SWK Holdings Corp - Annual Report: 2004 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2004

or

For the transition period from                      to                     

000-27163

(Commission File number)

KANA Software, Inc.

(Exact Name of Registrant as Specified in its Charter)

181 Constitution Drive

Menlo Park, California 94025

(Address of Principal Executive Offices)

(650) 614-8300

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

None

(Title of class)

Securities registered pursuant to section 12(g) of the Act:

Common Stock, $0.001 par value per share

(Title of class)

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  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes  ¨  No  x

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes  ¨  No  x

As of June 30, 2004, the last business day of the Registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $69,064,746 based upon the closing sales price of the Registrant’s Common Stock as reported on the NASDAQ National Market of $2.38.

As of August 15, 2005 the Registrant had outstanding approximately 30,872,064 shares of Common Stock.

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KANA Software, Inc.

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ANNUAL REPORT ON FORM 10-K

For The Year Ended December 31, 2004

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PART I

The following discussion of our business and other parts of this report contain forward-looking statements that are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” and variations of these words and similar expressions identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, many 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, but are not limited to, those described in “Risk Factors” and elsewhere in this report. Forward-looking statements that we believed to be true at the time we made them may ultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our 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

KANA develops customer service software for the largest companies in the world. We are a leading provider of Service Resolution Management (SRM) software solutions, primarily knowledge-powered customer service solutions that provide information to answer customer inquiries more efficiently, accurately, and consistently. Our solutions intelligently apply knowledge management techniques to the service resolution process. Our applications enable organizations to improve the quality and efficiency of interactions with customers and partners across multiple communication points, including web contact, web collaboration, email, and telephone. Our customers include some of the largest businesses in the world who use our products to better service, market to, and understand their customers and partners, while improving customer satisfaction and decreasing operational costs.

We are headquartered in the Silicon Valley in Menlo Park, California, with offices in Japan, Korea, and throughout the United States and Europe.

We were incorporated in July 1996 in California and reincorporated in Delaware in September 1999. We had no significant operations until 1997. References in this annual report on Form 10-K to “KANA,” “Company,” “we,” “our,” and “us” collectively refer to KANA Software, Inc., and our predecessor, and our subsidiaries and their predecessors. Our principal executive offices are located at 181 Constitution Drive, Menlo Park, California 94025 and our telephone number is (650) 614-8300. Our Internet website is located at http://www.kana.com. We make available free of charge on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

Our Strategy

Deliver world-class products that focus on improving customer satisfaction, increasing corporate revenue, and reducing the cost to provide service. A significant percentage of an enterprise’s cost of providing service to its customers consists of resolving individual customer questions and problems, or cases. These cases must be received, routed, tracked, and resolved by customer service agents. While many enterprises possess technology capable of routing and tracking cases, the actual resolution of customer issues is the least automated, and therefore the most costly phase. Our product portfolio addresses this largely underserved customer service resolution market. Our knowledge-powered customer service solutions focus on automating the service resolution process. The majority of our license revenues are for applications that are used by our customers’ agents, or directly by their customers, empowering them with knowledge and information to answer their questions.

Partner with the world’s leading system integrators. Our strategy is to focus our efforts on the sale of software and maintenance and to enter into strategic relationships with leading systems integrators in order to provide our customers with a wide range of implementation, systems integration and consulting services. Our customers can benefit from the integrators’ deep KANA product expertise, as well as their outstanding industry knowledge and

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proven integration success. In addition, these integrators employ larger sales forces than we do, and we generally coordinate our sales efforts with them.

Deliver industry-specific applications. Some industries, such as banking, telecommunications and healthcare, have exceptionally high volumes of customer interactions, and providing consistent and accurate feedback to customers of companies in these industries has become increasingly difficult as the products and offerings of such companies have become increasingly complicated. We continue to expand our portfolio of industry-specific applications to address the unique needs of our customers.

Products

KANA provides a comprehensive suite of customer service software. Around the world, KANA SRM solutions are helping Global 2000 companies provide more intelligent, effective interactions with customers, leading to loyal and lasting customer relationships while reducing costs in the contact center.

KANA’s suite of SRM solutions is built on open standards for a high degree of adaptability and flexibility. KANA solutions provide the critical link between contact centers and marketing departments, allowing organizations to have effective, efficient interactions with customers at all points of contact (including web contact, telephone and e-mail) and throughout the enterprise. KANA employs robust analytic tools across its entire product family to allow companies to continually analyze and improve their customer and partner relationships. These features enable Global 2000 companies and other enterprises to reduce the cost of information access for their employees, customers and partners while creating profitable customer relationships.

Our customers can deploy KANA’s SRM solutions as a complete suite or as separate applications. Our SRM solutions include the following products:

Our applications are designed to easily integrate with other enterprise software and legacy systems. They can be installed on systems running either Unix or Microsoft Windows NT operating systems, and provide customers with capabilities for personalization, customer profile management, inquiry management, universal business rules, knowledge management, and extranet workflow. They can be linked with customers’ legacy systems allowing customers to design their systems to preserve previous investments. Our service orientated SRM architecture uses data modeling to make data located in external systems available in our application without requiring the data to be moved or replicated. KANA’s applications are built on a single web-architected platform, which we refer to as KANA’s Enterprise Application Framework. This service-orientated framework provides KANA customers with full access to our applications using a standard web browser and without requiring them to install additional software on their individual computers.

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Alliances

We enter into strategic relationships with leading systems integrators that have developed significant expertise with our web-architected applications and are able to provide customers with a wide range of consulting, implementation and systems integration services. Our systems integrator partners are involved in nearly all customer engagements and, in 2001, we significantly reduced the size of our professional services team and narrowed the scope of our professional services program in part to ensure that we did not compete with these key partners for professional services engagements. In addition, many of these systems integrators act as resellers for our products, and we rely on them for assistance in driving our sales efforts. We believe that support for our products by these systems integrators is increasingly important in influencing new customers’ decisions to license our products. Our systems integrators include Accenture, BearingPoint, HCL Technologies, and IBM Business Consulting Services. These integrators have been integral to KANA’s success in selling its products to large-organizations such as Advanced Micro Devices, Blue Cross and Blue Shield of Minnesota, Dell Computer Corp., eBay, Highmark, O2, Sony Electronics, Inc., Sprint PCS, Wachovia, Yahoo! and others.

Services and Support

Customer Support. Our customer support group uses KANA’s own SRM applications to provide multi-channel global support for our customers and partners, including phone and e-mail support and self-service solutions via our KANA Customer and KANA Partner customer support portals. In the first quarter of 2005, we reduced the size of our internal customer support group and began training an outsourced team at HCL India such that the transfer of some customer support activities could occur in early April. As of June 30, 2005, we had 13 employees in our customer support group, down 10 from December 31, 2004. During that same period, the outsourced headcount went from zero to 20.

Professional Services. Our worldwide consulting and education services group provides business and technical expertise to support our alliance partners and customers. Our consulting services group works closely with systems integrators during implementations to lend technical experience and functional product expertise and to assist the integrators in providing our customers with high-quality, successful, enterprise-wide implementations. Education services provides a full set of training programs and materials for our customers and partners, including a comprehensive set of courses for end users, business consultants and developers, which are available through instructor-led, web-based and on-site classes. As of June 30, 2005, we had 13 employees in our consulting and education services department.

Each of our service groups provide up-to-date information to our customers and partners through quarterly newsletters, as well as real time updates to our customer and partner facing knowledge base.

Sales

Our sales strategy is to focus on Global 2000 companies through a combination of strategic alliances and our direct sales force. We maintain direct sales personnel across the United States and internationally throughout Europe, Asia-Pacific and Canada. Our direct sales force complements our systems integrator alliances. As of June 30, 2005, 55 of our employees were employed in sales and marketing activities.

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Customers

Our customers range from Global 2000 companies to growing companies pursuing an e-business strategy. The following is a list of customers that we believe are representative of our overall customer base:

One customer, IBM, accounted for 11% of our total revenues in 2004 and 2002. No customer accounted for 10% or more of our total revenues in 2003. A substantial portion of our license and service revenues in any given quarter has been, and we expect will continue to be, generated from a limited number of customers.

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Research and Development

We believe that strong product development capabilities are essential to our strategy of enhancing our core technology, developing additional applications incorporating that technology and maintaining the competitiveness of our product and service offerings. We have invested significant time and resources in creating a structured process for undertaking all product development. In the first quarter of 2003, we began implementing an outsourcing strategy, which involves subcontracting a significant portion of our software programming, quality assurance and technical documentation activities to Accenture, HCL, IBM and BearingPoint with staffing in India and China. A substantial amount of outsourcing resources was devoted to developing our new Service Resolution Management product, which was released in December 2004. We began to significantly reduce the scope of our outsourced development activities in early 2005 to better align our costs with our revenues. As of June 30, 2005, 30 of our employees were engaged in research and development activities.

Our success significantly depends on our ability to enhance our existing SRM solutions and to develop new services, functionality and technology that address the increasingly sophisticated and varied needs of our existing and prospective customers. The challenges of developing new products and enhancements 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 existing and potential customers to choose a competitor’s products.

Our research and development expenses were $19.5 million, $21.4 million, and $25.9 million in 2004, 2003, and 2002, respectively.

Competition

The market for our products and services is intensely competitive, evolving and subject to rapid technological change. We currently face competition for our products from software designed by our customers’ in-house development teams and by third parties. We expect that these competing software applications will continue to be a major source of competition for the foreseeable future. Our primary competitors for customer relationship management software platforms are larger, more established companies such as Siebel Systems and Oracle. We also face competition from E.piphany, Chordiant Software, ATG, Amdocs, Knova, RightNow, and Pegasystems with respect to several specific applications we offer. We may face increased competition upon introduction of new products or upgrades from competitors, especially knowledge-powered products.

We believe that the principal competitive factors affecting our industry include having a significant base of customers recommending our products, the breadth and depth of a given solution, product cost, product quality and performance, customer service, product scalability and reliability, product features, ability to implement solutions, and perception of financial position. We believe that our products currently compete favorably with respect to many of these factors, and, in particular, that our web-based architecture provides us with a competitive advantage because it allows for greater product scalability and rapid implementation. However, we may not be able to maintain our competitive position against current and potential competitors, especially those with greater financial, marketing, service, support, technical and other resources, and who may, for example, be able to add features or functionality to their competing products more quickly or decide to sell their products to their existing customer bases for other products.

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 possible introduction by competitors of new software hosting technologies, which could be more scalable, easier to implement and cheaper than the current technologies, and the ability or willingness of competitors to offer lower prices and other incentives that we cannot match. 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 industry consolidations.

