As filed with the Securities and Exchange Commission on March 31,2005

 

 

**UNITEDSTATES****SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-KSB**

 

**(Mark one)**

| **ý** | **ANNUAL  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934.**                                                                                                                                                                                      |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                                                                                                                 |
|       | **For the fiscal year ended  December 31, 2004**                                                                                                                                                                                                                                |
|       |                                                                                                                                                                                                                                                                                 |
|       | **OR**                                                                                                                                                                                                                                                                               |
|       |                                                                                                                                                                                                                                                                                 |
| **o**      | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934.**                                                                                                                                                                            |
|       |                                                                                                                                                                                                                                                                                 |
|       | **For the transition period from                    to                    ** |

 

**Commission File No: 000-46494**

 

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**PRIMALSOLUTIONS, INC.**

(Exact Name of Small Business Issuer in its Charter)

 
| **Delaware**(State or Other  Jurisdiction  of Incorporation or Organization) | ** ** | **36-4170318**(I.R.S. Employer  Identification No.) |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------|

 
| **18881 Von Karman Avenue  Suite 500  Irvine, California**(Address and  telephone number of Principal Executive Offices) | ** ** | **92612**(Zip Code) |   |
|-------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|--------|

 

**(949) 260-1500**(Issuer’s Telephone Number, Including Area Code)

 

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Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theExchanged Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes  ý   No  o 

 

Checkif disclosure of delinquent filers in response to Item 405 of Regulation S-B isnot contained in this form, and no disclosure will be contained, to the best ofthe registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB. ý 

 
| State issuer’s revenues for its most recent  fiscal year:                                                                                                                                                                                                    |   | $          | 7,608,886 |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|-----------|--------|
|                                                                                                                                                                                                                                                              |   |       |      |
| State the aggregate market value of the  voting and non-voting common equity held by non-affiliates computed by  reference to the price at which the common equity was sold, or the average  bid and asked price of such common equity, as of March 21, 2005 |   | $          | 7,217,335 |   |
|                                                                                                                                                                                                                                                              |   |       |      |   |
| Number of shares of Common Stock ($0.01 par  value) outstanding as of the close of business on March 21, 2005:                                                                                                                                               |   | 36,252,991 |      |

 
| Transitional Small Business Disclosure Format |   | Yes     o  |   | No    ý  |
|-----------------------------------------------|--------|------------------------------------------|--------|----------------------------------------|

 

 

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**PRIMAL SOLUTIONS, INC. AND SUBSIDIARY**

 

**TABLE OF CONTENTS**

 
|     | PART I                                                                                                                 | **Page** |
|----------|-----------------------------------------------------------------------------------------------------------------------------|----------|
|     |                                                                                                                        |     |
| Item 1.  | Business                                                                                                                    | 3        |
|     |                                                                                                                        |     |
| Item 2.  | Property                                                                                                                    | 21       |
|     |                                                                                                                        |     |
| Item 3.  | Legal Proceedings                                                                                                           | 21       |
|     |                                                                                                                        |     |
| Item 4.  | Submission  of Matters to a Vote of Security Holders                                                                        | 21       |
|     |                                                                                                                        |     |
|     | PART II                                                                                                                |     |
|     |                                                                                                                        |     |
| Item 5.  | Market for Common Equity  and Related Stockholder Matters                                                                   | 22       |
|     |                                                                                                                        |     |
| Item 6.  | Management’s  Discussion and Analysis                                                                                  | 23       |
|     |                                                                                                                        |     |
| Item 7.  | Financial Statements                                                                                                        | 39       |
|     |                                                                                                                        |     |
| Item 8.  | Changes In and Disagreements With  Accountants on Accounting and Financial Disclosure                                       | 39       |
|     |                                                                                                                        |     |
| Item 8A. | Controls and Procedures                                                                                                     | 39       |
|     |                                                                                                                        |     |
| Item 8B  | Other                                                                                                                       | 40       |
|     |                                                                                                                        |     |
|     | PART III                                                                                                               |     |
|     |                                                                                                                        |     |
| Item 9.  | Directors, Executive Officers, Promoters  and Control Persons, Compliance With Section 16(a) of the Exchange  Act | 41       |
|     |                                                                                                                        |     |
| Item 10. | Executive Compensation                                                                                                      | 43       |
|     |                                                                                                                        |     |
| Item 11. | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                             | 48       |
|     |                                                                                                                        |     |
| Item 12. | Certain Relationships and Related  Transactions                                                                             | 51       |
|     |                                                                                                                        |     |
| Item 13. | Exhibits                                                                                                                    | 51       |
|     |                                                                                                                        |     |
| Item 14. | Principal Accountant Fees and Services                                                                                      | 55       |

 

2

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# **PART I**

#  

**Item 1****. Business**

 

**Business Overview**

 

Primal Solutions, Inc. was formed in 1996 as PrimalSystems, Inc.  During 1999, PrimalSystems, Inc. was merged with and into a wholly-owned subsidiary of AveryCommunications, Inc. (“Avery”), ACI Telecommunications Financial Services, andthe surviving company changed its name to Primal Solutions, Inc.  In February 2001, Primal Solutions, Inc. wasspun-off as a separate public company by Avery.

 

**Industry Background**

 

From 2000 to 2002, the communications industryexperienced a world-wide economic downturn caused by several factors includingexcess capacity, high debt levels and price erosion.  Overall capital spending declined becauselarge, established communications service providers, or “CSPs,” focused onimproving financial results, and the number of start-up or emerging CSPs shrunkthrough market consolidation and lack of sustainable, profitable businessmodels.

 

During 2003, the communications industry showedsigns of improvement and increased capital spending in certain segments.  Specifically, the communications industrydemonstrated more willingness to increase spending primarily on operationssupport systems, or “OSS,” for next generation Internet protocol networks or “IPNetworks,” although CSPs continued to exhibit great caution related to overallspending.

 

During 2004, the telecommunications industry and the US sector inparticular, as measured by the Dow Jones US Telecommunications Index, ticker:IYZ, continued to show modest but steady growth.  This growth was similarly reflected in theOSS sector, which increased commercial software spending 10% from $1.79 billionin the third calendar quarter in 2003 to $1.97 billion in the third calendarquarter in 2004.

 

Additionally, in 2004 the telecommunications industry made a dramaticshift away from older, time division multiplex or TDM-based telephony towardinternet protocol based telephony, or “IP telephony,” and shipment of newVoice-over-IP, or “VoIP” lines or connections grew from 8.8 million lines to17.0 million while shipment of TDM lines declined from 31.7 million to 26.2million.  We expect that in the firsthalf of 2005, the growth in IP telephony lines will surpass TDM lines.

 

More significantly for Primal:

 

•                  Cable VoIPsubscribers in North America increased from almost 50,000 in 2003 to 500,000,or 900%  in 2004, with two multiplesystem operators (MSOs) accounting for most of the increase.

 

•                  Cable broadbandsubscribers increased from 17.7 million in 2003 to 22.4 million in 2004.

 

•                  North Americancable companies increased their investments in VoIP equipment from $63 millionin 2003 to $123 million in 2004.

 

•                  VoIP penetrationin the market is expected to increase from 2% in 2004 to 15% in 2007.

 

Because of the dramatic shift toward IP telephony, CSPs continue toface some of the most severe challenges in their histories.  The economics of IP telephony in general andVoIP in particular are forcing CSPs to cut costs while simultaneously expandingtheir portfolios of service offerings.  This in turn is putting enormous pressure on existing systems and IT departmentsto purchase and implement new, cost-effective OSS solutions, designed to workwith IP infrastructures.

 

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Historically, large CSPs evolved their networks andOSS slowly and systematically over long periods of time.  Generally, their networks and OSS weredesigned and optimized primarily for a single service offering, typically thetelephone.  As CSPs began to offer more services,such as high speed Internet, they installed parallel networks and OSS tofacilitate those additional services.  Ingeneral, CSPs made additional services available if and when they fit into theOSS and network management models. Because of this approach, CSPs introduced new services slowly which wereexpensive for the subscribers.  If majornew capabilities in the OSS or network were required for these new services,the time to market for the new services could often be measured in years.

 

As competition has become more prevalent, CSPs haveattempted to add new and distinct services, bundle services in new ways, becomemore competitive in pricing, provide near-real-time customer access toinformation, and improve customer relationship management "CRM".  In short, customer needs and desires, insteadof technical capabilities, have become a significant driving force indetermining what services the CSPs offer. Additionally, pricing and bundling ofservices have become more points of differentiation among CSPs and informationfrom the OSS is needed quicker and in different and new formats for differentcustomers.

 

CSPs initially reacted to these challenges, inincreasingly shorter timeframes, by adding OSS that provided incrementalfunctionality, but without true integration of the OSS.  As additional OSS were added, problems suchas data integrity issues across these systems and inflexible systemarchitectures created challenging OSS evolution issues, introduced additionalcosts, and slowed time-to-market for new services as convergent systems wereintroduced to replace multiple “legacy” systems.

 

The traditional architecture of existing OSSsbilling systems present a major implementation challenge for a truly convergentOSS operator.  Future OSS architecturesthat utilize databases, product catalogs, and mediation systems external to thebilling system provide substantial OSS implementation benefits and simplify OSSevolution.

 

As competition continues to evolve, we believe thatCSPs will be required to reduce costs and continue to expand serviceofferings.  This will lead to a new setof challenges, such as, how can the functionality of the OSS be increased whilereducing costs, increasing throughput, and improving operating performance;what can be done to extend the life of existing systems that remain a part ofthe OSS; can the new OSS infrastructure easily evolve as new services areoffered and evolve in their complexity; can the intelligence in the OSS andnetwork be capitalized to increase revenue and profitability; and what rolewill service level agreements “SLA” and quality of service requirements play inusage billing for services?  Weanticipate that these and other challenges will drive CSPs to attempt to createdynamic mediation environments that enable the transfer of information, inwhatever format is required, to whichever systems, processes, customers ortrading partners need the information.

 

We believe an effective mediation strategy becomes the foundation forthe evolution of the OSS into the next generation multi-service environment.Multi-service mediation acts as the conduit between and the building block forservice activation, pre-paid and post-paid accounting, event rating, andintegration of detailed usage information into customer relationship managementsystems.

 

**Our Business Focus**

 

Primal Solutions, Inc., and its wholly-ownedsubsidiary Wireless Billing Systems (“Primal” or the “Company”), deliversoftware and service solutions that enable CSPs to generate revenues and createactionable business information from the data produced when individuals orbusinesses consume services or transact business over IP networks.

 

Primal develops technologies and delivers businesssolutions for broadband services companies offering VoIP, high speed data overcable, and other new-generation, convergent communications and contentservices.  The growth in IP-basedservices and especially VoIP during 2004 has underscored Primal’s belief thatits greatest opportunities exist in serving CSPs who are using IP networks tooffer multiple converged services, including voice, data, and video.

 

4

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Primal’s real-time, high-volume, multi-servicemediation, rating and data management technologies provide the basis of oursolutions. We currently market these technologies as Connect IXCTM,Access IM®, Connect RTRTM, Connect PrepayTM, andConnect CCB®.   Our professionalservices teams use these technologies to create solutions that enable CSPs to:

 

•                                          Attract and retain customers by offeringVoIP, high speed data, video and other new-generation service offeringsdelivered over broadband infrastructures, especially cable and passive oractive fiber optic networks;

 

•                                          Deploy new-generation IP technologies such assoftswitches that can dramatically drive down network infrastructure costs;

 

•                                          Deploy new services and service combinationssuch as ‘triple play’ (voice, data and video), quad-play, (voice, data, videoand wireless), and eventually n-play offerings that combine communications,content-based and non-communications services, such as utility or securityservices;

 

•                                          Deploy new community broadband operationsthat are bringing the benefits of new-generation communications services tosmall and rural communities across America;

 

•                                          Offer usage-based and transaction-sensitiveservice offerings that are both competitive and profitable;

 

•                                          Rate and otherwise manage service consumptionin real time or post transaction environments;

 

•                                          Turn high volumes of usage and transactiondata into usable, actionable business information;

 

•                                          Use IP transaction data to make accurate,informed business decisions about service offerings, pricing strategies,customer behavior, and risk;

 

•                                          Use usage and customer data to assuresettlements and reconciliation accuracy with third-party services providers;

 

•                                          Prevent revenue leakage and network abuse byunderstanding and managing customer usage and transaction patterns.

 

**Markets Served**

 

Primal serves three primary markets:

 

•                                          Cable multi-system operators or “MSOs” –Large US cable companies operating multiple cable systems that are rolling outVoIP and high speed data and other IP-based communications services to theirconsumers and businesses

 

•                                          Managed services providers or “MSPs” – US orinternational companies offering managed VoIP, central office exchange servicesdesigned to manage multi-user phone systems used by businesses to control therouting of inbound and outbound calls and related solutions to enterprises andother groups or institutions

 

•                                          Community broadband, or “rural broadband” –typically public or private US entities deploying fiber broadband operations inthe United States

 

5

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**Cable MSO Market –**Primal’s solutions are enabling MSOs tochange the way they do business while they also roll-out, bill for, and managenew services such as VoIP and high speed data.

 

In the United States, MSOs have become powerfulforces in consumer communications, and increasingly they are introducingconsumer offerings as well as new business services, particularly for small andmedium enterprises. After years of upgrading networks to support two-way andIP-based technologies, MSOs are now well-positioned to deliver both truetwo-way broadband, as well as compelling new communications services alongsideor bundled with traditional TV and content-based services. In addition, MSOshave been working diligently in recent years to shed old reputations for highprice and poor service, and increasingly the US public is responding byselecting cable over digital subscriber line (DSL) offered by phone companiesor satellite services. Top-tier MSOs are also actively enriching theirportfolios by entering into agreements with cellular providers, which allowthose MSOs to support a range of broadband access technologies and a wide rangeof content and communications services. For these reasons, MSOs are becoming an increasingly serious threat toincumbent wireline and wireless providers.

 

Primal believes that MSOs will continue to takemarket share and grow revenues over the next several years.  Therefore, we work closely with our, MSOclients to establish Primal as a strategic solution provider (rather thansimply a vendor), and align our products roadmaps to meet our clients’ needsand provide critical windows of opportunity for our products and our business.

 

**Managed Services Provider (MSP)Market –**Primal isenabling MSPs to change the way businesses and institutions manage theircommunications infrastructures and services.

 

MSPs provide businesses and institutions of allsizes with options for managing voice and data services and for controllingcommunications costs and resource requirements. By outsourcing to an MSP,businesses and institutions can combine their voice, collaborativecommunications and data services over a single converged IPinfrastructure.  By doing so, users ofMSPs can reduce their capital expenditures and operating costs, obtain higherquality communications services and permit personnel to focus on primarybusiness activities.

 

Primal provides the critical applications softwareand services that can enable MSPs to collect high volumes of complex datacreated by IP network elements and applications, and to use this data to offerusage-based as well as flat rate pricing, and service offerings and price plansthat take into account quality-of-service and service level agreements.

 

**Community Broadband Market –**Primal provides business-critical softwaresolutions that help governmental and private entities cost-effectively andefficiently roll out broadband communications services to their constituenciesin small communities and rural areas in the United States.

 

Many small communities and rural areas in NorthAmerica still lack the comprehensive communication services now generallyavailable in metropolitan service areas. This lack of services is a significant disadvantage for communitiesseeking to attract businesses, grow their economies and improve the quality oflife for their citizenry. Local municipalities, electric utilities, plannedcommunity developers, and others are addressing this lack of services byrolling out fiber networks that deliver new-generation communications servicesto residential and commercial premises. These providers typically recognize that, to be economically viable,they must offer at least the “triple play” combination of voice, video and highspeed Internet.  Many providers areanticipating additional offerings in the near future, such as online gaming,tele-medicine, remote learning, tele-working, hosted business services andother offerings that require next generation broadband networks.

 

Primal has experience in and understands communitybroadband's unique needs. Primal has adapted its sales and delivery strategiesto fit the cultural and operational needs of community broadband providers, mostof whom have limited telephony and IP services experience and who servecustomers with different communications needs and service preferences whencompared to customers in large, urban markets.

 

Primal intends to leverage its track record servingcommunity broadband provider customers, including utilities to become thevendor of choice for billing and customer service solutions in this marketsegment.  Primal’s Connect CCBTM is acost-effective and integrated product tailored to the needs of community broadband.Primal helps its customers implement not only their software, but also thebusiness practices to ensure efficient operations and especially as theserelate to defining multi-service products, rolling out new services, pricingand bundling offerings, and managing customer service, provisioning andbilling.

 

6

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**Products and Services**

 

Through 2004 Primal marketed five branded productsor solutions as follows:

 

•                  AccessIM® - a high-volume mediation solution that collects, stores, and correlatesusage data from multiple IP communications network sources;

 

•                  ConnectRTRTM - a flexible real-time rating engine;

 

•                  Connect PrepayTM- a balance management solution for long distance voice and other services;

 

•                  ConnectIXCTM - an integrated IP mediation and rating solution that includes Connect IMand Connect RTR; and

 

•                  ConnectCCB® - an integrated customer care and billing solution that includes ordermanagement, payment processing, credit and collections, rating, invoiceprocessing, reporting, flow-through provisioning, and online care.

 

Beginning in 2005, we initiated product managementand development activities intended to enhance product capabilities, attractmore business, deliver greater value to our clients, support morecost-effective implementations and deliver greater value to ourstockholders.  As of March 2005, we nolonger market Access IM, Connect RTR, or Connect Prepay as separate products.The features of these products are being integrated into Connect IXC or ConnectCCB to create two new and enhanced solutions platforms that we expect toreintroduce to the marketplace in mid-2005. The evolution of our platforms will better position us to meet the needsof service providers and key partners to whom we market our Connect IXCplatform and the significantly different economic, technical and business needsof emerging community broadband providers to whom we market our Connect CCBproduct.

 

**Connect IXC –**WithConnect IXC, Primal is enabling MSOs and other CSPs to change the way theymanage usage data produced when transactions occur over convergent broadband IPinfrastructures.  Connect IXC wasdesigned to operate in high-volume, real-time environments and enables clientsto capture, transform, analyze, correlate, and communicate information about IPusage and transactions.  Connect IXC isalso enabling clients to disintermediate legacy billing and operations supportsystems that are unable to support real-time transactions, IP environments, orconvergent multi-services environments. Capabilities of this highly scalable product include:

 

•                                          **Intelligent IP mediation**:  Features that reliably and intelligentlycapture, transform, manage and store the high-volumes of data produced bytransactions over broadband networks

 

•                                          **Real-time and post-transaction rating, charging, andbalance management**:  Featuresfor processing calls, events or session-based transactions; for managing rateplans, rate-plan ‘what-if’ and comparative analysis, and for balance managementrequired by pre-pay and post-pay business models

 

•                                          **Data analysis and correlation features**:  Features to provide decision maker analysisand reports that help clients address business challenges and risks related tosettlements, reconciliation, revenue leakage, fraud and other types ofusage-related issues

 

•                                          **Web-based portal**:  Features to enable clients easily andsecurely to view and use data managed through Connect IXC

 

**Connect CCB - Integrated multi-servicecustomer care and billing -**Connect CCB is an integrated,end-to-end customer care, provisioning, and billing solution especiallytailored for community broadband providers offering voice, data, video andother services. Connect CCB’s features support order management, provisioning,customer service management, invoicing, electronic bill presentment, paymentprocessing, credit and collections, workforce management and managementreporting.

 

7

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**Delivery Models and Services**

 

Primal delivers solutions under either licensearrangements or subscription-based managed services offerings.  Licensed solutions are sold to clients whointend to host and operate their solutions, and require a one-time, up-front,right-to-use license fee plus annual maintenance fees.  Managed solutions are those where Primalhosts, manages, maintains and supports solutions on behalf of the client.  Managed solutions are subscription-based andrequire volume-based monthly payments that are calculated based on the numberof transactions processed or the number of customers managed. Primal alsooffers a build-operate-transfer model that we refer to as “Soft Landing”.  Under the Soft Landing arrangement, Primalhosts or remotely manages the client’s solution until the client is ready toassume responsibility for operating and managing the solution.  This model minimizes impact on clientoperations and staffing and is particularly attractive to clients launching newbusinesses or new services groups.

 

Services provided to clients may include any or allof the following:

 

•                  Applicationmanagement and hosting

 

•                  Consultingand customization

 

•                  Implementationand training

 

•                  Maintenanceand support services

 

Application management and hosting services consistof day-to-day management and maintenance of applications, and, in the case ofhosted services, the day-to-day operations of our products.  Managed applications may be physicallylocated in our facilities, in a third-party co-location facility or in our client’sfacilities. Hosted applications are operated in our own facilities. Applicationmanagement and hosting services are provided under separate service agreementsthat specify the applications and services included in the program and theminimum commitment required by the client.

 

Consulting services include solution analysis, training, andimplementation management.  Customizationservices represent a small portion of Primal’s business solutions and aretypically limited to required interfaces, data analysis and reporting.

 

Implementation services include program managementand services to integrate our products into the client’s environment.  As required, these services also includeconfiguration or customization of our software products to suit our customer’sbusiness needs. Training programs enable users to deploy, use and maintain ourproducts, and may be either classroom or one-on-one sessions held at ourheadquarters or on location at a client’s facility.

 

Maintenance and support services are provided undermaintenance agreements that are renewable on an annual basis. Maintenanceentitles our clients to telephone technical support and routine softwaremaintenance upgrades.  Services areprovided from our headquarters in Irvine, California.

 

**Sales and Marketing**

 

Primal maintains a direct sales force, but reliesheavily on channel partners and relationships with leading manufacturers ofnetwork equipment for leads and prospects. Primal’s direct sales force focuses on the North America market,however, because our channel partners have significant international salesforces and channels, we are able to extend our reach globally, particularlywith respect to the Asia-Pacific and Latin American regions. Because we workwith channel partners, many of our transactions are joint solutions. In the US,we prefer to manage sales, contracts and relationships directly with ourclients. This approach ensures that we can establish intimate knowledge of eachclient’s situation and can find the best solution to meet their business needs.For clients outside of the US, we work through our channel partners and theirlocal representatives to ensure successful sales and deliveries. Due to thecomplex nature of the products and services we sell, our sales cycle may rangefrom 60 days to over a year.

 

8

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Primalderives the majority of its revenues from products delivered or servicesperformed in the United States of America. Products delivered or services performed outside the United States ofAmerica represented approximately 14% and 16% of our total revenues in fiscalyears 2004 and 2003, respectively.  SeeNote 11 of the Notes to the Consolidated Financial Statements for a summary ofour revenue by geographic area.  Revenuefor a given period typically reflects products delivered or services performedduring the period with respect to relatively large financial commitments from asmall number of customers.

 

**Channels and Business Relationships**

 

Primal has established strong relationships withcurrent and emerging industry leaders, including Cisco Systems, Inc., SylantroSystems Corp., and ETI Software, Inc. Primal is actively working to strengthen these relationships and toidentify and build additional relationships that will enable us to extend ourmarket reach through either direct or indirect sales channels, obtain and usethe latest business intelligence to enhance and extend our products and meetmarket windows of opportunity, and meet our client needs and satisfy theirexpectations.

