SWK Holdings Corp - Quarter Report: 2007 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 30, 2007

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.    x  YES    ¨  NO

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

Large Accelerated Filer  ¨            Accelerated Filer  ¨            Non-Accelerated Filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  YES    x  NO

On October 31, 2007, approximately 36,832,485 shares of the registrant’s Common Stock, $0.001 par value per share, were outstanding.

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Kana Software, Inc.

Form 10-Q

Quarter Ended September 30, 2007

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PART I. FINANCIAL INFORMATION

KANA SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(Unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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KANA SOFTWARE, INC

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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KANA SOFTWARE, INC

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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KANA SOFTWARE, INC.

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Kana Software, Inc. and Summary of Significant Accounting Policies

Nature of Operations

Kana Software, Inc. and its subsidiaries (the “Company” or “KANA”) were incorporated in July 1996 in California and reincorporated in Delaware in September 1999. KANA develops, markets and supports customer communications software products. The Company sells its products primarily in the United States and Europe, and to a lesser extent, in Asia, through its direct sales force and third party integrators. References to “we,” “our” and “us” and “Company” collectively refer to KANA, our predecessor and our subsidiaries and their predecessors.

Principles of Consolidation

The unaudited condensed consolidated financial statements include the accounts of KANA and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated.

Unaudited Interim Financial Information

The unaudited condensed consolidated financial statements have been prepared by KANA and reflect all normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the interim financial information. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year ending December 31, 2007. 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 rules and regulations of the Securities and Exchange Commission (“SEC”). 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, 2006, filed with the SEC on April 2, 2007. The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

Restatement Relating to Stock-Based Compensation and Other Revenue and Expense Items

The financial information as of and for the three and nine months ended September 30, 2006 is restated since it has been revised from the amounts previously stated in our Quarterly Report on Form 10-Q filed with the SEC on November 13, 2006. Subsequent to the issuance of the Company’s interim condensed consolidated financial statements for the quarter ended September 30, 2006, the Company determined that non-cash compensation expenses relating to certain options granted in 1999 were incorrectly recorded in the first, second and third quarters of 2006. Additionally, certain other revenue and expense items were recorded in the improper quarter within 2006. The restatement is further discussed in Note 14 of the consolidated financial statements in the Company’s Form 10-K for the year ended December 31, 2006 filed with the SEC on April 2, 2007.

Use of Estimates

The preparation of the interim unaudited condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ materially from those estimates.

Revenue Recognition

The Company recognizes revenues in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended.

Revenue from software license agreements is recognized when the basic criteria of software revenue recognition have been met (i.e. persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable, and collection is probable). The Company uses the residual method described in AICPA SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” (“SOP 98-9”), to recognize revenue when a license agreement includes one or more elements to be delivered at a future date and vendor-specific objective evidence of the fair value of all undelivered elements exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as license revenue. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established.

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For all sales the Company uses either a signed license agreement, a signed amendment to an existing license agreement, a signed order form, a binding purchase order where we either have a signed master license agreement or an order form signed by the customer, or a signed statement of work as evidence of an arrangement.

Software delivery is primarily by electronic means. If the software or other deliverable is subject to acceptance for a specified period after the delivery, revenue is deferred until the acceptance period has expired or the acceptance provision has been met.

When licenses are sold together with consulting services, license fees are recognized upon delivery, provided that (1) the basic criteria of software revenue recognition have been met, (2) payment of the license fees is not dependent upon the performance of the consulting services, and (3) the consulting services do not provide significant customization of the software products and are not essential to the functionality of the software that was delivered. The Company does not provide significant customization of its software products.

Revenue arrangements with extended payment terms are generally considered not to be fixed or determinable, and the Company generally does not recognize revenue on these arrangements until the customer payments become due and all other revenue recognition criteria have been met.

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 revenue recognition and our results of operations.

Services revenues include revenues for consulting services, customer support and training, OnDemand and hosting. Consulting services revenues are generally recognized on a time and materials basis. For consulting services contracts that have a fixed fee, the Company recognizes the license and professional consulting services revenues using either the percentage-of-completion method or the completed contract method as prescribed by AICPA SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Product-Type Contracts” (“SOP 81-1”). KANA’s consulting arrangements do not include significant customization of the software. Customer support agreements provide technical support and the right to unspecified future upgrades on an if-and-when available basis. Customer support revenues are recognized ratably over the term of the support period (generally one year). Training services revenues are recognized as the related training services are delivered. The unrecognized portion of amounts billed in advance of delivery for services is recorded as deferred revenue. OnDemand includes our KANA OnDemand ‘software as a service’ and outsourcing offerings as well as Advanced Customer Services. OnDemand revenue is recognized in accordance with the SEC Staff Accounting Bulletin No. 104, “Revenue Recognition, corrected copy” (“SAB 104”). Revenues from OnDemand services are recognized ratably over the term of the arrangement, while application fees are recognized ratably over the sum of the term of the arrangement and the term of expected renewals. Hosting service arrangements are a means of deployment whereby the customer’s software and data is physically located in third party facilities. Customers pay a fee to remotely access the hosted software and data via a secure internet connection. Hosting fees are recognized as the hosting service is delivered in accordance with SAB 104.

Vendor-specific objective evidence for consulting and training services are 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 support services is generally based on the price charged when an element is sold separately or the stated contractual renewal rates.

Stock-Based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors, including employee stock options and employee stock purchases under an employee stock purchase plan, based on estimated fair values.

Stock-based compensation expense recognized during the three and nine months ended September 30, 2007 and 2006 is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We use the Black-Scholes option pricing model for determining the estimated fair value for stock-based awards. The Black-Scholes model requires the use of highly subjective and complex assumptions which determine the fair value of stock-based awards, including the option’s expected term and the price volatility of the underlying stock.