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Intellectual Property

We rely upon a combination of patent, copyright, trade secret and trademark laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. We currently have five issued U.S. patents, three of which expire in 2018 and one of which expires in 2020, and a number of U.S. patent applications pending. Our pending applications, if allowed, in conjunction with our issued patents, would cover a significant portion of the technology underlying our products and services. We have also filed international patent applications corresponding to some of our U.S. applications. In addition, we have several trademarks that are registered or pending registration in the U.S. or abroad. Although we rely on patent, copyright, trade secret and trademark law to protect our technology, we believe that factors such as the technological and creative skills of our personnel, new product development, frequent product enhancements and reliable product maintenance are more essential to establishing and maintaining a technology leadership position.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology or to develop products with the same functionality as our products. Policing unauthorized use of our products is difficult. Also, the laws of other countries in which we market our products may offer little or no effective protection of our proprietary technology. Furthermore, our competitors could independently develop technologies equivalent to ours, and our intellectual property rights may not be broad enough for us to prevent such competitors from selling products incorporating those technologies. 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.

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. Some of our competitors in the market for customer communications software may have filed or may intend to file patent applications covering aspects of their technology that they may claim our technology infringes. Such competitors could make a claim of infringement against us with respect to our products and technology. Third parties may currently have, or may eventually be issued, patents upon which our current or future products or technology infringe. Any of these third parties might make a claim of infringement against us. See “Risk Factors—We may become involved in litigation over proprietary rights, which could be costly and time consuming.”

Backlog

As of December 31, 2004 and 2003, we had $21.1 million and $27.7 million, respectively, in backlog, which relates to firm orders, with $2.2 million and $5.0 million, respectively, not expected to be recognized within one year due to either the timing of obligations in the underlying agreement or our collectibility assessment. The substantial majority of these firm orders relates to annual support contracts, and was invoiced and recorded as deferred revenue as of December 31, 2004 and 2003.

Employees

As of December 31, 2004, we had 181 full-time employees, compared to 211 full-time employees as of December 31, 2003. As of June 30, 2005, we had 141 permanent full-time employees. Of the June 30, 2005 employees, 26 were in our services and support group, 55 were in sales and marketing, 30 were in research and development, and 30 were in finance, legal, IT, and administration.

Our corporate office is located in Menlo Park, California, where we lease approximately 45,000 square feet under a lease that expires in April 2007. The annual base rent for this lease totals approximately $880,000. We also lease approximately 22,000 square feet of space in Manchester, New Hampshire. This lease expires in April 2008, and we have an option to extend the lease for an additional three-year term. The annual base rent for the New Hampshire lease totals approximately $411,000. We also lease approximately 6,410 square feet of space in Framingham, Massachusetts at an annual base rent of approximately $154,000. This lease expires in November 2007. Furthermore, we have an international lease for approximately 2,100 square feet of space in the Netherlands at an annual base rent of approximately $53,000. This lease expires in March 2006.

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In addition, we lease smaller offices in several cities throughout the United States, and internationally in Japan, Korea, and Hong Kong. The terms of these leases renew semi-annually unless terminated. We believe that our office space will be sufficient to meet our needs through at least the next 12 months.

We have a total of approximately 82,000 square feet of excess space available for sublease or renegotiation. The excess space is located in Menlo Park, California, Princeton, New Jersey and Marlow in the United Kingdom. Remaining lease commitment terms on these leases vary from three to seven years. We are seeking to sublease or renegotiate the obligations associated with the excess space.

The underwriters for our initial public offering, Goldman Sachs & Co., Lehman Bros, Hambrecht & Quist LLC, Wit Soundview Capital Corp as well as KANA and certain current and former officers of KANA were 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 various securities laws by more than 300 issuers of stock, including KANA, and the underwriters for such issuers, on behalf of a class of plaintiffs who, in the case of KANA, purchased KANA’s stock between September 21, 1999 and December 6, 2000 in connection with our initial public offering. Specifically, the complaints allege that the underwriter defendants engaged in a scheme concerning sales of KANA’s and other issuers’ securities in the initial public offering and in the aftermarket. In July 2003, we decided to join in a settlement negotiated by representatives of a coalition of issuers named as defendants in this action and their insurers. Although we believe that the plaintiffs’ claims have no merit, we have decided to accept the settlement proposal to avoid the cost and distraction of continued litigation. Because the settlement will be funded entirely by KANA’s insurers, we do not believe that the settlement will have any effect on our financial condition, results of operation or cash flows. The proposed settlement agreement is subject to final approval by the court. Should the court fails to approve the settlement agreement, we believe we have meritorious defenses to these claims and would defend the action vigorously.

Other third parties have from time to time claimed, and others may claim in the future that we have infringed their past, current or future intellectual property rights. We have in the past been forced to litigate such claims. These claims, whether meritorious or not, could be time-consuming, result in costly litigation, require expensive changes in our methods of doing business or could require us to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm our business.

The ultimate outcome of any litigation is uncertain, and either unfavorable or favorable outcomes could have a material negative impact on our results of operations, consolidated balance sheet and cash flows, due to defense costs, diversion of management resources and other factors.

Not applicable.

PART II

Our common stock is listed on the NASDAQ National Market under the symbol “KANAE”.

The following table sets forth the range of high and low sales prices for each period indicated:

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There were approximately 1,238 stockholders of record of our common stock as of August 15, 2005. The actual number of stockholders is greater than this number of record holders, and includes stockholders who are beneficial owners, but whose shares are held in street name by brokers and other nominees. This number of holders of record also does not include stockholders whose shares may be held in trust by other entities.

We have not paid any cash dividends on our capital stock. We currently intend to retain any earnings to fund the development and growth of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future. In addition, our existing credit facilities prohibit the payment of cash or stock dividends on our capital stock without the lender’s prior written consent. See Item 7—“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements and the related notes included elsewhere in this annual report on Form 10-K, and other information we have filed with the Securities and Exchange Commission.

The consolidated statement of operations data for each of the years in the five year period ended December 31, 2004, and the consolidated balance sheet data at December 31, 2004, 2003, 2002, 2001, and 2000 are derived from our audited consolidated financial statements. The diluted net loss per share computation excludes shares of common stock issuable upon exercise or conversion of other securities, including outstanding warrants and options to purchase common stock and common stock subject to repurchase rights, because their effect would be antidilutive. See Note 1 of “Notes to the Consolidated Financial Statements” included in Item 15 of this annual report for a detailed explanation of the determination of the shares used to compute basic and diluted net loss per share. Historical results are not necessarily indicative of results to be expected for any future period. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

The following discussion of our financial condition and results of operations and other parts of this report contain forward looking statements that are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” and variations of these words and similar expressions identify forward looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, many 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, but are not limited to, those described in “Risk Factors” and elsewhere in this report. Forward looking statements that we believed to be true at the time we made them may ultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our 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

KANA develops customer support software for many of the largest companies in the world. We are a leading provider of Service Resolution Management (SRM) software solutions: primarily knowledge-powered customer service solutions that provide information to resolve customer inquiries more efficiently, accurately, and consistently. Our applications enable organizations to improve the quality and efficiency of interactions with customers and partners across multiple communication points, including web contact, web collaboration, email, and telephone. As a result, our target market is comprised of large enterprises with high volumes of customer interactions, such as banks, telecommunications companies, high-tech manufacturers, healthcare organizations, and government agencies.

Our revenue is primarily derived from the sale of our software and related maintenance and support of the software. To a lesser extent, we derive revenues from consulting and training. Our products are generally installed by our customers using a systems integrator, such as IBM, Accenture, BearingPoint or HCL Technologies. To a large degree, we rely on our relationships with leading system integrators who co-develop, recommend, and install our software. This provides leverage in the selling phase, and also allows us to realize higher gross margins by selling primarily software licenses and support, which typically have higher margins than consulting and implementation services. However, since our applications are generally installed by our customers using a system integrator, these services generally increase the cost of the project substantially, subjecting their purchase to more levels of required approval and scrutiny of projected cost savings in their customer service and marketing departments. Consequently, we face difficulty predicting the quarter in which sales to expected customers will occur, if at all, which contributes to the uncertainty of our future operating results. To the extent that significant sales occur earlier or later than anticipated, revenues for subsequent quarters may be lower or higher, respectively, than expected.

We have grown rapidly through acquisitions until recent years. These acquisitions provided us with much of the core technology used in our applications. Over the period from 2001 through 2003, we substantially reduced the scale of our operations, started to leverage the service and development capabilities of system integrators, and reduced our costs. In the first quarter of 2005, we reduced our cost structure further, through the reduction of outsourced product development, a reduction in amortization related to the discontinuance of certain internal-use software, reduced headcount, and other cost reduction programs. We anticipate that these adjustments will reduce our expenses by up to $3.0 million to $3.5 million per quarter, beginning in the third quarter of 2005, relative to the average 2004 quarterly expense of approximately $16 million.

In the past four years, we have experienced a cautious purchasing environment in our industry. We believe that this was largely a reaction to the uncertain economy, which had a disproportionate effect on information technology spending. While general economic conditions began to stabilize and improve in the second half of 2003, we believe

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that our market continued to exhibit cautiousness and uncertainty and that, as a result, many enterprises continued to be reluctant to invest in large SRM applications. Since 1997 we have incurred substantial costs to develop our products and to recruit, train and compensate personnel for our engineering, sales, marketing, client services and administration departments. As a result, we have incurred substantial losses since inception. For the twelve months ended December 31, 2004, we recorded a net loss of $21.8 million. As of December 31, 2004, we had an accumulated deficit of $4.3 billion, which includes approximately $2.7 billion related to goodwill impairment charges. We expect our operating losses for 2005 to be less than those in 2004 as a result of our personnel and facility cost reductions. We expect our cash and cash equivalents and short-term investments on hand will be sufficient to meet our working capital and capital expenditures needs for the next 12 months. However, if we do not experience anticipated demand for our products, we will need to further reduce costs, or issue equity securities or borrow money, to meet our cash requirements. Any such equity issuances could be dilutive to our stockholders, and any financing transaction may be on unfavorable terms.

In the first quarter of 2003, we began implementing an outsourcing strategy, which involved subcontracting a significant portion of our software programming, quality assurance and technical documentation activities to Accenture, HCL, IBM and BearingPoint, which have staffing in India or China. As a result of completing certain product development goals and to align our costs with our revenues, we gave notice of our intention to discontinue subcontracting software programming to Accenture and BearingPoint in early 2005 and in the middle of the second quarter of 2005, responsibility for certain product support activities was transferred to HCL and IBM in India.

As of December 31, 2004, we had 181 full-time employees, which represents a decrease from 211 employees at December 31, 2003. As of June 30, 2005, we had 141 employees, which represents a decrease of 40 from the December 31, 2004 employee headcount.