 

**Competition**

 

Primal operates in a mature but evolving marketspace. Telecommunications markets across the globe are in constant flux as IPbroadband penetration rates increase and as convergence of wireless andwireline communications and content-based services and applications becomesmore commonplace.  These changes arecreating new market challenges and new opportunities. Primal has developedclose working relationships with market leaders like Time Warner Cable andCisco Systems to create new paradigms and to help MSOs and other CSPs adaptbusiness and process information for today’s converged IP-based communicationsservices environment.

 

Though we face significant competition from variouslarge and mature competitors, internal IT/IS departments, as well as varioussmall niche vendors.  Primal believes itis in a good position to embrace and drive change.  Primal believes it differentiates itself by(a) our exceptionally customer-focused culture, (b) our ability to act andreact very quickly on behalf of our customers and partners, (c) our trackrecord of delivery, (d) our unique combination of skills that includes IPnetwork mediation, telecommunications billing and rating expertise, applicationand database management, correlation analytics and high-volume real-timetransaction management, and (e) the price/value quotient associated with thesolutions we deliver.

 

**Research and Development**

 

Our research and development team is responsible fordeveloping new software products, product architecture, core technologies,product testing, quality assurance and ensuring the compatibility of ourproducts with hardware, switch network, and software platforms.  Additionally, our research and developmentteam supports pre-sale and customer support activities.  Our research and development team is dividedinto working groups based on our current line-up of products.  In addition, our product management andprofessional services staff helps our research and development team identifypotential new product features.  For theyears ended December 31, 2004 and 2003, our research and development costexpenditures  were $1.2  million and $1.0 million, respectively.

 

**Intellectual Property**

 

We rely upon a combination of U.S. patent,copyright, trade secret and trademark law to protect our intellectual property.We currently have two U.S. patents related to billing and mediation technology.In addition, we have five U.S. registered trademarks and two U.S. copyrights.While we rely on patent, copyright, trade secret and trademark law to protectour technology, we believe that factors such as the technological and creativeskills of our personnel, new product developments, frequent productenhancements and reliable product maintenance are more essential toestablishing and maintaining a technology leadership position. There can be noassurance that others will not develop technologies that are similar orsuperior to our technology.

 

We generally enter into confidentiality or licenseagreements with employees, consultants and corporate partners, and generallycontrol access to and distribution of our software, documentation and otherproprietary information. Despite our efforts to protect proprietary rights,unauthorized parties may attempt to copy or otherwise obtain and use ourproducts or technology or develop products with the same functionality as ourproducts. Policing

 

9

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unauthorizeduse of our products is difficult and we cannot be certain that the steps wehave taken will prevent misappropriation of its technology, particularly inforeign countries where the laws may not protect proprietary rights as fully asdo the laws of the United States of America. In addition, certain of ourlicense agreements require us to place the source code for our products into escrow.Such agreements generally provide that those parties with whom we contract willhave a limited, non-exclusive right to use our source code if (1) there is abankruptcy proceeding by or against Primal, (2) we cease to do business withouta successor or (3) we discontinue providing maintenance and support.

 

Our success and ability to compete are substantiallydependent upon our internally developed technology. However, portions of ourproducts incorporate software developed and maintained by third-party softwarevendors, such as operating systems, tools and database vendors. We may have torely on third-party software vendors and developers to a larger degree infuture products. Although we believe we could find other sources for theseproducts, any significant interruption in the supply of these products couldadversely impact our sales unless and until we can secure another source.

 

**Employees**

 

As of March 28, 2004, the Company had 45full-time employees, none of whom is represented by a union.  The Company believes that its relationshipwith its employees is good.

 

10

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# **RISKFACTORS**

#  

*Ownership of our common stockinvolves a high degree of risk, you should consider carefully the factors setforth below, as well as other information contained in this annual  report.*

 

**Risks Related to Our Business and Our Marketplace**

 

**Our largest customer has elected not to renewits license and services agreements.**

 

Following the completion of its merger with another wireless telecommunicationscompany in November 2004, our largest customer notified us of its intention notto renew its license and services agreement with us upon its expiration inaccordance with its terms in December 2005. Based upon our conversations with this customer, it is our understandingthat our customer’s election not to renew its agreement with us was a result ofa previous significant investment by its merger partner in an existing billingsystem in place prior to the merger, and on which most of the combined company’scustomers already reside.  We expect tocontinue to maintain our historically cooperative working relationship withthis customer and are in discussions to modify and extend our license andservices agreement to meet some of the customer’s on-going need to accesshistorical data.

 

Revenue from this customer represented approximately 56% or $4.3million based on total revenues of $7.6 million for the 12 months endedDecember 31, 2004, and approximately 69% or $4.5 million based on total revenuesof $6.5 million for the fiscal year ended December 31, 2003.  The related costs of revenues includestaffing, management and overhead costs.

 

As discussed elsewhere in this Annual Report, we have increased oursales and marketing staffing and efforts, and are currently evaluating otherstrategic initiatives as part of our effort to increase revenues from othersources.  In 2004, we worked to decreasethe percentage of revenue that our largest customer represents throughexpanding relationships with other customers and through increased customeracquisition activities. Unless we are able to increase our revenue from othersources, reduce our costs, or raise additional funds, the loss of revenueattributable to this customer may harm our business in the future.  We can provide no assurance that we will beable to increase our revenue or reduce our costs sufficiently to offset theloss of revenue associated with this customer, if at all.  Further we cannot be certain that additionalfinancing will be available to us on acceptable terms if and when required, orat all.

 

If we are unable to replace the loss of revenue associated with thiscustomer, we might need to reduce our operating costs, which could causedifficulty in maintaining and growing the customer base, decrease our abilityto attract and retain key employees and could result in a reduced stock priceamong other things.

 

**Our revenues are generated from a limitednumber of customers and our customer base is concentrated.**

 

A substantial portion of our license and services revenues has been,and is expected to continue to be, generated from a limited number of customerswith large financial commitments. Excluding revenues attributable to ourlargest customer, total revenues from our second largest customer during the 12months ended December 31, 2004 represented approximately 13% of totalrevenues.  The loss of an additionallarge customer would cause our business to be further harmed and, if a largecontract is cancelled or deferred or expires or if an anticipated contract doesnot materialize, our business would be harmed.

 

**We have a limited history as a provider ofcommunications software products.  As a result it is difficult to evaluateour business and prospects.**

 

Primal was founded in 1996.  We received our first revenues fromlicensing our communications software products and performing related servicesin 1999. Until 1999, substantially all of our revenues were derived fromperforming consulting services unrelated to our software products. Sales of oursoftware products and related services accounted for substantially all of ourrevenues since 1999. Because we have a limited operating history as a providerof communications software products, it is difficult to evaluate our businessand prospects.

 

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**We have not achieved profitability on anannual basis and expect to continue to incur net losses in future quarters.**

 

In order to become profitable, we must increase our revenues ordecrease expenses. We may not be able to increase or even maintain our revenuesand we may not achieve sufficient revenues or profitability in any futureperiod. We recorded net losses of $1.2 million and $278,000 for the years endedDecember 31, 2004 and December 31, 2003, respectively, and we couldincur net losses for the foreseeable future. As of December 31, 2004, we had an accumulated deficit of $13.9 million(which accumulated deficit includes $7.7 million of purchase price goodwillamortization expense and write-down, of which $5.6 million of Goodwill waswritten down in connection with our annual impairment test conducted in 2001,as required by *FASB Statement No. 142)*.

 

We will need to generate additional revenues from the sales of ourproducts and services or take steps to reduce operating costs further toachieve and maintain profitability. We expect that we will face increasedcompetition, which will make it more difficult to increase our revenues. Evenif we are able to increase revenues, we may experience price competition thatwill lower our gross margins and our profitability.  Any increase in thepercentage of our revenues attributed to indirect channels and services, bothof which generally have lower margins, will lower our gross margins.

 

In 2003, we established a new subscription-based recurring license feesoftware licensing model for new Connect IXC and Access IM customers that allowthem to pay a monthly fee based on the number of subscribers and/or transactionvolumes associated with our products, as compared to an up-front one-timelicense fee.  Under this subscription-based recurring payment pricingmodel, revenue from customers is expected to grow as their subscriber baseand/or transaction volumes grow and, thus, revenue from these customers isexpected to be low in the early part of the customer contracts and higher inlater years.  If our new customers do not or are not able to increase thenumber of subscribers as they expect, our revenues could be lower thananticipated.

 

If we do achieve profitability, we cannot be certain that we cansustain or increase profitability on a quarterly or annual basis.

 

**Our quarterly operating results may fluctuatein future periods and we may fail to meet expectations.**

 

Our revenues and operating results may vary significantly from quarterto quarter due to a number of factors. In future quarters, our operatingresults may be below the expectations of public market analysts and investorsand the price of our common stock may fall. Factors that could cause quarterly fluctuationsinclude:

 

•                  the timing andvolume of orders for our software. Customers typically order our products andservices only after other vendors have provided the infrastructure for theircommunications network. There can be delays in that process. It is thereforedifficult for us to predict the timing of orders for our products and servicesby customers;

 

•                  the ability ofour customers to expand their communications operations and increase theirsubscriber base, including their ability to obtain financing;

 

•                  changes in ourpricing policies or competitive pricing by our competitors;

 

•                  the timing ofreleases of new products by manufacturers of communications equipment withwhich our products operate; and

 

•                  the timing ofproduct introductions by competitors.

 

We have difficulty predicting the volume and timing of orders from newcustomers. For example, we expect an increasing percentage of our totalrevenues will come from licenses of Access IM, Connect RTR and Connect IXC andrelated services, but the markets for these products are in their early stagesof development and are therefore unpredictable. Significant sales may alsooccur earlier than expected, which could cause operating results for laterquarters to compare unfavorably with operating results from earlier quarters.

 

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Due to the foregoing factors, we believe that quarter-to-quartercomparisons of our operating results are not a good indication of our futureperformance.

 

**Our lengthy sales cycle makes it difficult toanticipate the timing of sales, and revenue may vary from period to period.**

 

The sales cycle associated with the purchase or license of our productsis lengthy, and the time between the initial proposal to a prospective customerand the signing of a license agreement can be as long as one year. Our productsinvolve a commitment of capital, time and internal resources that may besignificant to the customer. In addition, market conditions have lengthened thesales cycles associated with our products. These delays may reduce our revenuein a particular period without a corresponding reduction in our costs, whichcould hurt our results of operations for that period.

 

**If we are unable to attract additionalcustomers beyond our current limited number, our future success could belimited or adversely affected.**

 

Our future success will depend on our ability to attract additionalcustomers beyond our current limited number. The growth of our customer basecould be adversely affected by one or more of the following:

 

•                  customerunwillingness to implement our software products;

 

•                  anydelays or difficulties that we may incur in completing the development andintroduction of our planned products or product enhancements;

 

•                  ourcustomers’ inability to raise capital to finance their business plans andcapital expenditures;

 

•                  newproduct introductions by our competitors;

 

•                  anyfailure of our products to perform as expected;

 

•                  anydifficulty we may incur in meeting customers’ delivery requirements; or

 

•                  themarket perception of our financial condition and/or current stock price.

 

**If the multi-systems operator “MSO” marketdoes not expand as we anticipate, our future growth and success could belimited**.

 

The market for MSOs to provide communications services using internetprotocol networks (“IP networks”) is in its early stages. We believe thismarket shows signs of growth opportunities for our products and services.However the revenue opportunities in the MSO market are dependent on certainfactors, including the following:

 

•                  theadoption of voice-over cable services by the consumer;

 

•                  thetiming of the MSO providers offering voice-over cable services;

 

•                  ourcontracts with MSOs having volume-based characteristics;

 

•                  ourability to enable our products to conform and comply with industry standards;

 

•                  newcompetitors we might encounter; and

 

•                  changesto technical specifications before our products are accepted.

 

If the market does not grow as we expect, our future growth and successcould be limited.

 

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**Following our financing, we need to managegrowth effectively.**

 

We completed a private placement in June 2004, raising approximately$3.3 million in gross proceeds. We have used and plan to continue to use aportion of the net proceeds to stimulate growth by and among other things,continuing to expand our sales and marketing efforts.  We expect growth could place significantdemands on management, as well as on our administrative, operational and financialresources and controls. If we fail to manage any growth that we may achieveeffectively, our business could be adversely affected. If we cannot effectivelyestablish and improve processes, we may not be able to manage our growthsuccessfully.

 

**Our future success depends on our ability toattract and retain qualified personnel.**

 

We expect to continue hiring sales, support, marketing andadministrative personnel as needed. We may not be able to attract, assimilateor retain highly qualified personnel in the future. In particular, ourfinancial success and our ability to increase revenues in the future dependconsiderably upon the productivity of our direct sales force that hashistorically generated a majority of our license revenues. This productivity willdepend to a large degree on our success to recruit, train, and retain qualifieddirect salespeople. Our business will be harmed if we fail to hire or retainqualified personnel, or if newly hired employees, particularly salespeople,fail to develop the necessary sales skills or develop these skills more slowlythan we anticipate.

 

**Loss of our senior management could harm ourbusiness if we are unable to hire suitable replacements.**

 

Our future success depends to a significant extent on the continued servicesof our senior management. If we lose the services of any of our seniormanagement and are unable to hire suitable replacements, our business could beharmed. Our success also depends in large part on our ability to motivate andretain senior management. Significant turnover of our senior management couldhinder our ability to serve our existing customers effectively and compete fornew business, either of which could adversely affect our business and resultsof operations.

 

**Certain portions of the communicationsindustry are experiencing consolidation, which may reduce the number ofpotential clients for our software.**

 

Certain segments of the communications industry continue to experiencesignificant consolidation, while other segments are expanding. We cannot becertain that we will not lose clients as a result of consolidation of certainareas of the communications industry. In the future, there may be fewerpotential clients requiring our products, increasing the level of competitionfor new customers. In addition, larger consolidated communication serviceproviders have strengthened their purchasing power, which could create pressureon the prices and the margins we could realize. These companies are alsostriving to streamline their operations by combining different communicationssystems and the related operations support systems into one system, reducingthe number of vendors needed. We have sought to address this situation bycontinuing to market our products and services to new clients and by workingwith major CSPs to provide products and services that they need to remaincompetitive.

 

**If we are forced to compete with a smallnumber of incumbent operations support systems providers in selling productsand services to large CSPs, our business may be harmed.**

 

We believe large CSPs are seeking ways to reduce operating costs. ManyCSPs have a large number of OSS systems from a variety of different suppliers.In an effort to reduce operating costs, the CSPs could choose to reduce thenumber of OSS vendors they use in hopes to gain efficiencies. We could losecustomers if we were not selected as a surviving incumbent OSS provider. Inaddition, our ability to sell our products and services to the large CSPs couldbe limited if we had to compete directly with an incumbent OSS provider withgreater resources.

 

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**If our clients in the emerging marketsegments do not receive sufficient financing, it could affect our ability togrow.**

 

Some of our clients and potential clients are new entrants to thecommunications market and have limited or no operating histories and limitedfinancial resources. These clients often must obtain significant amounts offinancing to fund operations and to deploy their networks. We frequently workwith such companies prior to their receipt of financing. If these companiesfail to receive adequate financing, particularly after we have begun workingwith them, or are not able to implement their business plans successfully, ourresults of operations may be harmed. In addition, because of recent and currenteconomic conditions, these companies are experiencing difficulty in obtainingadequate financing.

 

**Our growth depends on the commercialacceptance of our products for IP networks, and it is uncertain to what extentthe market will accept these products.**

 

Our future growth depends on the commercial success of our products.Substantially all of our revenues are derived from licenses of these productsand related services. Our business will be harmed if our target customers donot adopt and purchase or license these software products. The market for IPnetwork mediation and rating software is in its early stages of development.Our future financial performance will also depend on the successfuldevelopment, introduction and customer acceptance of our software products forIP networks. We are not certain that our target customers will widely adopt anddeploy our software products in their communications operations. Our futurerevenues will also depend on our customers’ licensing software for additionalsubscribers or for additional event records. Their failure to do so could harmour business.

 

**An increasing number of contracts we enterinto are multiple years in length and include recurring fees related tolicensing and services. If our customers exercise early termination provisionsor experience a decline or lack of volume, our revenue could be harmed.**

 

An increasing number of our contracts with new customers are multi-yearagreements and include recurring license and service fees. Some of ourcontracts for new customers could include a recurring licensing and servicescomponent that may vary based on usage and volume throughout the duration ofthe contract. Also, some of our contracts include early termination clausesthat enable customers to terminate those contracts without cause. If ourcustomers exercise early termination or experience a decline or lack of volume,our revenue could be harmed.

 

**If we do not increase market awareness of ourproducts, our business may not grow.**

 

We sell and license our software products primarily through our directsales force. Our financial success and our ability to increase revenues in thefuture may depend considerably upon the productivity of our direct sales force.Our ability to increase revenues significantly will suffer if we fail toattract and retain qualified sales personnel.

 

During 2003 and 2004, we augmented our direct sales channel throughadditional third-party distribution arrangements, such as indirect saleschannels, including system integrators, hardware platform and softwareapplications developers and service providers, domestic and foreign resellersand value-added resellers. However, there is no guarantee that we willsuccessfully augment these arrangements or that the expansion of indirect salesdistribution methods will increase revenues. We may be at a competitivedisadvantage if we fail to enhance these indirect sales channels.

 

**If our software products do not continue tobe enhanced and continue to integrate and operate successfully with thecommunications equipment of the leading manufacturers, we may be unable tomaintain our existing customers and/or generate new sales.**

 

If we do not continue to improve our software products and develop newsoftware products that keep pace with competitive product introductions andtechnological developments, satisfy diverse and rapidly evolving customerrequirements and achieve market acceptance, we may be unable to maintainexisting customers and/or attract new customers.

 

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Additionally, the success of our software products depends upon thecontinued successful integration and operation of our software products withthe communications equipment of the leading manufacturers. We currently targeta customer base that uses a wide variety of communications networkinfrastructure equipment and software platforms, which are constantly changing.As such, we must continually modify our software products as new communicationsequipment is introduced. If our products fail to satisfy these demanding andrapidly changing technical challenges, our existing customers will bedissatisfied. As a result, we may be unable to generate future sales and ourbusiness will be materially adversely affected.

 

We have in the past experienced delays in releasing new softwareproducts and product enhancements and may experience similar delays in thefuture. These delays or problems in the installation or implementation of ournew releases may cause customers to forego purchasing or licensing our softwareproducts.

 

**We face intense competition from companiesthat may have greater resources than we do and, if we are unable to competewith them effectively, then our business may suffer.**

 

The market for our products is very competitive.  During 2000 to 2002, the economic downturn inthe communications industry resulted in fewer sales opportunities, which inturn resulted in more competition for each sales opportunity that existed.  Since 2002, the communications industry hasbeen and continues to show signs of improvement and increased capital spendingin certain segments.  Our principalcompetitors include mediation system providers, billing and customer caresystem providers, operation support system providers, system integrators andservice bureaus, and the internal information technology departments of largercommunications companies, which may elect to develop functionalities similar tothose provided by our product in-house rather than obtaining them from outsidesuppliers.

 

Many of our current and future competitors may have advantages over us,including:

 

•                  longeroperating histories;

 

•                  largercustomer bases;

 

•                  substantiallygreater financial, technical, sales and marketing resources; and

 

•                  greatername recognition.

 

Our current and potential competitors have established, and maycontinue to establish in the future, cooperative relationships among themselvesor with third parties that would increase their ability to compete with us. Inaddition, competitors may be able to adapt more quickly than we can to new oremerging technologies and changes in customer needs, or to devote moreresources to promoting and selling their products. If we fail to adapt tomarket demands and to compete successfully with existing and new competitors,our business and financial performance would suffer.

 

**We depend on our intellectual property andlitigation regarding our intellectual property could harm our business.**

 

Unauthorized use or misappropriation of our intellectual property couldseriously harm our business. Our intellectual property includes our proprietarytechnology, our trade secrets, patents, copyrights in our software products,and our trademarks. Our copyrights and patents are important to the protectionof our software, and our trademarks are important to the protection of ourcompany and product names. These copyrights, patents and trademarks discourageunauthorized use of our software and our company and product names and provideus with a way to enforce our rights in the event that this unauthorized useoccurs. Third parties may infringe upon our intellectual property rights, andwe may be unable to detect this unauthorized use or effectively enforce ourrights. Furthermore, the laws of certain countries in which we sell or licenseour products do not protect our software products and intellectual propertyrights to the same extent, as do the laws of the United States. In addition,any legal action that we may bring to protect our intellectual property rightscould be expensive and distract management from day-to-day operations.

 

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**Claims by others that we infringe theirproprietary technology could divert our resources, result in unexpected licensefees and harm our business.**

 

Third parties could claim that our current or future products ortechnology infringe their proprietary rights. An infringement claim against uscould be costly even if the claim is invalid, and could distract our managementfrom the operation of our business. Furthermore, a judgment against us couldrequire us to pay substantial damages and could also include an injunction orother court order that could prevent us from selling or licensing our productoffering. If we faced a claim relating to proprietary technology orinformation, we might seek to license technology or information, or develop ourown, but we might not be able to do so. Our failure to obtain the necessarylicenses or other rights or to develop non-infringing technology could preventus from selling or licensing our products and could seriously harm ourbusiness.

 

**If our software contains errors or oursoftware product development is delayed, our business will suffer.**

 

We face possible claims and higher costs as a result of the complexityof our software products and the potential for undetected errors. Due to theimportance of our products to our customers’ operations, undetected errors areof particular concern. Computer software such as ours always containsundetected errors. The implementation of our products, which we accomplishthrough our services division, typically involves working with sophisticatedsoftware, computing and communications systems. If we experience difficultieswith an implementation or do not meet project milestones in a timely manner, wecould be obligated to devote more customer support, engineering and otherresources to a particular project and to provide these services at reduced orno cost. If our software contains significant undetected errors or we fail tomeet our customers’ expectations or project milestones in a timely manner, wecould experience loss of or delay in revenues, loss of customers, injury to ourreputation, legal actions by customers against us, and increased service andwarranty costs.

 

Our license agreements with our customers generally contain provisionsdesigned to limit our exposure to potential product liability claims, such asdisclaimers of warranties and limitations on liability for special, consequentialand incidental damages. In addition, our license agreements generally cap theamounts recoverable for damages to the amount paid by the licensee to us forthe product or service, giving rise to the damages. However, all domestic andinternational jurisdictions may not enforce these limitations. We may encounterproduct liability claims in the future. Product liability claims, whether ornot successful, brought against us could divert the attention of management andkey personnel, could be expensive to defend and may result in adversesettlements and judgments.

 

**Fixed price services engagements can impactour profitability if we fail to complete them within the estimated budget.**

 

We perform some of our professional services engagements on a fixedprice basis. If the project requires more labor or products than was estimatedby us in determining the fixed price agreed to with the customer, our marginsand profitability will be adversely affected. In addition, failure to completeservices as required or to obtain written acceptance of completed milestonesmay result in deferral of revenue until such completion or acceptance occurs, aloss of anticipated cash flow, or may cause revenues to be recognized inperiods other than as initially expected or forecast.