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Employee stock-based compensation expense recognized under SFAS 123(R) was $729,000 and $1.5 million for the three months ended September 30, 2007 and 2006, respectively, and $2.1 million for each of the nine month periods ended September 30, 2007 and 2006. The effect on net income (loss) per share for the three months ended September 30, 2007 and 2006 was $0.02 and $0.04 per share, respectively, and $0.06 per share for the nine month periods ended September 30, 2007 and 2006, respectively.

For stock options granted to non-employees, the Company recognizes compensation expense in accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which require such equity instruments to be recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying equity instruments vest. The Company amortizes compensation expense related to non-employee stock options in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” (“FIN 28”). In 2005 and 2006, the Company extended the vesting period of approximately 1,000,000 stock options held by four terminated employees who had agreements to provide consulting services. In fiscal year 2006, the Company granted a total of 57,500 stock options to four non-employees who had agreements to provide consulting services. During the three and nine months ended September 30, 2007 there were no stock option grants to non-employees.

As a result of these stock option modifications to former employees and the stock option grants to consultants, the Company recorded non-employee stock-based compensation expense of $2,000 and $266,000 for the three months ended September 30, 2007 and 2006, respectively, and expense of $105,000 and $520,000 for the nine months ended September 30, 2007 and 2006, respectively, allocated as follows:

Net Income (Loss) per Share

Basic net loss per share is computed using the weighted average number of outstanding shares of common stock. 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 per share amounts):

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For each of the three and nine month periods ended September 30, 2007, outstanding stock options and warrants to purchase common stock in an aggregate of approximately 13,053,000 shares have been excluded from the calculation of diluted net loss per share as all such securities were anti-dilutive. For the three and nine month periods ended September 30, 2006, outstanding stock options and warrants to purchase common stock in an aggregate of approximately 7,740,000 and 12,119,000 shares, respectively, have been excluded from the calculation of diluted net loss per share as all such securities were anti-dilutive.

Effect of Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. The standard requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of a company’s choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which a company has chosen to use fair value on the face of the balance sheet. This statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS 157. The Company is currently evaluating whether the adoption of SFAS 159 will have a material effect on its financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). The purpose of SFAS 157 is to define fair value, establish a framework for measuring fair value and enhance disclosures about fair value measurements. The measurement and disclosure requirements are effective for the Company beginning in the first quarter of fiscal 2008. The Company is currently evaluating the effects of implementing SFAS 157.

In June 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement 109” (“FIN 48”). FIN 48 establishes a single model to address accounting for uncertain tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company adopted FIN 48 on January 1, 2007. During the implementation, the Company identified, evaluated, and measured the amount of income tax benefits to be recognized for all material income tax positions. The net assets recognized under FIN 48 did not materially differ from the net assets recognized before adoption, and, therefore, the Company did not record an adjustment related to the adoption of FIN 48. At the adoption date of January 1, 2007, the Company had $145,000 of unrecognized tax benefits, all of which would affect the Company’s effective tax rate if recognized. At September 30, 2007, the Company had $145,000 of unrecognized tax benefits.

Our continuing practice is to recognize interest and/or penalties related to income tax matters as a component of income tax expense. Upon implementation of FIN 48 approximately $28,000 of accrued interest and penalties had already been recorded related to uncertain tax positions. There was no change in the amount of unrecognized tax benefits or accrued interest and penalties during the third quarter ended September 30, 2007.

The tax years 2003-2006 remain open to examination by the major taxing jurisdictions to which the Company is subject.

Note 2. Goodwill and Intangible Assets

Additions to purchased intangible assets during the nine months ended September 30, 2007, include $2.5 million of customer relationships purchased in connection with the acquisition of eVergance Partners LLC (“eVergance”) in June 2007. See Note 11 for further details. Purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the assets, which is five years. The Company reported amortization expense on purchased intangible assets of $125,000 and $34,000 for the three months ended September 30, 2007 and 2006, respectively, and $164,000 and $100,000 for the nine months ended September 30, 2007 and 2006, respectively.

The estimated future amortization expense of purchased intangible assets as of September 30, 2007 is as follows (in thousands):

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Additions to goodwill during the nine months ended September 30, 2007, include $3.9 million relating to the eVergance acquisition in June 2007. See Note 11 for further details.

The components of goodwill and other intangibles are as follows (in thousands):

Note 3. Stockholders’ Deficit

In May 2006, the Company amended the registration agreement related to the June and September 2005 private placements (collectively referred to as “Private Placements”) to extend the registration deadline of the shares of common stock and underlying shares of common stock of the warrants issued to September 30, 2006 from January 27, 2006 and to change the penalty for failure to register the underlying shares of common stock from a cash penalty to a share-based payment, in exchange for the issuance of 593,854 shares of common stock. The shares were valued at approximately $1.0 million based on the fair market value of the Company’s common stock on the date of the amendment less a 10% discount to reflect that unregistered stock was issued. The September 30, 2006 registration deadline was not met and an additional 59,383 shares of common stock was issued. The shares were valued at approximately $166,000 based on the fair market value of the Company’s common stock on September 30, 2006 less a 10% discount to reflect that unregistered stock was issued. Registration rights penalties of $166,000 and $1.2 million were recorded as non-operating expenses during the three and nine months ended September 30, 2006, respectively

On November 9, 2006, the Company completed the registration of the shares of common stock and shares of common stock underlying the warrants issued to the investors in the Private Placements.

The Company’s 1999 Stock Incentive Plan (the “1999 Stock Incentive Plan”), as successor to the 1997 Stock Option Plan (the “1997 Stock Option Plan”), provides for shares of the Company’s common stock to be granted to employees, independent contractors, officers, and directors. Options are granted at an exercise price equivalent to the closing fair market value on the date of grant. All options are granted at the discretion of the Company’s Board of Directors and have a term not greater than 10 years from the date of grant. Options are immediately exercisable when vested and generally vest monthly over four years.

