SWK Holdings Corp - Quarter Report: 2004 September (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 30, 2004

For the transition period from                      to                     

Commission File number 000-27163

KANA Software, Inc.

(Exact Name of Registrant as Specified in its Charter)

181 Constitution Drive

Menlo Park, California 94025

(Address of Principal Executive Offices)

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

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

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

On October 29, 2004, approximately 29,299,263 shares of the Registrant’s Common Stock, $0.001 par value per share, were outstanding.

Table of Contents

KANA Software, Inc.

Form 10-Q

Quarter Ended September 30, 2004

Index

Table of Contents

Part I: Financial Information

KANA SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

3

Table of Contents

KANA SOFTWARE, INC

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

4

Table of Contents

KANA SOFTWARE, INC

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

5

Table of Contents

KANA SOFTWARE, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1. Basis of Presentation and Summary of Revenue Recognition Policy

The unaudited condensed consolidated financial statements have been prepared by KANA Software, Inc. (“KANA” or the “Company”), and reflect all normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the interim financial information under US GAAP. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year ending December 31, 2004. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted under the Securities and Exchange Commission’s (“SEC”) rules and regulations. These unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with KANA’s audited consolidated financial statements and notes included in KANA’s annual report on Form 10-K for the year ended December 31, 2003.

Certain reclassifications have been made to the prior year’s financial statements to conform with the current year’s presentation. These reclassifications had no effect on prior year’s stockholders’ equity or results of operations.

The consolidated financial statements include the financial statements of KANA and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

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

The Company believes that its existing cash balances and anticipated cash flows from operations will be sufficient to meet its anticipated capital requirements for the next 12 months. However, failure to increase future orders and revenues beyond the level achieved in the first nine months of 2004 would require the Company to seek additional capital to meet its working capital needs during or beyond the next twelve months if the Company is unable to reduce expenses to the degree necessary to avoid incurring losses. If the Company has a need for additional capital resources, it may be required to sell additional equity or debt securities, secure additional lines of credit or obtain other third party financing. The timing and amount of such capital requirements cannot be determined at this time and will depend on a number of factors, including demand for the Company’s products and services. There can be no assurance that such additional financing will be available on satisfactory terms when needed, if at all. Failure to raise such additional financing, if needed, may result in the Company not being able to achieve its long-term business objectives.

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

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.

6

Table of Contents

Consulting revenues are generated primarily by providing specific subject matter expertise as opposed to overall project management and are recognized as services are performed.

Revenues from training services are recognized as services are performed.

Note 2. Recent Accounting Pronouncements

In May 2003, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 150, ”Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. In November 2003, the FASB issued FASB Staff Position No. FASB 150-03 which deferred the measurement provisions of SFAS No. 150 indefinitely for certain mandatorily redeemable non-controlling interests that were issued before November 5, 2003. The FASB plans to reconsider implementation issues and, perhaps, classification or measurement guidance for those non-controlling interests during the deferral period. To date, the effective provisions of SFAS No. 150 have not had a material impact on the Company’s results of operations, financial position or cash flows and the deferred elements of SFAS No. 150 are not expected to have a material impact on the Company’s financial position, results of operations or cash flows when they become effective.

In March 2004, the FASB approved Emerging Issues Task Force (“EITF”) Issue 03-06 “Participating Securities and the Two-Class Method under FAS 128”. EITF Issue 03-06 supersedes the guidance in Topic No. D-95, “Effect of Participating Convertible Securities on the Computation of Basic Earnings per Share”, and requires the use of the two-class method for participating securities. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. In addition, EITF Issue 03-06 addresses other forms of participating securities, including options, warrants, forwards and other contracts to acquire an entity’s common stock, with the exception of stock-based compensation (unvested options and restricted stock) subject to the provisions of APB Opinion No. 25 and FASB Statement No. 123. EITF Issue 03-06 is effective for reporting periods beginning after March 31, 2004 and should be applied by restating previously reported earnings per share. The adoption of EITF Issue 03-06 did not have a material impact on the Company’s financial position, results of operations or cash flows.