 

**Barriers to international expansion couldlimit our future growth.**

 

We are considering an expansion of our international operations, and inthe event we do so, we may face significant barriers to this expansion. Ourfailure to manage our international operations effectively could limit thefuture growth of our business.  While ourrevenues attributable to international operations during 2004 have increased,the percentage of our revenues attributable to international operationsrelative to total revenues has decreased. International customers represented approximately 14% and 16% of ourtotal revenue for the years ended December 31, 2004 and 2003.  We conduct our international sales primarilywith partners with operations around the world.  Any expansion of ourexisting international operations and entry into additional internationalmarkets may require significant management attention and may require additionalfinancing.

 

Our international operations face numerous risks. Our products must belocalized—customized to meet local user needs—in order to be sold in particularforeign countries. Developing local versions of our products for foreignmarkets is difficult and can take longer than we anticipate. We currently havelimited experience in localizing products

 

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and in testing whether these localized products will be accepted in thetargeted countries. In addition, we have only a limited history of marketing,licensing, selling and supporting our products and services internationally. Asa result, we may need to focus on entering into strategic relationships withcompanies in international markets. If we are not able to maintain successfulstrategic relationships internationally or recruit additional companies toenter into strategic relationships, our future growth could be limited.

 

We also face certain other risks inherent in conducting businessinternationally, such as:

 

•                  difficultiesand costs of securing and training international partners;

 

•                  languageand cultural differences;

 

•                  difficultiesin collecting accounts receivable and longer collection periods;

 

•                  seasonalbusiness activity in certain parts of the world;

 

•                  fluctuationsin currency exchange rates;

 

•                  legaland governmental regulatory requirements;

 

•                  tradebarriers; and

 

•                  potentiallyadverse tax consequences.

 

Any of these factors could seriously harm our international operationsand, consequently, our business.

 

To date, a majority of our international revenue and costs have beendenominated in United States Dollars. However, future international revenue andcosts may be denominated in currencies other than the United States Dollar. Wehave not engaged in any foreign exchange hedging transactions, and we aretherefore subject to foreign currency risk.

 

**If we acquire additional companies in thefuture, they could prove difficult to integrate, disrupt our business, dilutestockholder value or adversely affect our operating results.**

 

We may decide to make other investments in complementary companies. Wemay not realize the anticipated benefits of any other acquisition orinvestment. The success of our acquisition program will depend on our abilityto overcome substantial obstacles, such as the availability of acquisitioncandidates, our ability to compete successfully with other acquirers seekingsimilar acquisition candidates, the availability of funds to financeacquisitions and the availability of management resources to oversee theoperation of acquired businesses. Furthermore, we may have to incur debt orissue equity securities to pay for any additional future acquisitions orinvestments, the issuance of which could be dilutive to us or our existingstockholders. In addition, our profitability may suffer because ofacquisition-related costs or future impairment costs for acquired goodwill andother intangible assets. We have limited resources and we can offer noassurance that we will succeed in consummating any additional acquisitions orthat we will be able to integrate and manage any acquisitions successfully.

 

We have no present commitments, understandings or plans to acquireother companies.

 

**If we fail to modify or improve our softwareproducts in response to evolving industry standards, our software productscould rapidly become obsolete, which would harm our business.**

 

Future versions of hardware and software platforms embodying newtechnologies and the emergence of new industry standards could render ourproducts obsolete. Our future success will depend upon our ability to developand introduce a variety of new products and product enhancements to address theincreasingly sophisticated needs of our customers.

 

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Our products are designed to work on a variety of hardware and softwareplatforms used by our customers. However, our products may not operatecorrectly on evolving versions of hardware and software platforms, programminglanguages, database environments, accounting and other systems that ourcustomers use. We must constantly modify and improve our products to keep pacewith changes made to these platforms and to back-office applications and otherInternet-related applications. This may result in uncertainty relating to thetiming and nature of new product announcements, introductions or modifications,which may harm our business.

 

**Our operating results may be affected when weare required to change our accounting for employee stock options.**

 

We currently account for the issuance of stock options under AccountingPrinciples Board (“APB”) Opinion No. 25, “*Accountingfor Stock Issued to Employees*.” Under APB No. 25, nocompensation expense is recognized for options granted to employees where theexercise price equals the market price of the underlying stock on the date ofgrant. In December 2004, the FASB issued SFAS No. 123 (revised), “*Share-Based Payment”*.  This standard revises APB Opinion No. 25 andrelated accounting interpretations, and eliminates the use of the intrinsicvalue method for employee stock-based compensation currently adopted by theCompany.  SFAS No. 123(R) requirescompensation costs related to share-based payment transactions to be recognizedin the financial statements over the period that an employee provides servicein exchange for the award.  The effectivedate of this standard will be January 1, 2006. Our operating results could be negatively impacted as a result of theadditional expenses associated with the expensing of stock options under thisnew standard.  Management is currentlyassessing the extent of the negative impact, if any, that this new standardwill have on the Company’s financial statements.  See Note 6 of the “*Notes to Consolidated Financial Statements*”for the year ended December 31, 2004, for a more detailed presentation ofour accounting for stock-based compensation.

 

**Governmental regulations that limit thegrowth of the Internet or the communications industry could limit our potentialmarket.**

 

The communications carriers that constitute our clients are regulatedat the federal, state and local levels. Federal and state regulations mayinhibit the growth of the Internet or communications industry, affect thedevelopment of Internet enhanced services, limit the number of potentialclients for our services, impede our ability to offer competitive services tothe Internet and communications markets, or otherwise have an adverse effect onour business, financial condition, results of operations and cash flows.

 

In addition, some states have pending legislation that prohibitsmunicipal utilities from offering telecommunication services.

 

The Telecommunications Act of 1996, which in large measure deregulatedthe telecommunications industry, has caused, and is likely to continue tocause, significant changes in the industry, including the entrance of newcompetitors, consolidation of industry participants and the introduction ofbundled services, such as wireless, wireline, data, and video. Those changescould in turn subject us to increased pricing pressures, decrease the demandfor our products and services, increase our cost of doing business or otherwisehave a materially adverse effect on our business, financial condition, resultsof operations and cash flows.

 

**Risks Related to Owning Our Stock**

 

**Future sales of our common stock may depressour stock price.**

 

A significant number of shares of our common stock are freelytradable.  Additionally, we registered,as part of a 2004 registration statement, shares representing 77.0% of ourissued and outstanding common stock as of March 2, 2005 and 63.4% afterissuance of all currently un-issued shares included in the RegistrationStatement. If any of our stockholders sell substantial amounts of our commonstock in the public market, the market price of our common stock could fall. Inaddition, such sales could create the perception in the public of difficultiesor problems with our software products and services. As a result, these salesalso might make it more difficult for us to sell equity or equity-relatedsecurities in the future at a time and price that we deem appropriate.  Currently, the Registration Statement is not effectivedue to the passage of time.  If apost-effective amendment to the Registration Statement is filed and declaredeffective, the shares covered by such Registration Statement will again befreely tradable.

 

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**Since first trading on March 14, 2001,our common stock has experienced significant price and volume volatility and weexpect that it will continue to do so in the future, which substantiallyincreases the risk of loss to persons owning our common stock.**

 

There was no market for our common stock prior to our initialdistribution in 2001. Because of the limited trading market for our commonstock, and because of the possible price volatility, you may not be able tosell your shares of common stock when you desire to do so. The inability tosell your shares in a rapidly declining market may substantially increase yourrisk of loss because of such illiquidity and because the price for our commonstock may suffer greater declines because of its price volatility.

 

In addition, the stock market has experienced extreme price and volumefluctuations, which have particularly affected the market prices of manyInternet and computer software companies, including ours, and which we believehave often been unrelated to the operating performance of these companies orour Company.

 

**We are not required to meet or maintain anylisting standards for our common stock to be quoted on the OTC Bulletin Boardor in the Pink Sheets, which could affect our stockholders’ ability to accesstrading information about our common stock.**

 

The OTC Bulletin Board and the Pink Sheets are each separate anddistinct from the Nasdaq Stock Market and any national stock exchange, such asthe New York Stock Exchange or the American Stock Exchange. Although the OTCBulletin Board is a regulated quotation service operated by the NASD, thatdisplays real-time quotes, last sale prices, and volume information inover-the-counter (“OTC”) equity securities like our common stock, and althoughPink Sheets’ Electronic Quotation Service is an Internet-based, real-timequotation service for OTC equities for market makers and brokers that providespricing and financial information for the OTC securities markets, we are notrequired to meet or maintain any qualitative or quantitative standards for ourcommon stock to be quoted on either the OTC Bulletin Board or in the PinkSheets. Our common stock does not presently meet the minimum listing standardsfor listing on the Nasdaq Stock Market or any national securities exchange,which could affect our stockholders’ ability to access trading informationabout our common stock.  Additionally, weare required to satisfy the reporting requirements under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”).  If we fail to do so, our shares may no longerbe quoted on the OTC.

 

 **We do not intend to paydividends; you will not receive funds without selling shares.**

 

We have never declared or paid any cash dividends on our capital stockand do not intend to pay dividends in the foreseeable future. We intend toinvest our future earnings, if any, to fund our growth. Therefore, you will notreceive any funds without selling your shares.

 

**Because some stockholders togetherbeneficially own or have the right to vote 45.8% and 21.4%, respectively, ofour voting stock, the voting power of other stockholders may be limited.**

 

Persons affiliated with the Special Situations Funds beneficially ownor control, directly or indirectly, outstanding shares of common stock, whichin the aggregate represent approximately 45.8% of the outstanding shares ofcommon stock. In addition, our executive officers and directors beneficiallyown or control, directly or indirectly, outstanding shares of common stock,which in the aggregate represent approximately 21.4% of the outstandingshares of common stock. As a result, if some of these persons or entities acttogether, they may have the ability to control all matters submitted to ourstockholders for approval, including the election and removal of directors andthe approval of any business combination. This may delay or prevent anacquisition or cause the market price of our stock to decline. Some of thesepersons or entities may have interests different than yours. For example, theymay be more interested than our other stockholders in selling Primal to anacquirer or in pursuing alternative strategies.

 

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**Provisions in our charter documents andDelaware law may delay or prevent an acquisition of us.**

 

Our certificate of incorporation and bylaws contain provisions thatcould make it harder for a third party to acquire Primal without the consent ofour Board of Directors. The acquirer will not be able to cumulate votes at ameeting of our stockholders, which will require the acquirer to hold moreshares to gain representation on the Board of Directors than if cumulativevoting were permitted. In addition, Section 203 of the Delaware GeneralCorporation Law limits business combination transactions with 15% stockholdersthat have not been approved by the Board of Directors. These provisions andother similar provisions make it more difficult for a third party to acquire uswithout negotiation.

 

Furthermore, our Board of Directors could choose not to negotiate withan acquirer that it did not feel was in the strategic interests of Primal. Ifthe acquirer was discouraged from offering to acquire us or prevented fromsuccessfully completing a hostile acquisition by the anti-takeover measures,you could lose the opportunity to sell your shares at a favorable price.

 

**Our common stock may be subject to pennystock rules, which may make it more difficult for our stockholders to sell theircommon stock.**

 

Broker-dealer practices in connection with transactions in “pennystocks” are regulated by certain penny stock rules adopted by the Securitiesand Exchange Commission (“SEC”). Penny stocks generally are equity securitieswith a price of less than $5.00 per share. The penny stock rules require abroker-dealer, prior to a purchase or sale of a penny stock not otherwiseexempt from the rules, to deliver to the customer a standardized riskdisclosure document that provides information about penny stocks and the risksin the penny stock market. The broker-dealer also must provide the customerwith current bid and offer quotations for the penny stock, the compensation ofthe broker-dealer and its salesperson in the transaction, and monthly accountstatements showing the market value of each penny stock held in the customer’saccount. In addition, the penny stock rules generally require that prior to atransaction in a penny stock the broker-dealer make a special writtendetermination that the penny stock is a suitable investment for the purchaserand receive the purchaser’s written agreement to the transaction. Thesedisclosure requirements may have the effect of reducing the level of tradingactivity in the secondary market for a stock that becomes subject to the pennystock rules.

 

**Item 2.****Properties**

 

We do not own any real estate properties, but leaseapproximately 13,500 square feet of general and administrative office space inIrvine, California.  Our monthly rentpayment is approximately $33,000.  Ourlease expires in April 2007.  In February2004, we entered into a lease agreement for an additional 7,000 square feetwhich includes a data center and general and administrative office space inIrvine, California with a monthly rent payment of approximately $9,000 throughMay 2006.  We also lease an executivesuite in Amsterdam, The Netherlands on a monthly basis.  Our monthly rent payment for the executivesuite is approximately $700.

 

# **Item 3.****Legal Proceedings**

#  

We are not currently a party to any material legalproceeding.

 

# **Item 4****. Submission of Mattersto a Vote of Security Holders**

#  

On November 12, 2004, the Company held its 2004 Annual Meeting ofStockholders.  At the Annual Meeting, theCompany’s Stockholders were asked to vote upon, either in person or by proxy,the Company’s 2004 Flexible Incentive Plan, the election of the Company’s Boardof Directors and ratification of the appointment of Haskell & White LLP asthe Company’s independent auditors for the fiscal year ending December 31,2004.

 

21

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At the conclusion of the Company’s 2004 Annual Meeting of Stockholders,all matters submitted to stockholder vote were approved.  The following is a summary of the results ofthe Company’s 2004 Annual Meeting of Stockholders:

 
| **Proposal**                                                                                                                                             | ** ** | **For**    | ** ** | **Against  Or  Withheld** | ** ** | **Abstain*** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|---------------------------|------------|--------------|------------|
|                                                                                                                                                     |       |       |       |                      |       |         |       |
| Election of Joseph R. Simrell to Board of  Directors (1)                                                                                                 |       | 29,109,271 |       | 16,000                    |       | n/a          |       |
|                                                                                                                                                     |       |       |       |                      |       |         |       |
| Election of David Haynes to Board of  Directors (1)                                                                                                      |       | 29,109,271 |       | 16,000                    |       | n/a          |       |
|                                                                                                                                                     |       |       |       |                      |       |         |       |
| Election of John Faltys to Board of  Directors (1)                                                                                                       |       | 28,699,959 |       | 425,312                   |       | n/a          |       |
|                                                                                                                                                     |       |       |       |                      |       |         |       |
| Election of Louis A. Delmonico to Board of  Directors (1)                                                                                                |       | 29,109,271 |       | 16,000                    |       | n/a          |       |
|                                                                                                                                                     |       |       |       |                      |       |         |       |
| Election of John E. Rehfeld to Board of  Directors (1)                                                                                                   |       | 29,109,271 |       | 16,000                    |       | n/a          |       |
|                                                                                                                                                     |       |       |       |                      |       |         |       |
| Approval of Company’s 2004 Flexible  Incentive Plan                                                                                                 |       | 19,733,760 |       | 1,438,273                 |       | 416,812      |       |
|                                                                                                                                                     |       |       |       |                      |       |         |       |
| Appointment of Haskell & White LLP as  the independent certified public accountants of the Company for the fiscal  year ended December 31, 2004 |       | 25,639,566 |       | 10,000                    |       | 1,700        |       |

 

----

*Excludes 8,258,351 broker non-votes

 

(1) To serve until his successor is dulyelected and qualified or until his death, resignation of removal from office.

 

**PART II**

 

**Item 5.****Market for Common Equity andRelated Stockholder Matters**

 

Ourcommon stock has been quoted on the OTC Bulletin Board sinceFebruary 2001, and currently is quoted on the OTC Bulletin Board and thePink Sheets under the trading symbol “PSOL.” The following table sets forth thehigh and low bid prices for our common stock for the periods indicated, asreported by OTC Bulletin Board. Such quotations reflect inter-dealer prices,without retail mark-up, mark-down or commissions, and may not necessarilyrepresent actual transactions.

 
| ** **                    | ** ** | **Bid**  | ** ** |
|-------------------------------|------------|----------|------------|
| ** **                    | ** ** | **High** | ** ** | **Low** | ** ** |
| Year ended December 31, 2004: |       |     |       |   |   |
| First Quarter                 |       | $        | 0.35       |   | $ | 0.21 |   |
| Second Quarter                |       | 0.45     |       | 0.20 |   |
| Third Quarter                 |       | 0.30     |       | 0.12 |   |
| Fourth Quarter                |       | 0.40     |       | 0.14 |   |
|                          |       |     |       |   |   |
| Year ended December 31, 2003: |       |     |       |   |   |
| First Quarter                 |       | $        | 0.15       |   | $ | 0.04 |   |
| Second Quarter                |       | 0.07     |       | 0.05 |   |
| Third Quarter                 |       | 0.18     |       | 0.04 |   |
| Fourth Quarter                |       | 0.40     |       | 0.10 |   |

 

As of March 21, 2005, there were approximately 350holders of record of our common stock.

 

22

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We have never declared or paid any cash dividends onour common stock. For the foreseeable future, we expect to retain any earningsto finance the operation and expansion of our business.

 

# **Item 6****. Management’sDiscussion And Analysis Of Financial Condition And Results Of Operations**

#  

The following discussion should be read in conjunction with ourconsolidated financial statements and related notes and the other financialinformation included elsewhere in this report.

 

**A NOTE ABOUT FORWARD-LOOKING STATEMENTS**

 

The statements, other than statements ofhistorical fact, included in this report are forward-looking statements.Forward-looking statements generally can be identified by the use offorward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,”“anticipate,” “plan,” “seek,” or “believe.” We believe that the expectationsreflected in such forward-looking statements are accurate. However, we cannotassure you that such expectations will occur. Our actual future performancecould differ materially from such statements. You should not unduly rely onthese forward-looking statements, which speak only as of the date of thisAnnual Report. Except as required by law, we are not obligated to releasepublicly any revisions to these forward-looking statements to reflect events orcircumstances occurring after the date of this report or to reflect theoccurrence of unanticipated events.

 

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**General**

 

We deliver software and service solutionsthat allow the communications service providers to generate revenue from its IPnetwork. Our communications software products and services enable usage-basedbilling and customer usage management for IP network services without requiringthe CSP to undertake expensive changes or upgrades to existing back-officebilling and customer care systems.

 

We have focused our marketing and productstrategy around IP networks. We believe that the greatest opportunity forgrowth in sales of both our products and services will be to CSPs who utilizeIP networks for multiple services including voice, data, and video. Our IPmediation system, Access IM®, our event rating system, Connect RTRTM,our integrated mediation, rating and web presentation system, Connect IXCTM, and our customer care and billingsystem, Connect CCB®, form the foundation for the solutions we provide tocustomers.

 

We believe the primary markets that showsigns of growth opportunities for our products and services are cable multipleservice operators; rural broadband CSPs, including rural utilities andmunicipal agencies investing in broadband systems such as fiber-to-the-homenetworks (collectively referred to as “Rural Broadband CSPs”); and managednetwork service providers that provide enhanced voice and data services to businesscustomers on a single IP network.

 

**Current Conditions**

 

Our largest customer, which accounted for $4.3 million in revenuesduring the 12 months ended December 31, 2004 or approximately 56% of totalrevenues, following the completion of its merger with and into another wirelesstelecommunications company in November 2004, notified us of its intention notto renew its license and services agreement with us.  This customer accounted for approximately 69%or $4.5 million in revenue based on total revenues of $6.5 million for the 12months ended December 31, 2003.  Ourlicense and services agreement with this customer is scheduled to expire inDecember 2005 according to its terms. Based upon our conversations with this customer, it is our understandingthat our customer’s election not to renew its agreement with us was a result ofa previous significant investment by its merger partner in an existing billingsystem in place prior to the merger, and on which most of the combined company’scustomers already reside.  We expect tocontinue to maintain our historically cooperative working relationship withthis customer and are in discussions to modify and extend our license andservices agreement to meet some of the customer’s on-going need to accesshistorical data.

 

As discussed elsewhere in this Report in June2004, we issued an aggregate of 14,284,782 shares of our common stock (the “Shares”)and warrants to purchase 7,142,393 shares of our common stock (the “Warrants”)to certain institutional and accredited investors (the “Private Placement”)resulting in gross proceeds of approximately $3.3 million. We have usedand plan to continue to use a portion of the net proceeds from the PrivatePlacement to expand the sales and marketing efforts in the near term and forother general working capital purposes.

 

In 2004, we began expanding our sales andmarketing capabilities to seek new sales opportunities for our products andservices through our direct sales force and our relationships withcommunications infrastructure providers. The markets for these products havebeen and continue to be very competitive. Sales opportunities in the UnitedStates have continued to be limited due to the continued constrained economicconditions experienced by the communications industry, although we have begunto see improvements in the marketplace. While we believe there is a goodopportunity to sell or license our solutions to Community Broadband CSPs, thesales cycle in this market can be six months or longer because Community BroadbandCSPs are frequently local municipal utilities and are subject to variousregulatory requirements and agency oversight that can delay the timeline for aCommunity Broadband CSP attempting to offer new services to its customers.While sales opportunities have been available in international markets, such asAsia-Pacific and Europe, currently, we are not actively pursuing thesegeographic markets because of competition from larger competitors who have alocal presence in these international markets, or locally based competitors inthese international markets due to our current lack of a more fully-developedinternational sales and support capability.

 

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During 2003 and 2004, we successfullydeployed our products and services into the “tier-one” Cable MSO and ruralbroadband markets, and have continued to focus on these domestic targetmarkets. Additionally, we launched our application management and hostingservices during 2003. To date, these services have served, and we anticipatewill continue to serve, as an increasingly important element of our growth.

 

Our other notable activities andaccomplishments during 2003 and 2004 were as follows:

 

•                  Increasedour Connect IXC deployment support to a “tier-one” Cable MSO customer to assistthis customer in rolling out its voice-over-IP networks (“VOIP”) service to its31 U.S. cable markets by the end of 2004.

 

•                  DeployedConnect IXC for another “tier-one” Cable MSO for its rollout of VoIP servicesthat began later in 2004.

 

•                  DeployedConnect CCB, an integrated customer care and billing solution, and Connect IXCat a municipal utility to support its rollout of VOIP, cable televisionservices, and high-speed data services.

 

•                  Enteredinto two multi-year agreements with separate rural municipalities to deploytheir operation support systems on a “next generation” network to supportvoice, video and data services on the same network (“triple play”).

 

•                  Enhancedour products to provide additional value for the customers in our targetmarkets.

 

•                  Furtherestablished relationships with communication infrastructure providers who areactive in the rural broadband market.

 

•                  Increasedour marketing activities to build market awareness of our solutions throughincreased participation in trade shows and other activities.

 

•                  Continuedassisting our largest customer in migrating from our legacy billing system toour new billing system.

 

•                  Expandedand strengthened our management team.

 

During 2003, we increased revenue by $389,000to $6.5 million for the year ended December 31, 2003 in comparison tothe year ended December 31, 2002.  During2004, we increased revenue by an additional $1.1 million or 17% to $7.6 millionfor the year ended December 31, 2004. Despite our improvements, we do not expect to achieve profitability inthe near future as we continue to invest in growing our business.