In February 2004, we completed the acquisition of Hipbone, Inc., a provider of online customer interaction solutions. The total purchase price approximated $1.4 million. Under the terms of the agreement, the Company paid $265,000 in cash and issued a total of 262,500 shares of the Company’s common stock valued at approximately $926,000 using the five-trading-day average price surrounding the date the acquisition was announced on January 5, 2004, or $3.62 per share. The Company incurred a total of approximately $169,000 in direct transaction costs. As a result of this acquisition, we now offer Hipbone’s Web collaboration, chat, co-browsing and file-sharing capabilities as part of our SRM software solutions.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these consolidated financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to revenue recognition, collectibility of receivables, goodwill and intangible assets, contract loss reserve, income taxes, and restructuring. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies and the related judgments and estimates significantly affect the preparation of our consolidated financial statements:

Revenue Recognition. License revenue is recognized when there is persuasive evidence of an arrangement, delivery to the customer has occurred, provided the arrangement does not require significant customization or modification of the software, the fee is fixed or determinable and collection of the resulting receivable is reasonably assured.

In software arrangements that include rights to multiple software products and/or services, the Company allocates the total arrangement fee using the residual method, under which revenue is allocated to undelivered elements based on vendor-specific objective evidence of fair value of such undelivered elements with the residual amounts of revenue being allocated to the delivered elements. Elements included in multiple element arrangements primarily

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consist of software products, maintenance (which includes customer support services and unspecified upgrades), consulting services or training. Vendor-specific objective evidence for consulting services and training is based on the price charged when an element is sold separately or, in the case of an element not yet sold separately, the price established by authorized management, if it is probable that the price, once established, will not change before market introduction. Vendor-specific objective evidence for maintenance is generally based on the price charged when an element is sold separately or the stated contractual renewal rates.

Probability of collection is based upon assessment of the customer’s financial condition through review of their current financial statements or publicly-available credit reports. For sales to existing customers, prior payment history is also considered in assessing probability of collection. The Company is required to exercise significant judgment in deciding whether collectibility is reasonably assured, and such judgments may materially affect the timing of our revenues and our results of operations.

Customer support revenues arise primarily from providing global support to our customers and partners, including phone and e-mail support and self-service solutions, as well as unspecified updates on a when-and-if available basis. Customer support service revenues are recognized ratably over the term of the contract, typically one year.

Consulting revenues are primarily from providing specific subject matter expertise as opposed to overall project management. Such services are performed on a time-and-materials basis and are recognized as services are performed.

Revenues from training are recognized as services are performed.

Reserve for Loss Contract. For professional services arrangements involving a fixed fee, we assess whether a loss reserve is necessary, estimate the total expected costs of providing services necessary to complete the contract, and compare these costs to the fees expected to be received under the contract. For example, we were party to a contract with a customer that provided for fixed fee payments in exchange for services upon meeting certain milestone criteria. Based on analysis we performed in the fourth quarter of 2000, we expected the costs to complete the project to exceed the associated fees and, accordingly, we recorded a loss reserve of $1.4 million in the quarter ended December 31, 2000. As a result of our restructuring in the third quarter of 2001, substantially all of the remaining professional services required under the contract were being provided by a third party, and we recorded an additional loss reserve of $6.1 million based upon an analysis of costs to complete these services. In the second quarter of 2002, we began discussions with the customer regarding the timing and scope of the project deliverables, which led to an amendment in August 2002 to the original contract. Based on the amendment and associated negotiations with a third-party integrator that had been providing implementation services to the customer, we recorded a charge of approximately $15.6 million to cost of services revenue in the second quarter of 2002 and, in accordance with the terms of the amendment, we were relieved from providing any further implementation services under the contract. The amendment required that we transfer $6.9 million to an escrow account (which included $5.8 million previously reported as restricted cash) to compensate any third-party integrator for the continued implementation of the customer’s system. The charge also included $8.5 million of fees that we had paid the third-party integrator prior to the amendment. During the second quarter of 2002, we received a scheduled payment of $4.0 million associated with the original agreement that we reported as deferred revenue. The $4.0 million is being recognized as revenue as we fulfill our support and training obligations. As of December 31, 2004, we had recognized $2.2 million of the $4.0 million as revenue, and $1.8 million remained in deferred revenue. Of the amount categorized as deferred revenue, $0.9 million related to support and will be recognized ratably through the first quarter of 2006, and $0.9 million related to training and will be recognized as we perform training obligations, but not later than the third quarter of 2005 when the training credits expire.

Accounting for Internal-Use Software. Internal-use software costs, including fees paid to third parties to implement the software, are capitalized beginning when we have determined various factors are present, including among others, that technology exists to achieve the performance requirements, we have made a decision as to whether we will purchase the software or develop it internally, and we have authorized funding for the project. Capitalization of software costs ceases when the software implementation is substantially complete and is ready for its intended use, and the capitalized costs are amortized over the software’s estimated useful life (generally five years) using the straight-line method. As of December 31, 2004, we had $13.2 million of capitalized costs for internal use software, net of $6.2 million accumulated depreciation.

When events or circumstances indicate the carrying value of internal use software might not be recoverable, we assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows

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and is recognized as a write down of the asset. In addition, if it is no longer probable that computer software being developed will be placed in service, the asset will be adjusted to the lower of its carrying value or fair value, if any, less direct selling costs. Any such adjustment would result in an expense in the period recorded, which could have a material adverse effect on our consolidated statement of operations. In the fourth quarter ended December 31, 2004, the Company’s IT department reviewed its operations and technology requirements, and decided to discontinue its use of certain internal use software, which resulted in a non-cash impairment charge of $1.1 million Additionally, during the first quarter of fiscal 2005 we decided to discontinue the use of certain other internal-use software, which resulted in an additional $6.3 million impairment expense in the first quarter of fiscal 2005.

Restructuring. During 2001, we recorded significant liabilities in connection with our restructuring program. These reserves included estimates pertaining to contractual obligations related to excess leased facilities. We have a total of approximately 82,000 square feet of excess space available for sublease or renegotiation. Locations of the excess space include Menlo Park, California, Princeton, New Jersey and Marlow in the United Kingdom. Remaining lease commitment terms on these leases vary from seven to eight years. We are seeking to sublease or renegotiate the obligations associated with the excess space. We had $10.8 million in accrued restructuring costs as of December 31, 2004, which was our estimate, as of that date, of the exit costs of these excess facilities. We have worked with real estate brokers in each of the markets where the properties are located to help us estimate the amount of the accrual. This process involves significant judgments regarding these markets. If we determine that any of these real estate markets has deteriorated further, additional adjustments to this accrual may be required, which would result in additional restructuring expenses in the period in which such determination is made. Likewise, if any of these real estate markets strengthen, and we are able to sublease the properties earlier or at more favorable rates than projected, or if we are otherwise able to negotiate early termination of obligations on favorable terms, adjustments to the accrual may be required that would increase income in the period in which such determination is made. As of December 31, 2004, our estimate of accrued restructuring cost included an assumption that we would receive $5.6 million in sublease payments that are not yet subject to any contractual arrangement and for which, in most cases, a potential sublessee has not been identified. We have assumed that the majority of these sublease payments will begin in 2005 through 2007 and continue through the end of the related leases.

Goodwill and Intangible Assets. Consideration paid in connection with acquisitions is required to be allocated to the acquired assets, including identifiable intangible assets, and liabilities acquired. Acquired assets and liabilities are recorded based on our estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates. For intangible assets other than goodwill, we are required to estimate the useful life of the asset and recognize its cost as an expense over the useful life. We use the straight-line method to expense long-lived assets, which results in an equal amount of expense being recorded in each period. Amortization of goodwill ceased as of January 1, 2002 upon our adoption of Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets”. Instead, we are now required to test goodwill for impairment under certain circumstances and write it down when it is impaired.

We regularly evaluate all potential indicators of impairment of goodwill and intangible assets. Our judgments regarding the existence of impairment indicators are based on market conditions and operational performance. Future events could cause us to conclude that impairment indicators exist and that goodwill and other intangible assets associated with our acquired businesses are impaired.

Under the transition provisions of SFAS No. 142, there was no goodwill impairment at January 1, 2002 based upon our analysis completed at that time. However, during the quarter ended June 30, 2002, circumstances developed that indicated goodwill was likely impaired. The circumstances that lead to the impairment included the revision of estimates of our revenues and net loss for the second quarter of 2002 and subsequent quarters, based upon preliminary revenue results late in the second quarter of 2002 and the reduction of estimated revenue and cash flows. As a result, we announced preliminary second quarter 2002 results on July 2, 2002. Following this announcement, the decline in the trading price of our common stock reduced our market capitalization, and we performed an impairment analysis as of June 30, 2002. This analysis resulted in a $55.0 million impairment expense to reduce goodwill. The circumstances that led to the impairment included the lower-than-previously-expected revenues and net loss for the second quarter of 2002 and the revision of estimates of our revenues and net loss for subsequent quarters, based upon financial results for the second quarter of 2002 and the reduction of estimated cash flows in future quarters. We used a combination of discounted cash flows and relevant market data, including our market capitalization during the period following the announcement of preliminary results for the second quarter of 2002, to calculate an estimated fair value and the resulting goodwill impairment. The estimated fair value was compared to the corresponding carrying value of goodwill at June 30, 2002, which resulted in a reduction of goodwill as of

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June 30, 2002 by $55.0 million. The remaining amount of goodwill as of December 31, 2004 was $8.9 million. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

We continue to assess whether any potential indicators of impairment of goodwill have occurred and have determined that no such indicators have arisen since June 30, 2004. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

Income Taxes. We estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as net operating loss carryforwards, and stock-based compensation, for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We then assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not more likely than not, we establish a valuation allowance. We concluded that a full valuation allowance was required for all periods presented. While we have considered future taxable income in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would be made, increasing our income in the period in which such determination was made. Pursuant to the Internal Revenue Code, the amounts of and benefits from net operating loss carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses that we may utilize include, but are not limited to, a cumulative change of more than 50% ownership of the company, as defined, over a three year period. The portion of the net operating loss and tax credit carryforwards subject to potential expiration has not been included in deferred tax assets.

Contingencies and Litigation. We are subject to lawsuits and other claims and proceedings. We assess the likelihood of any adverse judgments or outcomes to these matters as well as ranges of probable losses. A determination of the amount of loss contingency required, if any, for these matters are made after careful analysis of each individual matter. The required loss contingencies may change in the future as the facts and circumstances of each matter changes.

Stock Based Compensation. We currently account for our stock-based compensation arrangements with employees using the intrinsic-value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Deferred stock-based compensation is recorded on the date of grant when the deemed fair value of the underlying common stock exceeds the exercise price for stock options or the purchase price for the shares of common stock. However, we have adopted the disclosure requirements of SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure”, and disclose in our financial statement footnotes what the net loss and net loss per share would have been adjusted to if we accounted for options using the fair-value method under SFAS No. 123, “Accounting for Stock-Based Compensation”.

The preparation of the financial statement footnotes requires us to estimate the fair value of stock options granted to employees. While fair value may be readily determinable for awards of stock, market quotes are not available for long-term, nontransferable stock options because these instruments are not traded. We currently use the Black-Scholes option-pricing model to estimate the fair value of employee stock options. However, the Black-Scholes model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including but not limited to stock price volatility. Because our stock options have characteristics significantly different from those of traded options and changes to the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, existing models to not provide a reliable single measure of the fair value of our employee stock options. We are currently evaluating our option valuation methodologies and assumptions in light of evolving accounting standards related to employee stock options. See Recent Accounting Pronouncements below.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment”, which is a revision of SFAS No. 123. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Pro forma disclosure in financial statement footnotes is no longer an alternative. We are required to adopt SFAS 123R on January 1, 2006.

