash flow initiatives. Additional financing may not be available on terms that are acceptable to us, especially in the uncertain market climate, and we may not be successful in implementing or negotiating such other arrangements to improve our cash position. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and these securities might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds were not available on acceptable terms, our ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.

In addition, our expectations as to when we can achieve positive cash flows, and as to our future cash balances, are subject to a number of assumptions, including assumptions regarding anticipated increases in our revenue, improvements in general economic conditions and customer purchasing and payment patterns, many of which are beyond our control.

We have completed a number of mergers, and those mergers may result in disruptions to our business and management due to difficulties in assimilating personnel and operations.

We may not realize the benefits from the significant mergers we have completed. In August 1999, we acquired Connectify, in December 1999, we acquired netDialog and Business Evolution, and in April 2000, we acquired Silknet. In June 2001, we completed our merger with Broadbase. Similarly, prior to its acquisition by us, Broadbase also acquired several companies, including Rubric, Servicesoft, Decisionism and Panopticon. We may not be able to successfully assimilate the additional personnel, operations, acquired technology and products into our business. In particular, we will need to assimilate and retain key professional services, engineering and marketing personnel. This is particularly difficult with Business Evolution, Servicesoft and Silknet, since their operations are located on the east coast and we are headquartered on the West coast. Key personnel from the acquired companies have in certain instances decided, and they may in the future decide, that they do not want to work for us. In addition, products of these companies will have to be integrated into our products, and it is uncertain whether we may accomplish this easily or at all.

The integration of acquired companies has been and will continue to be a complex, time consuming and expensive process and might disrupt our business if not completed efficiently or in a timely manner. We must demonstrate to customers and suppliers that these recent acquisitions will not result in adverse changes in customer service standards, or dilution of or distraction to our business focus. The difficulties of integrating other businesses could be greater than we anticipate, and could disrupt our ongoing business, disrupt our management and

employees and increase our expenses. Acquisitions are inherently risky and we may also face unexpected costs, which may adversely affect operating results in any quarter.

If we do not successfully integrate the operations of Broadbase in a timely manner, we may not achieve the benefits we expect from that merger.

The integration of Broadbase into our business will be a complex, time consuming and expensive process and may disrupt our business if not completed in a timely and efficient manner. We must operate as a combined organization utilizing common information and communication systems, operating procedures, financial controls and human resources practices. In addition, we must integrate Broadbase's product development operations, products and technologies with our own. We may encounter substantial difficulties, costs and delays involved in integrating Broadbase's operations into our own, including:

The merger may also have the effect of disrupting customer relationships. Our customers may not continue their current buying patterns. Customers may defer purchasing decisions as they evaluate the likelihood of successful integration of Broadbase's products and services with ours, and our future product and service strategy. Also, because of the broader product and service offering that we will now offer as a result of the merger, some of our customers may view us as more of a direct competitor than they did KANA or Broadbase as independent companies, and may therefore cancel or fail to place additional orders.

Integration may take longer than expected, and we may be required to expend more resources on integration than anticipated. The need to expend additional resources on integration would reduce the resources that would otherwise be spent on developing our products and technologies. If we cannot successfully integrate Broadbase's operations, products and technologies with our own, or if this integration takes longer than anticipated, we may not be able to operate efficiently or realize the expected benefits of the merger. In addition, failure to complete the integration successfully could result in the loss of key personnel and customers.

To achieve the anticipated benefits of the Broadbase acquisition, we must develop and introduce new products that use the assets of both companies.

We expect to develop and introduce new products, and enhanced versions of our currently existing analytic and eCRM products, that interoperate as a single platform. In particular, we plan to increase the level of integration of Kana's and Broadbase's products so that they function as a unified solution from a common database. The timely development and introduction of new products and versions that work effectively together and allow customers to achieve the benefits of a broader product offering presents significant technological, market and other obstacles in addition to the risks inherent in the development and introduction of new products. For example, our products have historically operated on a variety of operating platforms, including UNIX and Windows NT, while most of Broadbase's products have historically operated only on Windows NT. This may create integration issues between the technologies and challenges in selling the combined product line. We may not be able to overcome these obstacles. In addition, because our market is characterized by rapidly shifting customer requirements, we may not be able to assess these requirements accurately, or our joint products may not sufficiently satisfy these requirements or achieve market acceptance. Further, the introduction of these anticipated new products and versions may result in longer sales cycles and product implementations, which may cause revenue and operating income to fluctuate and fail to meet expectations.

In addition, we intend to offer our current products to Broadbase customers, and Broadbase's current products to our existing customers. The customers of either company may not have an interest in the other company's products and services. The failure of cross-marketing efforts would diminish our ability to achieve the benefits of the merger.

The role of acquisitions in our future growth may be limited, which could seriously harm our continued operations.