 

For the year ended December 31, 2004, weincreased services revenue $1.2 million or 30% to $5.2 million, as compared to$4.0 million for the year ended December 31, 2003.  This increase came primarily from ourapplication management and hosting services as well as from delivering customerusage analytics products and other new services which we believe will continueto support revenue growth throughout 2005. By leveraging our application management and hosting services and ourapproach to solutions delivery, we believe we are able to deliveruniquely-tailored solutions for clients that solve business challenges in timeframes that make business sense for their businesses and we are able to createrecurring revenue streams over and above those from software maintenance.  We believe that our business model is mostsuccessful when we combine our application management and hosting services withdelivery of software solutions and when we deliver to each client a series ofsmaller solutions rather than any single large solution.  We believe that our success is enhanced whenwe take advantage of opportunities to provide value-added extensions or add-onsto help clients maximize the value they derive from the vast quantities of datacreated through their day-to-day operations. Through this approach, we believe that we are able to establishcredibility, create strong relationships with our customers, and identify newopportunities to serve our clients as we get to know their needs overtime.  This strategy has been usedsuccessfully in serving both larger MSOs and other CSPs as well as communitybroadband providers

 

25

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We expect revenue to continue to increase in2005 and we expect services revenue to become a larger portion of total revenueas a result of the deployment of services to more customers. As we continue tobuild our services offering, we expect margins associated with services revenueto improve as certain fixed costs of services are leveraged to produce moreservices revenue.

 

Working capital has significantly improveddue to the closing of our $3.3 million Private Placement in the secondquarter of 2004.  We increased our cashbalances by $1.4 million to $2.6 million at December 31, 2004 compared toDecember 31, 2003.

 

The following discussion and analysisprovides information that we believe is relevant for an assessment andunderstanding of our consolidated financial condition and results ofoperations. The discussion should be read in conjunction with our consolidatedfinancial statements and related notes and the other financial informationincluded elsewhere in this Report.

 

**Spin-Off of  Primal**

 

We were spun-off as a separate public companyby Avery Communications, Inc. (“Avery”) in February 2001. OnFebruary 13, 2001 and in connection with the Primal Solutions, Inc.Preliminary Distribution Agreement (the “Distribution Agreement”), dated July 31,2000, by and among Avery, us, and other parties listed therein, Averydistributed approximately 13.2 million shares of our common stock to Avery’ssecurity holders (the “Distribution”). As part of the Distribution:

 

•                  Eachcommon shareholder of Avery on February 12, 2001, received one share ofour common stock for each share of Avery’s common stock held on that date;

 

•                  Ownersof shares of Avery’s Series A, B, C, D, and E convertible preferred stockreceived our common stock, in the amount of the preferred stock’s common stockequivalent for each share of Avery preferred stock held on the payment date ofthe Distribution;

 

•                  Averyredeemed 7,126,894 shares of its Series G preferred stock fromMessrs. John Faltys, Joseph R. Simrell, David Haynes, Mark J. Nielsen,Arun Anand, Murari Cholappadi, and Sanjay Gupta (collectively, the “Old PrimalStockholders”) in consideration of the issuance of 6,207,026 shares of ourcommon stock, each dated February 9, 2001; and

 

•                  Weissued 250,000 shares of our common stock to a former executive officer ofAvery.

 

**Selected Financial Information Line ItemExplanations**

 

Our revenues are primarily derived from thesale of software licenses and related services to communications and Internetcarriers.

 

System revenues consist of software licensefees charged to our customers for their use of our software. Software licensefees include one-time and recurring license charges, and license upgradecharges for our communications software products. Software license fees arevolume sensitive and generally are based on the number of subscribers, callrecords, or number of events.

 

Service revenues are generated by providingservices relating to our software products. These services include maintenancefees, installation services, training, application management and hostingservices and custom software development.

 

26

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Revenues from sales of software licenses,which generally do not contain multiple elements, are recognized upon deliveryof the related product if the requirements of SOP 97-2 are met. If therequirements of SOP 97-2, including evidence of an arrangement, clientacceptance, a fixed or determinable fee, collectibility or vendor-specificobjective evidence about the value of an element, are not met at the date ofdelivery, revenue recognition is deferred until such items are known orresolved. Revenue from post-signing customer support is deferred and recognizedratably over the term of the contract. Revenues from services are recognized asthe services are performed under the agreements.

 

We believe that future license revenues willbe generated from three sources: license fees from new customers; license feesfor new products to existing customers; and growth in our customers’ subscriberbases and call records or events volume, which may lead to increased revenuefrom these volume-based licenses.

 

System cost of revenues includes hardwarecosts and software license fees paid to third-parties under equipment resaleand technology license arrangements.

 

Service cost of revenues includes all costsassociated with the customer service organization, including staffing expenses,travel, communications costs, and other support costs related with installing,training, providing help desk services, providing application management andhosting services and customization for our communications software products.

 

Operating expenses are comprised of sales andmarketing costs, research and development, and general and administrativecosts.

 

Sales and marketing costs include salariesand benefits, commissions, trade shows, advertising and promotional andpresentation materials.

 

Research and development costs consist ofsalaries and benefits and other support costs.

 

General and administrative costs consist ofgeneral management and support personnel salaries and benefits, informationsystems costs, facilities costs, legal and accounting fees, travel andentertainment costs, public company related expenses and other support costs.

 

27

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**RESULTS OF OPERATIONS FOR THE YEARS ENDEDDECEMBER 31, 2004 AND 2003**

 

**Statement of Operations Data (in thousands)**

 
| ** **                        | ** ** | **Year Ended  December 31,** | ** ** | **Change** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|------------|------------|
| ** **                        | ** ** | **2004**                          | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| REVENUES:                         |       |                              |       |       |       |   |   |   |   |
| System revenue                    |       | $                                 | 2,442      |       | $          | 2,549 |   | (107 | ) | (4 | )% |
| Service revenue                   |       | 5,167                             |       | 3,968      |       | 1,199 |   | 30 | % |
| Total revenues                    |       | 7,609                             |       | 6,517      |       | 1,092 |   | 17 | % |
| COST OF REVENUES:                 |       |                              |       |       |       |   |   |   |   |
| System revenue                    |       | 96                                |       | 244        |       | (148 | ) | (61 | )% |
| Service revenue                   |       | 3,620                             |       | 2,692      |       | 928 |   | 34 | % |
| Total cost of revenues            |       | 3,716                             |       | 2,936      |       | 780 |   | 27 | % |
| GROSS MARGIN                      |       | 3,893                             |       | 3,581      |       | 312 |   | 9 | % |
| OPERATING EXPENSES:               |       |                              |       |       |       |   |   |   |   |
| Research and development          |       | 1,245                             |       | 994        |       | 251 |   | 25 | % |
| Sales and marketing               |       | 1,922                             |       | 1,050      |       | 872 |   | 83 | % |
| General and administrative        |       | 1,798                             |       | 1,608      |       | 190 |   | 12 | % |
| Total operating expenses          |       | 4,965                             |       | 3,652      |       | 1,313 |   | 36 | % |
| INCOME (LOSS) FROM OPERATIONS     |       | (1,072                            | )          | (71        | )          | (1,001 | ) | (1,410 | )% |
| INTEREST AND OTHER EXPENSE, NET   |       | (126                              | )          | (205       | )          | 79 |   | 39 | % |
| INCOME (LOSS) BEFORE INCOME TAXES |       | (1,198                            | )          | (276       | )          | (922 | ) | (334 | )% |
| INCOME TAX PROVISION              |       | 2                                 |       | 2          |       | — |   | — |   |
| NET INCOME (LOSS)                 |       | $                                 | (1,200     | )          | $          | (278 | ) | (922 | ) | (332 | )% |
|                              |       |                              |       |       |       |   |   |   |   |
| Supplemental data:                |       |                              |       |       |       |   |   |   |   |
| Depreciation and Amortization     |       | $                                 | 239        |       | $          | 374 |   | (135 | ) | (36 | )% |

 

28

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**Overview**

 

Total revenues for the 12 months endedDecember 31, 2004 were $7.6 million, an increase of $1.1 million, or 17%, from$6.5 million for the same period in 2003.  Despite the increase inrevenues, the gross margin percentage of 51% was 4% lower than the 55% grossmargin percentage achieved in the same period in 2003.  This decline wasprimarily due to a higher percentage of 2004 revenues from services revenue, alower gross margin percentage business compared to the systems segment.Operating expenses and net loss for the 12 months ended December 31, 2004 were$5.0 million and $1.2 million, respectively, increases of $1.3 million and $1.0million, respectively, compared to operating expenses and net loss of $3.7million and $278,000 for the same period in 2003.  The increase wasprimarily due to expenses related to expanding the sales and marketing effortsand increased general and administrative expenses attributable to the hiring ofadditional sales people, expending additional marketing costs to increase salesactivity, and increased facility and technology costs.

 

**Total Revenue**

 

Total revenues for the 12 months ended December 31, 2004 were $7.6million, an increase of $1.1 million or 17% from $6.5 million for the sameperiod in 2003.  This growth was primarily due to increased revenues fromimplementation services, application management, hosting services and other newprofessional services.

 

System revenues for the 12 months ended December 31, 2004 were $2.4million, or 32% of total revenues, a decrease of $107,000 from $2.5 million, or39% of total revenues for the same period in 2003.  This is primarily dueto a decline in the sale of third-party software and hardware.  Revenuesfrom the sale of third-party software and hardware for the 12 months endedDecember 31, 2004 were $98,000, a decrease of $185,000 from $283,000 for thesame period in 2003.  As we sell or license more solutions to our targetcustomers, we expect to see an increase in license revenues, but not anincrease in third-party software and hardware sales. In addition, our increaseduse of subscription-based licensing and managed-services pricing models isexpected to have a greater impact on our system revenues in future quarters, ifour customers increase their subscriber bases and transaction volumes afterdeploying our products and services into their markets. Under these models, weexpect that system revenues would increase as our customers’ subscriber basesand/or transaction volumes grow and thus, related licensing revenues would alsoincrease during their contract periods.

 

Service revenues for the 12 months ended December 31, 2004 were $5.2million, or 68% of total revenues, an increase of $1.2 million from $4.0million or 61% of revenues for the same period in 2003.  This growth wasprimarily due to an increase in application management and monthly recurringhosting services revenue, building customer usage analytics tools and other newservices.  Revenue from these services were $1.2 million for the 12 monthsended December 31, 2004, an increase of $1.0 million over the same period in2003.  In 2004, we increasingly assisted our customers in their roll-outof new products and services to target markets and supported them with toolsthat monitor progress and growth.  We anticipate that services revenueswill increase in future periods as we continue to enter into arrangements withnew customers and also expand our service offerings to existing and newcustomers.

 

Service revenue is primarily due to applications management and hostingservices, customer usage analytics services, maintenance revenue, delivery ofrecurring professional services associated with our existing customer base andthe delivery of professional services associated with new customercontracts.  In general, service revenue can fluctuate with the volume ofnew customer sales, as well as the renewal or non-renewal of maintenancecontracts or application management and hosting contracts on an annual basis.In addition, the services we provide to a customer can vary depending on thesolution that has been licensed, the complexity of the customer’s informationtechnology environment, the resources directed by the customers to theirimplementation projects, and the extent to which consulting organizationsprovide services directly to customers.

 

Forthe 12 months ended December 31, 2004, we had two customers that accounted forgreater than 10% of total revenues in the amount of $4.3 million and $1.0million, respectively, which represents 56% and 13%, respectively, of totalrevenues of $7.6 million.  In the same period in 2003,  we had onecustomer that accounted for greater than 10% of our total revenues in theamount of $4.5 million which represents 69% of total revenues of $6.5 million.

 

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**Cost of Revenues**

 

Totalcost of revenues for the 12 months ended December 31, 2004 was $3.7 million, or49% of total revenues, an increase of $780,000 from $2.9 million, or 45% oftotal revenues, for the same period in 2003.  This increase was primarilydue to service segment costs increase of $1.1 million required to fulfill theincreased activity in new service orders.  Services segment cost ofrevenue has a higher percentage cost of revenue as compared to our systemssegment.

 

Costof systems revenue for the 12 months ended December 31, 2004 was $96,000, or 3%of total cost of revenues, a decrease of $148,000 from $244,000, or 8% of totalcost of revenues, for the same period in 2003.  The decrease is primarilydue to a decrease in the sale of third-party software and hardware.  Cost of system revenue consists primarily of computer hardware resale andlicense fees paid to third parties under technology license arrangements.

 

Costof service revenue increased for the 12 months ended December 31, 2004, ascompared to the same period in 2003 primarily because of a higher level ofprofessional services activity and resultant revenues caused by increasedcustomer demand.  We have realized some inefficiency with the increasedactivity necessary to meet customer requirements.  We are taking stepsthat will include implementing new systems of control that should result indecreasing those inefficiencies during 2005.  Cost of service revenueincludes the costs of providing professional services including installation,training, maintenance, applications management and hosting services,customization, deployment and other professional services.

 

**Research and Development**

 

Researchand development expenses consist primarily of personnel and related costsassociated with our product development efforts.  Research and developmentexpenses for the 12 months ended December 31, 2004  were $1.2 million, or 16% of total revenues,an increase of $251,000 from $994,000, or 15% of total revenues for the same periodin 2003.  This increase primarily resulted from labor costs associatedwith our increased activity for new products development.

 

Our research and development efforts are focused on developing newproducts to meet the growing needs of our customers and on improving existingproducts by incorporating new features and technologies.  We believe thatthe timely development of new products and enhancements is essential tomaintaining our competitive position in the marketplace. In our research and developmenteffort, we work closely with our customers, end-users and leading technologypartners in tailoring new features that are incorporated into future versionsof products available to all customers.

 

**Sales and Marketing**

 

Salesand marketing expenses consist of payroll and related expenses for personnelengaged in sales and marketing activities, trade shows, marketing materials andrelated costs.  Sales and marketing expenses for the 12 months endedDecember 31, 2004 were $1.9 million, or 25% of total revenues, an increase of$872,000 from $1.1 million, or 16% of total revenues for the same period in2003.  This increase was primarily due to the addition of sales staff toimprove our direct sales capabilities and the increase in the marketingactivities to improve our marketing awareness.  During 2004, we hiredadditional sales personnel and participated at several trade shows.  Weexpect to continue to expand our sales and marketing efforts in future periods.

 

**General and Administrative**

 

Generaland administrative expenses consist of payroll and related expenses forexecutive, finance, administrative, facilities and information servicespersonnel, facilities and other general corporate expenses.  General andadministrative expenses for the 12 months ended December 31, 2004 were $1.8million, or 24% of total revenues, an increase of $190,000 from $1.6 million,or 25% of total revenues for the same period in 2003.  This increase wasprimarily due to increases in professional services, personnel, contract laborand facilities costs.

 

Depreciationand amortization expense for the 12 months ended December 31, 2004 was$239,000, a decrease of $135,000 from $374,000 for the same period in2003.  This decrease resulted from certain fixed assets acquired in 1999becoming fully depreciated during 2004.

 

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**Interest and Other Expense, Net**

 

Interestand other expense, net consist of interest expense, interest income and netgain or loss from the sale of fixed assets.  Interest and other expense,net for the 12 months ended December 31, 2004 was $126,000, a decrease of$79,000 from $205,000 for the same period in 2003.  This decrease wasprimarily due to the reduction in notes payable outstanding balances, whichresulted in lower interest costs.

 

**Income Tax Provision**

 

The income tax provision for the years ended December 31,2004 and 2003 consisted of the minimum state taxes due to the operating lossesfor the years.

 

**Liquidity and Capital Resources**

 

**Balance Sheet Data (in thousands)**

 
| ** **                                      | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **Change** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003**              | ** ** | **$**      | ** ** | **%** | ** ** |
| Cash and  cash equivalents                      |       | $                     | 2,603      |                  | $          | 1,249      |       | 1,354 |   | 108 |   |
| Accounts  receivable                            |       | 499                   |       | 640                   |       | (141       | )          | (22 | ) |
| Cash, cash  equivalents and accounts receivable |       | 3,102                 |       | 1,889                 |       | 1,213      |       | 64 |   |
| Current  Assets                                 |       | 3,225                 |       | 2,078                 |       | 1,147      |       | 55 |   |
| Accounts  payable and accrued expenses          |       | 1,255                 |       | 912                   |       | 343        |       | 38 |   |
| Current  portion notes payable                  |       | 634                   |       | 303                   |       | 331        |       | 109 |   |
| Deferred  revenue                               |       | 727                   |       | 1,002                 |       | (275       | )          | (27 | ) |
| Current  Liabilities                            |       | 2,616                 |       | 2,217                 |       | 399        |       | 18 |   |
| Working  Capital Surplus (Deficit)              |       | 609                   |       | (139                  | )          | 748        |       | 538 |   |
| Long-term  notes payable                        |       | 855                   |       | 1,625                 |       | (770       | )          | (47 | ) |
|                                                 |            |                       |            |                       |            |            |            |  |  |  |  |

 

**Overview**

 

Working capital increased to $609,000 at December 31,2004, an increase of $748,000 from a working capital deficit of $139,000 at December 31,2003.  This increase was primarily due to an increase in cash proceedsfrom our Private Placement net of related costs, less payments that reduced thebalance on notes payable and the net loss for the 12 months ended December 31,2004.  In the first quarter of 2004, we restructured the note payable toCorsair Communications, Inc. (“Corsair”), extending the maturity date of thenote from December 2004 to December 2006 and increasing our monthlypayments from approximately $25,000 to approximately $50,000 beginning in January 2005. In June 2004, we made an accelerated principal payment of $250,000 on thesame note payable to Corsair, as required under the terms of the restructurednote.

 

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**Cash and Accounts Receivable**

 

Cash and cash equivalents and AccountsReceivable increased to $3.1 million at December 31, 2004 from $1.9million at December 31, 2003, primarily from the closing of our PrivatePlacement.  Accounts Receivable balance decreased to $499,000 from$640,000 at December 31, 2003 primarily due to the decrease in revenuesfrom customers to whom we extend credit, and the timing of significant invoicesto and collections from customers at the end or beginning of the periods.

 

**Liabilities**

 

Accounts payable and accrued expensesincreased  by $343,000 at December 31,2004 due to incurred and unpaid Private Placement related costs, outside andprofessional fees, and payroll and related costs.  As mentioned above, werestructured the Corsair note payable in March 2004.  This note previously required monthlypayments of $25,000.  Under the newterms, the note now requires monthly payments of approximately $50,000 whichbegan in January 2005.  This resulted in the current portion of notespayable to increase from 2003 to 2004.

 

**Cash Flows**

 

Net cash used by operating activities of$672,000 for the 12 months ended December 31, 2004 resulted primarily fromnet loss and decreases in accounts receivable, prepaid expenses and othercurrent assets and deferred revenue and by increases in accounts payable andaccrued liabilities and accrued salaries and benefits.  Net cash providedby operating activities of $206,000 for the 12 months ended December 31,2003 resulted from the net loss for the year and the increase in accountsreceivable and prepaid expenses and other current assets, accounts payable andaccrued liabilities and deferred revenues.  The increase in net cash usedby operations of $878,000 for the 12 months ended December 31, 2004,compared to the same period in 2003 was primarily due to the increase in netloss of $1.2 million, an increase in accrued liabilities and a decrease indepreciation expense of $135,000 caused by certain fixed assets becoming fullydepreciated in 2004.

 

Net cash used in investing activitiesincreased to $236,000 for the 12 months ended December 31, 2004, ascompared to $98,000 for the same period in 2003, due to the increase inpurchases of computer equipment.

 

Net cash provided by financing activitiesincreased to $2.3 million for the 12 months ended December 31, 2004, anincrease of $2.3 million from $42,000 cash used by financing activities for thesame period in 2003.  This increase islargely due to the 2004 funding of our Private Placement, which provided grossproceeds of $3.3 million less applicable offering costs for net proceeds of$2.7 million.  In addition, repayments onnotes payable totaled $463,000 and included a $250,000 principal payment on theCorsair note payable.

 

 We believe the current cash balance,combined with cash to be provided from future operations, will be sufficient tosupport our working capital requirements through at least the next 12months.  In future periods, we may seek to finance certain equipmentpurchases through the issuance of debt. We cannot, however, be certain that additional financing will beavailable to us on acceptable terms when required, or at all.

 

Historically, our sources of liquidityprimarily have been cash from operations and, to a lesser extent, debtfinancing in 2003 and equity financing in 2004. In 2005, we expect our sourcesof liquidity primarily will include cash from operations, investment proceedsfrom our 2004 Private Placement and we may seek additional financing sources.

 

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The following table includes all thecontractual obligations, including principal and interest payments, as of December 31,2004:
| ** **                   | ** ** | **Payments Due by Period** | ** ** |
|------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**  | ** ** | **Total**                  | ** ** | **Less  than 1  year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **More  than 5  Years** | ** ** |
|                         |       |                       |       |   |   |   |   |   |   |   |   |
| Long-Term  Debt              |       | $                          | 1,644,000  |   | $ | 704,000 |   | $ | 603,000 |   | $ | 337,000 |   | $ | — |   |
|                         |       |                       |       |   |   |   |   |   |   |   |   |
| Operating  Lease Obligations |       | 1,284,000                  |       | 546,000 |   | 674,000 |   | 21,000 |   | 43,000 |   |
|                         |       |                       |       |   |   |   |   |   |   |   |   |
|                         |       | $                          | 2,928,000  |   | $ | 1,250,000 |   | $ | 1,277,000 |   | $ | 358,000 |   | $ | 43,000 |   |

 

There were no commercial commitmentsoutstanding as of December 31, 2004.

 

**Other Events**

 

**Our largest customer has elected not to renewits license and services agreements**

 

Following the completion of its merger withanother wireless telecommunications company in November 2004, our largestcustomer notified us of its intention not to renew its license and servicesagreement with us upon its expiration in accordance with its terms at the endof December 2005.  Based upon ourconversations with this customer, it is our understanding that our customer’selection not to renew its agreement with us was a result of a previoussignificant investment by its merger partner in an existing billing system inplace prior to the merger, and on which most of the combined company’scustomers already reside.  We expect tocontinue to maintain our historically cooperative working relationship withthis customer and are in discussions to modify and extend our license andservices agreement to meet some of the customer’s on-going need to accesshistorical data.

 

As a result of this event, we incurred aliability for one time termination benefits to be paid to our impactedemployees, provided that each impacted employee fulfill his contractualobligations. We announced the terms of such termination benefits to ouremployees in January 2005. In accordance with SFAS 146 we measured theliability estimated to be approximately $155,000 and will record the chargepro-rata throughout 2005. In accordance with SFAS 146 the estimated liabilitywill be re-measured throughout 2005.

 

Revenue from ourlargest customer represented approximately 56% or $4.3 million based on totalrevenues of $7.6 million for the 12 months ended December 31, 2004, andapproximately 69% or $4.5 million based on total revenues of $6.5 million forthe fiscal year ended December 31, 2003. Revenues from our second largest customer during the 12 months ended December 31,2004 represented approximately 13% of total revenues.  The related costs of revenues includestaffing, management and overhead costs.

 

**PrivatePlacement**

 

On June 15, 2004, we sold a total of14,284,782 Shares and Warrants to purchase a total of 7,142,393 shares of ourcommon stock in the Private Placement. Investors received a Warrant to purchaseone share of common stock for each two Shares purchased. The effective price inthe Private Placement was $0.23 for each unit. The Warrants are exercisable incash, representing a potential $2.0 million in additional proceeds,bringing the total gross proceeds of this offering to approximately$5.3 million upon full exercise of the Warrants. There can be no assurancethat any or all of the Warrants will be exercised.