Note 3. Business Combinations and Identifiable Intangible Assets

On February 10, 2004, the Company completed the acquisition of a 100% equity interest in Hipbone, Inc. (Hipbone), a provider of online customer interaction solutions. The acquisition allows the Company to add Hipbone’s Web collaboration, chat, co-browsing and file-sharing capabilities to its products. This transaction was accounted for using the purchase method of accounting, and operations of the acquired entity from February 10, 2004 are included in the Company’s statement of operations for the nine-month period ended September 30, 2004. Under the terms of the agreement, the Company paid $265,000 and issued a total of 262,500 shares of KANA’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. The estimated purchase price was approximately $1.4 million, summarized as follows (in thousands):

7

Table of Contents

As of the acquisition date, the Company recorded the fair market value of Hipbone’s assets and liabilities. Fair market value is defined as the amount at which an asset could be bought or sold in a current transaction between willing parties. The values of Hipbone’s intangible assets were determined primarily using the income approach. To the extent that the purchase price exceeded the fair value of the assets and liabilities assumed, goodwill was recorded. The resulting intangible assets acquired in connection with the acquisition are being amortized over a three-year period. The allocation of the purchase price to assets acquired and liabilities assumed was as follows (in thousands):

In addition, in connection with the Company’s acquisition of Silknet Software, Inc. (“Silknet”) in April 2000, the Company acquired purchased intangible assets of $14.4 million relating to existing technology of Silknet. The purchased intangible assets related to Silknet were fully amortized as of April 2003.

Purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the assets, which is three years. The Company reported amortization expense on purchased intangible assets of $85,000 and approximately $1.5 million for the nine months ended September 30, 2004 and 2003, respectively. For the nine months ended September 30, 2004, $54,000 of the amortization expense which related to purchased technology from Hipbone was included in cost of licenses.

The Company’s identifiable intangible assets are reviewed for impairment whenever events or changes in circumstance indicate that the carrying amount of an intangible may not be recoverable.

Expected amortization expense is $118,000 in 2004, $132,000 in 2005 and 2006, and $18,000 in 2007. Of these amounts, 62.5% relates to purchased technology and 37.5% relates to customer relationships, based upon the allocation of the Hipbone purchase price above.

Note 4. Stockholders’ Equity

(a) Warrants

In September 2000, in connection with a global strategic alliance with Accenture, the Company issued to Accenture 40,000 shares of common stock and a warrant to purchase up to 72,500 shares of common stock at $371.25 per share, through December 2005. The shares of the common stock issued were fully vested, and the Company reported a charge of approximately $14.8 million, which was amortized over the term of the associated warrant agreement through December 2003. As of September 30, 2004, 33,997 shares of common stock subject to the warrant were fully vested and 38,503 had been forfeited. The warrant was valued using the Black-Scholes model, resulting in charges totaling $2.0 million of which $1.0 million was amortized over the term of the associated alliance agreement through December 2003 and $1.0 million was immediately expensed in the fourth quarter of 2000.

In September 2001, the Company issued to Accenture an additional warrant to purchase up to 150,000 shares of common stock at $3.33 per share in connection with its global strategic alliance. The warrant was exercised in February 2002 on a net basis, where Accenture surrendered 39,716 shares subject to the warrant in lieu of paying the exercise price with cash. The warrant was valued using the Black-Scholes model resulting in a charge of approximately $946,000, which is being amortized on a straight-line basis over the term of the associated alliance agreement through September 2004.

In September 2001, the Company issued to a customer a warrant to purchase up to 5,000 shares of common stock at $7.50 per share, exercisable until September 2006. The warrant will be fully vested in September 2006 and has a provision for acceleration of vesting with respect to 1,250 shares annually over four years if the customer meets certain marketing criteria. The warrant was valued using the Black-Scholes model resulting in a charge to stock-based compensation of approximately $29,000, which is being amortized over the five-year term of the agreement on a straight-line basis.

In December 2003, the Company issued to a customer a warrant to purchase up to 230,000 shares of common stock at $5.00 per share in connection with a marketing agreement. The warrant is fully exercisable and expires five years from the date of issuance. The warrant was valued at approximately $459,000, using the Black-Scholes model, and its issuance was accounted for as a reduction of revenue in the fourth quarter of 2003.

(b) Stock-Based Compensation

The Company accounts for its 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

8

Table of Contents

stock-based compensation is recorded on the date of grant if 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.

The Company accounts for stock-based compensation arrangements with non-employees in accordance with Emerging Issues Task Force Abstract No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”. Accordingly, unvested options and warrants held by non-employees are subject to revaluation at each balance sheet date based on the then-current fair market value of the Company’s common stock.

The Company amortizes deferred stock-based compensation on an accelerated basis by charges to operations over the vesting period of the options, consistent with the method described in FASB Interpretation No. 28 (“FIN 28”). As of September 30, 2004, there was approximately $104,000 of total deferred stock-based compensation remaining to be amortized related to warrants and past employee stock option grants. The Company expects to amortize approximately $50,000 of this deferred stock-based compensation in the remainder of 2004, and approximately $54,000 in 2005. Amortization may be reduced in future periods to the extent employees are terminated prior to vesting.