In the past, acquisitions have been an important part of the growth strategy for us. To gain access to key technologies, new products and broader customer bases, we have acquired companies in exchange for shares of our common stock. Because the recent trading prices of our common stock have been significantly lower than in the past, the role of acquisitions in our growth may be substantially limited. If we are unable to acquire companies in exchange for our common stock, we may not have access to new customers, needed technological advances or new products and enhancements to existing products. This would substantially impair our ability to respond to market opportunities.

If we acquire additional companies, products or technologies, we may face risks similar to those faced in our other mergers.

If we are presented with appropriate opportunities, we intend to make other investments in complementary companies, products or technologies. We may not realize the anticipated benefits of any other acquisition or investment. If we acquire another company, we will likely face the same risks, uncertainties and disruptions as discussed above with respect to our other mergers. Furthermore, we may have to incur debt or issue equity securities to pay for any additional future acquisitions or investments, the issuance of which could be dilutive to our existing stockholders or us. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for acquired goodwill and other intangible assets.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of the company.

Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock. Without any further vote or action on the part of the stockholders, the board of directors has the authority to determine the price, rights, preferences, privileges and restrictions of the preferred stock. This preferred stock, if issued, might have preference over and harm the rights of the holders of common stock. Although the issuance of this preferred stock will provide us with flexibility in connection with possible acquisitions and other corporate purposes, this issuance may make it more difficult for a third party to acquire a majority of our outstanding voting stock. We currently have no plans to issue preferred stock.

Our certificate of incorporation, bylaws and equity compensation plans include provisions that may deter an unsolicited offer to purchase us. These provisions, coupled with the provisions of the Delaware General Corporation Law, may delay or impede a merger, tender offer or proxy contest involving us. Furthermore, our board of directors is divided into three classes, only one of which is elected each year. Directors are removable by the affirmative vote of at least 66 2/3% of all classes of voting stock. These factors may further delay or prevent a change of control of us.

Failure to comply with Nasdaq's listing standards could result in our delisting by Nasdaq from the Nasdaq National Market and severely limit the ability to sell any of our common stock.

Our stock is currently traded on the Nasdaq National Market. Under Nasdaq's listing maintenance standards, if the closing bid price of our common stock is under $1.00 per share for 30 consecutive trading days, NASDAQ will notify us that it may be delisted from the NASDAQ National Market. If the closing bid price of our common stock does not thereafter regain compliance for a minimum of 10 consecutive trading days during the 90 days following notification by NASDAQ, NASDAQ may delist our common stock from trading on the NASDAQ National Market. We are convening a special meeting of our shareholders in early December 2001 to approve a one for ten reverse split of our common stock. There can be no assurance that our shareholders will approve this reverse split, and accordingly that our common stock will remain eligible for trading on the NASDAQ National Market. If our stock were delisted, your ability to sell any of our common stock at all would be severely, if not completely, limited. Since our common stock began trading publicly in September 1999, our common stock reached a high of $175.50 per share and traded as low as

$0.36 per share through November 9, 2001. The last reported sales price of our shares on November 13, 2001 was $1.40 per share.

If the Internet and web-based communications fail to grow and be accepted as media of communication, demand for our products and services will decline.

We sell our products and services primarily to organizations that receive large volumes of e-mail and web-based communications. Many of our customers have business models that are based on the continued growth of the Internet. Consequently, our future revenues and profits, if any, substantially depend upon the continued acceptance and use of the Internet and e-mail, which are evolving as media of communication. Rapid growth in the use of the Internet and e-mail is a recent phenomenon and may not continue. As a result, a broad base of enterprises that use e-mail as a primary means of communication may not develop or be maintained. In addition, the market may not accept recently introduced products and services that process e-mail, including our products and services. Moreover, companies that have already invested significant resources in other methods of communications with customers, such as call centers, may be reluctant to adopt a new strategy that may limit or compete with their existing investments.

Consumers and businesses might reject the Internet as a viable commercial medium, or be slow to adopt it, for a number of reasons, including potentially inadequate network infrastructure, slow development of enabling technologies, concerns about the security of transactions and confidential information and insufficient commercial support. The Internet infrastructure may not be able to support the demands placed on it by increased Internet usage and bandwidth requirements. In addition, delays in the development or adoption of new standards and protocols required to handle increased levels of Internet activity, or increased governmental regulation, could cause the Interest to lose our viability as a commercial medium. If these or any other factors cause use of the Internet for business to decline or develop more slowly than expected, demand for our products and services will be reduced. Even if the required infrastructure, standards, protocols or complementary products, services or facilities are developed, we might incur substantial expenses adapting our products to changing or emerging technologies.

Future regulation of the Internet may slow our growth, resulting in decreased demand for our products and services and increased costs of doing business.

State, federal and foreign regulators could adopt laws and regulations that impose additional burdens on companies that conduct business online. These laws and regulations could discourage communication by e-mail or other web-based communications, particularly targeted e-mail of the type facilitated by our Connect product, which could reduce demand for our products and services.