 

Pursuant to the Purchase Agreement, we issuedan aggregate of 13,043,478 Shares at a price of $0.23 per share to theInstitutional Investors and received gross proceeds of $3.0 million incash from the Institutional Investors. We also issued Warrants to theInstitutional Investors to purchase an aggregate of 6,521,739 shares of ourcommon stock at an exercise price of $0.28 per share for a five-year period.Additionally, we and the Institutional Investors entered into a RegistrationRights Agreement, whereby, among other things, we agreed to file a “resale”registration statement and maintain and update it as necessary, covering theShares and Warrants Shares in connection with the Private Placement, no laterthan July 30, 2004, which securities are part of the subject matter of aregistration statement on Form SB-2 filed pursuant to the Securities Act, withthe SEC on July 30, 2004, as amended (the “Registration Statement”).  A form of the Purchase Agreement, theRegistration Rights Agreement, and Warrant Agreement are filed herewith asExhibits 10.20, 10.21, and 10.22, respectively (collectively, the “InstitutionalInvestor Agreements”), to the Registration Statement.

 

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As a condition precedent to closing thePrivate Placement with the Institutional Investors under the InstitutionalInvestor Agreements, we were required to have received gross proceeds from thesale of our common stock and warrants of not less than $250,000 from accreditedinvestors on terms no more favorable than those offered to the InstitutionalInvestors. The Institutional Investors also required that the accreditedinvestors be comprised of at least, but not limited to, each member of ourBoard of Directors, our Chief Executive Officer, and our then-current ChiefFinancial Officer. Accordingly, those accredited investors who are members ofour management (hereafter referred to as “Management Accredited Investors,” andthose accredited investors who are not members of our management hereafterreferred to as “Non-Management Accredited Investors”) contributed grossproceeds of $125,500 in cash to purchase an aggregate of 545,653 Shares at aprice of $0.23 per share and Warrants to purchase an aggregate of 272,827shares of our common stock exercisable at $0.28 per share for five years.Additionally, the Non-Management Accredited Investors contributed grossproceeds of $160,000 in cash to purchase an aggregate of 695,651 Shares at aprice of $0.23 per share and Warrants to purchase an aggregate of 347,827shares of our common stock exercisable at $0.28 per share for five years.

 

In connection therewith, the Non-ManagementAccredited Investors entered into the Institutional Investor Agreements. We andeach of the Management Accredited Investors executed a Purchase Agreement and aRegistration Rights Agreement, and we issued Warrants to them on terms no morefavorable than as offered to the Institutional Investors. Additionally, each ofthe Management Accredited Investors was required by the Institutional Investorsto execute a Lock-Up Agreement providing for certain restrictions on thetransfer of shares of our common stock owned by such person as set forth in theLock-Up Agreement. A form of the Purchase Agreement, the Registration RightsAgreement, Warrant Agreement, and Lock-Up Agreement entered into with theManagement Accredited Investors are filed herewith as Exhibits 10.23,10.24, 10.25, and 10.26, respectively, to the Registration Statement.

 

In accordance with the provisions ofAccounting Principles Board Opinion No. 14, we allocated the grossproceeds received in the private placement to the common stock and warrantsissued based on their relative estimated fair values. The Warrants and thePlacement Warrants issued in the private placement had an estimated fair valueof $1,776,000 and $163,000, respectively, based on the Black-Scholes option-pricingmodel. As a result of this analysis, we allocated proceeds of $1,036,000 to theWarrants and $163,000 to the Placement Warrants.

 

The Black-Scholes option-pricing modelrequires the input of subjective assumptions including the expected life of thewarrants and our expected stock price volatility. Because changes in thesubjective input assumptions can materially affect the fair value estimates,this model may not provide a reliable measure of the fair value of the Warrantsor the Placement Warrants. If we had made different assumptions, the relatedfair value estimates of the Warrants and Placement Warrants could have beensignificantly different.

 

**Registration Rights Agreements**

 

Under the terms of the private placement, wegranted the Institutional Investors and the Non-Management Accredited Investorsthe following registration rights as to their Shares, including Warrant Sharesissuable upon the exercise of the Warrants:

 

•                  We filed aregistration statement on Form SB-2 under the Securities Act with the SEC on July 30,2004, as amended by Amendment No. 1 filed with the SEC on August 30, 2004,as further amended by Amendment No. 2 filed with the SEC on September 9,2004, to register and thereby enable shares described hereunder to be resold.If such registration statement had not been filed with the SEC on or beforesuch date, we would have been required to pay liquidated damages to eachinvestor in an amount equal to 1.5% of the aggregate amount invested by suchinvestor for each 30-day period, or pro rata for any portion thereof, that theregistration statement was not filed (“Liquidated Damages”).

 

•                  Upon demand byany investor and upon any change in the exercise price of the Warrants suchthat additional shares of common stock become issuable upon the exercise of theWarrants (“Additional Shares”), we are obligated to file a registrationstatement on Form SB-2 covering the resale of the Additional Shares. If we donot file such registration statement within five days of an investor’s demand,we will pay Liquidated Damages to each investor.

 

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•                  Within ten daysof the Company becoming eligible to use a registration statement onForm S-3 for the Shares, Warrant Shares, and the Additional Shares, wewill file a registration statement on Form S-3. If such registrationstatement is not filed with the SEC on or before such time, we are obligated topay Liquidated Damages to each such investor.

 

If the registration statement had not beendeclared effective by the SEC by September 13, 2004 (October 13, 2004if the SEC had not reviewed the registration statement) or if any otherrequired registration statement covering Additional Shares is not declaredeffective by the SEC within 90 days of the time it is required to havebeen filed pursuant to the Registration Rights Agreement (120 days if theSEC reviews such registration statement), we would have been obligated to payLiquidated Damages to each such investor. Further, we are obligated to usecommercially reasonable efforts to cause the registration statement(s) to remaineffective until the earlier of (i) the date on which all registrablesecurities covered by such registration statement have been sold, or(ii) the date on which all registrable securities covered by suchregistration statement may be sold pursuant to Rule 144(k).

 

Further, we areobligated to use reasonable efforts to register or qualify or cooperate withsuch investors in connection with the registration or qualification of theirshares in any public offering under the blue sky laws of the following states:New York, New Jersey, Connecticut, Massachusetts, Pennsylvania, Texas,California, and Nevada.

 

All expenses offiling and causing each the registration statement to become and remaineffective shall be borne by us.

 

We granted theManagement Accredited Investors registration rights that are no more favorablethan the terms described above.

 

**Warrants**

 

We issued Warrants to the InstitutionalInvestors and the Non-Management Accredited Investors that may be exercised ata price of $0.28 per share, subject to certain anti-dilutive adjustments. TheWarrants expire on June 15, 2009. The Warrants may be called by theCompany at the price of $0.01 per Warrant Share if the closing bid price asreported by Bloomberg equals or exceeds $0.56 per share (subject to adjustment)for 30 consecutive trading days commencing after June 15, 2006 and afterthe registration statement has been declared effective by the SEC.

 

Warrant holders do not have any of the rightsor privileges of our stockholders, including voting rights, prior to exerciseof the Warrants. We have reserved sufficient shares of authorized common stockto cover the issuance of common stock subject to the Warrants.

 

The Warrants issued to the ManagementAccredited Investors contain terms that no more favorable than those describedabove.

 

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**Lock-up Agreements**

 

Pursuant to the terms of the Lock-UpAgreement, each of the Management Accredited Investors has agreed that he willnot sell any shares of our common stock, any options or warrants to acquire ourcommon stock, or any securities convertible into our common stock, whether nowowned or hereafter acquired, before the earliest of:

 

•                  December 15,2005 (18 months from the closing of the Private Placement);

 

•                  the end of aperiod of 20 consecutive trading days, which period commences December 15,2004 (the six-month anniversary of the closing), for which the closing bidprice of a share of our common stock as reported on Bloomberg equals or exceeds$0.60;

 

•                  the date onwhich the Institutional Investors no longer beneficially own in the aggregateat least 50% of the number of shares of our common stock (including sharesunderlying the Warrants) issued to the Institutional Investors pursuant to thePrivate Placement;

 

•                  the completionby us of an underwritten public offering of shares of our common stock for ouraccount;

 

•                  a “Change inControl” as defined in the Lock-Up Agreement; or

 

•                  the terminationof such respective selling stockholder’s employment with the Company other thanfor cause (as such term is defined below) (the earliest of such dates, the “RestrictedPeriod”).

 

Notwithstanding the foregoing, subject toapplicable law and any policies or procedures regarding the sale of stock byaffiliates of the Company, during the Restricted Period, Messers. JosephSimrell, John Faltys, and David Haynes each may sell his shares for aggregategross proceeds not to exceed $100,000 if such selling stockholder first givesthe Institutional Investors at least five business days’ prior written noticeof any proposed sale and shall sell such shares to the Institutional Investorsat such prevailing market prices if the Institutional Investors so elect.

 

**Critical Accounting Policies**

 

We prepare our consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America. As such, we are required to make certain estimates,judgments and assumptions that we believe are reasonable based upon theinformation available. These estimates and assumptions affect the reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the periods presented. Thesignificant accounting policies which we believe are the most critical to aidin fully understanding and evaluating our reported financial results includethe following:

 

*Revenue Recognition*—Revenuesfrom sales of software licenses, which generally contain multiple elements, arerecognized upon shipment of the related product if the requirements of theAmerican Institute of Certified Public Accountants Statement of Position 97-2, *Software Revenue Recognition*, as amended (“SOP97-2”), are met. If the requirements of SOP 97-2, including evidence of anarrangement, client acceptance, a fixed or determinable fee, collectibility orvendor-specific objective evidence about the value of an element, are not metat the date of shipment, revenue recognition is deferred until such items areknown or resolved. Revenue from post-contract customer support is deferred andrecognized ratably over the term of the contract. Revenues from services arerecognized as the services are performed under the agreements. Certainlicensing and services arrangements with our customers are billed monthly andthe associated revenue is recognized monthly.

 

*Accounts Receivable*—Weperform ongoing credit evaluations of our customers and adjust credit limitsbased upon payment history and the customer’s current creditworthiness, asdetermined by our review of their current credit information. We continuouslymonitor collections and payments from our customers and maintain a provisionfor estimated credit losses based upon our historical experience and anyspecific customer collection issues that we have identified. While such creditlosses have historically been within our expectations and the provisionsestablished, we

 

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cannot guarantee that we will continue to experience the same creditloss rates that we have in the past. Since our accounts receivable areconcentrated in a relatively few number of customers, a significant change inthe liquidity or financial position of any one of these customers could have amaterial adverse impact on the collectibility of our accounts receivables andour future operating results. See Risk Factor “Our revenues are generated froma limited number of customers; our customer base is concentrated; and the lossof one or more of our customers could cause our business to suffer.”

 

*Accounting for theImpairment or Disposal of Long-Lived Assets*—We accountfor the impairment and disposition of long-lived assets in accordance with theStatement of Financial Accounting Standards (“SFAS”) No. 144, *Accounting for the Impairment of Long-Lived Assetsand for Long-Lived Assets to Be Disposed Of*. In accordance with SFASNo. 144, long-lived assets to be held are reviewed for events or changesin circumstances that indicate that their carrying value may not berecoverable. This statement addresses financial accounting and reporting forthe impairment of long-lived assets and for the disposal of long-lived assets..We evaluate the carrying value of intangible assets for impairment of valuebased on undiscounted future cash flows, which are subject to change. We cannotguarantee that there will not be impairment in the future. Any futureimpairment charge would negatively affect our results of operations.

 

*Change in Accountingfor Goodwill and Other Intangible Assets*—On January 1,2002 we adopted SFAS No. 142, *Goodwilland Other Intangible Assets*. SFAS No. 142 requires thatgoodwill and intangible assets with indefinite useful lives no longer beamortized. It also establishes a new method of testing goodwill for impairmenton an annual basis or on an interim basis if an event occurs or circumstanceschange that would reduce the fair value of a reporting unit below its carryingvalue.  We have completed a review ofeach of our reporting units, Systems and Services, and have concluded that thefair value of each reporting unit exceeds its carrying value, indicating nogoodwill impairment was present as of September 30, 2003 and 2004. Webelieve no events or circumstances have changed subsequent to September 30,2004 that would require us to re-evaluate the fair value of our goodwill. Wewill continue to complete an annual testing of goodwill for impairment on September 30thof each year. Such fair value measurements involve significant estimates andassumptions, including the future cash flows, comparable market multiples anddiscount rates. Changes in such estimates and assumptions could significantlyaffect the fair value and potential impairment.

 

**Recently Adopted Accounting Principles**

 

On January 1, 2003, we adopted Statementof Financial Accounting Standards (“SFAS”) No. 143, *Accounting for Asset Retirement Obligations,*whichaddresses financial and reporting for obligations associated with theretirement of long-lived assets and related asset retirement costs. SFASNo. 143 establishes accounting standards for the recognition andmeasurement of an asset retirement obligation and its associated assetretirement cost. It also provides accounting guidance for legal obligationsassociated with the retirement of tangible long-lived assets. The adoption ofSFAS No. 143 did not have a material impact on our consolidated financialstatements.

 

On January 1, 2003, we adopted SFASNo. 146, *Accounting for CostsAssociated with Exit or Disposal Activities*, which addressesfinancial accounting and reporting for costs associated with exit or disposalactivities and supersedes Emerging Issues Task Force (“EITF”) Issue 94-3, *Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)*. SFAS No. 146 requires thata liability for a cost associated with an exit or disposal activity berecognized when the liability is incurred. Under EITF Issue 94-3, a liabilityfor an exit cost, as defined in EITF Issue 94-3, was recognized at the date ofan entity’s commitment to an exit plan. SFAS No. 146 also establishes thatthe liability should initially be measured and recorded at fair value. Theadoption of SFAS No. 146 for exit or disposal activities did not have amaterial impact on our consolidated financial statements for the year ended December 31,2004.

 

On January 1, 2003, we adopted FinancialAccounting Standards Board Interpretation (“FIN”) No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*.FIN No. 45 requires increased financial statement disclosures by aguarantor about its obligations under certain guarantees it has issued. FINNo. 45 also requires that a guarantor recognize a liability for the fairvalue of a certain guarantees made after December 31, 2002. We adopted thedisclosure provisions of FIN No. 45 at December 31, 2002, with noimpact on our financial position or results of operations.

 

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In January 2003, the FASB issued FINNo. 46, *Consolidation of VariableInterest Entities*. In general, a variable interest entity is acorporation, partnership, trust, or any other legal structure used for businesspurposes that either (a) does not have equity investors with voting rightsor (b) has equity investors that do not provide sufficient financialresources for the entity to support its activities. FIN No. 46 requires avariable interest entity to be consolidated by us if we are subject to a majorityof the risk of loss from the variable interest entity’s activities or entitledto receive a majority of the entity’s residual returns or both. Theconsolidation requirements of FIN No. 46 apply immediately to variableinterest entities created after January 31, 2003. The consolidationrequirements apply to older entities in the first fiscal year or interim periodbeginning after June 15, 2003. Certain of the disclosure requirementsapply in all financial statements issued after January 31, 2003,regardless of when the variable interest entity was established. We did nothave any variable interest entities as of December 31, 2002 and 2003. Theadoption of FIN No. 46 did not have a material impact on our consolidatedfinancial statements.

 

In November 2002, the EITF reached aconsensus on Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*. Issue 00-21 providesguidance on how to account for arrangements that involve the delivery orperformance of multiple products, services and/or rights to use assets. Theprovisions of Issue 00-21 apply to revenue arrangements entered into in fiscalperiods beginning after June 15, 2003. The adoption of Issue 00-21 did nothave a material effect on our consolidated financial position, results ofoperations or cash flows.

 

**Recently Issued Accounting Pronouncements**

 

In May 2003, the FASB issued SFASNo. 150, *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity*(“SFAS No. 150”). SFAS No. 150 establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity. SFAS No. 150 applies specifically to a numberof financial instruments that companies have historically presented withintheir financial statements either as equity or between the liabilities section andthe equity section, rather than as liabilities. SFAS No. 150 is effectivefor financial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003. However, in November 2003, the FASB issued StaffPosition No. 150-3, which defers the effective date for certain provisionsof the statement. Once required in its entirety, SFAS No. 150 is notexpected to have a material impact on our consolidated financial statements.

 

In December 2003, the FinancialAccounting Standards Board (“FASB”) issued a revision to InterpretationNo. 46, *Consolidation of VariableInterest Entities, an Interpretation of ARB No. 51* (“FIN 46R”).FIN 46R clarifies the application of ARB No. 51, “Consolidated FinancialStatements,” to certain entities in which equity investors do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support provided by any parties, including the equityholders. FIN 46R requires the consolidation of these entities, known asvariable interest entities (“VIEs”), by the primary beneficiary of the entity.The primary beneficiary is the entity, if any, that will absorb a majority ofthe entity’s expected losses, receive a majority of the entity’s expectedresidual returns, or both.

 

Among other changes, the revisions of FIN 46R(a) clarified some requirements of the original FIN 46, which had beenissued in January 2003, (b) eased some implementation problems, and(c) added new scope exceptions. FIN 46R deferred the effective date of theInterpretation for public companies to the end of the first reporting periodending after March 15, 2004, except that all public companies must, at aminimum, apply the unmodified provisions of the Interpretation to entities thatwere previously considered “special-purpose entities” in practice and under theFASB literature prior to the issuance of FIN 46R by the end of the firstreporting period ending after December 15, 2003. As of December 31,2003 and 2002, management believes that the Company is not the primarybeneficiary of any VIE’s.

 

We account for employee stock-basedcompensation under the “intrinsic value” method prescribed in AccountingPrinciples Board Opinion No. 25, *Accountingfor Stock Issued to Employees* (“APB 25”), as opposed to the “fairvalue” method prescribed by Statement of Financial Accounting StandardsNo. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”). Pursuant to the provisions of APB25, we generally do not record an expense for the value of stock-based awardsgranted to employees.

 

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In December 2004, the FASB issues SFASNo. 123 (Revised), “*Share-Based Payment*”.  This standard revised SFAS No. 123, APBOpinion No. 25 and related accounting interpretations and eliminates the use ofthe intrinsic value method for employee stock-based compensation.  SFAS No. 123(R) requires compensation costsrelated to share-based payment transactions to be recognized in financialstatements over the period that an employee provides service in exchange forthe award.  Currently, the Company usesthe intrinsic value method of APB Opinion No. 25 to value share-based optionsgranted to employees and board members. This standard requires the expensing of all share-based compensation,including options, using the fair value based method.  The effective date of this standard for theCompany will be January 1, 2006. Management is currently assessing the impact that this new standard willhave on the Company’s financial statements.

 

**Item 7.  Financial Statements**

 

Our consolidated financial statements required to beincluded in Item 7 are set forth in the Index to Financial Statements set forthon page F-1 of this report.

 

# **Item8.  Changes In and Disagreements**WithAccountants on Accounting and Financial Disclosure.

# ** **

On April 22, 2003, we dismissed Deloitte &Touche LLP (“D&T”) as our principal accountant effective on such date.  On April 22, 2003, we appointed Haskell& White LLP (“H&W”) as our new principal accountant.  D&T’s report on our financial statementsfor fiscal years 2001 and 2002 did not contain an adverse opinion or adisclaimer of opinion, nor was it qualified or modified as to uncertainty,audit scope or accounting principles. The decision to change accountants was recommended and approved by ouraudit committee.

 

During fiscal years 2001 and 2002 and the subsequentinterim period through April 22, 2003, there were no disagreements withD&T on any matter of accounting principles or practices, financialstatement disclosure or auditing scope or procedure, which disagreement(s), ifnot resolved to the satisfaction of D&T, would have caused them to makereference to the subject matter of the disagreement(s) in connection with theirreport, nor were there any reportable events as defined in Item304(a)(l)(iv)(B) of Regulation S-B.

 

We engaged H&W as our new independent accountanton April 22, 2003.  During fiscalyears 2001 and 2002 and the subsequent interim period through April 22,2003, neither we nor someone on our behalf engaged H&W regarding either theapplication of accounting principles to a specified transaction, eithercompleted or proposed, or the type of audit opinion that might be rendered onour financial statements, or any matter that was either the subject of a “disagreement”or a “reportable event,” both as such terms are defined in Item 304 ofRegulation S-B.

 

We have requested D&T to furnish the registrantwith a letter addressed to the Commission stating whether it agrees with thestatements made by the registrant in this current report and, if not,expressing the respects in which it does not agree.  We have filed the letter as an exhibit tothis report.

 

**Item8A.  Controls and**Procedures

** **

TheCompany maintains a system of disclosure controls and procedures which aredesigned to ensure that information required to be disclosed by the Company inthe reports filed under the Exchange Act is recorded, processed, summarized andreported within the time periods specified under the Securities and ExchangeCommission’s rules and forms.  Based onan evaluation performed, the Company’s certifying officers have concluded thatthe disclosure controls and procedures were effective as of the end of theperiod covered by this report to provide reasonable assurance of theachievement of these objectives.

 

Notwithstandingthe foregoing, there can be no assurance that the Company’s disclosure controlsand procedures will detect or uncover all failures of persons within theCompany to disclose material information otherwise required to be set forth inthe Company’s reports.

 

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We do not believe that there has been any change inthe Company’s internal control over financial reporting during the periodcovered by this report that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

**Item 8B. Other Information**

 

Effective March 25, 2005, the Companyand Robert Richardson agreed to amend and restate that certain letter agreementdated August 18, 2003 between the Company and Robert Richardson to providei) a 90 day period of transition assistance pay in the event Mr. Richardson’semployment with the Company is terminated without cause, ii) that in the eventof a change of control of the Company, Mr. Richardson is terminated withoutcause, or Mr. Richardson terminates his employment for good reason, alloutstanding unvested stock options and all previously granted unvestedrestricted stock awards granted to Mr. Richardson shall accelerate andvest.

 

Effective March 25,2005, William C. Bousema entered into a letter agreement for at-will employmentas Primal’s Senior Vice President, Chief Financial Officer and Secretary.  Under the terms of the letter agreement Mr.Bousema’s base annual salary is $175,000. In addition, Mr. Bousema is entitledto receive incentive compensation bonuses in an amount not less than 35% of hissalary subject to achieving certain individual and corporate performance goals.Mr. Bousema is also entitled to participate in such stock option, restricted stock,pension, profit sharing, life insurance, hospitalization, major medical,tuition reimbursement, medical flexible spending accounts and other employeebenefit plans provided by us from time to time. During the first year of his employment, if we terminate Mr. Bousema’semployment without cause or Mr. Bousema resigns for good reason, Mr. Bousemashall be entitled to nine-month’s severance, 75% of his incentive compensationfor that year, calculated assuming 100% of the targets under such incentivecompensation plans are achieved (provided that any such severance payments mustbe made within two and one-half months following the close of the calendar yearin which such termination occurred), and continuation of his medical, dental,life, and disability coverage for himself and his spouse and dependents for aperiod not to exceed 9 months, conditioned upon Mr. Bousema’s execution of arelease in favor of Primal. 60 days prior to the end of the 1st yearof his employment, we must commence good faith negotiations regarding the newterms of Mr. Bousema’s termination and severance section of his letteragreement. If, following such good faith negotiations, we are unable to reachagreement regarding the new provisions, the termination and severance sectionof his letter agreement will expire on their terms. If we fail to negotiate ingood faith, Mr. Bousema’s letter agreement will expire on the one yearanniversary of his employment, his employment with Primal will be terminated,and he will be paid the severance benefits provided for in the letteragreement, and all outstanding unvested stock options granted to Mr. Bousemawill accelerate and vest. Finally, in the event, (i) Mr. Bousema is terminatedwithout cause, or (ii) Mr. Bousema terminates his employment for good reason,all outstanding unvested stock options granted to him shall accelerate andvest.