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SFAS 123R permits public companies to adopt its requirements using one of two methods:

We plan to adopt SFAS 123R using the modified prospective method.

As permitted by SFAS No. 123, we currently account for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R fair value method will have a significant impact on our results of operations, although it will have no impact on our cash position. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. We cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options, and whether we will be in a taxable position). There will be no tax impact related to the prior periods since we are in a net loss position.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. which addresses the measurement of exchanges of non-monetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for non-monetary asset exchanges beginning in our third quarter of 2005. We do not believe adoption of SFAS No. 153 will have a material effect on our consolidated financial position, results of operations or cash flows.

In December 2004, the FASB issued FASB Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004”. The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FSP FAS 109-2 provides accounting and disclosure guidance for the repatriation provision. Although FSP FAS 109-2 is effective immediately, until the Treasury Department or Congress provides additional clarifying language on key elements of the repatriation provision, we do not believe we will have any foreign earnings that we would repatriate. Therefore, we do not believe adoption of FSP FAS 109-2 will have a material effect on our consolidated financial position, results of operations or cash flows.

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RESULTS OF OPERATIONS

The following table sets forth in thousands selected data for the periods presented. Percentages are expressed as a percentage of total revenues.

Comparison of the Years Ended December 31, 2004 and 2003

Revenues

Total revenues decreased by 20% to $48.9 million for the year ended December 31, 2004 from $61.0 million for the year ended December 31, 2003, primarily as a result of fewer license transactions in 2004 than in 2003. We believe the decrease in 2004 was due to many factors including competitive pressures, greater-than-anticipated delays in completing expected license transactions through systems integrators, and a slow recovery in the information technology spending environment.

License revenues include licensing fees only, and exclude associated maintenance and consulting revenue. The majority of our licenses to customers are perpetual and associated revenues are recognized upon shipment provided that all revenue recognition criteria are met as discussed in “Revenue Recognition” under “Critical Accounting Policies” above. License revenues decreased by 46% to $14.2 million for the year ended December 31, 2004 from $26.2 million for 2003. This decrease in license revenue was primarily due to a decrease in the average selling price of license transactions due to competitive pricing pressures, as well as a decrease in the number of license transactions closed during the year. We expect our average selling price to continue to fluctuate in future quarters given the relatively low number of new transactions that comprise the majority of our license revenue recognized per quarter. As an example, the average quarterly selling price of license transactions exceeding $100,000 varied from a low of approximately $136,000 in the second quarter of 2004 to a high of approximately $407,000 in the third quarter of 2004.

Our license revenue for first quarter 2005 is estimated to be approximately $1.5 million and our second quarter 2005 is estimated to be $2.2 million (compared to fourth quarter 2004 license revenue of $4.7 million). The market for our products is unpredictable and intensely competitive, and the economic environment over the last few years has had an effect on corporate purchasing, which has adversely affected sales of our products.

Our service revenues consist of support revenues and professional services fees. Support revenues relate to providing customer support, product maintenance and updates to our customers (including when-and-if-available

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upgrades). Professional services revenues relate to providing consulting, training and, to a lesser extent, implementation services to our customers. Service revenues remained flat at $34.7 million for the year ended December 31, 2004 compared to $34.8 million for 2003. The consistency in service revenue amount was in line with expectations since the relatively small percentage of support renewal cancellations is typically more than offset by new maintenance contracts associated with new license transactions. In addition, we maintained a relatively constant professional services headcount in 2004 compared with 2003. Support revenues are the largest component of service revenues, and, in 2004, were relatively consistent with our 2003 support revenues, at $31.0 million in 2004 versus $30.6 million in 2003. The drop in sales of new licenses in 2004 affected service revenues less than license revenues because the majority of our maintenance revenues relate to ongoing maintenance contracts with existing customers. We expect that service revenues in 2005 will be fairly consistent with those from 2004 in absolute dollars.

Revenues from international sales were $17.2 million, or 35% of total revenues, in the year ended December 31, 2004 and $17.2 million, or 28% of total revenues, in the year ended December 31, 2003. Our international revenues were derived from sales in Europe, Canada and Asia Pacific.

During 2004 we experienced a slight increase in sales to companies in the telecommunications sector, representing approximately 42% of our revenues in 2004 compared to approximately 41% in 2003. Sales to companies in the financial services sector remained constant at 30% for both 2004 and 2003. We also experienced an increase in sales to companies in the high technology sector, representing approximately 8% of our revenues in 2004 compared to approximately 5% in 2003.

Costs and Expenses

Total cost of revenues decreased by 16% to $12.0 million for the year ended December 31, 2004 from $14.3 million for the year ended December 31, 2003.

License. Cost of license revenues consists of third party software royalties, costs of product packaging, documentation, and production and delivery costs for shipments to customers. Cost of license revenues as a percentage of license revenue for 2004 was 17% compared to 12% in 2003. The increase was due to royalty costs associated with a relatively higher proportion of non-revenue-related shipments, such as upgrades and updates during 2004. We expect that our cost of license revenue as a percentage of sales in 2005 will be similar to that from 2004.

Service. Cost of service revenues consists primarily of salaries and related expenses for our customer support, consulting, and training services organization, and allocation of facility costs and system costs incurred in providing customer support. Cost of service revenues decreased to 27% of service revenues, or $9.5 million, for 2004 compared to 28%, or $9.7 million, for the prior year. Both totals exclude amortization of stock-based compensation of $346,000 and $430,000 for periods ending December 31, 2004 and 2003, respectively. The consistency in service margins in 2004 compared to 2003 was due to consistency in our strategy and professional service staffing levels throughout 2004 and 2003. We anticipate that our cost of service revenues will decrease slightly in absolute dollars, and as a percentage of service revenue, in 2005 compared to 2004 due to our transfer of some service responsibilities to our development partner in India.

Amortization of Identifiable Intangibles. The amortization of identifiable intangible assets recorded in 2004 and 2003 related to $14.8 million of purchased technology recorded as an intangible asset in connection with the mergers with Silknet Software, Inc. in April 2000 and Hipbone, Inc. February 2004, respectively. The amortization of the assets related to Silknet concluded in April 2003. Amortization totaled $0.1 million and $1.5 million for the years ended December 31, 2004 and 2003, respectively.

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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 materials. Sales and marketing expenses decreased by 14% to $25.1 million for the year ended December 31, 2004 from $29.2 million for the year ended December 31, 2003. This decrease was partly attributable to reductions in sales and marketing personnel during 2004, from 77 positions as of December 31, 2003 to 70 positions as of December 31, 2004 and a reduction in information technology support. In addition, commission expense in 2004 was $0.6 million lower than in 2003 due to decreases in license revenues in 2004 as discussed above. We anticipate that sales and marketing expenses in 2005 will be lower than 2004 in absolute dollars, and will fluctuate as a percentage of revenues depending on the timing and amount of revenues. The lower expenses in 2005 will primarily be due to lower headcount.

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 by 9% to $19.5 million for the year ended December 31, 2004 from $21.4 million for the year ended December 31, 2003. This decrease was partly attributable to a reduction in research and development personnel during 2004 by 15%, from 40 as of December 31, 2003 to 34 at December 31, 2004 and a reduction in information technology support. The decrease can also be attributed to lower outsourcing expenses paid to our development partners with staffing in India and China. We anticipate that research and development expenses will be lower in absolute dollars in 2005 than in 2004 as certain product development activities were completed, and will fluctuate as a percentage of revenues depending on the timing and amount of revenues.

General and Administrative. General and administrative expenses consist primarily of compensation and related costs for finance, legal, human resources, corporate governance, and bad debt expense. Information technology and facilities costs are allocated among all operating departments. General and administrative expenses decreased by 11% to $8.1 million for the year ended December 31, 2004 from $9.1 million for the year ended December 31, 2003. This decrease was primarily attributable to a reduction in information technology support, professional services, bad debt expense and other general and administrative expenses for the year ended December 31, 2004. We anticipate that general and administrative costs in 2005 will be slightly higher in absolute dollars compared to 2004, and will fluctuate as a percentage of revenues depending on the timing and amount of revenues.

Amortization of Stock-Based Compensation. We amortize employee-related 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 Interpretations No. 28. The amortization of deferred stock-based compensation related to fully vested warrants to third parties are amortized on a straight-line basis. Amortization of stock-based compensation was $1.2 million and $5.9 million for the years ended December 31, 2004 and 2003, respectively. In 2004 and 2003, there were no options granted with an exercise price below the fair value of the option shares on the grant date.

As of December 31, 2004, a total of approximately $58,000 of unearned deferred stock-based compensation remained to be amortized. We anticipate to fully amortize the remaining stock-based compensation expense in 2005. The amortization of stock-based compensation for 2004 and 2003, by operating expense, is detailed as follows (in thousands):

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Impairment of Internal Use Software. In the fourth quarter ended December 31, 2004, the Company’s IT department reviewed its operations and technology requirements, and decided to discontinue its use of certain internal use software. As a result, a material charge for impairment was required under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The capitalized cost of this internal-use software included capitalized fees paid to third parties to implement the software. The total non-cash impairment charge related to this software was $1.1 million in the fourth quarter.

In the first quarter ended March 31, 2005, we reviewed all continuing operating expenses across the entire company, including our technology requirements. One result of this review was a decision to discontinue our use of certain internal use software. The total non-cash impairment charge related to this software was $6.3 million which will be recorded in the first quarter of 2005.

Restructuring Costs. During the year ended December 31, 2004, we recorded $3.3 million in restructuring costs related to a change in evaluation of real estate market conditions in the United Kingdom, and changes in sublease estimates based on offers from potential subtenants in the United States. For the year ended December 31, 2003, we recorded approximately $1.7 million in restructuring related to a change in real estate market conditions relating to excess leased facilities, and discussions with our respective landlords.

The following table summarizes our restructuring expenses, payments, and liabilities at and for the years ended December 31, 2004 and 2003 (in thousands):

We made payments of $2.6 million against restructuring liabilities in 2004, net of contractual sublease payments received. The remainder will be paid relatively evenly from 2005 through 2011.

Goodwill Impairment. During June 2004 we performed our annual test for goodwill impairment as required by SFAS No. 142. Based on our evaluation, we concluded that goodwill was not impaired as the fair value of the Company exceeded its carrying value, including goodwill. There have been no events or circumstances from June 30, 2004 to December 31, 2004 that have affected our June 30, 2004 conclusion regarding the recoverability of goodwill. The remaining amount of goodwill and intangibles as of December 31, 2004 was $8.9 million. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

Other Income (Expense), net

Other income (expense), net consists of interest income, interest expense and other income (expense). Interest income consisted primarily of interest earned on cash and short-term investments and was approximately $0.1 million and $0.3 million during the years ended December 31, 2004 and 2003. The decrease in other income (expense), net related to lower amounts of interest income earned due to lower average cash balances in 2004 than in 2003. Interest expense consisted primarily of interest expense related to our line of credit and was approximately

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$0.2 million and $0.2 million during the years ended December 31, 2004 and 2003. Other income also consisted of net gains on asset disposals.