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The following table summarizes activity under the equity incentive plans for the indicated periods:

At September 30, 2007, the Company had 6,464,912 options available for grant under its equity incentive plans.

Options vested and exercisable at September 30, 2007 include certain options which are vested but not yet exercisable. In certain situations, a stock option will be vested but not exercisable. The number of shares vested and not exercisable at September 30, 2007 was 325,662 and the weighted average exercise price of such shares as $5.06 per share.

At September 30, 2007, the Company had $4.6 million of total unrecognized stock-based compensation expense, net of estimated forfeitures, related to stock options that will be recognized over the weighted average remaining period of 2.8 years. This amount excludes unrecognized stock-based compensation expense that relates to non-employee stock options, which cannot be estimated prior to the measurement date.

The following table summarizes significant ranges of outstanding and vested and exercisable options as of September 30, 2007:

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The Company uses the Black-Scholes option pricing model for estimating the fair value of options granted under the Company’s equity incentive plans. The weighted average assumptions that were used to calculate the grant date fair value of the Company’s employee stock option grants for the three and nine months ended September 30, 2007 are as follows:

Risk-free interest rates for the options were taken from the Daily Federal Yield Curve Rates on the grant dates for the expected life of the options as published by the Federal Reserve.

The expected volatility of the stock options was based upon historical data and other relevant factors such as the Company’s changes in historical volatility and its capital structure in addition to mean reversion.

In the analysis of expected life the Company used an approach that determines the time from grant to exercise for options that have been exercised and adjusts this number for the expected time to exercise for options that have not yet been exercised. The expected time to exercise for options that have not yet been exercised is calculated from grant as the midpoint of contractual termination of the option and the later of measurement date or vesting date. All times are weighted by number of option shares in developing the expected life assumption.

The weighted-average fair value of options granted during the three and nine months ended September 30, 2007 was $1.25 and $1.52 per share, respectively.

The forfeiture rate of employee stock options for 2007 was calculated using the Company’s historical terminations data.

Note 4. Warrant Liability

The warrants issued in June, September and October 2005 (collectively referred to as the “Warrants”) had cash penalties for the failure to register the underlying shares of common stock. Pursuant to Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”), the Company recorded the Warrants as liabilities at their fair value using the Black-Scholes option pricing model with changes in value reported to other income or expense each period. For the three and nine months ended September 30, 2006, $0 and $774,000 respectively, was recorded to other expense for the change in fair value of the Warrants.

The Warrants require physical settlement but allow for net-share settlement if the underlying shares of common stock are not registered. A maximum of 1,914,586 shares of common stock could be issued to settle the Warrants under a net-share settlement.

As noted above in Note 3, in May 2006, the Company amended the registration agreements related to the Private Placements to extend the registration deadline of the shares of common stock and underlying shares of common stock of the Warrants. The Company amended the penalty for failure to register the underlying shares of common stock from cash to share-based payments, with a maximum limit of 59,383 penalty shares to be issued. Pursuant to EITF 00-19, with the elimination of these cash penalties and a maximum limit on penalty shares, the fair value of the Warrants on the date of this amendment was reclassified to equity from liability, and gains or losses recorded to account for the contract at fair value during the period that the contract was classified as a liability were not reversed.

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Note 5. Comprehensive Income (Loss)

Comprehensive income (loss) is comprised of net income (loss) and foreign currency translation adjustments. The total changes in comprehensive income (loss) during the three and nine month periods ended September 30, 2007 and 2006 were as follows (in thousands):

Note 6. Commitments and Contingencies

The Company leases its facilities under non-cancelable operating leases with various expiration dates through January 2011. In connection with its existing leases, the Company entered into letters of credit totaling $771,000 expiring in 2007 and through 2010. The Company’s letters of credit can be supported by either restricted cash or the Company’s line of credit. At September 30, 2007, the Company had $13.1 million in non-cancelable operating lease obligations offset by $4.4 million of sublease income from subleases that are under contract.

At September 30, 2007, the Company had other future contractual obligations requiring payments of $2.9 million. The obligations represent payments on a legal settlement, minimum payments to vendors for future royalty fees, marketing services, training services, consulting services, engineering services, and sales events.

On January 24, 2007, RightNow Technologies, Inc. (“RightNow”) filed a suit against the Company and four former RightNow employees who had joined the Company in the Eighteenth Judicial District Court of Gallatin County, Montana. The suit alleges violation of certain provisions of employment agreements, misappropriation of trade secrets, as well as other claims, and seeks damages. The Company is undertaking to defend itself and the named individuals to the extent required by applicable laws. The Company believes it has meritorious defenses to these claims and intends to defend against this action vigorously.

On March 16, 2006, Polaris IP, LLC filed a suit against the Company, Sirius Satellite Radio, Inc., Priceline.com, Capital One, Continental Airlines, Inc., and E*Trade Financial in the U.S. District Court for the Eastern District of Texas alleging infringement of U.S. Patent Nos. 6,411,947 and 6,278,996 and seeking injunctive relief, damages and attorneys’ fees. On March 23, 2007, the parties entered into a settlement agreement and this matter was dismissed with prejudice on April 26, 2007.