 

Additionally, Mr.Bousema’s letter agreement contains certain covenants by him not to solicit thecustomers and employees of Primal during the course of his employment and for solong thereafter as he is entitled to severance benefits under his letteragreement. A state court may determine not to enforce, or only to enforcepartially, these covenants.

 

Primal has alsoentered into a Change of Control Agreement with Mr. Bousema effective March 25,2005 (the “Bousema Change Agreement”). The Bousema Change Agreement providesthat if, within 12-months of a “change of control transaction,” (i) Primalterminates Mr. Bousema’s employment (except upon his death or disability, hisreaching the mandatory retirement age, if any, or upon other “cause toterminate” his employment) or (ii) Mr. Bousema voluntarily terminates hisemployment for “good reason”, we will tender in a single lump sum payment (a)any accrued and unpaid salary and vacation through the termination date, (b) anamount equal to 100% of Mr. Bousema’s then-current annual salary and (c) anamount equal to 100% of his incentive compensation for that year, calculatedassuming 100% of the targets under such incentive compensation plans areachieved, payable within 10 days of termination provided that any such paymentmust be made within two and one-half months following the close of the calendaryear in which such termination occurred. Further, Primal is obligated to tender such payments if, not more thanthree months prior to the closing of a change of control transaction, (i)Primal terminates Mr. Bousema’s employment, and such termination arose inconnection with or in anticipation of the change of control transaction or (ii)Mr. Bousema voluntarily terminates his employment for good reason. Lastly, inanticipation of a change of control transaction, our directors could adopt aresolution deeming that a change of control transaction has closed for purposesof activating the Bousema Change Agreement obligations.

 

The Bousema ChangeAgreement additionally provides that in the event the severance payment issubject to excise tax, Primal will gross-up the severance payment to Mr.Bousema so that the net severance payment received shall be the equivalent tothe severance payment that would have been received if no excise tax had beenimposed. However, Primal will reduce a severance payment by the amount of anyother severance or termination benefits that it is obligated to pay to Mr.Bousema.  The Bousema Change Agreementfurther provides for up to 12 months following the termination of Mr. Bousema’semployment, we will continue to provide Mr. Bousema and his spouse anddependents with uninterrupted medical, dental, life, and disability coverage,or a lump sum payment equal to the cost of obtaining substantially similarcoverage.

 

40

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Lastly, theBousema Change Agreement provides that upon the occurrence of a change ofcontrol transaction, all outstanding unvested stock options and all previouslygranted unvested restricted stock awards granted to Mr. Bousema shallaccelerate and vest.

 

**PART III**

 

# **Item9.  Directors, Executive Officers,**Promotersand Control Persons; Compliance with Section 16(a) of the Exchange Act

# ** **

**ExecutiveOfficers and Directors**

** **

The following table sets forth certaininformation regarding our executive officers and directors as of March 21,2005:

 
| **Name**              | ** ** | **Age** | ** ** | **Position**                                                  |
|-----------------------|------------|---------|------------|---------------------------------------------------------------|
| Joseph R. Simrell     |       | 47      |       | Chairman of the Board, Chief Executive  Officer and President |
|                  |       |    |       |                                                          |
| William C. Bousema(1) |       | 54      |       | Senior Vice President, Chief Financial  Officer and Secretary |
|                  |       |    |       |                                                          |
| Bob Richardson        |       | 39      |       | Executive Vice President of Operations                        |
|                  |       |    |       |                                                          |
| David Haynes          |       | 40      |       | Director                                                      |
|                  |       |    |       |                                                          |
| John Faltys           |       | 41      |       | Director                                                      |
|                  |       |    |       |                                                          |
| Louis A. Delmonico    |       | 64      |       | Director                                                      |
|                  |       |    |       |                                                          |
| John E. Rehfeld       |       | 65      |       | Director                                                      |

----

(1)    As discussed elsewhere in this report, Mr.Bousema was appointed Senior Vice President, Chief Financial Officer, andSecretary on March 25, 2005.

41

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*JosephR. Simrell, Chairman of the Board, Chief Executive Officer and President.*  Mr. Simrell joined Primal in January 1999as Chief Financial Officer and Vice President of Finance and Administration.Mr. Simrell was elected as Chief Executive Officer and President as of January 31,2003 (serving those positions on an interim basis from January 31, 2003 toMay 12, 2003, when he became the permanent Chief Executive Officer andPresident) and was elected Chairman of the Board as of February 3,2003.  Mr. Simrell also served as ourChief Financial Officer and Secretary between October 15, 2004 and March 25,2005.  Mr. Simrell had previouslyserved as Secretary from August 2000 and as Chief Financial Officer from January 1999until August 2003. From August 1997 to December 1998,Mr. Simrell served as an outside consultant to Primal. From November 1991to July 1997, Mr. Simrell served as Executive Vice President andChief Financial Officer of GDI, an information technology company. Prior to1991, Mr. Simrell held various management positions at BellSouth,InteGroup, and SCI.

 

*William C. Bousema, Senior VicePresident, Chief Financial Officer and Secretary.*  Mr. Bousema joined Primal in March 2005.From October 2004 to March 2005, Mr. Bousema served as an outsideconsultant to the Company. From September 2001 to October 2004 Mr.Bousema founded a consulting practice that lead Sarbanes-Oxley implementationprojects for Dow Jones 30 and Fortune 500 companies and provided turnaroundexpertise. From February 2001 to September 2001, Mr. Bousema wasChief Financial Officer for Starwire Corporation, an ASP content managementsoftware startup firm. From February 2000 to February 2001, Mr.Bousema was Chief Operating Officer and Chief Financial Officer forInformIns.com. Prior to 2000, Mr. Bousema held various management positions atpublicly-traded and privately owned entities including The Irvine Company,Arthur Andersen and KPMG.  Mr. Bousema isa Certified Public Accountant and holds an active license.

 

*RobertRichardson, EVP of Operations.*  Mr. Richardson joined Primal in August 2003as the Senior Vice President of Services responsible for Customer Support andConsulting Services and launching Primal’s new application management andhosting services. In July 2004, Mr. Richardson was promoted toExecutive Vice President of Operations. From December 2001 to August 2003,Mr. Richardson was a consulting project manager for Sony PicturesEntertainment and responsible for the delivery of the billing and cashapplication portions of a custom accounting system. In January 1998Mr. Richardson founded StrataSource, Inc. and until October 2001served as its Executive Vice President, responsible for defining its strategicdirection.  Mr. Richardson earnedhis Bachelor of Science degree in computer science from University of SouthernCalifornia.

 

*DavidHaynes.* Mr. Haynes has served as a Director since August 2000 and hasserved as a member of the Audit Committee and Compensation Committee since July 2002.Mr. Haynes joined Primal in August 1997 as Vice President of Salesand served as Vice President of Sales and Marketing from May 2000 untilMay 2002 when he resigned the position. From May 1997 to September 1997,Mr. Haynes served as Senior Business Development Manager atDeloitte & Touche Consulting Group, a consulting firm. From January 1995to April 1997, Mr. Haynes was Director of Sales at GDI. From December 1988to January 1995, Mr. Haynes was one of the founding associates of ITXTechnologies, a software company. Mr. Haynes currently serves as theExecutive Vice President of Fabrication Concepts Corporation, a high-techequipment manufacturer. Mr. Haynes has a Masters in BusinessAdministration degree from Pepperdine University and a bachelors degree incivil engineering from the University of Saskatchewan.

 

*JohnFaltys.* Mr. Faltys has served as a Director since November 1996(inception) and a member of the Compensation Committee since July 2002.Mr. Faltys founded Primal in November 1996 and served as the ChiefTechnology Officer until April 2001 when he resigned the position. Inaddition, Mr. Faltys served as President from inception to September 1999.Prior to founding Primal, Mr. Faltys was Vice President of SoftwareDevelopment for GDI from November 1991 to September 1996.Mr. Faltys currently serves as President of PersistentWorldZ, Inc.,an online game service provider.

 

*Louis A. Delmonico, Ph.D.*  Dr. Delmonicohas served as a Director of Primal since April 2001 and as Chairman of theCompensation Committee, and a member of the Audit Committee since July 2002.From 1999 to 2000, Dr. Delmonico served as Chairman and CEO of Motive, asoftware company. Since September 1994, he has also served as thePresident of L. A. Delmonico Consulting Inc., an independent consultingfirm. From September 1994 to May 1995, Dr. Delmonico served asthe Vice Chairman of the MacNeal Schwendler Corporation, a publicly tradedNASDAQ-listed engineering software and services company. From May 1987 to August 1994,Dr. Delmonico served as the Chairman and CEO of

 

42

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PDAEngineering Inc., a publicly traded NASDAQ-listed engineering software andservices company. In addition, he is currently an advisor to and a director ofseveral private companies. Dr. Delmonico earned his bachelor degree ineconomics from St. John’s University in New York, his Ms.S. in consumerbehavior from the University of Stockholm, Sweden and his Ph.D. in marketingfrom the University of Uppsala, Sweden.

 

*John E.Rehfeld.* Mr. Rehfeld has served as a Director, Chairman of the AuditCommittee and member of the Compensation Committee of Primal since July 2002.Since 1997, Mr. Rehfeld has served as the Chairman and CEO of ProshotGolf, Inc. From 1996 to 1997, Mr. Rehfeld served as the President andCEO of Proxima Corporation, a NASDAQ-listed public company. From 1993 to 1996,he served as the President and CEO of Etak, Inc., a business unit of NewsCorp. From 1989 to 1993, he served as President and Chief Operating Officer ofSeiko Instruments America. Mr. Rehfeld currently serves as a Director ofsix high technology companies, including Seiko Instruments America. He has alsopreviously served as an outside board member of four other companies, includingWonderware, a NASDAQ listed public company. Mr. Rehfeld is also a FederalTrade Commission Monitor overseeing the sale of a business unit of MSCSoftware, and a Professor of Marketing in the Executive MBA Program atPepperdine University. Mr. Rehfeld holds a Masters in BusinessAdministration degree from Harvard University and a Bachelor of Science degreein chemistry from University of Minnesota.

 

Unless otherwise specified herein, eachDirector is subject to election at our annual meeting of stockholders.

 

On July 24, 2002, the Board of Directorsformed a separately-designated standing audit committee of the Company (the “AuditCommittee”), appointing Mr. John E. Rehfeld as Chairman and Mr. Louis A.Delmonico, PhD. and Mr. David Haynes as members.  The Board of Directors has determined and Mr.Rehfeld has agreed to serve as the Audit Committee’s financial expert.  We believe that Mr. Rehfeld isindependent, as that term is used in Item 7(d)(3)(iv) of Schedule 14Aunder the Exchange Act. Because we are not a listed issuer, the members of theAudit Committee are not subject to the independence requirements of anynational securities exchange or association. Notwithstanding, we believe that amajority of our Audit Committee members satisfy the independence requirementsof NASDAQ.

 

We do not have a class of equity securitiesregistered under Section 12 of the Exchange Act.

 

We have not adopted a Code of Ethics for ourprincipal executives, financial and accounting officers.  Historically we have felt that such a policyis unnecessary given our relatively small size, however, we are consideringadopting a Code of Ethics.

 

**Item10.  Executive Compensation**

** **

The following table sets forth certain information with respect to thecompensation of our Chief Executive Officer and each of our other most highlycompensated executive officers who earned more than $100,000 for the fiscalyears ended December 31, 2004, 2003 and 2002.

 

**Summary Executive Compensation Table**

** **
| ** **                                                                                         | ** ** | ** **       | ** ** | **Annual Compensation**  | ** ** | **Long Term  Compensation   Awards** | ** ** | **All Other**          | ** ** |
|----------------------------------------------------------------------------------------------------|------------|------------------|------------|--------------------------|------------|--------------------------------------|------------|------------------------|------------|
| **Name and Principal Position**                                                                    | ** ** | **Year**         | ** ** | **Salary**               | ** ** | **Bonus**                            | ** ** | **Stock**              | ** ** | **Options** | ** ** | **Compensation** | ** ** |
| ** **                                                                                         | ** ** | ** **       | ** ** | **($)**                  | ** ** | **($)**                              | ** ** | ** **             | ** ** | **(#)** | ** ** | **(1)** | ** ** |
| Joseph R.  Simrell  Chief Executive Officer and  President                               |       | 2004

2003

2002 |       | 200,000  195,833 150,000 |       | 77,088  105,523 23,513               |       | —

—

— |       | 250,000  —  — |   | 12,040  1,478

  |   |
| Bob  Richardson   Executive Vice President Of  Operations                                     |       | 2004

2003

2002 |       | 150,000 

56,250

— |       | 240,696 

27,460

—             |       | —

—

— |       | —

360,000

— |   | 18,072 

3,548

— |   |
| Todd Taylor  (2)   Chief Financial Officer and Vice President Finance and Administration |       | 2004  2003  2002 |       | 95,500   95,500   95,500 |       | 5,712 35,131  14,018                 |       | —

—

— |       | —   153,500   23,400 |   | 28,933 

1,413  343 |   |

 

----

(1)                                  Includespremiums paid by Primal on certain health insurance, term-life insurancepolicies and contribution paid by us on behalf of the individual to our Section 401(k)Plan, which matches a portion of each such individual’s contributions to thesame plan.

 

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(2)                                  Mr.Taylor resigned as Chief Financial Officer, Vice President of Finance andAdministration effective October 15, 2004.

 

(3)                                  Mr.Bousema was not an employee of the Company at December 31, 2004.  Mr. Bousema became Senior Vice President,Chief Financial Officer and Secretary on March 25, 2005.

 

**Option/SAR Grants in the Last Fiscal Year**

 

**Option/SARGrants in the Last Fiscal Year**

 
| ** **         | ** ** | **Individual Grants**                                                 | ** ** |
|--------------------|------------|-----------------------------------------------------------------------|------------|
| **Name**           | ** ** | **Number of  Securities  Underlying  Options/SARs  Granted (#)** | ** ** | **% of Total  Options/SARs  Granted to  Employees in  Fiscal Year** | ** ** | **Exercise  Price  ($/Sh)** | ** ** | **Expiration  Date** | ** ** |
|               |       |                                                                  |       |   |   |   |   |   | ** ** |
| Joseph R.  Simrell |       | 250,000                                                               |       | 49 | % | $ | 0.25 |   | 1/16/2014 |   |
|               |       |                                                                  |       |   |   |   |   |   |   |
| Bob  Richardson    |       | —                                                                |       | — |   | — |   | — |   |
|               |       |                                                                  |       |   |   |   |   |   |   |
| Todd Taylor        |       | —                                                                |       | — |   | — |   | — |   |
|                    |            |                                                                       |            |  |  |  |  |  |  |  |

 

**Aggregated Option/SAR Exercises in the LastFiscal Year and FY-End Option/SAR Values**

 
| **Name**           | ** ** | **Shares Acquired  on Exercise** | ** ** | **Value Realized** | ** ** | **Number of Unexercised  Securities Underlying  Options at FY-end (#)  Exercisable/Unexercisable** | ** ** | **Value of Unexercised   In-The-Money Options  at FY-end ($)  Exercisable/Unexercisable** | ** ** |
|--------------------|------------|----------------------------------|------------|--------------------|------------|---------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|
|               |       |                             |       |               |       |                                                                                                    |       |                                                                                           |       |
| Joseph R.  Simrell |       | —                           |       | —             |       | 162,500/187,500                                                                                         |       | $10,500/$12,115                                                                                |       |
|               |       |                             |       |               |       |                                                                                                    |       |                                                                                           |       |
| Bob  Richardson    |       | —                           |       | —             |       | 150,000/360,000                                                                                         |       | $10,800/$25,920                                                                                |       |
|               |       |                             |       |               |       |                                                                                                    |       |                                                                                           |       |
| Todd Taylor        |       | 87,597                           |       | $                  | 11,388     |                                                                                                    | —     |                                                                                           |       |   |
|                    |            |                                  |            |                    |            |                                                                                                         |            |                                                                                                |            |  |

 

**EmploymentAgreements**

** **

Effective January 28, 2003,Mr. Simrell entered into an employment agreement with us, which wasamended as of May 17, 2004. Under the terms of the employment agreement,as amended, Mr. Simrell serves as our Chairman of the Board, ChiefExecutive Officer and President. The initial term of the employment agreementexpires December 16, 2005. The Board of Directors is required to begingood faith negotiations with Mr. Simrell for a new employment

 

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agreement no later than October 17, 2005, which new agreementshall provide for 12-months’ severance and benefits continuation.Mr. Simrell’s base annual salary is $200,000. In addition,Mr. Simrell is entitled to receive bonuses in an amount not less than 50%of his salary, subject to us achieving performance goals set by the Board.Mr. Simrell is also entitled to participate in such stock option,restricted stock, pension, profit sharing, life insurance, hospitalization,major medical, tuition reimbursement, medical flexible spending accounts andother employee benefit plans provided by us from time to time. In the event weterminate Mr. Simrell’s employment without cause or Mr. Simrellresigns for good reason, Mr. Simrell shall be entitled to 12-months’severance, 100% of his incentive compensation for that year, calculatedassuming 100% of the targets under such bonus plans are achieved, andcontinuation of his medical, dental, life, and disability coverage for himselfand his spouse and dependents for a period not to exceed 12 months,provided he signs a release in our favor.

 

The employment agreement withMr. Simrell contains certain covenants by him not to solicit the customersand employees of Primal during his employment and for one year thereafter. Astate court may determine not to enforce, or only to enforce partially, these covenants.

 

We are also a party to a Change of ControlAgreement with Mr. Simrell, which was amended as of May 17, 2004 (the“Change Agreement”). The Change Agreement provides that we will tender certain “severancepayments” to Mr. Simrell if, within 12 months of a “change of controltransaction,” (i) we terminate his employment (except upon his death ordisability, his reaching our mandatory retirement age, if any, or his providingus with other “cause to terminate” his employment) or(ii) Mr. Simrell voluntarily terminates his employment for “goodreason.” Further, we are obligated to tender such payments if, not more thanthree months prior to the closing of a change of control transaction,(i) we terminate Mr. Simrell’s employment, and such termination arosein connection with or in anticipation of the change of control transaction or(ii) Mr. Simrell voluntarily terminates his employment for goodreason. Lastly, in anticipation of a change of control transaction, ourdirectors could adopt a resolution deeming that a change of control transactionhas closed for purposes of activating the Change Agreement obligations.

 

Under the Change Agreement, a “change ofcontrol transaction” will have occurred if:

 

•                  an otherwiseunaffiliated person acquires the beneficial ownership of 35% or more of thecombined voting power of our then outstanding voting securities. Theacquisition of the shares can be in one transaction or in a series of relatedtransactions and the person’s ownership can be direct or indirect;

 

•                  an otherwiseunaffiliated person acquires the beneficial ownership of 50% or more of thecombined voting power of any of our material subsidiaries. The acquisition ofthe shares can be in one transaction or in a series of related transactions andthe person’s ownership can be direct or indirect. A material subsidiary means asubsidiary that represents at least 50% of our combined revenue or assets;

 

•                  a change of amajority of the members of our Board of Directors during any 12 consecutivemonths. If, by a two-thirds majority, our Board of Directors elected a newmember or nominated a new member for election by our stockholders, such newmember will be considered to have been an original member of our Board ofDirectors;

 

•                  Our stockholdershave approved a complete liquidation or dissolution of us or a disposition ofall or substantially all of our assets;

 

•                  We, in a singletransaction or series of transactions, engage in a business combinationtransaction that results in our pre-transaction stockholders owning less than50% of the combined voting power of the outstanding voting securities of theresulting entity; or

 

•                  any other eventoccurs that would require disclosure of “Changes in Control of Registrant”through our filing of a Current Report on Form 8-K.

 

45

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Our “cause to terminate” Mr. Simrellmeans his intentional act which materially injures us, his intentional refusalor failure to follow lawful and reasonable directions of the Board of Directorsor an individual to whom he reports (as appropriate), his willful or habitualneglect of duties, or his conviction of, or the entering of a guilty plea orplea of no contest with respect to, a felony involving an act of moralturpitude.

 

Mr. Simrell’s “Good Reason” to resignmeans:

 

•                  Our failure tocure a material breach of its obligations under any employment-relatedagreement with Mr. Simrell;

 

•                  Our unilateral,material reduction in Mr. Simrell’s title, status, overall position,responsibilities or duties, reporting relationship, and general workingenvironment;

 

•                  Our requirementthat Mr. Simrell relocate his residence outside of Orange County, or therelocation of Mr. Simrell’s office more than 50 miles from its location onMay 17, 2004;

 

•                  Our failure toobtain an assumption by our successor or assignee of substantially all of ourbusiness of any material written agreement between Mr. Simrell and us; or

 

•                  any materialchange in the benefits or incentive compensation offered to Mr. Simrellfrom those in which he is participating as of May 17, 2004.

 

The term of the Change Agreement isco-terminus with our employment of Mr. Simrell. The “severance payment”shall be paid within 10 days of Mr. Simrell’s termination ofemployment and the effective date of the applicable release signed byMr. Simrell in our favor. It will consist of a single cash payment that isthe sum of:

 

•                  all accrued andunpaid portion of Mr. Simrell’s salary and vacation through the date oftermination;

 

•                  all accrued andunpaid portion of Mr. Simrell’s incentive compensation and other bonusesfrom our prior fiscal year;

 

•                  an amountequivalent to 150% of Mr. Simrell’s then-current annual salary; and

 

•                  an amountequivalent to 150% of all incentive and other bonus compensation that wouldotherwise have been payable to Mr. Simrell for the fiscal year in progressas if he remained employed by us (calculated on the assumption that 100% of thetargets under such bonus plans are achieved).

 

In the event the severance payment is subjectto excise tax, we will gross-up the severance payment to Mr. Simrell sothat the net severance payment received shall be the equivalent to theseverance payment that would have been received if no excise tax had beenimposed. However, we will reduce a severance payment by the amount of any otherseverance or termination benefits that we are obligated to pay toMr. Simrell.

 

Further, for up to 18 months followingthe termination of Mr. Simrell’s employment, we will continue to provideMr. Simrell and his spouse and dependents with uninterrupted medical,dental, life, and disability coverage, or a lump-sum payment equal to the costof obtaining substantially similar coverage. We may terminate such insurancecoverage prior to the expiration of the 18-month period if Mr. Simrell obtainsany such benefits pursuant to a subsequent employer’s benefit plans.

 

Lastly, upon the occurrence of a change ofcontrol transaction, all outstanding unvested stock options and all previouslygranted unvested restricted stock awards granted to Mr. Simrell shallaccelerate and vest.

 

Effective August 14, 2003, the Companyentered into an at-will employment letter agreement with Robert Richardson, inwhich Mr. Richardson initially agreed to serve as the Company’s Senior VicePresident – Professional

 

46

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Services.  In July 2004, Mr.Richardson was promoted to Executive Vice President of Operations.  Under the terms of the letter agreementMr. Richardson’s base annual salary is $150,000. In addition,Mr. Richardson is entitled to receive incentive compensation bonuses in anamount not less than 100% of his salary subject to achieving certain individualand corporate performance goals. Mr. Richardson is also entitled toparticipate in those stock option, restricted stock, pension, profit sharing,life insurance, hospitalization, major medical, tuition reimbursement, medicalflexible spending accounts and other employee benefit plans provided by theCompany from time to time.