The growth and development of the market for online services may prompt calls for more stringent consumer protection laws or laws that may inhibit the use of Internet-based communications or the information contained in these communications. The adoption of any additional laws or regulations may decrease the expansion of the Internet. A decline in the growth of the Internet, particularly as it relates to online communication, could decrease demand for our products and services and increase our costs of doing business, or otherwise harm our business. Any new legislation or regulations, application of laws and regulations from jurisdictions whose laws do not currently apply to our business, or application of existing laws and regulations to the Internet and other online services could increase our costs and harm our growth.

Regulation of the collection and use of personal data could reduce demand for our Broadbase products.

Many of our Broadbase products connect to and analyze data from various applications, including Internet applications, that enable businesses to capture and use information about their customers. Government regulation that limits Broadbase's customers' use of this information could reduce the demand for Broadbase's products. A number of jurisdictions have adopted, or are considering adopting, laws that restrict the use of customer information from Internet applications. The European Union has required that its member states adopt legislation that imposes restrictions on the collection and use of personal data, and that limits the transfer of personally-identifiable data to countries that do not impose equivalent restrictions. In the United States, the Childrens Online Privacy Protection Act was enacted in October 1998. This legislation directs the Federal Trade Commission to regulate the collection of data from children

on commercial websites. In addition, the Federal Trade Commission has begun investigations into the privacy practices of businesses that collect information on the Internet. These and other privacy-related initiatives could reduce demand for some of the Internet applications with which our Broadbase products operate, and could restrict the use of these products in some e-commerce applications. This could reduce demand for some Broadbase products.

The imposition of sales and other taxes on products sold by our customers over the Internet could have a negative effect on online commerce and the demand for our products and services.

The imposition of new sales or other taxes could limit the growth of Internet commerce generally and, as a result, the demand for our products and services. Recent federal legislation limits the imposition of state and local taxes on Internet-related sales. Congress may choose not to renew this legislation in 2001, in which case state and local governments would be free to impose taxes on electronically purchased goods. We believe that most companies that sell products over the Internet do not currently collect sales or other taxes on shipments of their products into states or foreign countries where they are not physically present. However, one or more states or foreign countries may seek to impose sales or other tax collection obligations on out-of-jurisdiction companies that engage in e-commerce. A successful assertion by one or more states or foreign countries that companies that engage in e-commerce should collect sales or other taxes on the sale of their products over the Internet, even though not physically in the state or country, could indirectly reduce demand for our products.

Privacy concerns relating to the Internet are increasing, which could result in legislation that negatively affects our business, in reduced sales of our products, or both.

Businesses using our products capture information regarding their customers when those customers contact them on-line with customer service inquiries. Privacy concerns could cause visitors to resist providing the personal data necessary to allow our customers to use our software products most effectively. More importantly, even the perception of privacy concerns, whether or not valid, may indirectly inhibit market acceptance of our products. In addition, legislative or regulatory requirements may heighten these concerns if businesses must notify Web site users that the data captured after visiting certain Web sites may be used by marketing entities to unilaterally direct product promotion and advertising to that user. While we are not aware of any such legislation or regulatory requirements currently in effect in the United States, other countries and political entities, such as the European Union, have adopted such legislation or regulatory requirements and the United States may do so as well. If consumer privacy concerns are not adequately addressed, our business could be harmed.

Our security could be breached, which could damage our reputation and deter customers from using our services.

We must protect our computer systems and network from physical break-ins, security breaches and other disruptive problems caused by the Internet or other users. Computer break-ins could jeopardize the security of information stored in and transmitted through our computer systems and network, which could adversely affect our ability to retain or attract customers, damage our reputation and subject us to litigation. We have been in the past, and could be in the future, subject to denial of service, vandalism and other attacks on our systems by Internet hackers. Although we intend to continue to implement security technology and establish operational procedures to prevent break-ins, damage and failures, these security measures may fail. Our insurance coverage in certain circumstances may be insufficient to cover losses that may result from such events.

Item 3: Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. At September 30, 2001, our portfolio included money market funds, commercial paper, municipal bonds, government agency bonds, and corporate bonds. The diversity of the portfolio helps us to achieve our investment objective. At September 30, 2001, the weighted average maturity of our portfolio was 97 days.

We are exposed to market risk from fluctuations in foreign currency exchange rates. We manage exposure to variability in foreign currency exchange rates primarily through the use of natural hedges, as both liabilities and assets are denominated in the local currency. However, different durations in our funding obligations and assets may expose us to the risk of foreign exchange rate fluctuations. We have not entered into any derivative instrument transactions to manage this risk. Based on our overall foreign currency rate exposure at September 30, 2001, we do not believe that a hypothetical 10% change in foreign currency rates would materially adversely affect our financial position.

We develop products in the United States and sell these products in North America, Europe, Asia, Australia and Latin America. Generally, our sales and expenses are incurred in local currency. At September 30, 2001 and December 31, 2000, our primary net foreign currency market exposures were in Japanese yen, Euros and British pounds. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.

Foreign currency rate fluctuations can impact the U.S. dollar translation of our foreign operations in our consolidated financial statements. To date, these fluctuations have not been material to our operating results.

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.