The underwriters for the Company’s initial public offering, Goldman Sachs & Co., Lehman Bros, Hambrecht & Quist LLC, Wit Soundview Capital Corp as well as the Company and certain current and former officers of the Company 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 the Company, and the underwriters for such issuers, on behalf of a class of plaintiffs who, in the case of the Company, purchased the Company’s stock between September 21, 1999 and December 6, 2000 in connection with the Company’s initial public offering. Specifically, the complaints allege that the underwriter defendants engaged in a scheme concerning sales of the Company’s and other issuers’ securities in the initial public offering and in the aftermarket. In July 2003, the Company decided to join a settlement negotiated by representatives of a coalition of issuers named as defendants in this action and their insurers. In April 2005, the court requested a modification to the original settlement arrangement which was approved by the Company. Although the Company believed that the plaintiffs’ claims had no merit, the Company had decided to accept the settlement proposal to avoid the cost and distraction of continued litigation. The Company was a party to a global settlement with the plaintiffs that would have disposed of all claims against it with no admission of wrongdoing by the Company or any of its present or former officers or directors. The settlement agreement had been preliminarily approved by the District Court. However, while the settlement was awaiting final approval by the District Court, in December 2006, the Court of Appeals

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reversed the District Court’s determination that six focus cases could be certified as class actions. In April 2007, the Court of Appeals denied plaintiffs’ petition for rehearing, but acknowledged that the District Court might certify a more limited class. At a June 26, 2007 status conference, the District Court approved a stipulation withdrawing the proposed settlement. The parties had agreed upon a July 31, 2007 deadline for plaintiffs to file an amended complaint, and a September 27, 2007 deadline for filing a motion for class certification. On July 30, 2007, the plaintiffs requested and the District Court approved an extension and theplaintiffs filed an amended complaint on August 14, 2007. On November 9, 2007, the defendants filed a motion to dismiss the complaint for failure to state a claim. The Company believes it has meritorious defenses to these claims and intends to defend against this action vigorously. Because the settlement will be funded entirely by the Company’s insurers, the Company does not believe that the settlement will have any effect on its consolidated financial condition, results of operation or cash flows and accordingly, the Company has not accrued an amount for this loss contingency in its consolidated financial statements at September 30, 2007.

Other 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 in the past has 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 the Company’s results of operations, consolidated balance sheets and cash flows, due to defense costs, diversion of management resources and other factors.

Many of our software license agreements require us to indemnify our customers for 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 was 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. Such indemnification provisions are accounted for in accordance with SFAS No. 5 “Accounting for Contingencies” (“SFAS 5”). In prior periods, the Company has incurred minimal costs related to such claims under such indemnifications provisions; accordingly, the amount of such obligations cannot be reasonably estimated. The Company did however record a settlement charge resulting from a settlement of an infringement claim on the Company’s consolidated statement of operations for the year ended December 31, 2006, which was not considered material. There were no outstanding claims of infringement at September 30, 2007.

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, 2007.

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Note 7. Restructuring Costs

The following table provides a summary of restructuring activity during the nine months ended September 30, 2007 and 2006 (in thousands):

In July 2007, we implemented various cost reduction and restructuring activities to reduce operating costs. The expense related to our reduction in work force was approximately $240,000 and expense related to ceasing use of one of our offices was approximately $8,000.

In September 2007, we agreed with the landlord of one of the facilities included in our restructuring accrual to surrender the remaining term of the lease in exchange for a lump sum cash payment. As a result of this agreement we recorded additional restructuring expense of approximately $319,000 and reclassified the long-term portion of the restructuring liability to accrued restructuring under current liabilities. Additionally, we reclassified the related lease deposit from other assets to other current assets.

Note 8. Information About Geographic Areas

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 licensing and support of its software applications. Revenue classification is based upon customer location.

Geographic information on revenues for the three and nine months ended September 30, 2007 and 2006 is as follows (in thousands):

During the three months ended September 30, 2007, one customer represented approximately 16% of revenues. During the nine month period ended September 30, 2007, no customer represented more than 10% of total revenues. During the three months ended September 30, 2006, one customer represented 15% of total revenues and during the nine months ended September 30, 2006, one customer represented 12% of total revenues.

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Geographic information on the Company’s long-lived assets (Property and Equipment, net, and Other Assets), based on physical location, is as follows (in thousands):

Note 9. Loan Payable and Note Payable

On November 30, 2005, the Company established a new banking relationship with Bridge Bank N.A. (“Bridge”) and entered into a Business Financing Agreement and Intellectual Property Security Agreement with Bridge under which the Company has access to a Loan Facility of $7.0 million (“November Loan”). This November Loan is made up of two parts: (i) a Formula Revolving Line of Credit of up to $5.0 million and (ii) a Non-Formula Revolving Line of Credit of up to $6.0 million, of which $2.0 million is available for stand-by letters of credits, settlement limits on foreign exchange contracts or cash management products. The combined total borrowing under the two parts cannot exceed $7.0 million. The Formula Revolving Line of Credit is collateralized by all of our assets and expired on November 29, 2006. Interest for the Formula Revolving Line of Credit accrues at Bridge’s Prime Lending Rate plus 2% while interest for the Non-Formula Revolving Line of Credit accrues at Bridge’s Prime Lending Rate plus 0.50%. On December 29, 2005, the Company entered into a Business Financing Agreement with Bridge, which provided for additional advances up to $1.5 million based on an advance rate of 80% of eligible receivables. The overall November Loan was increased to $7.5 million.

On March 30, 2006, the Company modified the Business Financing Agreement with Bridge to increase the additional advances for accounts receivable to $2.0 million and the overall November Loan to $8.0 million.

On November 28, 2006 the Business Financing Agreement was further modified to extend the expiration date to February 28, 2007.

On February 27, 2007, the Company entered into an Amended and Restated Loan and Security Agreement with Bridge under which the Company has access to a Loan facility of $10.0 million (“February Loan”). The February Loan is a formula based revolving line of credit based on 80% of eligible receivables subject to two sub limits; a sub-limit of $2.5 million that is available for stand-by letters of credit, settlement limits on foreign exchange contracts or cash management products and a maximum amount of $5.0 million available as a term loan. The total combined borrowing under the February Loan and sub-limits cannot exceed $10.0 million. The February Loan is collateralized by all of the Company’s assets and expires February 27, 2009 at which time the entire balance under the formula based line of credit will be due. The Company has a twelve month period to draw down against the term loan, which is repaid over a 36 month period. Interest for the formula based revolving line of credit accrues at the Wall Street Journal’s (“WSJ”) Prime Lending Rate plus 1.25% while interest for the term loan accrues at the WSJ’s Prime Lending Rate plus 1.75%. The February Loan contains certain restrictive covenants including but not limited to certain financial covenants such as maintaining profitability net of stock-based compensation and maintenance of certain key ratios. If the Company is not in compliance with the covenants of the February Loan, Bridge has the right to declare an event of default and all of the outstanding balances owed under the February Loan would become immediately due and payable.