The Company has adopted the disclosure requirements of SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure”. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair-value based method of accounting for stock-based compensation provided for by SFAS No. 123, “Accounting for Stock Based Compensation”. The following table presents pro forma amounts if the Company had adopted SFAS No. 123 and accounted for stock-based compensation using the fair-value based method (in thousands, except per share amounts):

9

Table of Contents

Note 5. Net Loss Per Share

Basic net loss per share is computed using the weighted–average number of outstanding shares of common stock, excluding common stock subject to repurchase. Diluted net loss per share is computed using the weighted-average number of outstanding shares of common stock and, when dilutive, shares of common stock issuable upon exercise of options and warrants deemed outstanding using the treasury stock method. The following table presents the calculation of basic and diluted net loss per share (in thousands, except net loss per share):

All outstanding warrants and stock options have been excluded from the calculation of diluted net loss per share as all such securities were anti-dilutive for all periods presented. The total number of shares excluded from the calculation of diluted net loss per share was (in thousands):

Note 6. Comprehensive Loss

Comprehensive loss is comprised of net loss, unrealized gains and losses on short-term investments and foreign currency translation adjustments. The total changes in comprehensive loss during the three and nine months ended September 30, 2004 and 2003 were as follows (in thousands):

10

Table of Contents

Note 7. Commitments and Contingencies

(a) Legal Proceedings

The underwriters for KANA’s 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 the Company’s 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, the Company decided to join in a settlement negotiated by representatives of a coalition of issuers named as defendants in this action and their insurers. Although KANA believes that the plaintiffs’ claims have no merit, the Company has decided to accept the settlement proposal to avoid the cost and distraction of continued litigation. The proposed settlement agreement is subject to final approval by the court. Should the court fail to approve the settlement agreement, KANA believes it has meritorious defenses to these claims and would defend the action vigorously. Because the settlement will be funded entirely by KANA’s insurers, KANA does not believe that the settlement will have any effect on its financial condition, results of operation or cash flows.

On April 16, 2002, Davox Corporation (now Concerto Software) filed an action against the Company in the Superior Court, Middlesex, Commonwealth of Massachusetts, asserting breach of contract, breach of implied covenant of good faith and fair dealing, unjust enrichment, misrepresentation and unfair trade practices, in relation to an OEM Agreement between the Company and Concerto. The Company settled this matter on October 6, 2004 pursuant to a settlement agreement with Concerto and the Company’s insurance company. Under the settlement agreement, in exchange for a release by the parties of all claims related to the action, the Company and its insurer agreed to pay Concerto a total of $1.3 million, with the insurer paying $650,000 and the Company paying Concerto $500,000 in October 2004, and an additional $150,000 in January 2005. The Company’s obligation was fully accrued at September 30, 2004.

Third parties have from time to time claimed, and others may claim in the future that the Company has infringed their past, current or future intellectual property rights. The Company has 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 the Company to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm the Company’s business.

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

(b) Guarantees

The Company leases its facilities under noncancelable operating leases with various expiration dates through December 2010. As of September 30, 2004, in connection with its existing leases, the Company has outstanding letters of credit totaling $0.9 million expiring in 2004 through 2011. The letters of credit are supported by either restricted cash or the Company’s line of credit.

(c) Indemnifications

The Company enters into standard indemnification agreements in its ordinary course of business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party in connection with any patent, copyright, or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is generally limited to the amount of fees received on the sale. The Company believes the estimated fair value of these agreements is insignificant. Accordingly, the Company has no liabilities recorded for these agreements as of September 30, 2004.

As permitted by Delaware law, the Company has agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer is, or was, serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a director and officer insurance policy that limits its exposure and enables the Company to recover a portion of any such amounts. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is insignificant. Accordingly, the Company has no liabilities recorded for these agreements as of September 30, 2004.

11

Table of Contents

(d) Warranties

The Company offers warranties on its software products. To date, there have been no material payments or costs incurred related to fulfilling these warranty obligations. Accordingly, the Company has no liabilities recorded for these warranties as of September 30, 2004. The Company assesses the need for a warranty reserve on a quarterly basis and there can be no guarantee that a warranty reserve will not become necessary in the future.