 

Effective March 25, 2005, the Companyand Robert Richardson agreed to amend and restate that certain letter agreementdated August 18, 2003 between the Company and Robert Richardson to providei) a 90 day period of transition assistance pay in the event Mr.Richardson’s employment with the Company is terminated without cause, andii) that in the event of a change of control of the Company, Mr.Richardson is terminated without cause, or Mr. Richardson terminates hisemployment for good reason, all outstanding unvested stock options and all previouslygranted unvested restricted stock awards granted to Mr. Richardson shallaccelerate and vest.

 

As discussed elsewhere in this report,effective March 25, 2005, Mr. Bousema entered into an employment letteragreement and related Change of Control Agreement and was appointed our SeniorVice President, Chief Financial Officer and Secretary.

 

**Compensationof Directors**

** **

During 2003, each non-employee member of ourBoard of Directors received a one-time grant of a warrant to purchase 250,000shares of common stock at an exercise price equal to the fair market value atthe time of the grant. As a policy, each newly elected and re-electednon-employee member of the Board of Directors receives a grant of a warrant topurchase 50,000 shares of common stock at an exercise price determined by ourBoard at the time of issuance. Beginning in 2003, each of our non-employeedirectors also receives an annual stipend of $14,000 and $1,750 for each Boardmeeting attended.

 

There are currently two standing Boardcommittees, an audit committee and a compensation committee. Each non-employeemember serving on a Board committee also receives compensation of $250 for eachindividual committee meeting attended in conjunction with a Board meeting, upto $750 for attendance of multiple committee meetings, and $750 for eachcommittee meeting attended separate from a Board meeting. In addition, eachnon-employee director is entitled to reimbursement of travel expenses.

 

In addition, our Lead Director receives astipend of $250 per hour with a per day cap of $1,500.  The Lead Director periodically performsstrategic projects as requested by the Board.

 

In April 2003, as discussed above, weissued 250,000 warrants to each of the four non-employee Board members under Section 4(2)of the Securities Act. The warrants were issued at an exercise price equal tothe fair market value of our common stock, have vested and expire within tenyears of grant. As the warrants were issued at fair market value, we did notrecord any expense for the warrants issued in accordance with AccountingPrinciples Board Opinion No. 25. These warrants fully vested on June 15,2004, as a result of the Private Placement.

 

We periodically form and maintain ad hoccommittees for specific and limited purposes and duration. Such ad hoccommittee members may receive nominal compensation for such service.

 

Our non-employee directors may be grantednon-statutory stock options and restricted stock under the 2001 FlexibleIncentive Plan and 2004 Flexible Incentive Plan.

 

47

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**Item 11. Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters**

** **

As of March 21, 2005, the Company had 36,252,991shares of common stock outstanding.

** **

The table following sets forth information regardingthe beneficial ownership of common stock for each person who is known by us tobe the beneficial owner of more than five percent of our voting securities, foreach of our directors and named executive officers, and all of our directorsand executive officers as a group. Unless otherwise indicated in the footnotes, each person named below hassole voting and investment power over the shares indicated.

 

For purposes of this table, a person is deemed to bethe “beneficial owner” of the number of shares of common stock that such personhas the right to acquire within 60 days of March 21, 2005 through theexercise of any option, warrant or right, through the conversion of anysecurity, through the power to revoke a trust, discretionary account, orsimilar arrangement, or through the automatic termination of a trust,discretionary account or similar arrangement.

 

| **Name of Beneficial Owner /  Management**                        | ** ** | **Number of Shares** | ** ** | **Percent of Class** | ** ** |
|-------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
|                                                              |       |                 |       |                 |       |
| David  Mechler (1)                                                |       | 2,740,815            |       | 7.6                  | %          |
|                                                              |       |                 |       |                 |       |
| John Faltys(2)                                                    |       | 2,230,541            |       | 6.1                  | %          |
|                                                              |       |                 |       |                 |       |
| Joseph R.  Simrell (3)                                            |       | 1,717,920            |       | 4.7                  | %          |
|                                                              |       |                 |       |                 |       |
| Todd R.  Taylor (4)                                               |       | 94,119               |       | *                    |       |
|                                                              |       |                 |       |                 |       |
| Robert  Richardson (5)                                            |       | 210,000              |       | 4.8                  | %          |
|                                                              |       |                 |       |                 |       |
| David Haynes   (6)                                           |       | 1,763,755            |       | 4                    | %          |
|                                                              |       |                 |       |                 |       |
| Louis A.  Delmonico  (7)                                     |       | 521,522              |       | 1.4                  | %          |
|                                                              |       |                 |       |                 |       |
| John E.  Rehfeld  (8)                                        |       | 1,214,322            |       | 3.3                  | %          |
|                                                              |       |                 |       |                 |       |
| Austin W.  Marxe and David M. Greenhouse(9)                       |       | 19,674,417           |       | 45.8                 | %          |
|                                                              |       |                 |       |                 |       |
| All  executive officers and directors as a group (6 persons) (10) |       | 7,658,060            |       | 21.0                 | %          |

 

----

*Constitutes less than 1%

 

(1)                                  Includes2,632,119 shares of common stock beneficially owned by Mr. Mechler and 108,696shares of common stock underlying warrants exercisable as of the date set forthabove and within 60 days thereafter.  Thebusiness address for this person is P.O. Box 1439, Medina, Texas 78055.

 

(2)                                  Includes1,954,454 shares of common stock beneficially owned by Mr. Faltys and 276,087shares of common stock underlying warrants exercisable as of the date set forthabove or within 60 days thereafter.  Thebusiness address for this person is 18881 Von Karman, Suite 500, Irvine,California 92612.

 

(3)                                  Includes1,459,407 shares of common stock beneficially owned by Mr. Simrell and 258,513shares of common stock underlying options exercisable as of the date set forthabove or within 60 days thereafter.  Thebusiness address for this person is 18881 Von Karman Avenue, Suite 500, Irvine,California 92612.

 

(4)                                  Includes94,119 shares of common stock beneficially owned by Mr. Taylor.  The business address for this person is 18881Von Karman Avenue, Suite 500, Irvine, California 92612.  Mr. Taylor resigned as Chief FinancialOfficer and Vice President Finance and Administration effective October 15,2004.

 

(5)                                  Includes210,000 shares of common stock underlying warrants beneficially owned by Mr.Richardson exercisable as of the date set forth above or within 60 daysthereafter.  The business address forthis person is 18881 Von Karman Avenue, Suite 500, Irvine, California 92612.

 

(6)                                  Includes1,459,407 shares of common stock beneficially owned by Mr. D. Haynes and304,348 shares of common stock underlying warrants exercisable as of the dateset forth above or within 60 days thereafter. The business address for this person is 18881 Von Karman Avenue, Suite500, Irvine, California 92612.

 

48

----

 

(7)                                  Includes154,348 shares of common stock beneficially owned by Dr. Delmonico and 367,174shares of common stock underlying options exercisable as of the date set forthabove or within 60 days thereafter. The business address for this person is18881 Von Karman Avenue, Suite 500, Irvine, California 92612.

 

(8)                                  Includes1,105,626 shares of common stock beneficially owned by Mr.Rehfeld and 108,696shares of common stock underlying options exercisable as of the date set forthabove or within 60 days thereafter.  Thebusiness address for this person is 18881 Von Karman Avenue, Suite 500, Irvine,California 92612.

 

(9)                                  Consistsof (i) 6,578,039 shares of common stock held by Special Situations PrivateEquity Fund, L.P. and 3,260,870 shares of common stock underlying warrantsexercisable as of the date set forth above or within 60 days thereafter,(ii) 1,052,878 shares of common stock held by Special SituationsTechnology Fund, L.P. and 521,739 shares of common stock underlying warrantsexercisable as of the date set forth above or within 60 days thereafter,and (iii) 5,521,761 shares of common stock held by Special SituationsTechnology Fund II, L.P. and 2,739,130 shares of common stock underlying warrantsexercisable as of the date set forth above or within 60 days thereafter.SST Advisers, L.L.C. (“SSTA”) is the general partner of and investment adviserto the Special Situations Technology Fund, L.P. and the Special SituationsTechnology Fund II, L.P. MG Advisers, L.L.C. (“MG”) is the general partner ofand investment adviser to the Special Situations Private Equity Fund, L.P.Austin W. Marxe and David M. Greenhouse are the principal owners of SSTA and MGand are principally responsible for the selection, acquisition and dispositionof the portfolio securities by each investment adviser on behalf of itsrespective funds. The business address for Messrs. Marxe and Greenhouse is153 E. 53 Street, 55th Floor, New York, New York 10022.

 

(10)                            Includes all shares and options described inNotes 2, 3, 5, 6, 7 and 8 above.

 

**Institutional Investors**

 

It is our belief that the Special SituationsFunds may be deemed to constitute a “group” within the meaning of Section 13(d)(3)of the Exchange Act, for purposes of disclosure in this Annual Report. Each ofthe Management Accredited Investors expressly disclaims the existence of a “group”either among them or between any of them and any other investor in the PrivatePlacement or any other record or beneficial owner of our voting securities. Wehave not received any indication from any other investor in the PrivatePlacement that it will act as a “group” either among them or between any ofthem and any other investor in the Private Placement or any other record or beneficialowner of our voting securities.

 

The consummation of the Private Placementresulted in no changes to the composition of our Board of Directors, our ChiefExecutive Officer or our Chief Financial Officer; and we do not know of anyarrangements or understandings among or between any of the investors in thePrivate Placement with respect to the election of directors.

 

Without acting in concert as a “group” withthe intent to control or influence our business or affairs, none of theInstitutional Investors has a majority of the voting power of our common stockas a result of the Private Placement. See the discussion under the heading “SecurityOwnership of Certain Beneficial Owners and Management” beginning on page 48.

 

49

----

 

**Securities Authorized for Issuance Under EquityCompensation Plans:**

 

**Equity Compensation PlanInformation**

 
| **Plan category**                                            | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average   exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available  for future issuance  under equity  compensation plans  (excluding securities  reflected in column  (a))** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **(a)**                                                                                             | ** ** | **(b)**                                                                             | ** ** | **(c)**                                                                                                                                                | ** ** |
| Equity  compensation plans approved by security holders:     |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
|                                                         |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
| 2001  Flexible Incentive Plan                                |       | 3,639,064                                                                                           |       | $                                                                                   | 0.06       |                                                                                                                                                   | 20,428     |   |
|                                                         |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
| 2004  Flexible Incentive Plan (1)                            |       | —                                                                                              |       | —                                                                              |       | 5,451,073                                                                                                                                              |       |
|                                                         |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
| Equity  compensation plans not approved by security holders: |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
|                                                         |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
| Warrants  issued to Board of Advisors Member (2)             |       | 25,000                                                                                              |       | $                                                                                   | 0.22       |                                                                                                                                                   | —     |   |
|                                                         |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
| Warrants  issued to Board Members (3)                        |       | 750,000                                                                                             |       | $                                                                                   | 0.05       |                                                                                                                                                   | —     |   |
|                                                         |       |                                                                                                |       |                                                                                |       |                                                                                                                                                   |       |
| **Total**                                                    |       | 4,414,064                                                                                           |       | $                                                                                   | 0.06       |                                                                                                                                                   | 5,471,501  |   |

 

----

(1)                                  TheCompany’s stockholders approved the adoption of Primal’s 2004 FlexibleIncentive Plan at the Company’s 2004 Annual Meeting of Stockholders held November 12,2004.  Pursuant to the 2004 FlexibleIncentive Plan, the Company may issue up to an aggregate of 5,451,073 shares ofthe Company’s common stock.  The Company’s2004 Flexible Incentive Plan provides that the Company’s Board of Directors orsuch appropriately appointed committee, as the case may be, may refrain fromissuing awards under the 2004 Flexible Incentive Plan until such time as theBoard of Directors or such committee has determined that such issuance ofawards under the 2004 Flexible Incentive Plan will not violate applicablefederal or state securities laws.

 

(2)                                  Issuedin August, 2004 to a member of our Board of Advisors at an exercise price of$0.22 and with a term of 10 years.

 

(3)                                  Issuedin April 2003 to our non-employee Board members at an exercise price of$0.05, vesting over two years and with a term of 10 years.  These warrants fully vested on June 15,2004 as a result of the Private Placement.

 

(4)                                  Thepreceding table does not include an option to purchase up to 360,000 shares ofour common stock granted to an officer of the Company in January 2004.  The officer was terminated in January 2005.  At the time of termination, the option hadvested with respect to 119,988 shares, which option is exercisable for the90-day period following termination.

 

50

----

 

# **Item12.  Certain Relationships And RelatedTransactions**

# ** **

**Issuanceof Common Stock**

 

As discussed elsewhere in this report, in June 2004,we closed a Private Placement of our securities to the Institutional Investorsand the Accredited Investors, which included each member of our Board ofDirectors, our Chief Executive Officer, and our then Chief Financial Officer,and Mr. David Mechler. See the discussion under the heading “Management’sDiscussion And Analysis Of Financial Condition And Results Of Operations”beginning on page 23 and “Security Ownership of Certain Beneficial Owners andManagement” beginning on page 48.

 

In September 2003, the Board ofDirectors approved and completed the sale of 688,253 shares of our common stockto members of the Board of Directors at a price equal to fair market value.

 

**Item 13.  Exhibits**

** **

(a) Exhibits

 

**INDEX TOEXHIBITS**
| **Exhibit**  **Number** | ** ** | **Description of Document**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.1                          |       | Primal Solutions, Inc. Preliminary  Distribution Agreement, dated July 31, 2000, by and among Avery  Communications, Inc., a Delaware corporation, Primal  Solutions, Inc., a Delaware corporation, John Faltys, Joseph R. Simrell,  David Haynes, Mark J. Nielsen, Arun Anand, Murari Cholappadi, Sanjay Gupta,  Thurston Group, Inc., a Delaware corporation, Patrick J. Haynes, III and  Scot M. McCormick (filed as Exhibit 2.1 to the Company’s registration  Statement on Form SB-2 filed July 30, 2004 and incorporated by reference  herein) |
|                         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.1                          |       | Certificate of Correction to the  Certificate of Amendment of the Certificate of Incorporation of the Company  (filed as Exhibit 3.1 to the Company’s registration Statement on Form SB-2  filed July 30, 2004 and incorporated by reference herein)                                                                                                                                                                                                                                                                                                                          |
|                         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.2                          |       | Second Amended and Restated Bylaws (filed  as Exhibit 3.3 to the Company’s quarterly report on Form 10-QSB  filed on August 14, 2002 and incorporated by reference herein)                                                                                                                                                                                                                                                                                                                                                                                          |
|                         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.1                         |       | Agreement and Plan of Merger, dated as of March 19,  1999, by and among Avery Communications, Inc., ACI Telecommunications  Financial Services Corporation, Primal Systems Inc., Mark J.  Nielsen, John Faltys, Joseph R. Simrell and David Haynes  (filed as Exhibit 10.1 to the Company’s registration Statement on Form SB-2  filed July 30, 2004 and incorporated by reference herein)                                                                                                                                                 |
|                         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.2                         |       | Primal Solutions, Inc. 2001 Flexible  Incentive Plan, as amended (filed as Exhibit 99.1 to the Company’s  registration statement on Form S-8 filed on May 4, 2001 (Registration  No. 333-60298) and incorporated by reference herein)                                                                                                                                                                                                                                                                                                                          |
|                         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.3                         |       | Governance Document, as amended (filed as  Exhibit 99.2 to the Company’s registration statement on Form S-8  filed on May 4, 2001 (Registration No. 333-60298) and incorporated by  reference herein)                                                                                                                                                                                                                                                                                                                                                               |
|                         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.4                         |       | Form of Indemnification Agreement (filed as  Exhibit 10.2a to the Company’s annual report on Form 10-KSB filed March 27,  2002 and incorporated by reference herein)                                                                                                                                                                                                                                                                                                                                                                                                |

 

51

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| 10.5   |   | Indemnification Agreement between Primal  Solutions, Inc. and Louis A. Delmonico, dated April 25, 2001  (filed as Exhibit 10.12 to the Company’s annual report on  Form 10-KSB filed March 27, 2002 and incorporated by reference  herein)                           |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.6   |   | Employment Agreement for David Haynes  dated December 31, 2001 (filed as Exhibit 10.6 to the Company’s  annual report on Form 10-KSB filed March 27, 2002 and incorporated  by reference herein)                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.7   |   | Form of Master Software License Agreement  (filed as Exhibit 10.7 to Amendment No. 1 to the Company’s registration  statement on Form SB-2 filed January 8, 2001 (Registration No.  333-46494) and incorporated by reference herein)                                                |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.8   |   | Form of Change of Control Agreement, as  modified on May 3, 2002 (filed as Exhibit 10.8 to the Company’s  quarterly report on Form 10-QSB filed on May 14, 2002 and  incorporated by reference herein)                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.9   |   | Form of Lease between Spieker  Properties, L.P. and Primal Solutions, Inc. dated October 26,  2000 (filed as Exhibit 10.9 to the Company’s annual report on  Form 10-KSB filed March 27, 2002 and incorporated by reference  herein)                                 |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.10  |   | First Amendment to Lease between Spieker  Properties, L.P. and Primal Solutions, Inc. dated June 13, 2001  (filed as Exhibit 10.9a to the Company’s annual report on  Form 10-KSB filed March 27, 2002 and incorporated by reference  herein)                             |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.11  |   | Promissory Note of Primal  Solutions, Inc. in favor of Spieker Properties, L.P., dated June 15,  2001 (filed as Exhibit 10.10 to the Company’s annual report on  Form 10-KSB filed March 27, 2002 and incorporated by reference  herein)                                  |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.12  |   | Assignment of Lease between Corsair  Communications and Lightbridge, Inc., dated February 7, 2001 (filed  as Exhibit 10.12 to the Company’s registration Statement on Form SB-2 filed July 30,  2004 and incorporated by reference herein)                                          |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.13  |   | Guaranty, dated December 27, 2002, in  favor of Lightbridge, Inc., successor in interest to Corsair  Communications, Inc. (filed as Exhibit 10.11c to the Company’s  quarterly report on Form 10-QSB filed on August 14, 2003 and  incorporated by reference herein) |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.14  |   | Agreement of Sublease between Primal  Solutions, Inc. and Lightbridge, Inc., dated January 30, 2004  (filed as Exhibit 10.14 to the Company’s registration Statement on Form SB-2  filed July 30, 2004 and incorporated by reference herein)                                   |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.15  |   | Landlord Consent to Sublease among CA-Tower  17 Limited Partnership, Lightbridge, Inc. and Primal Solutions, dated February 27,  2004 (filed as Exhibit 10.15 to the Company’s registration Statement on Form  SB-2 filed July 30, 2004 and incorporated by reference herein)       |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.16  |   | Employment Transition Agreement and General  Release between Primal Solutions, Inc. and William Salway, dated January 27,  2003 (filed as Exhibit 10.13 to the Company’s annual report on  Form 10-KSB filed March 28, 2003 and incorporated by reference  herein)        |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.17  |   | Employment Agreement between Primal  Solutions, Inc. and Joseph R. Simrell dated January 28, 2003  (filed as Exhibit 10.14 to the Company’s annual Report on Form 10-KSB  filed on March 28, 2003 and incorporated by reference herein)                                   |
|   |   |                                                                                                                                                                                                                                                                                                    |
| 10.18  |   | Consolidation Agreement between Wireless  Billing Systems dba Primal Billing Solutions and Metrocall, Inc. dated December 30,  2002 (filed as Exhibit 10.15 o the Company’s annual Report on Form  10-KSB filed on March 28, 2003 and incorporated by reference herein)        |

 

52

----

 
| 10.19  |   | 2004 Amended and Restated Promissory Note  by Wireless Billing Systems, Inc. in favor of Lightbridge, Inc.,  successor in interest to Corsair Communications, Inc., dated March 27,  2004, amending the 2002 Amended and Restated Promissory Note Payable by  Wireless Billing Systems, Inc. in favor of Corsair  Communications, Inc. (filed as exhibit 10.17 to the Company’s  annual report on Form 10-KSB filed March 30, 2004 and incorporated  by reference herein) |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.19a |   | Confirmation of Guaranty by Primal  Solutions, Inc. relating to the 2004 Amended and Restated Promissory  Note (filed as Exhibit 10.17a to the Company’s annual report on  Form 10-KSB filed March 30, 2004 and incorporated by reference  herein)                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.20  |   | Purchase Agreement between registrant and  certain institutional investors and accredited investors, dated June 8,  2004 (filed as exhibit 10.18 to the Company’s current report on  Form 8-K filed June 18, 2004 and incorporated by reference herein)                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.21  |   | Registration Rights Agreement between the  registrant and the institutional investors and accredited investors, dated June 8,  2004 (filed as exhibit 10.19 to the Company’s current report on  Form 8-K filed June 18, 2004 and incorporated by reference herein)                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.22  |   | Form of Warrants for the issuance of  warrants to the institutional investors and accredited investors (filed as  exhibit 10.20 to the Company’s current report on Form 8-K filed June 18,  2004 and incorporated by reference herein)                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.23  |   | Purchase Agreement between registrant and  Management, dated June 8, 2004 (filed as exhibit 10.21 to the  Company’s current report on Form 8-K filed June 18, 2004 and  incorporated by reference herein)                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.24  |   | Registration Rights Agreement between  registrant and Management, dated June 8, 2004 (filed as  exhibit 10.22 to the Company’s current report on Form 8-K filed June 18,  2004 and incorporated by reference herein)                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.25  |   | Form of Warrants for the issuance of  warrants to Management (filed as exhibit 10.23 to the Company’s current  report on Form 8-K filed June 18, 2004 and incorporated by  reference herein)                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.26  |   | Form of Lock-up Agreement, dated June 8,  2004 (filed as exhibit 10.24 to the Company’s current report on  Form 8-K filed June 18, 2004 and incorporated by reference herein)                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.27  |   | Amended and Restated Change of Control  Agreement, dated as of May 17, 2004, between Joseph R. Simrell and  Primal Solutions, Inc. (filed as Exhibit 10.27 to the Company’s  registration Statement on Form SB-2 filed July 30, 2004 and incorporated  by reference herein)                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.28  |   | Promissory Note by Primal  Solutions, Inc. in favor of Sunwest Bank, dated April 8, 2002 (in  the amount of $100,000.00) (Loan No. 0100961001) (filed as Exhibit 10.28  to the Company’s registration Statement on Form SB-2 filed July 30, 2004  and incorporated by reference herein)                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.29  |   | Commercial Security Agreement, between  Primal Solutions, Inc., Wireless Billing Systems, and Sunwest Bank,  dated April 8, 2002 (filed as Exhibit 10.29 to the Company’s  registration Statement on Form SB-2 filed July 30, 2004 and incorporated  by reference herein)                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.30  |   | Subordination Agreement between Wireless  Billing Systems, Corsair Communication, Inc. and Sunwest Bank, dated April 8,  2002 (filed as Exhibit 10.30 to the Company’s registration Statement on Form  SB-2 filed July 30, 2004 and incorporated by reference herein)                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.31  |   | Business Loan Agreement between Primal  Solutions, Inc. and Sunwest Bank, dated April 8, 2002 (filed as  Exhibit 10.31 to the Company’s registration Statement on Form SB-2 filed July 30,  2004 and incorporated by reference herein)                                                                                                                                                                                                                                                                  |