On May 7, 2007, the Company entered into a Second Amendment to the February Loan with Bridge (the “Second Amendment”) in which Bridge waived the Company’s compliance with certain financial ratios for any period prior to the month and quarter ending June 30, 2007 and consented to the Company’s acquisition of eVergance. The terms of the Second Amendment limit the maximum borrowing under the February Loan to $5 million until the Company has met certain restrictive covenants for two consecutive quarters.

On June 14, 2007, the Company entered into a Third Amendment to the February Loan (the “Third Amendment”) which provided for additional loans to the Company in the amount of $1.5 million, all of which were advanced on June 14, 2007, to fund mergers and acquisitions activities and pay acquisition related expenses. The Third Amendment also provides for an additional $500,000 of such loans to be available to the Company under certain circumstances. These loans were required to be repaid on October 1, 2007, and bear interest at the lender’s prime rate plus 1.75%. In addition, the Third Amendment provides for Bridge to make equipment advances to the Company from time to time to finance capital expenditures, in an aggregate amount of up to $1 million (subject to increase to $2 million under certain circumstances). These equipment advances will bear interest at the lender’s prime rate plus 1.25%, subject to reduction under certain circumstances, and are required to be repaid in 33 monthly installments beginning on March 31, 2008. The Third Amendment also modified the financial covenants set forth in the February Loan, provided for the payment of certain fees to Bridge, and limited the total amount of loans under the February Loan to $10 million (excluding equipment advances).

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On August 21, 2007, the Company entered into a Loan and Security Modification Agreement to the February Loan that provided a one-time waiver for of out-of-compliance conditions with certain financial covenants that existed for the period ended June 30, 2007.

On October 3, 2007, the Company entered into a Loan and Security Modification Agreement to the February Loan (the “October 3rd Modification”) that provided a one-time waiver for of out-of-compliance conditions with certain financial covenants that existed for the period ended July 31, 2007. In addition, the October 3 Modification extended the due date for the repayment of loans related to mergers and acquisitions until November 30, 2007. Maturity of the other loans remains the same as agreed in the February Loan as described above. The October 3rd Modification also provided that in lieu of compliance with certain financial covenants the Company may sell its equity securities in an underwritten offering pursuant to a registration statement filed under the Securities Act of 1933 and provided for the payment of certain fees to Bridge.

As of September 30, 2007, the Company had $6.5 million drawn against the February Loan all of which is shown as current liabilities on the condensed consolidated balance sheet as the Company was not in compliance with certain financial covenants.

As of September 30, 2007, there was $2.1 million classified as current portion of note payable and $115,000 classified as long-term. The long-term portion was included in other long-term liabilities on the condensed consolidated balance sheet. The note payable consists of three obligations. The first is a promissory note with De Lage Landen Financial Services, Inc. for the financing of software license and support purchased and has a fixed interest rate of 3.15%, payable in monthly installments of principal and interest. The second is with First Insurance Funding Corp of California for short-term financing of Errors and Omissions insurance and has a fixed interest rate of 9.87%, payable in monthly installments of principal and interest. The third is to former members of eVergance in connection with the acquisition of all the membership interests of eVergance and bears no interest. This note was recorded at its present value using a discount rate of 9.5%. The Company recognizes imputed interest expense as the note matures. At September 30, 2007, the Company had future payments of $562,000 for the three months ending December 2007, and $1.7 million and $73,000 for the years ending December 2008 and 2009, respectively, with no required payments thereafter. As of December 31, 2006, there was $327,000 classified as current portion of note payable and $242,000 classified as long-term.

Note 10. Related Party Transactions

On October 30, 2006, the Company entered into a consulting agreement (“the Consulting Agreement”) with William T. Clifford, a member of KANA’s Board of Directors. Mr. Clifford provided consulting services to KANA’s management as an independent contractor on matters pertaining to strategic planning and business (in addition to his role as a member of the Board of Directors) for a period of twelve months that commenced on January 24, 2006. During the nine months ended September 30, 2007, the Company paid Mr. Clifford a fee of $59,900 in consideration for his consulting services pursuant to the terms of the Consulting Agreement.

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Note 11. Purchase Acquisition

On May 4, 2007, the Company executed a definitive agreement with the members of eVergance to acquire all of their membership interests. On June 14, 2007 (the “Closing Date”), the Company agreed to issue an aggregate of 600,000 shares of its common stock (the “Stock”) to the former members of eVergance and Mr. Angel, and an aggregate of 400,000 non-equity plan options to purchase shares of its common stock (the “Options”) and $3.3 million in cash consideration to the former members of eVergance. Twenty-five percent of the Stock was issued as of the Closing Date and twenty-five percent was issued three months after the Closing Date and an additional twenty-five percent will be issued six and nine months after such date. The fair value of KANA’s stock was determined using a value of $3.16, which was the average closing price of KANA’s stock two days before and after the announcement date of May 7, 2007, less a 10% discount to reflect that unregistered stock was issued and is issuable. The unissued stock is accounted for as common stock subscription on the condensed consolidated balance sheet. Twenty-five percent of the Options were issued and are exercisable as of the Closing Date and twenty-five percent were issued three months after the Closing Date and an additional twenty-five percent of the Options will be issued and exercisable six and nine months after such date. The Options have an exercise price per share equal the closing sale price of the Company’s common stock on June 13, 2007 as quoted on the Over the Counter Bulletin Board. The fair value of the options was determined using the Black-Scholes option pricing model, using assumptions of a risk-free interest rate of 4.76%, expected volatility of 53%, the ten year contractual term, and no expected dividends. The fair value of the common stock underlying the options was discounted as discussed above. The options granted have been excluded from the summaries of options outstanding in Note 3 and had a fair value of $2.19 per share upon grant. The aggregate consideration for the transaction was as follows (in thousands):