Provision for Income Taxes

We have incurred operating losses on a consolidated basis for all periods from inception through December 31, 2004. Accordingly, 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 more likely than not. In 2004 and 2003, certain of our foreign subsidiaries were profitable, based upon application of our intercompany transfer pricing agreements, which resulted in us reporting income tax expense totaling approximately $0.3 million and $0.3 million, respectively, in those foreign jurisdictions.

As of December 31, 2004, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $425.0 million and $358.1 million, respectively. The Company also had foreign net operating loss carryforwards of approximately $20.0 million. The federal net operating loss carryforwards, if not offset against future taxable income, will expire from 2011 through 2024. Pursuant to the Internal Revenue Code, the amounts and benefits from net operating loss carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses that we may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period. As such, the portion of the net operating loss and tax credit carryforwards subject to potential expiration has not been included in deferred tax assets. In addition it is possible additional limitations may exist.

Comparison of the Years Ended December 31, 2003 and 2002

Revenues

Total revenues decreased by 23% to $61.0 million for the year ended December 31, 2003 from $79.1 million for the year ended December 31, 2002, primarily as a result of fewer license deals in 2003 than in 2002, as well as a 31% decrease in the average sales price per license deal over $100,000 realized during 2003 compared to 2002. We believe the decrease in 2003 was due to a multitude of factors including competitive pricing pressures and the continuing slow down in the information technology spending environment.

License revenues decreased by 37% to $26.2 million for the year ended December 31, 2003 from $41.5 million for 2002. This decrease in license revenue was primarily due to a decrease in the average selling price of license deals, as well as a decrease in the number of license deals closed during the year. The decrease in the average selling price of license deals was primarily experienced in the first half of the year.

Our service revenues consist of either support revenues or professional services. Support revenues relate to providing customer support and product maintenance and updates to our customers. Professional services revenues relate to providing consulting, training and, to a lesser extent, implementation services to our customers. Service revenues decreased by 7% to $34.8 million for the year ended December 31, 2003 from $37.6 million for 2003. The decrease in service revenues was primarily in professional services, due to our customers’ increased use of independent third party integrators for implementation services in 2003. Support revenues were relatively consistent with 2002, at $30.6 million in 2003 versus $30.8 million in 2002. The reduction in the sales of new licenses in 2003 affected service revenues less than license revenues because the majority of our maintenance revenues relate to ongoing maintenance contracts with existing customers.

Revenues from international sales were $17.2 million, or 28% of total revenues, in the year ended December 31, 2003 and $25.5 million, or 32% or total revenues, in the year ended December 31, 2002. The decrease in international sales in 2003 is primarily as a result of large sales through our integration partner in the United Kingdom in 2002 that did not recur to the same extent in 2003. Our international revenues were derived from sales in Europe, Canada, Asia Pacific and Latin America.

During 2003 we experienced an increase in sales to companies in the telecommunications and financial services sector, representing approximately 41% and 30%, respectively, of our revenues in 2003 compared to approximately 27% and 10%, respectively, in 2002. We also experienced a decrease in sales to companies in the high technology sector, representing approximately 5% of our revenues in 2003 compared to approximately 23% in 2002.

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Costs and Expenses

License. Cost of license revenues as a percentage of license revenue for 2003 was 12% compared to 8% in 2002. The increase was due to royalty costs associated with a relatively higher proportion of non-revenue-related shipments, such as upgrades and updates during 2003.

Service. Cost of service revenues decreased to 28% of service revenues, or $9.7 million, for 2003 compared to 78%, or $29.3 million, for the prior year. Cost of service revenues in 2002 included approximately $15.6 million, or 42% of service revenues, related to a loss contract with a customer, as discussed in “Reserve for Loss Contract” under “Critical Accounting Policies” above. The improvement in service margins in 2003 was also due to the change in service revenues mix throughout 2002 following a shift in our strategy in September 2001 to have customers use independent third party integrators to provide implementation services, rather than purchase those services from us. As a result, support revenues comprised a larger percentage of service revenues during the entire year of 2003, which yielded better margins than professional services revenues since the ratio of customers-to-personnel is significantly higher for customer support

Amortization of Identifiable Intangibles. The amortization of identifiable intangible assets recorded in the current and prior year relates to $14.4 million of purchased technology recorded as an intangible asset in connection with the merger with Silknet in April 2000. The amortization of these assets concluded in April 2003. Amortization totaled $1.5 million and $4.8 million for the years ended December 31, 2003 and 2002, respectively.

Sales and Marketing. Sales and marketing expenses decreased by 22% to $29.2 million for the year ended December 31, 2003 from $37.4 million for the year ended December 31, 2002. This decrease was primarily attributable to reductions in sales and marketing personnel during 2003 by 27%, from 106 positions as of December 31, 2002 to 77 positions at December 31, 2003, which resulted in approximately $4.2 million in savings in salaries and related benefits. In addition, commission expense in 2003 was $2.3 million lower than in 2002 due to decreases in license revenues in 2003 discussed above. We also spent $2.2 million less in marketing programs in 2003 than in 2002.

Research and Development. Research and development expenses decreased by 17% to $21.4 million for the year ended December 31, 2003 from $25.9 million for the year ended December 31, 2002. This decrease was attributable primarily to the reduction of personnel during 2003 by 69%, from 128 as of December 31, 2002 to 40 at December 31, 2003 and resulted in savings of approximately $8.5 million in compensation, benefits, and allocated facility and operations costs. These reductions in personnel were offset by approximately $6.0 million in fees associated with our outsourcing strategy begun in the first quarter of 2003, which involves subcontracting a significant portion of our software programming, quality assurance and technical documentation activities to development partners with staffing in India and China. Likewise, expense for contractors in the United States decreased by $0.8 million in 2003 compared to 2002. We also realized savings in depreciation expense charged to research and development of $0.9 million in 2003 compared to 2002 due to assets placed in service in 2000 becoming fully depreciated in 2003.

General and Administrative. General and administrative expenses decreased by 30% to $9.1 million for the year ended December 31, 2003 from $13.1 million for the year ended December 31, 2002. This decrease was attributable to the 23% reduction in general and administrative personnel during 2003, from 30 finance, legal and human resources-related positions at December 31, 2002 to 23 such positions at December 31, 2003, as well as $2.0 million in net reductions to bad debt expense in 2003.

Amortization of Stock-Based Compensation. As of December 31, 2003, a total of approximately $1.5 million of unearned deferred stock-based compensation remained to be amortized.

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The amortization of stock-based compensation by operating expense, for 2003 and 2002, is detailed as follows (in thousands):

Restructuring Costs. During the fourth quarter of 2003, we recorded $1.7 million in restructuring costs related to a change in evaluation of real estate market conditions in the United Kingdom, and changes in sublease estimates based on communication from current and potential subtenants in the United States. For the year ended December 31, 2002, we recorded approximately $5.1 million in restructuring cost savings related to an amendment to a facility lease, our evaluation of real estate market conditions relating to this and other excess leased facilities, and discussions with our other landlords.

During 2003 and 2002, we realized personnel-related costs savings associated with reductions in headcount as a result of our restructuring in 2001, of approximately $36.1 million in each year. Cost savings in 2003 relating to facilities reductions from our restructuring in 2001 included $348,000 in sublease payments received and $2.1 million in reduced rent obligations relating to an amendment in 2002 to a facility lease. Cost savings in 2002 relating to facilities reductions from our restructuring in 2001 included $814,000 in sublease payments received and $340,000 in reduced rent obligations relating to the lease amendment in 2002. Reductions in rent obligations related to this amendment ranged from approximately $2.1 million in 2003, increasing to approximately $2.8 million in 2010.

Goodwill Impairment. During the quarter ended June 30, 2002, circumstances developed that indicated our goodwill was likely impaired and we performed an impairment analysis as of June 30, 2002. This analysis resulted in a $55.0 million impairment expense to reduce goodwill. The circumstances that led to the impairment included the lower-than-previously-expected revenues and net loss for the second quarter of 2002 and the revision of estimates of our revenues and net loss for subsequent quarters, based upon financial results for the second quarter of 2002 and the reduction of estimated cash flows in future quarters. We used a combination of discounted cash flows and relevant market data, including our market capitalization during the period following the revision of estimates, to calculate an estimated fair value and the resulting goodwill impairment. The estimated fair value was compared to the corresponding carrying value of goodwill at June 30, 2002, which resulted in a revaluation of goodwill as of June 30, 2002.

Impairment of Investment

In connection with the merger with in April 2000, we assumed a $1.5 million investment in preferred stock of a privately held company. We recorded a $1.0 million impairment charge in the fourth quarter of 2001 and another $0.5 million impairment charge in the fourth quarter of 2003 in order to reduce the carrying value of the investment

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to zero at December 31, 2003. The impairment charge in 2003 was based upon the decline in the estimated fair value of the asset based upon evaluation of the business prospects. The impairment charge in 2001 was based on a substantial decline in the estimated fair value of the investment based, in part, on the terms of a recent financing involving significant new investors.

Other Income (Expense), net

Interest income consisted primarily of interest earned on cash and short-term investments and was approximately $315,000 and $965,000 during the years ended December 31, 2003 and 2002. The decrease in other income (expense), net related to lower amounts of interest income earned due to lower average cash balances in 2003 than in 2002. Interest expense consisted primarily of interest expense related to our line of credit and was approximately $174,000 and $107,000 during the years ended December 31, 2003 and 2002. Other income consisted primarily of net gains on asset disposals.

Provision for Income Taxes

We had recorded a valuation allowance for the full amount of our gross deferred tax assets, as the future realization of the tax benefit was not more likely than not. In 2003, certain of our foreign subsidiaries were profitable, based upon application of our intercompany transfer pricing agreements, which resulted in us reporting income tax expense totaling approximately $318,000 in those foreign jurisdictions.

Cumulative Effect of Change in Accounting Principle

As part of the adoption of SFAS No. 142 on January 1, 2002, unamortized negative goodwill was to be immediately recognized as the effect of a change in accounting principle. Accordingly, approximately $3.9 million was eliminated and reported as the cumulative effect of accounting change in the year ended December 31, 2002. Additionally, under SFAS 142, goodwill is no longer amortized. Accordingly, amortization of goodwill ceased as of January 1, 2002.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2004, we had $20.1 million in cash, cash equivalents and short-term investments, compared to $33.0 million as of December 31, 2003. As of December 31, 2004, we had negative working capital of $9.7 million. $17.6 million of our current liabilities consists of current deferred revenue (primarily reflecting payments for future maintenance services under our software licenses).