(e) Outsourcing Arrangements

In January 2003, the Company began implementing an outsourcing strategy, which involves subcontracting a significant portion of its software programming, quality assurance and technical documentation activities to development partners with staffing in India and China. As a result of transitioning these activities offshore, the Company reduced its research and development department by 88 employees in 2003. The Company signed contracts with development partners in 2003, with billings from vendors under these contracts totaling approximately $6.7 million in the nine months ended September 30, 2004. One contract requires a 90-day notice for cancellation, which would result in continued payments totaling $840,000 during the notice period.

Note 8. Restructuring costs

As of September 30, 2004, $7.9 million in restructuring liabilities remained on the Company’s unaudited consolidated balance sheet in accrued restructuring costs. Cash payments for excess leased facilities during the nine months ended September 30, 2004 totaled approximately $2.6 million. Cash received during the nine months ended September 30, 2004 from subleases, totaled $141,000. The following table provides a summary of restructuring payments and liabilities during the first nine months of 2004 (in thousands):

If facilities rental rates continue to decrease, or if it takes longer than expected to find a suitable tenant to sublease the excess facilities, the actual loss could exceed this estimate. Future cash outlays are anticipated through December 2010 unless the Company negotiates to exit the leases at an earlier date.

Note 9. Segment Information

The Company’s chief operating decision-maker reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single industry segment, specifically the license, implementation and support of its software applications. The Company’s long-lived assets are primarily in the United States. The following table provides geographic information on revenue, based upon the location of the customers, for the three and nine months ended September 30, 2004 and 2003 (in thousands):

12

Table of Contents

During the three and nine months ended September 30, 2004, one customer represented 23% and 11%, respectively, of total revenues. During the three and nine months ended September 30, 2003, another customer represented 13% and 4%, respectively, of total revenues.

Note 10. Notes Payable and Other Obligations

At September 30, 2004, the Company maintained a line of credit totaling $5.0 million, which is collateralized by all of its assets and bears an annual interest rate equal to the greater of the bank’s prime rate or 4.0% (4.75% as of September 30, 2004 and 4.25% as of September 30, 2003). Total borrowings as of September 30, 2004 and 2003 were $3.4 million under this line of credit. The line of credit contained a financial covenant that required the Company to maintain at least a $6.0 million balance in cash or cash equivalents with the lending bank at all times or pay a one-time fee of $10,000. The line of credit also required that the Company maintain at all times a minimum of $20.0 million as short-term unrestricted cash and cash equivalents and short-term investments. As of September 30, 2004, the Company was in compliance with all financial covenants. The line of credit was renewed in November 2004. The renewed line of credit contains a financial covenant that requires the Company to maintain at least a $7.0 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 that the Company maintain at all times a minimum of $13.0 million as short-term unrestricted cash and cash equivalents and short-term investments. The line of credit expires in November 2005, at which time the entire balance of the line of credit will be due.

Future payments due under the Company’s debt and other obligations as of September 30, 2004 were as follows (in thousands):

The following discussion of our financial condition and results of operations and other parts of this report contains forward-looking statements that are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as “anticipate,” “believe,” “estimate,” “expects,” “intend,” “plan,” “will” 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 those described in “Risk Factors” and elsewhere in this report. Forward-looking statements that were believed to be true at the time made may ultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our

13

Table of Contents

management’s view only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

Overview

We are a leading provider of Service Resolution Management (SRM) software solutions. SRM refers to 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 a high volume 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 training and consulting. Our products are generally installed by our customers, using a system integrator, such as IBM, Accenture or Bearing Point. To a large degree, we rely on our relationships with these 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, the overall cost of implementing our software can be increased substantially, subjecting the prospective customers’ 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 period in which sales to expected customers will occur, if at all, which results in greater uncertainty with respect to our future operating results. To the extent that significant sales occur earlier or later than anticipated, revenues for subsequent quarters may be higher or lower, 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, reduced our costs and focused our product offerings.

In the past four years, we have experienced a cautious purchasing environment in our industry. We feel that this is 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 that our market continued to exhibit cautiousness and uncertainty and that as a result, many enterprises continued to be reluctant to invest in large software applications, particularly in our industry.

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 three and nine months ended September 30, 2004, we recorded a net loss of $3.4 million and $13.9 million, respectively. As of September 30, 2004, we had an accumulated deficit of $4.3 billion, which included approximately $2.7 billion related to goodwill impairment charges in prior years. We expect our total operating expenses in 2004 to be lower in absolute dollars than in 2003 as a result of our personnel and facility cost reductions throughout 2003. 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.

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 Bearing Point with staffing in India and China.

In November 2003, we announced the completion of an underwritten public offering of 4,080,000 shares of our common stock at a price to the public of $3.00 per share. We offered the common stock under our shelf registration statement. In addition to the 4,080,000 shares sold in the public offering, the underwriter exercised, in full, an option to purchase a maximum of 612,000 additional shares to cover over-allotments of shares. The proceeds from the offering, net of expenses, were approximately $13.1 million.