The Company relied on an exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”), and Rule 506 promulgated thereunder. The former members of eVergance represented to KANA that they were “accredited investors” as defined in Rule 501(a) promulgated in the Securities Act and that they were purchasing the Registrable Securities for their own account and not with a present view towards the public sale or distribution thereof.

eVergance is a management consulting and systems integration firm offering end-to-end consulting services for CRM optimization, knowledge management, and web self-service deployments. Through this acquisition, the Company will significantly expand its professional services portfolio to meet growing demand for consulting and implementation services. Under the term of the definitive agreements related to the acquisition, the purchase consideration consisted of cash, Stock and Options issued and issuable.

This transaction was accounted for using the purchase method of accounting. Management allocated the purchase price to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date giving consideration to an independent appraisal. To the extent that the purchase price exceeded the fair value of the assets and liabilities assumed, goodwill was recorded. The intangible assets acquired in connection with the acquisition are being amortized over a five-year period.

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The following is a summary of the preliminary allocation of the purchase price (in thousands):

The unaudited condensed consolidated financial statements include the operating results of eVergance from the date of acquisition. Pro forma results of operations for the eVergance acquisition have not been presented because the effect of the acquisition was not material to the Company’s financial results.

Note 12. Subsequent Events

On October 3, 2007, the Company entered into a Loan and Security Modification Agreement to the February Loan (the “October 3rd Modification”) with Bridge Bank, which provided a one-time waiver of out-of-compliance conditions with certain financial covenants that existed for the period ended July 31, 2007. In addition, the October 3rd Modification extended the due date for the repayment of loans related to mergers and acquisitions until November 30, 2007. The October 3rd Modification also provided that, in lieu of compliance with certain financial covenants the Company may sell its equity securities in an underwritten offering pursuant to a registration statement filed under the Securities Act of 1933 and provided for the payment of certain fees to Bridge.

In November 2007, we executed an agreement with a landlord to surrender the remaining term of our facility lease on the facility in Marlow, UK. The terms of the agreement include a lump sum payment in exchange for release of all remaining liability related to our original lease. The Company has adjusted the accrued restructuring liability as of September 30, 2007.

In addition to historical information, this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The forward-looking statements 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, but are not limited to, 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.

The following discussion should be read in conjunction with our Annual Report on Form 10-K filed on April 2, 2007, and the consolidated financial statements and notes thereto. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

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Overview

Kana Software, Inc. and its subsidiaries (the “Company” or “KANA,” and references to “we,” “our”, “us”, and similar pronouns refer to KANA) offer an innovative approach to customer service with cost-effective solutions that enhance the quality of customer interaction. Built on open standards for a high degree of adaptability and integration, KANA solutions intelligently automate the processes needed to successfully serve our clients’ customers, so that our clients can deliver higher value service at lower cost. KANA provides an integrated solution which enables organizations to deliver consistent, managed service across all channels, including email, chat, call centers, and Web self-service, ensuring a consistent service experience across communication channels.

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 larger customers often use a systems integrator, such as IBM, Accenture or BearingPoint, for the project to install KANA software as well as do the business process, workflow, and other associated required work. KANA’s professional services group assists the integrators as subject matter experts, and in other cases will act as the prime contractor for implementation of our software. While we continue this practice, we are increasingly providing consulting and implementation services directly to our customers. These services may be provided to our existing customers who would prefer us to review their KANA implementations or to new customers who are not large enough to gain the interest of a systems integrator to provide initial implementation services. However, in the case of most of the initial installations of our applications that are generally installed by our customers using a system integrator, these services generally increase the cost of a project substantially and subject their purchase to more approval levels and cost savings reviews resulting in longer sales cycles. This contributes to the difficulty that we face in predicting the quarter in which sales to expected customers will occur and 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. In addition, we recently began offering our software on a hosted basis for a subscription fee, through our OnDemand service. In June 2007, we purchased eVergance Partners LLC (“eVergance”), a management consulting and systems integration firm, and our service revenues and related expenses have increased due to this acquisition. Through this acquisition, we significantly expanded our professional services portfolio to meet growing demand for consulting and implementation services.

In late 2005, we made a decision to eliminate outsourced product development and bring core technology development back to our personnel in the United States in a process that we refer to as “back-shoring” and, by the end of the third quarter of 2006, we brought back all core technology development to the United States, except for development on one product group, which was brought back in the first quarter of 2007. We also back-shored our technical support during the fourth quarter of 2006. As we continue to rebuild the sales organization and increase our marketing, our sales and marketing expenses increased in 2007 due to increases in headcount, commissions as a result of higher revenues, and marketing programs. We will strive to match our spending with the anticipated revenue but, given the unpredictability of our license revenue, we are unable to predict with any certainty the period(s) when we will be profitable, if at all.

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. On September 30, 2007, we had ending cash and cash equivalents of $1.4 million and $8.7 million of borrowings outstanding under a loan payable and notes payable. As of September 30, 2007, we had an accumulated deficit of $4.3 billion and a negative working capital of $21.3 million. Loss from operations was $729,000 and $7.8 million for the three and nine months ended September 30, 2007, respectively. Net cash used for operating activities was $8.6 million and $623,000 for the first nine months of 2007 and 2006, respectively.