History and recent trends. We have had negative cash flows from operations in each year since inception. To date, we have funded our operations primarily through issuances of common stock and, to a lesser extent, cash acquired in acquisitions. However, our cash used in operations has decreased significantly in recent years, from $42.2 million in 2002 to $12.7 million in 2003 and $13.1 million in 2004. This reduction in operating cash outflows has resulted from a 44% decrease in overall cost of revenues, sales and marketing, research and development, general and administrative, and merger and restructuring costs from 2002 to 2004, offset in part, by a 38% decrease in revenues during the same period. Our cost reductions have been realized through our restructuring plan in 2001, as well as various cost controls and operational efficiencies realized since 2001. In 2004, 2003 and 2002, we had net workforce reductions of approximately 30, 154 and 44 employees, respectively.

Primary driver of cash flow. Our ability to generate cash in the future relies upon our success in generating sufficient sales, especially new license sales. We expect our maintenance renewals in 2005 will be fairly consistent with 2004. Since our new license transactions are relatively small in volume and are difficult to predict, we may not be able to generate new license transactions as anticipated in any particular future period. From time to time, changes in working capital will affect our cash flows. However, we do not expect this to materially impact our future cash flows over time, since we expect relative stability, or slight growth, in our assets and liabilities.

Operating cash flow. Our use of $13.1 million of cash for operating activities for the year ended December 31, 2004, included a $21.8 million net loss from continuing operations offset by non-cash charges of $5.5 million in depreciation, $1.4 million in amortization of deferred stock-based compensation and identifiable intangible assets, and $1.1 million in write-off of fixed assets. Other working capital changes totaled a negative $3.6 million, resulting

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primarily from a $4.1 million decrease in accounts receivable offset by $0.8 million decrease in prepaid expenses and other assets, a $0.6 million reduction in the allowance for doubtful accounts, $3.6 million reduction in deferred revenue, and $3.4 million in net payments relating to restructuring liabilities. Our operating activities used $12.7 million and $42.2 million of cash and cash equivalents for the year ended December 31, 2003 and December 31, 2002, respectively. These expenditures were primarily attributable to net losses experienced during these periods, offset in part by non-cash charges related to impairment of goodwill and amortization of intangibles and stock-based compensation.

Investing cash flow. Our investing activities provided $9.4 million of cash for the year ended December 31, 2004, and consisted primarily of net transfers of short-term investments to cash totaling $10.4 million, offset by purchases of property and equipment of $0.9 million and cash paid for acquisitions of $0.4 million. Our investing activities used $4.5 million of cash for the year ended December 31, 2003, and consisted primarily of net transfers of short-term investments to cash totaling $3.3 million and purchases of property and equipment of $1.2 million. Our investing activities used $0.4 million of cash for the year ended December 31, 2002, and consisted primarily of reductions of restricted cash of $10.6 million, net transfers of short-term investments to cash totaling $1.3 million, offset by purchases of property and equipment of $12.3 million. Our purchases of property and equipment were $0.9 million, $1.2 million and $12.2 million in 2004, 2003 and 2002, respectively. The decreases were primarily to due to the completion of $15.2 million in expenditures on internal-use software as of January 2003, and to a lesser extent, the reduction in purchases of infrastructure and various employee related equipment in 2003 and 2004.

Financing cash flow. On June 30, 2005, we announced completion of a private placement of 1,631,541 shares of common stock with institutional investors at a price of $1.471 per share for aggregate gross proceeds of $2.4 million. In addition, we issued these investor warrants to purchase a total of 815,769 shares of common stock at an exercise price of $2.452. Financing activities provided $0.8 million in cash for the year ended December 31, 2004, due to net proceeds from issuances of common stock. Our financing activities provided $14.2 million in cash for the year ended December 31, 2003, due to net proceeds from issuances of common stock, particularly the public offering in November 2003, which raised $13.1 million in net proceeds. Our financing activities provided $36.1 million in cash for the year ended December 31, 2002, primarily due to net proceeds of approximately $31.4 million from our private placement of approximately 2.9 million shares of our common stock in February 2002.

Existence and timing of contractual obligations. We have a line of credit totaling $5.0 million, which is collateralized by all of our assets, had an interest rate of 5.25% as of December 31, 2004 (the higher of the bank’s prime rate or 4.0%), and expires in November 2005, at which time the entire balance under the line of credit will be due. Total borrowings as of December 31, 2004 and 2003 were $3.4 million under this line of credit. Under the terms of an amendment signed August 24, 2005, the line of credit requires us to maintain at least a $8.0 million dollar balance in cash or cash equivalents with the lending bank at all times or pay a one-time fee of $10,000, and to maintain at all times a minimum of $11.0 million as short-term unrestricted cash and cash equivalents and short-term investments. Starting September 30, 2005, the minimum required balance will be increased from $11.0 million to $13.0 million. As long as we have a minimum of $13.0 million in short-term unrestricted cash and cash equivalents and short-term investments, the interest rate remains at the bank’s prime rate. If our unrestricted cash and cash equivalents and short-term investments fall below $13.0 million, the rate would become prime plus 0.5 percentage point through June 30, 2005 and prime plus 1.0 percentage point thereafter. The line of credit also requires us to maintain EBITDA covenant of not less than $0 for the second quarter ending June 30, 2005 and not less than $500,000 for each fiscal quarter after the quarter ending September 30, 2005. The minimum EBITDA requirement for the second quarter ended June 30, 2005 will be eliminated if our net loss for that quarter does not exceed $1.9 million. If we default under this line of credit, including through a violation of any of these covenants, the entire balance under the line of credit could become immediately due and payable unless the Company obtains a waiver. As of July 31, 2005, we were in compliance with all financial covenants of the line of credit agreement.

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Our future payments due under debt and lease obligations and other contractual commitments as of December 31, 2004 are as follows (in thousands):

Off-balance sheet arrangements. In accordance with GAAP, none of our operating lease obligations are reflected on our balance sheet. The vast majority of our operating leases relates to facilities and do not involve a transfer of ownership at the end of the lease. We have no other off-balance sheet arrangements.

Cash held in foreign locations. As of December 31, 2004, we had $6.8 million held by our 100%-owned foreign subsidiaries, primarily in Europe and Japan. We believe our access to this cash is unencumbered, and would not result in withholding or repatriation charges due to our intercompany receivable balances and transfer pricing arrangements with these entities.

Outlook. Based on our current 2005 revenue expectations, 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 twelve months. If we do not experience anticipated demand for our products, we will need to further reduce costs, or issue equity securities or borrow money to meet our cash requirements. If we raise additional funds through the issuance of equity or convertible securities, the percentage ownership of our stockholders would be reduced and the securities we issue 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 our future cash flows and 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.

RISK FACTORS

We operate in a dynamic and rapidly changing business environment that involves substantial risks and uncertainty, 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. Any of these risks could cause, or contribute to causing, our actual results to differ materially from expectations. 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.

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Risks Related to Our Business

The large size of many of our expected license transactions could contribute to our failure to meet expected sales in any given quarter and could materially harm our operating results.

Our quarterly revenues are especially subject to fluctuation because they depend on the completion of relatively large orders for our products and related services. The average size of our license transactions is generally large relative to our total revenue in any quarter, particularly as we have focused on larger enterprise customers and on licensing our more comprehensive integrated products and have involved system integrators in our sales process. For example, in 2004, one customer, IBM, represented 11% of our total revenues. 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. This dependence on large orders makes our net revenue and operating results more likely to vary from quarter to quarter, and more difficult to predict, because the loss of any particular large order is significant. In recent periods, we have experienced increases in the length of a typical sales cycle. This trend may add to the uncertainty of our future operating results and reduce our ability to anticipate our future revenues. Moreover, to the extent that significant sales occur earlier than anticipated, revenues for subsequent quarters may be lower than expected. As a result, our operating results could suffer if any large orders are delayed or canceled in any future period. In part as a result of this aspect of our business, our quarterly revenues and operating results may fluctuate in future periods and we may fail to meet the expectations of investors and public market analysts, which could cause the price of our common stock to decline. We expect the concentration of revenues among fewer customers to continue in the future.

We may not be able to forecast our revenues accurately because our products have a long and variable sales cycle and we rely on systems integrator partners for sales.

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 anywhere from 6 to 18 months. Since the slowdown in the general economy that began in 2001, we believe that many existing and potential customers have reassessed and reduced their planned technology and software investments and are deferring purchasing decisions, requiring additional evaluations and levels of internal approval for software investment and lengthening their purchase cycles. Our sales cycle typically requires 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. The continuing stagnancy of information technology spending in our markets has led to a significant increase in the time required for this process.

Furthermore, we increasingly rely on systems integrators to identify, influence and manage large transactions with customers, and we expect this trend to continue as our industry consolidates. Selling our products in conjunction with our systems integrators who incorporate our products into their offerings can involve a particularly long and unpredictable sales cycle, as it typically takes more time for the prospective customer to evaluate proposals from multiple vendors. In addition, when systems integrators propose the use of our products to their customers, it is typically part of a larger project, which can require more levels of customer approvals. We have little or no control over the sales cycle of an integrator-led transaction or our customers’ budgetary constraints and internal decision-making and acceptance processes.

As a result of increasingly long sales cycles, we have faced increased difficulty in predicting our operating results for any given period, and have experienced significant unanticipated fluctuations in our revenues from period to period. Any failure to achieve anticipated revenues for a period could cause our stock price to decline.

Our business relies heavily on service resolution management solutions, including new products that we have recently begun to offer, and these solutions may not gain market acceptance.

We have made service resolution management, or SRM, solutions our main focus and, in recent periods, have allocated a significant portion of our research and development and marketing resources to the development and promotion of such products. For our current business model to succeed, we believe that we will need to convince

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new and existing customers of the merits of purchasing our SRM solutions over traditional customer relationship management, or CRM, solutions. Many of these customers have previously invested substantial resources in adopting and implementing their existing CRM products, whether such products are ours or are those of our competitors. We may be unable to convince customers and potential customers that it is worth them purchasing substantial new software packages to provide them with SRM capabilities. If our strategy of offering SRM solutions fails, we may not be able to sell sufficient quantities of our key new product offerings to generate significant license revenues, and our business could be harmed.

We introduced our new KANA Resolution SRM product in December 2004 and have not yet obtained any revenue from licenses of this product. We devoted significant resources to the development and marketing of this product and if it is not accepted by potential customers our business would be materially adversely affected.

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

Most of our expenses, such as employee compensation and rent, are relatively fixed in the short term. Moreover, our forecast is based, in part, upon 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. Accordingly, such a revenue shortfall would have a disproportionate effect on our expected operating results for that quarter.

If we fail to generate sufficient revenues to support our business and require additional financing, failure to obtain such financing would affect our ability to maintain our operations and to grow our business, and the terms of any financing we obtain may impair the rights of our existing stockholders.