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. As a result of this acquisition, we now offer Hipbone’s Web collaboration, chat, co-browsing and file-sharing capabilities.

14

Table of Contents

KANA is headquartered in the Silicon Valley in Menlo Park, California, with offices in Japan, Korea, and throughout the United States and Europe. As of September 30, 2004, we had 187 full-time employees, which represents a slight decrease from 211 employees at December 31, 2003.

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. 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, 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. Revenue recognition rules for software companies are complex, and various judgments affect the recognition of revenues. The amount and timing of our revenue is difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.

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

In software arrangements that include rights to multiple software products and/or services, we allocate 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 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. Evaluating whether sufficient and appropriate vendor-specific objective evidence exists to use in allocating revenue to undelivered elements, and the interpretation of such evidence to determine the fair value of undelivered elements is subject to judgment and estimates that affect when and to what extent we may recognize revenues from a given contractual arrangement.

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. We 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 generated primarily by providing specific subject matter expertise as opposed to overall project management and are recognized as services are performed.

Revenues from training services 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

15

Table of Contents

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 service revenue in the second quarter of 2002 and in accordance with the terms of the amendment 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, which we reported as deferred revenue. The $4.0 million is being recognized as revenue as we fulfill our support and training obligations. As of September 30, 2004, we had recognized $2.1 million of the $4.0 million as revenue, and $1.9 million remained in deferred revenue, of which $1.1 million relates to support and will be recognized in equal installments through the first quarter of 2006. The remaining $0.9 million relates 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.

Collectibility of Receivables. In order to recognize revenue from a transaction, collectibility must be determined by management to be reasonably assured. If collectibility is not determined to be reasonably assured, amounts billed to customers are recorded as deferred revenue. For sales to existing customers, prior payment history is a factor in assessing probability of collection.

We make judgments as to our ability to collect outstanding receivables and provide allowances for receivables that may not be collectible. A considerable amount of judgment is required to assess the ultimate realization of receivables. In assessing collectibility, we consider the age of the receivable, our historical collection experience, current economic trends, and the current credit-worthiness of each customer. In the future, additional provisions for doubtful accounts may be needed and future results of operations could be materially affected.

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 September 30, 2004, we had $8.8 million of capitalized costs of internal use software, net of $6.3 million of 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 of these assets. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows 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. Based on our assessment as of September 30, 2004, we determined that no such impairment of internal-use software existed.

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 estimated exit costs of $7.9 million in accrued restructuring costs relating to excess leased facilities as of September 30, 2004. We have worked with real estate brokers in each of the markets where the properties are located to help us estimate the amount and timing of potential sub-leases for the respective facilities. This process involves significant judgments regarding these markets. If we determine that any of these real estate markets continues to deteriorate, additional adjustments to this accrual may be required, which would result in additional restructuring expenses in the period in which such determination is made. For example, in December 2003, we recorded $1.7 million in restructuring costs related to a change in evaluation of real estate market

16

Table of Contents

conditions in the United Kingdom, and changes in sublease estimates based on communication from current and potential subtenants in the United States. 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 September 30, 2004, our estimate of accrued restructuring cost assumes receipt of $10.7 million in sublease payments that are not yet subject to any contractual arrangement and, in most cases, a potential sublessor 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, Goodwill and Other Intangible Assets (“SFAS 142”). We are now required to test goodwill for impairment at least annually and write down goodwill when it is impaired. We have determined that our consolidated results comprise one reporting unit for the purpose of impairment testing through September 30, 2004.

During the three months ended June 30, 2004 we performed our annual test for goodwill impairment as required by SFAS 142. We completed our evaluation and concluded that goodwill was not impaired as the fair value of KANA exceeded its carrying value, including goodwill. The amount of goodwill as of September 30, 2004 was $8.6 million. 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.

We continually monitor for any potential indicators of impairment of goodwill and we have determined that no such indicators have arisen during 2004. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

Intangible assets are reviewed for impairment whenever events or changes in circumstance indicate that the carrying amount of an intangible may not be recoverable. Intangible assets are comprised of purchased technologies and acquired customer lists.

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 utilized to offset future taxable income and to the extent we believe that such offset is not likely, we establish a valuation allowance. We have 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.

17

Table of Contents

Results of Operations Data

The following table sets forth selected data for the indicated periods. Percentages are expressed as a percentage of total revenues (in thousands, except %’s).