We added 30 employees through the eVergance acquisition, and as of September 30, 2007, we had 231 full-time employees which represent an increase from 181 employees at December 31, 2006 and an increase from 153 employees at September 30, 2006.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed 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 condensed consolidated financial statements requires us to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. 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. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates.

We believe the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments.

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Revenue Recognition

We recognize revenues in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended.

Revenue from software license agreements is recognized when the basic criteria of software revenue recognition have been met (i.e. persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable, and collection is probable). We use the residual method described in AICPA SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” (“SOP 98-9”), to recognize revenue when a license agreement includes one or more elements to be delivered at a future date and vendor-specific objective evidence of the fair value of all undelivered elements exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as license revenue. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established.

For all sales, we use either a signed license agreement, a signed amendment to an existing license agreement, a signed order form, a binding purchase order where we either have a signed master license agreement or an order form signed by the Company, or a signed statement of work as evidence of an arrangement.

Software delivery is primarily by electronic means. If the software or other deliverable is subject to acceptance for a specified period after the delivery, revenue is deferred until the acceptance period has expired or the acceptance provision has been met.

When licenses are sold together with consulting services, license fees are recognized upon delivery, provided that (1) the basic criteria of software revenue recognition have been met, (2) payment of the license fees is not dependent upon the performance of the consulting services, and (3) the consulting services do not provide significant customization of the software products and are not essential to the functionality of the software that was delivered. We do not provide significant customization of its software products.

Revenue arrangements with extended payment terms are generally considered not to be fixed or determinable, and we generally do not recognize revenue on these arrangements until the customer payments become due and all other revenue recognition criteria have been met.

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 are required to exercise significant judgment in deciding whether collectibility is reasonably assured, and such judgments may materially affect the timing of our revenue recognition and our results of operations.

Services revenues include revenues for consulting services, customer support and training, and OnDemand and hosting. OnDemand includes our KANA OnDemand ‘software as a service’ and outsourcing offerings as well as Advanced Customer Services. Consulting services revenues and the related cost of services are generally recognized on a time and materials basis. For consulting services contracts that have a fixed fee, we recognize the license and professional consulting services revenues using either the percentage-of-completion method or the completed contract method as prescribed by AICPA SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Product-Type Contracts” (“SOP 81-1”). KANA’s consulting arrangements do not include significant customization of the software. Customer support agreements provide technical support and the right to unspecified future upgrades on an if-and-when available basis. Customer support revenues are recognized ratably over the term of the support period (generally one year). Training services revenues are recognized as the related training services are delivered. The unrecognized portion of amounts billed in advance of delivery for services is recorded as deferred revenue. OnDemand revenue is recognized in accordance with the SEC Staff Accounting Bulletin No. 104, “Revenue Recognition, corrected copy” (“SAB 104”). Revenues from OnDemand services are recognized ratably over the term of the arrangement, while application fees are recognized ratably over the sum of the term of the arrangement and the term of expected renewals. Hosting service arrangements are a means of deployment whereby the customer’s software and data is physically located in third party facilities. Customers pay a fee to remotely access the hosted software and data via a secure internet connection. Hosting fees are recognized as the hosting service is delivered in accordance with SAB 104.

Vendor-specific objective evidence for consulting and training services are 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 support services is generally based on the price charged when an element is sold separately or the stated contractual renewal rates.

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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.

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 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 condensed consolidated statements of operations.

Our capitalized costs for internal use software of $561,000 have been fully amortized as of September 30, 2007.

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 in Menlo Park, California; Princeton, New Jersey; Framingham, Massachusetts; and Marlow in the United Kingdom. Remaining lease commitments terminate over various dates beginning in April 2007 and through January 2011. We are seeking to sublease or renegotiate the obligations associated with the excess space. We have subleased some of the excess space, but in all cases, the sublease income is less than the rent we pay the landlord. We had $5.0 million in accrued restructuring costs as of September 30, 2007, 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 September 30, 2007, our estimate of accrued restructuring cost included an assumption that we would receive $861,000 in sublease payments that are not subject to any contractual arrangement as of September 30, 2007. We have assumed that the majority of these assumed sublease payments will begin in 2008 and continue through the end of the related leases. In December 2006, we determined that we may not be able to sublease a leased facility in Princeton, New Jersey, and we changed our assumption of subleasing this excess space. We recorded a restructuring charge of $739,000 during the three months ended December 31, 2006 mainly related to this change in estimate of sublease assumption that is not subject to any contractual arrangement.

In July 2007, we implemented various cost reduction and restructuring activities to reduce operating costs. The expense related to our reduction in work force was approximately $240,000 and expense related to ceasing use of one of our offices was approximately $8,000.

In September 2007, we agreed with the landlord of one of the facilities included in our restructuring accrual to surrender the remaining term of the lease in exchange for a lump sum cash payment. As a result of this agreement we recorded additional restructuring expense of approximately $319,000 and reclassified the long-term portion of the restructuring liability to accrued restructuring under current liabilities. Additionally, we reclassified the related lease deposit from other assets to other current assets.

Goodwill and Intangible Assets

We regularly evaluate all potential indicators of impairment of goodwill and intangible assets, but at a minimum, test goodwill and intangible assets for impairment on an annual basis. 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.

The remaining balance of goodwill as of September 30, 2007 is $12.5 million. 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, 2007, the date of our annual goodwill impairment test. Any future impairment loss could have a material adverse impact on our financial condition and results of operations.

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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.

On January 1, 2007, we adopted FASB Interpretation No. 48 “accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement 109” (“FIN 48”). FIN 48 establishes a single model to address accounting for uncertain tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement classification, interest and penalties, accounting in interim periods, disclosure and transition. During the implementation, we identified, evaluated, and measured the amount of income tax benefits to be recognized for all material income tax positions. The net income tax assets recognized under FIN 48 did not materially differ from the net assets recognized before adoption, and, therefore, we did not record an adjustment related to the adoption of FIN 48. At the adoption date of January 1, 2007, we had $145,000 of unrecognized tax benefits, all of which would affect our effective tax rate if recognized. At September 30, 2007, we had $145,000 of unrecognized tax benefits.