In the future, we may be required to seek additional financing to fund our operations or growth, and such financing may not be available to us, or may impair the rights of our existing stockholders. Furthermore, any failure to raise sufficient capital in a timely fashion could prevent us from growing or pursuing our strategies or cause us to limit our operations and cause potential customers to question our financial viability. Our operating activities used $13.1 million of cash in 2004. Our license revenues are estimated to be $1.5 million in the first quarter and $2.2 million in the second quarter of 2005 and if future orders do not increase, we would likely be required to seek additional capital to meet our working capital needs if we are unable to reduce expenses to the degree necessary to avoid incurring significant net cash reductions. Furthermore, although we had cash and cash equivalents including short term investments of $20.1 million at December 31, 2004, it is possible that, if we fall significantly below these levels in the coming quarters, customers will be concerned about our cash situation and our ongoing ability to update and maintain our products. This could significantly harm our sales efforts. At June 30, 2005, we had cash and cash equivalents including short term investments of $14.6 million. Since an April 15, 2005 amendment on our bank loan, any failure to maintain cash above $11.0 million ($13 million after September 30, 2005) would trigger a covenant violation under our line of credit, which could further lower our cash balance if the bank were to enforce repayment of borrowing under that line ($5.0 million as of June 30, 2005). In addition, any failure to achieve a minimum EBITDA of $0 (or a net loss of not more than $1.9 million) for the quarter ended June 30, 2005 would trigger a covenant violation under our line of credit, which could further lower our cash balance if the bank were to enforce repayment. Factors such as the commercial success of our existing products and services, the timing and success of any new products and services, the progress of our research and development efforts, our results of operations, the status of competitive products and services, and the timing and success of potential strategic alliances or potential opportunities to acquire or sell technologies or assets may require us to seek additional funding sooner than we expect. In the event that we require additional cash, we may not be able to secure additional financing on terms that are acceptable to us, especially in the current uncertain market climate, and we may not be successful in implementing or negotiating 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 the securities we issue 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.

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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, new product lines or new product features, our current customers might not require the additional functionality we offer and might not ultimately license these products. Furthermore, 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. Also, if customers elect not to renew their maintenance agreements, our services revenue could decline significantly. If customers are unable to pay for their current products or are unwilling to purchase additional products, our revenues would decline. Additionally, a substantial percentage of our sales continues to come from repeat customers. If a significant existing customer or a group of existing customers decide not to repeat business with us, our revenues would decline and our business would be harmed.

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. From time to time, some of our competitors have 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. If our international development partners do not adequately perform the software programming, quality assurance and technical documentation activities we outsourced, we may not be able to respond to such changes as quickly or effectively. Changes in our products may also make it more difficult for our sales force to sell effectively. In addition, changes in customers’ demand for the specific products, product features and services of other companies’ 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 with our products from systems designed in-house and by our competitors. We expect that these systems will continue to be a major source of competition for the foreseeable future. Our primary competitors for eCRM platforms are larger, more established companies such as Siebel Systems and Oracle. We also face competition from Chordiant Software, E.piphany, ATG, Knova, RightNow, Amdocs, and Pegasystems with respect to specific applications we offer. We may face increased competition upon introduction of new products or upgrades from competitors, or if we expand our product line through acquisition of complementary businesses or otherwise. As we have combined and enhanced our product lines to offer a more comprehensive software solution, we are increasingly competing with large, established providers of customer management and communication solutions 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. 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 anticipated future consolidations.

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We have a history of losses and may not be able to generate sufficient revenue to achieve and maintain profitability.

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 December 31, 2004, our accumulated deficit was approximately $4.3 billion, which includes approximately $2.7 billion related to goodwill impairment charges. We continue to commit a substantial investment of resources to sales, product marketing, and developing new products and enhancements, and we will need to 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. Our history of losses has previously caused some of our potential customers to question our viability, which has in turn hampered our ability to sell some of our products. Additionally, our revenue has been affected by the uncertain economic conditions in recent years, both generally and in our market. As a result of these conditions, we have experienced and expect to continue to experience difficulties in attracting new customers, which means that we may continue to experience losses, even if sales of our products and services grow.

We rely on marketing, technology and distribution relationships for the sale, installation and support 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, including systems integrators and consulting firms that, among other things, generate leads for the sale of our products and provide our customers with implementation and ongoing support. If we cannot maintain successful marketing and technology relationships or if we fail to enter into additional such relationships, we could have difficulty expanding the sales of our products and our growth might be limited.

A significant percentage of our revenues depend on leads generated by systems integrators, or “SIs”, and their recommendations of our products. If SIs do not successfully market our products, our operating results will be materially harmed. In addition, many of our direct sales are to customers that will be relying on SIs to implement our products, and if SIs are not familiar with our technology or able to successfully implement our products, our operating results will be materially harmed. We expect to continue increasing our leverage of SIs as indirect sales channels and, if this strategy is successful, our dependence on the efforts of these third parties for revenue growth and customer service will increase. Our reliance on third parties for these functions has reduced our control over such activities and reduced our ability to perform such functions internally. If we come to rely primarily on a single SI that subsequently terminates its relationship with us, becomes insolvent or is acquired by another company with which we have no relationship, or decides not to provide implementation services related to our products, we may not be able to internally generate sufficient revenue or increase the revenues generated by our other SI relationships to offset the resulting lost revenues. Furthermore, SIs typically suggest our solution in combination with other products and services, some of which may compete with our solution. SIs are not required to promote any fixed quantities of our products, are not bound to promote our products exclusively, and may act as indirect sales channels for 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 to relying on SIs to recommend our products, we also rely on SIs and other third-party resellers to install and support our products. Our substantial reduction in the size of our professional services team in 2001, and to a lesser extent in 2002, increased our customers’ reliance on third parties for product installations and support. If the companies providing these services fail to implement our products successfully for our customers, the customer may be unable to complete implementation on the schedule that it had anticipated and we may have increased customer dissatisfaction or difficulty making future sales as a result. We might not be able to maintain our relationships with SIs and other indirect sales channel partners 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, we might have difficulty expanding the sales of our products and our growth could be limited. In addition, if such 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 margins because it costs us more to hire subcontractors to perform these services than it would to provide the services ourselves.

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Reductions in our workforce may adversely affect our ability to release products and product updates in a timely manner.

We have substantially reduced our headcount over the last two years from a total of 365 employees as of December 31, 2002 to 211 as of December 31, 2003 to 181 as of December 31, 2004. The majority of this reduction was the result of our decision to shift a significant portion of our software programming, quality assurance and technical documentation activities to international development partners in early 2003. We reduced the size of our research and development department from 88 employees as of December 31, 2003 to 34 employees as of December 31, 2004. In addition, we reduced the level of our expenditures on outsourced development in the first quarter of 2005, which will take effect in the second quarter of 2005. The reductions in our research and development headcount and the recent reductions in our outsourced development capacity may limit our ability to release products within expected timeframes. For example, many of the employees who were terminated in headcount reductions possessed specific knowledge or expertise that may prove to have been important to our operation. We further reduced our headcount from 181 as of December 31, 2004 to 141 as of June 30, 2005. As a result of these staff reductions, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. Personnel reductions 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. Our termination of two outsourcing arrangements in early 2005 may further reduce our ability to respond to development challenges and to introduce new products in expected timeframes.

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

Concern over our long-term financial strength may create concern among existing employees about job security, which could lead to increased turnover and reduce our ability to meet the needs of our current and future customers. Because our stock price declined drastically in recent years, and has not experienced any sustained recovery from the decline, stock-based compensation, including options to purchase our common stock, may have diminished effectiveness as employee hiring and retention devices. If we are unable to retain qualified personnel, 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 customer service and execute our strategy would be negatively affected.

For example, our ability to increase revenues in the future depends considerably upon our success in training and retaining effective direct sales personnel and the success of our direct sales force. We might not be successful in these efforts. Our products and services require sophisticated sales efforts. The majority of our senior sales management have recently joined the company. In addition, we have experienced significant turnover in our sales force, and may experience further turnover in future periods. It generally takes a new salesperson nine or more months to become productive, and they may not be able to generate new sales. Our business will be harmed if we fail to retain qualified sales personnel, or if newly hired salespeople fail to develop the necessary sales skills or develop these skills more slowly than anticipated.

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. Our industry is characterized by rapid and substantial developments in the technologies and products that enjoy widespread acceptance among prospective and existing customers. The development of proprietary technology and necessary service enhancements entails significant technical and business risks and requires substantial expenditures and lead-time. In addition, if our international development partners fail to provide the development support we need, our products and product documentation could fall behind those produced by our competitors, causing us to lose customers and sales. We might not be successful in marketing and supporting recently released versions of our products, such as our SRM and On-Demand offerings, 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 experienced delays in releasing new products and product enhancements in the past and could experience similar delays in the future. These delays or problems in the installation or implementation of our new releases could cause us to lose customers.

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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. Furthermore, software adapters are necessary to integrate our 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. Furthermore, if our international development partners fail to respond adequately when adaptation of our products is required, our ability to respond would be hampered even if such uncertainties were eliminated. If we fail to modify or improve our products in response to evolving industry standards, our products could rapidly become obsolete.

Failure to develop new products or enhancements to existing products on a timely basis would hurt our sales and damage our reputation.

The challenges of developing new products and enhancements require us to commit a substantial investment of resources to development, and we might not be able to develop or introduce new products on a timely or cost-effective basis, or at all, which could be exploited by our competitors and lead potential customers to choose alternative products. 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 negatively affected by the diversion of resources to development of our suite of products, and responding to changes in competitive products and in the demands of our customers. If we experience product delays in the future, we may face:

Furthermore, delays in bringing new products or enhancements to market can result, for example, from potential difficulties with managing outsourced research and development, including overseeing such activities occurring in India and China or from loss of institutional knowledge through reductions in force, or the existence of defects in new products or their enhancements.

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 of these licenses 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 face higher royalty payments and our products may lose certain attributes or features. 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.

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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 we expect that it will continue to do so in the future, as a result of a number of factors, many of which are outside our control, such as:

In addition, stock markets in general, and particularly the NASDAQ National Market, have experienced extreme price and volume fluctuations that have affected the market prices of many technology and computer software companies, particularly Internet-related companies. Such fluctuations 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 becoming a publicly traded security listed on NASDAQ in September 1999, our common stock has reached a closing high of $1,698.10 per share and closing low of $0.65 per share. The last reported sale price of our shares on June 30, 2005 was $1.60 per share. 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 may choose to notify us that it may delist our common stock from the NASDAQ National Market. If the closing bid price of our common stock did not thereafter regain compliance for a minimum of 10 consecutive trading days during the 180 days following notification by NASDAQ, our common stock could be delisted from trading on the NASDAQ National Market.

Our independent auditors have identified material weaknesses in our internal controls that, if not remediated, could affect our ability to prepare timely and accurate financial reports, which could cause investors to lose confidence in our reported financial information and have a negative effect on the trading price of our stock.