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

On January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors including employee stock options and employee stock purchases under an employee stock purchase plan based on estimated fair values.

Stock-based compensation expense recognized during the three and nine months ended September 30, 2007 and 2006 is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We use the Black-Scholes option pricing model for determining the estimated fair value for stock-based awards. The Black-Scholes model requires the use of highly subjective and complex assumptions which determine the fair value of stock-based awards, including the option’s expected term and the price volatility of the underlying stock.

Employee stock-based compensation expense recognized under SFAS 123(R) for the three months ended September 30, 2007 and 2006 was $729,000 and $1.5 million, respectively and was $2.1 million for each of the nine month periods ended September 30, 2007 and 2006.

For stock options granted to non-employees, we recognize compensation expense in accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which require such equity instruments to be recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying equity instruments vest. We amortize compensation expense related to non-employee stock options in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” (“FIN 28”). In 2005 and 2006, we extended the vesting period of approximately 1,000,000 stock options held by four terminated employees who had agreements to provide consulting services. In fiscal year 2006, we granted a total of 57,500 stock options to four non-employees who had agreements to provide consulting services. As a result of these stock option modifications to former employees and the stock option grants to consultants, we recorded non-employee stock-based compensation expense of $2,000 and $266,000 for the three months ended September 30, 2007 and 2006, respectively, and expense of $105,000 and $520,000 for the nine months ended September 30, 2007 and 2006, respectively.

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Also see stock-based compensation in Note 1 to the condensed consolidated financial statements.

Effect of Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. The standard requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of acompany’s choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which a company has chosen to use fair value on the face of the balance sheet. This Statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). We are currently evaluating whether the adoption of SFAS 159 will have a material effect on its financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS 157. The purpose of SFAS 157 is to define fair value, establish a framework for measuring fair value and enhance disclosures about fair value measurements. The measurement and disclosure requirements are effective for us beginning in the first quarter of fiscal 2008. We are currently evaluating the effects of implementing SFAS 157.

In June 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes- an interpretation of FASB Statement 109” (“FIN 48”). FIN 48 establishes a single model to address accounting for uncertain tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted FIN 48 on January 1, 2007. During the implementation, we identified, evaluated, and measured the amount of income tax benefits to be recognized for all material income tax positions. The net income tax assets recognized under FIN 48 did not materially differ from the net assets recognized before adoption, and, therefore, we did not record an adjustment related to the adoption of FIN 48. At the adoption date of January 1, 2007, we had $145,000 of unrecognized tax benefits, all of which would affect the Company’s effective tax rate if recognized. At September 30, 2007, we had $145,000 of unrecognized tax benefits.

Our continuing practice is to recognize interest and/or penalties related to income tax matters as a component of income tax expense. Upon implementation of FIN 48 approximately $28,000 of accrued interest and penalties had already been recorded related to uncertain tax positions. There was no change in the amount of unrecognized tax benefits or accrued interest and penalties during the third quarter ended September 30, 2007.

The tax years 2003-2006 remain open to examination by the major taxing jurisdiction to which we are subject.

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Results of Operations Data

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

Revenues

Total revenues increased by 28% to $16.8 million for the three months ended September 30, 2007 from $13.2 million for the three months ended September 30, 2006, as a result of higher license revenues and services revenues in 2007 than in 2006. Total revenues increased by 10% to $43.3 million for the nine months ended September 30, 2007 from $39.2 million for the nine months ended September 30, 2006, as a result of higher services revenues partially offset by lower license revenues in 2007 than in 2006.

License revenues include licensing fees only, and exclude associated support, training and consulting revenue. The majority of our licenses to customers are perpetual and associated revenues are recognized upon delivery provided that all revenue recognition criteria are met as discussed in “Revenue Recognition” under “Critical Accounting Policies” above. License revenues increased by 33% to $5.8 million for the three months ended September 30, 2007 from $4.3 million for the same period in the prior year. License revenues decreased by 2% to $12.9 million for the nine months ended September 30, 2007 from $13.1 million for the same period in the prior year. The increase for the three months ended September 30, 2007 compared to the same quarter in the prior year was the result of an increased number of license transactions in the three months of 2007 compared to 2006 and the inclusion of a larger multi-million dollar transaction in 2007. License revenue for the nine month periods ended September 30, 2007 and 2006, were basically flat. While we are focused on increasing license revenue, we are unable to predict such revenue from period to period with any degree of accuracy because, among other things, the market for our products is unpredictable and intensely competitive, and our sales cycle is long and unpredictable.

Our services revenues consist of support revenues and professional services fees. Support revenues relate to providing customer support, product maintenance and updates to our customers. Professional services revenues relate to providing consulting, training and implementation services to our customers including hosting and OnDemand, software as a service option. Services revenues increased by 25% to $11.0 million for the three months ended September 30, 2007, compared to

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$8.8 million for the same period in 2006. Services revenues increased by 17% to $30.3 million for the nine months ended September 30, 2007, compared to $26.0 million for the same period in 2006. Support revenues are the largest component of services revenues, and during the three and nine months ended September 30, 2007, support revenues remained flat compared to the same periods in 2006, because support revenues from new maintenance contracts associated with new license transactions offset support renewal cancellations. The other part of services revenues are professional services fees that increased for the three and nine months ended September 30, 2007 compared to the same periods in 2006 mainly due to an increase in consulting, training and OnDemand revenues. Consulting and training revenues increased as a result of increased license sales in prior quarters and the inclusion of a full quarter of eVergance revenue. Customers who purchase licenses frequently purchase implementation consulting and training, which usually occur subsequent to the license sales.