In the course of the audit of our consolidated financial statements for the year ended December 31, 2004, our independent auditors identified and reported material weaknesses in our internal control over financial reporting. A material weakness is a reportable condition in which our internal controls do not reduce to a low level the risk that undetected misstatements caused by error or fraud may occur in amounts that are material to our audited financial statements. In addition, our Chief Executive Officer and our Chief Financial Officer performed an, evaluation of our disclosure controls and procedures and found that they were not effective. First, we had weaknesses in our general accounting processes related to insufficient documentation and analyses to support our consolidated financial statements, failure to properly evaluate estimates of royalties due, and insufficient staffing in the accounting and reporting function, which is exacerbated by changes in management and accounting personnel and insufficient training of our accounting department. Second, there was no independent review of journal entries, and insufficient documentation or support for journal entries and consolidation entries. In a number of cases, these required adjustments to our financial statements for the year ended December 31, 2004.

Finally, during the first quarter of 2005, our Audit Committee completed an examination of certain of our internal controls relating to travel and entertainment expenses and determined that we had made erroneous expense reimbursements to our Chief Executive Officer and certain other executive officers, primarily as a result of inconsistent travel and entertainment policies, inadequate review of expense reimbursement requests and carelessness.

Our management has determined that these deficiencies constitute material weaknesses as of December 31, 2004 which continued to exist during the first two quarters of 2005. As a result, we are unable to conclude that our disclosure controls and procedures were effective as of December 31, 2004. (See Item 9A) We believe that these

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deficiencies did not have a material impact on our financial statements included in this report due to the fact that we performed substantial analysis on and for the December 31, 2004 and prior years’ balances, including performing historical account reconciliations, having account balance analysis reviewed by senior management, and reconstructing certain account balances. However, these deficiencies increase the risk that a transaction will not be accounted for consistently and in accordance with established policy or generally accepted accounting principles, and they increase the risk of error.

Management, with the oversight of the Audit Committee of the Board of Directors, has begun to address these control deficiencies and is committed to effectively remediating these deficiencies as expeditiously as possible. The Chief Financial Officer joined the company in mid October 2004. The Vice President of Finance for EMEA has been promoted to Vice President of Finance for all of KANA and he is in the process of recruiting additional experienced staff. Some new processes and controls have already been approved and are being implemented. The Company plans to develop and implement further improvements and additional controls. In addition, management believes that it has remediated the material weakness relating to travel and entertainment expense reimbursement during the first quarter of 2005. The Company’s other weaknesses will not be considered remediated until new internal controls are developed and implemented throughout the Company, are operational for a period of time, are tested, and management concludes that these controls are operating effectively.

Our remediation measures may not be successful in correcting the material weakness reported by our auditors. In addition, we cannot assure you that additional material weaknesses or significant deficiencies in our internal controls will not be discovered in the future. In addition, controls may become inadequate because of changes in conditions, and the degree of compliance with the policies or procedures may deteriorate. Any failure to remediate the material weaknesses described above or to implement and maintain effective internal controls could harm our operating results, cause us to fail to meet our reporting obligations or result in material misstatements in our financial statements. Deficiencies in our internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

We face additional risks and costs as a result of the delayed filing of our annual report on Form 10-K for the year ended December 31, 2004 and our quarterly reports on Form 10-Q for the quarters ended March 31, and June 30, 2005.

As a result of the delayed filing of our annual report on Form 10-K for the year ended December 31, 2004 and our quarterly reports on Form 10-Q for the quarters ended March 31, and June 30, 2005, we have experienced additional risks and costs. As previously disclosed, we have received Staff Determination letters from the NASDAQ Stock Market indicating that the Company’s securities are subject to delisting from The NASDAQ Stock Market due to the delayed filings of the Form 10-K for the year ended December 31, 2004 and the Form 10-Q’s for the quarters ended March 31, and June 30, 2005. The NASDAQ Stock Market notified us that the NASDAQ Listing Qualifications Panel has granted our request for the continued listing of our common stock on the NASDAQ National Market provided that KANA files this annual report on Form 10-K on or before August 26, 2005 and our quarterly reports on Form 10-Q for the quarters ended March 31, 2005 and June 30, 2005 on or before September 21, 2005. The delinquency in filing, and possibility of delisting, will not be cured until we file our first and second quarter Form 10-Qs as well as this Form 10-K, and will not be cured if we are also delinquent in filing our third quarter Form 10-Q. The Company cannot provide any assurances that the NASDAQ Listing Qualifications Panel will grant the Company’s request for continued listing on The NASDAQ Stock Market, or as to the timing of its Form 10-Q filings.

Finally, as a result of our delayed filing of our annual report on Form 10-K for the year ended December 31, 2004 and our quarterly reports on Form 10-Q for the quarters ended March 31 and June 30, 2005, we will be ineligible to register our securities on Form S-3 for sale by us or resale by others until we have timely filed all periodic reports under the Securities Exchange Act of 1934 for one year. The Company may use Form S-1 to raise capital or complete acquisitions, which could increase transaction costs and adversely affect our ability to raise capital or complete acquisitions of other companies during this period. There can be no assurance that our common stock will remain eligible for trading on the NASDAQ National Market. If our stock were delisted, the ability of our stockholders to sell any of our common stock at all would be severely, if not completely, limited, causing our stock price to continue to decline.

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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 currently have five issued U.S. patents, three of which expire in 2018 and one of which expires in 2020, and multiple U.S. patent applications pending relating to our software. 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.

In addition to patents, we 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. However, despite the precautions that we have taken:

Also, the laws of some 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.

The software and Internet industries are characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. As the number of entrants into our market increases, the possibility of an intellectual property claim against us grows. Our technologies may not be able to withstand any third-party claims or rights against their use. Some of our competitors in the market for customer communications software may have filed or may intend to file patent applications covering aspects of their technology that they may claim our technology infringes. Such competitors could make a claim of infringement against us with respect to our products and technology. Third parties may currently have, or may eventually be issued, patents upon which our current or future products or technology infringe. Any of these third parties might make a claim of infringement against us. For example, from time to time, companies have asked us to evaluate the need for a license of patents they hold, and we cannot assure you that patent infringement claims will not be filed against us in the future. Other companies may also have pending patent applications (which are typically confidential for the first eighteen months following filing) that cover technologies we incorporate in our products.

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In addition, many of our software license agreements require us to indemnify our customers from any claim or finding of intellectual property infringement. We periodically receive notices from customers regarding patent license inquiries they have received which may or may not implicate our indemnity obligations. 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 alternative 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 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 limit 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, some 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.

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 many of our products and services, errors could be particularly problematic. 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, we could face:

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.

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Our international operations expose us to additional risks.

A substantial proportion of our revenues are generated from sales outside North America, exposing us to additional financial and operational risks. Sales outside North America represented 35% of our total revenues in 2004, and 28% of our total revenues in 2003. We have established offices in the United Kingdom, Japan, the Netherlands, Hong Kong and South Korea. Sales outside North America could increase as a percentage of total revenues as we attempt to expand our international operations. In addition to the additional costs and uncertainties of being subject to international laws and regulations, international operations require significant management attention and financial resources, as well as additional support personnel. To the extent our international operations grow, we will also need to, among other things, expand our international sales channel management and support organizations and develop relationships with international service providers and additional distributors and system integrators. In addition, international operations can lead to greater difficulty with collecting accounts receivable, longer sales cycles and collection periods, greater seasonal fluctuations in business activity and increases in our tax rates. Any growth in our international operations would compound these difficulties. Furthermore, 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 expected.

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 its 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 have not yet experienced, but may in the future experience, significant foreign currency transaction losses, especially because we generally do not engage in currency hedging. To the extent the international component of our revenues grows, our results of operations will become more sensitive to foreign exchange rate fluctuations.

If we acquire companies, products or technologies, we may face risks associated with those acquisitions.

We acquired Hipbone, Inc. in early 2004, and if we are presented with appropriate opportunities, we may make other investments in complementary companies, products or technologies. We may not realize the anticipated benefits of any acquisition or investment. For example, since inception, the Company has recorded $2.7 billion of impairment charges for the cost of goodwill obtained from acquisitions. If we acquire another company, we will likely face risks, uncertainties and disruptions associated with the integration process, including, among other things, difficulties in the integration of the operations, technologies and services of the acquired company, the diversion of our management’s attention from other business concerns and the potential loss of key employees of the acquired businesses. If we fail to successfully integrate other companies that we may acquire, our business could be harmed. Also, acquisitions can expose us to liabilities and risks facing the company we acquire, including lawsuits or claims against the company that are unknown at the time of the acquisition. 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. In addition, our operating results may suffer because of acquisition-related costs or amortization expenses or charges relating to acquired goodwill and other intangible assets.

The role of acquisitions in our future growth may be limited, which could harm our business and strategy.

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. In the past, acquisitions have been an important part of our growth strategy. To gain access to key technologies, new products and broader customer bases, we have acquired

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companies in exchange for shares of our common stock. 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.

Compliance with new regulations governing public company corporate governance and reporting will result in additional costs.

Our continuing preparation for and implementation of various corporate governance reforms and enhanced disclosure laws and regulations adopted in recent years requires us to incur significant additional accounting and legal costs. We, like other public companies, are preparing for new accounting disclosures required by laws and regulations adopted in connection with the Sarbanes-Oxley Act of 2002. In particular, we are preparing to provide, if required, beginning with our annual report on Form 10-K for the fiscal year ending December 31, 2005, an annual report on our internal control over financial reporting and auditors’ attestation with respect to our report required by Section 404 of the Sarbanes-Oxley Act. Any unanticipated difficulties in preparing for and implementing these and other corporate governance and reporting reforms could result in material delays in compliance or significantly increase our costs. Also, there can be no assurance that we will be able to fully comply with these new laws and regulations. Any failure to timely prepare for and implement the reforms required by these new laws and regulations could significantly harm our business, operating results, and financial condition.

Changes in the accounting treatment of stock options could adversely affect our results of operations.

In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, Share-Based Payment to require companies to expense employee stock options for financial reporting purposes. This standard is effective for the Company for our annual period beginning on January 1, 2006. Such stock option expensing will require us to value our employee stock option grants pursuant to an option valuation formula and amortize that value against our earnings over the vesting period in effect for those options. We currently account for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and have adopted the disclosure-only alternative of SFAS No. 123, Accounting for Stock-Based Compensation. When we are required to expense employee stock options in the future, this change in accounting treatment could materially and adversely affect our reported results of operations as the stock-based compensation expense would be charged directly against our reported earnings. For pro forma disclosure illustrating the effect such a change on our recent results of operations, see Note 1 (o) of the Consolidated Financial Statements. The adoption of SFAS 123R could adversely affect our ability to comply with the profitability covenants of our credit facility with our bank.

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 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 ability to issue this preferred stock provides us with flexibility in connection with possible acquisitions and other corporate purposes, it can also be used to 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. Furthermore, our board of directors is divided into three classes, only one of which is elected each year. In addition, directors are only 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.

Risks Related to Our Industry

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