 

53

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| 10.32  |   | Change in Terms Agreement between Primal  Solutions, Inc. and Sunwest Bank, dated March 13, 2004 (filed as  Exhibit 10.32 to the Company’s registration Statement on Form SB-2 filed July 30,  2004 and incorporated by reference herein)                                               |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.33  |   | Promissory Note between Primal  Solutions, Inc. and Sunwest Bank, dated May 13, 2002 (in the amount  of $60,702.50) (Loan No. 0100961002) (filed as Exhibit 10.33 to the  Company’s registration Statement on Form SB-2 filed July 30, 2004 and  incorporated by reference herein) |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.34  |   | Letter Agreement between Primal Solutions,  Inc. and Robert Richardson dated August 14, 2003 (filed as Exhibit 10.34  to post-effective amendment no. 1 to the Company’s registration Statement on  Form SB-2 filed March 10, 2005 and incorporated by reference herein)                     |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.35  |   | Letter Agreement between Primal Solutions,  Inc. and Robert Richardson dated August 18, 2003 (filed as Exhibit 10.35  to post-effective amendment no. 1 to the Company’s registration Statement on  Form SB-2 filed March 10, 2005 and incorporated by reference herein)                     |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.36* |   | Amended and Restated Letter Agreement  between Primal Solutions, Inc. and Robert Richardson dated March 25,  2005                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.37* |   | Letter Agreement dated March 25, 2005  between Primal and William C. Bousema                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.38* |   | Change of Control Agreement dated March 25,  2005 between Primal and William C. Bousema.                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.39* |   | Form Services Agreement                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 10.40* |   | Form Software License and Services  Agreement                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 16.1   |   | Letter on Change in Certifying Accountant  (filed as Exhibit 16.1 to the Primal Form 8-K filed on April 24, 2003  and incorporated by reference herein)                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 23.1*  |   | Consent of Haskell & White LLP                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 31.1*  |   | Certification pursuant to Section 302  of the Sarbanes-Oxley Act                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 31.2*  |   | Certification pursuant to Section 302  of the Sarbanes-Oxley Act                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 32.1*  |   | Certification pursuant to Section 906  of the Sarbanes-Oxley Act                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 99.1   |   | Primal Solutions, Inc. 2001 Flexible  Incentive Plan, as amended (filed as Exhibit 99.1 to the Company’s Registration  Statement on Form S-8 (Registration No. 333-60298) (“Primal Form S-8”) and  incorporated by reference herein)                                                    |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 99.2   |   | Governance Document, as amended (filed as  Exhibit 99.2 to Primal Form S-8 and incorporated by reference herein)                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 99.3   |   | Primal Solutions, Inc. 2004 Flexible  Incentive Plan (filed as Exhibit 99.1 to the Company’s Registration Statement  on Form S-8 (Registration No. 333 - 121902 “2004 S-8” and incorporated by  reference herein)                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                        |
| 99.4   |   | Governance Document (filed as  Exhibit 99.2 to the 2004 S-8 and incorporated by reference herein.                                                                                                                                                                                                      |

 

----

*                                         Filedherewith

 

54

----

 

**Item 14. Principal Accountant Fees and Services**

** **

For the year ended December 31, 2004 and 2003,Haskell & White LLP audited the Company’s consolidated financial statementsand provided tax return and tax related services.

 

The aggregate feesbilled for professional services by Haskell & White LLP in 2004 and 2003were as follows:

 
| ** **         | ** ** | **2004**                    | ** ** | **2003**                    | ** ** |
|--------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **         | ** ** | **Haskell & White LLP** | ** ** | **Haskell & White LLP** | ** ** |
| ** **         | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Audit Fees (1)     |       | $                           | 67,845     |                        | $          | 62,135 |   |
|               |       |                        |       |                        |       |
| Audit Related Fees |       | —                      |       | —                      |       |
|               |       |                        |       |                        |       |
| Tax Fees (2)/(3)   |       | 7,500                       |       | 7,500                       |       |
|               |       |                        |       |                        |       |
| All Other Fees     |       | —                      |       | —                      |       |
|               |       |                        |       |                        |       |
| Total              |       | $                           | 75,345     |                        | $          | 69,635 |   |

 

----

(1) Includes$10,620 in audit fees to be billed in 2005.

(2) To be billedin 2005

(3) Tax return andrelated tax services.

 

It is our AuditCommittee’s policy and procedure to approve in advance all audit engagementfees and terms and all permitted non-audit services provided by our independentauditors.  We believe that all auditengagement fees and terms and permitted non-audit services provided by ourindependent auditors as described in the above table were approved in advanceby our Audit Committee.

 

55

----

**SIGNATURES**

 

In accordance with Section 13 or 15(d) of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|   | PRIMAL  SOLUTIONS, INC. |
|--------|-------------------------|
|   |                    |
|   | By:                     | /S/ JOSEPH R. SIMRELL |   |
|   |                    | Joseph  R. Simrell |
|   |                    | Chief Executive Officer and President |
|   |                    |   |
|   |                    | PRIMAL SOLUTIONS, INC. |
|   |                    |
|   | By                      | /s/  William C. Bousema |   |
|   |                    | William  C. Bousema |
|   |                    | Senior Vice President, Chief Financial Officer and  Secretary |
|   |                    |   |
|   | Date:  March 31, 2005   |

 

In accordance with the Exchange Act, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature**          | ** ** | **Title**                                                    | ** ** | **Date**       |
|------------------------|------------|--------------------------------------------------------------|------------|----------------|
| ** **             | ** ** | ** **                                                   | ** ** | ** **     |
| /s/ Joseph R. Simrell  |       | Chief Executive Officer, President and Director              |       | March 31, 2005 |
| Joseph R. Simrell      |       | (Principal Executive Officer)                                |       |           |
|                   |       |                                                         |       |           |
| /s/ William C. Bousema |       | Senior Vice President, Chief Financial Officer and Secretary |       | March 31, 2005 |
| William C. Bousema     |       | (Principal Financial Officer)                                |       |           |
|                   |       |                                                         |       |           |
| /s/ David Haynes       |       | Director                                                     |       | March 31, 2005 |
| David Haynes           |       |                                                         |       |           |
|                   |       |                                                         |       |           |
| /s/ John Faltys        |       | Director                                                     |       | March 31, 2005 |
| John Faltys            |       |                                                         |       |           |
|                   |       |                                                         |       |           |
| /s/ Louis A. Delmonico |       | Director                                                     |       | March 31, 2005 |
| Louis A. Delmonico     |       |                                                         |       |           |
|                   |       |                                                         |       |           |
| /s/ John E. Rehfeld    |       | Director                                                     |       | March 31, 2005 |
| John E. Rehfeld        |       |                                                         |       |           |
|                   |       |                                                         |       |           |

 

 

56

----

 

**PRIMALSOLUTIONS, INC.**

 

**INDEX TOFINANCIAL STATEMENTS**

 
|                                                                                                                |   | **Page** |
|---------------------------------------------------------------------------------------------------------------------|--------|----------|
| Report of Independent  Registered Public Accounting Firm                                                            |   | F-2      |
|                                                                                                                |   |     |
| Financial Statements:                                                                                               |   |     |
|                                                                                                                |   |     |
| Consolidated Balance Sheets at  December 31, 2004 and December 31, 2003                                   |   | F-3      |
|                                                                                                                |   |     |
| Consolidated Statements of Operations for  the years ended December 31, 2004 and 2003                          |   | F-4      |
|                                                                                                                |   |     |
| Consolidated Statements of Stockholders’  Equity (Deficit) for the years ended December 31, 2004 and 2003 |   | F-5      |
|                                                                                                                |   |     |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2004 and 2003                          |   | F-6      |
|                                                                                                                |   |     |
| Notes to Consolidated Financial Statements                                                                          |   | F-7      |

 

F-1

----

 

**REPORT** OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directorsand Stockholders

Primal Solutions, Inc.

 

We have audited the accompanying consolidatedbalance sheets of Primal Solutions, Inc. (the “Company”) as ofDecember 31, 2004 and 2003 and the related consolidated statements ofoperations, stockholders’ equity (deficit) and cash flows for each of the yearsthen ended. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financialstatements present fairly, in all material respects, the financial position ofPrimal Solutions, Inc. as of December 31, 2004 and 2003 and theresults of its operations and its cash flows for each of the years then endedin conformity with accounting principles generally accepted in the UnitedStates of America.

 

 
| HASKELL &  WHITE LLP |
|-------------------------------|
|                          |
| Irvine, California            |
| February 25, 2005        |

 

F-2

----

 

**PRIMAL SOLUTIONS, INC.**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                    | ** ** | **December 31,****2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
|                                                                                                                          |       |                          |       |                        |       |
| **ASSETS**                                                                                                                    |       |                          |       |                        |       |
| CURRENT  ASSETS:                                                                                                              |       |                          |       |                        |       |
| Cash and  cash equivalents                                                                                                    |       | $                             | 2,603,132  |                        | $          | 1,249,237 |   |
| Accounts  receivable, net of allowance for doubtful accounts

of $-0- (2004) and $-0-  (2003)                                 |       | 499,107                       |       | 639,761                     |       |
| Prepaid  expenses and other current assets                                                                                    |       | 122,853                       |       | 189,475                     |       |
| Total  current assets                                                                                                         |       | 3,225,092                     |       | 2,078,473                   |       |
| PROPERTY AND  EQUIPMENT, net of accumulated depreciation

of $1,353,931 (2004) and $1,125,914 (2003)                          |       | 493,065                       |       | 493,407                     |       |
| GOODWILL                                                                                                                      |       | 592,540                       |       | 592,540                     |       |
| OTHER ASSETS                                                                                                                  |       | 88,718                        |       | 79,633                      |       |
|                                                                                                                          |       | $                             | 4,399,415  |                        | $          | 3,244,053 |   |
|                                                                                                                          |       |                          |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                      |       |                          |       |                        |       |
| CURRENT  LIABILITIES:                                                                                                         |       |                          |       |                        |       |
| Accounts  payable                                                                                                             |       | $                             | 222,264    |                        | $          | 179,503 |   |
| Accrued  liabilities                                                                                                          |       | 479,039                       |       | 262,906                     |       |
| Accrued  salaries and benefits                                                                                                |       | 553,923                       |       | 469,151                     |       |
| Deferred  revenue                                                                                                             |       | 727,681                       |       | 1,001,773                   |       |
| Current  portion of note payable to Corsair                                                                                   |       | 533,706                       |       | 182,256                     |       |
| Current  portion of notes payable                                                                                             |       | 100,000                       |       | 120,917                     |       |
| Total  current liabilities                                                                                                    |       | 2,616,613                     |       | 2,216,506                   |       |
|                                                                                                                          |       |                          |       |                        |       |
| NOTE PAYABLE  TO CORSAIR, less current portion                                                                                |       | 578,001                       |       | 1,371,874                   |       |
| NOTES  PAYABLE, less current portion                                                                                          |       | 276,940                       |       | 253,452                     |       |
| Total  liabilities                                                                                                            |       | 3,471,554                     |       | 3,841,832                   |       |
|                                                                                                                          |       |                          |       |                        |       |
| COMMITMENTS  AND CONTINGENCIES (Note 4, 5 and 9)                                                                              |       |                          |       |                        |       |
| STOCKHOLDERS’  EQUITY (DEFICIT):                                                                                         |       |                          |       |                        |       |
| Preferred  stock, $0.01 par value; 5,000,000 authorized; none issued and outstanding                                          |       | —                        |       | —                      |       |
| Common  stock, $0.01 par value; 95,000,000 shares authorized; 36,178,441 (2004) and  20,968,083 (2003) issued and outstanding |       | 361,784                       |       | 209,681                     |       |
| Additional  paid-in capital                                                                                                   |       | 13,232,265                    |       | 11,863,413                  |       |
| Warrants  (Note 7)                                                                                                            |       | 1,204,500                     |       | —                      |       |
| Accumulated  deficit                                                                                                          |       | (13,870,688                   | )          | (12,670,873                 | )          |
| Net  stockholders’ equity (deficit)                                                                                      |       | 927,861                       |       | (597,779                    | )          |
|                                                                                                                          |       | $                             | 4,399,415  |                        | $          | 3,244,053 |   |

 

See accompanying notes toconsolidated financial statements

 

F-3

----

 

**PRIMAL SOLUTIONS, INC.**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                    | ** ** | **For The  Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                                    | ** ** | ** **                                | ** ** | ** ** | ** ** |
| REVENUES:                                                     |       |                                      |       |   |   |
| System  revenue                                               |       | $                                         | 2,441,978  |   | $ | 2,548,980 |   |
| Service  revenue                                              |       | 5,166,908                                 |       | 3,967,685 |   |
| Total  revenues                                               |       | 7,608,886                                 |       | 6,516,665 |   |
|                                                          |       |                                      |       |   |   |
| Cost of  systems                                              |       | 96,357                                    |       | 244,107 |   |
| Cost of  services                                             |       | 3,620,193                                 |       | 2,692,041 |   |
| COST OF  REVENUES                                             |       | 3,716,550                                 |       | 2,936,148 |   |
| GROSS MARGIN                                                  |       | 3,892,336                                 |       | 3,580,517 |   |
| OPERATING  EXPENSES:                                          |       |                                      |       |   |   |
| Research and  development                                     |       | 1,244,628                                 |       | 993,760 |   |
| Sales and  marketing                                          |       | 1,921,716                                 |       | 1,050,445 |   |
| General and  administrative                                   |       | 1,797,922                                 |       | 1,608,050 |   |
| Total  operating expenses                                     |       | 4,964,266                                 |       | 3,652,255 |   |
|                                                          |       |                                      |       |   |   |
| LOSS FROM  OPERATIONS                                         |       | (1,071,930                                | )          | (71,738 | ) |
| INTEREST AND  OTHER EXPENSE, net                              |       | (126,285                                  | )          | (205,244 | ) |
| LOSS BEFORE  INCOME TAX PROVISION                             |       | (1,198,215                                | )          | (276,982 | ) |
| INCOME TAX  PROVISION                                         |       | 1,600                                     |       | 1,600 |   |
| NET LOSS                                                      |       | $                                         | (1,199,815 | ) | $ | (278,582 | ) |
|                                                          |       |                                      |       |   |   |
| Basic and  diluted net loss per share                         |       | $                                         | (.04       | ) | $ | (.01 | ) |
| Weighted-average  basic and diluted common shares outstanding |       | 29,238,864                                |       | 20,369,380 |   |

 

See accompanying notes toconsolidated financial statements

 

F-4

----

 

**PRIMAL SOLUTIONS, INC.**

 

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’****EQUITY (DEFICIT)**

 
| ** **                                                                    | ** ** | **Common  shares** | ** ** | **Amount** | ** ** | **Additional  paid-in  capital** | ** ** | **Accumulated  deficit** | ** ** | **Net  stockholders’  equity  (deficit)** | ** **  |
|-------------------------------------------------------------------------------|------------|--------------------|------------|------------|------------|----------------------------------|------------|--------------------------|------------|------------------------------------------------|-------------|
|                                                                          |       |               |       |       |       |                             |       |                     |       |                                           |        |
| BALANCE,

December 31, 2002                                              |       | 20,131,212         |       | 201,312    |       | 11,805,614                       |       | (12,392,291              | )          | (385,365                                       | )           |
|                                                                          |       |               |       |       |       |                             |       |                     |       |                                           |        |
| Issuance of  common stock to members of the Board of Directors                |       | 688,235            |       | 6,883      |       | 51,617                           |       | —                   |       | 58,500                                         |        |
| Exercise of  stock options issued to employees                                |       | 4,545              |       | 45         |       | 273                              |       | —                   |       | 318                                            |        |
| Exercise of  stock options issued to employees through cashless exercise, net |       | 109,091            |       | 1,091      |       | (1,091                           | )          | —                   |       | —                                         |        |
| Stock grant  to employee                                                      |       | 35,000             |       | 350        |       | 7,000                            |       | —                   |       | 7,350                                          |        |
| Net loss                                                                      |       | —             |       | —     |       | —                           |       | (278,582                 | )          | (278,582                                       | )           |
|                                                                          |       |               |       |       |       |                             |       |                     |       |                                           |        |
| BALANCE,

December 31, 2003                                              |       | 20,968,083         |       | $          | 209,681    |                             | $          | 11,863,413               |       | $                                              | (12,670,873 | ) | $ | (597,779 | ) |
|                                                                          |       |               |       |       |       |                             |       |                     |       |                                           |        |
| Exercise of  stock options issued to employees                                |       | 925,576            |       | 9,255      |       | 22,924                           |       |                     |       | 32,179                                         |        |
| Warrants  issued in lieu of fees                                              |       |               |       |       |       | 5,500                            |       |                     |       | 5,500                                          |        |
| Registration  Expenses                                                        |       |               |       |       |       | (602,524                         | )          |                     |       | (602,524                                       | )           |
| Employee  Exercise of Grant below FV                                          |       |               |       |       |       | 4,800                            |       |                     |       | 4,800                                          |        |
| Issuance of  common stock in Private Placement                                |       | 14,284,782         |       | 142,848    |       | 3,142,652                        |       |                     |       | 3,285,500                                      |        |
| Net loss                                                                      |       |               |       |       |       |                             |       | (1,199,815               | )          | (1,199,815                                     | )           |
|                                                                          |       |               |       |       |       |                             |       |                     |       |                                           |        |
| BALANCE,

December 31, 2004                                              |       | 36,178,441         |       | $          | 361,784    |                             | $          | 14,436,765               |       | $                                              | (13,870,688 | ) | $ | 927,861 |   |

 

See accompanying notes toconsolidated financial statements

 

F-5

----

 

**PRIMAL SOLUTIONS, INC.**

 

**CONSOLIDATED STATEMENTS OF CASH**FLOWS

 
| ** **                                                                              | ** ** | **For The  Year Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                                  |       |                                       |       |   |   |
| Net loss                                                                                |       | $                                          | (1,199,815 | ) | $ | (278,582 | ) |
| Adjustments  to reconcile net loss to net cash (used) provided by operating activities: |       |                                       |       |   |   |
| Depreciation  and amortization                                                          |       | 238,688                                    |       | 374,141 |   |
| Provision  for doubtful accounts                                                        |       | —                                     |       | (7,724 | ) |
| Loss on  disposal of equipment                                                          |       | (2,000                                     | )          | 51,089 |   |
| Non-cash  stock based compensation                                                      |       | —                                     |       | 7,350 |   |
| Charitable  contribution of equipment                                                   |       | —                                     |       | 988 |   |
|                                                                                    |       |                                       |       |   |   |
| Changes in  operating assets and liabilities:                                           |       |                                       |       |   |   |
| Accounts  receivable                                                                    |       | 140,654                                    |       | (237,709 | ) |
| Prepaid  expenses and other current assets                                              |       | 57,538                                     |       | (25,126 | ) |
| Accounts  payable and other accrued liabilities                                         |       | 343,666                                    |       | 119,414 |   |
| Accrued  salaries and benefits                                                          |       | —                                     |       | 132,604 |   |
| Increase in  non-current accrued interest payable                                       |       | 23,488                                     |       | 21,462 |   |
| Deferred  revenue                                                                       |       | (274,092                                   | )          | 48,010 |   |
| Net cash  (used) provided by operating activities                                       |       | (671,873                                   | )          | 205,917 |   |
|                                                                                    |       |                                       |       |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                  |       |                                       |       |   |   |
| Purchases of  property and equipment                                                    |       | (224,571                                   | )          | (98,856 | ) |
| Leasehold  improvements                                                                 |       | (13,776                                    | )          | — |   |
| Proceeds  from sales of property and equipment                                          |       | 2,000                                      |       | 1,244 |   |
| Net cash  used in investing activities                                                  |       | (236,347                                   | )          | (97,612 | ) |
|                                                                                    |       |                                       |       |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                  |       |                                       |       |   |   |
| Payments on  capital lease obligations                                                  |       | —                                     |       | (2,502 | ) |
| Proceeds  from notes payable                                                            |       | —                                     |       | 100,000 |   |
| Payments on  notes payable                                                              |       | (20,917                                    | )          | (25,128 | ) |
| Payments on  note payable to Corsair                                                    |       | (442,423                                   | )          | (165,078 | ) |
| Proceeds  from issuance of common stock                                                 |       | 2,725,455                                  |       | 50,318 |   |
| Net cash  provided (used) in financing activities                                       |       | 2,262,115                                  |       | (42,390 | ) |
|                                                                                    |       |                                       |       |   |   |
| INCREASE IN  CASH AND CASH EQUIVALENTS                                                  |       | 1,353,895                                  |       | 65,915 |   |
| CASH AND  CASH EQUIVALENTS, beginning of the year                                       |       | 1,249,237                                  |       | 1,183,322 |   |
| CASH AND  CASH EQUIVALENTS, end of the year                                             |       | $                                          | 2,603,132  |   | $ | 1,249,237 |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION                                      |       |                                       |       |   |   |
| Cash paid  during the year for:                                                         |       |                                       |       |   |   |
| Interest                                                                                |       | $                                          | 193,054    |   | $ | 140,748 |   |
| Income taxes                                                                            |       | $                                          | 1,600      |   | $ | 1,600 |   |
|                                                                                    |       |                                       |       |   |   |
| NONCASH  INVESTING AND FINANCING ACTIVITIES:                                            |       |                                       |       |   |   |
| Issuance of  common stock in satisfaction of liability                                  |       | $                                          | 5,500      |   | $ | 8,500 |   |

 

See accompanying notes toconsolidated financial statements

 

F-6

----

 

**PRIMAL SOLUTIONS, INC. AND SUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****              BASIS OFPRESENTATION, ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES**

 

*Organizationand Nature of Operations*- Primal Systems, Inc. wasincorporated on June 28, 1996 to provide computer software programming,customization, program maintenance, and product marketing for a variety ofsoftware languages and platforms.  During1999, Primal Systems, Inc. acquired certain assets from CorsairCommunications, Inc. through its wholly owned subsidiary, Wireless BillingSystems, which provides software and services to the telecommunicationsindustry.  Effective October 1,1999, Primal Systems, Inc. was merged with and into a wholly-ownedsubsidiary of Avery Communications, Inc. (“Avery”), ACI TelecommunicationsFinancial Services, and the surviving company changed its name to PrimalSolutions, Inc.  Primal Solutions, Inc.,and its subsidiary, Wireless Billing Systems, (the “Company”), develop, marketand support convergent network mediation and convergent integrated billingsoftware for providers of voice and data transmission services using theInternet and wireless networks.

 

TheCompany was spun-off as a separate public company by Avery in February 2001.On February 13, 2001 and in connection with the Distribution Agreement,Avery distributed approximately 13.2 million shares of common stock of theCompany to Avery’s security holders (the “Distribution”). As part of theDistribution:

 

•                  Each common shareholder of Avery, on February 12,2001, received one share of the Company’s common stock for each share of Avery’scommon stock held on that date.

 

•                  Owners of shares of Avery’s Series A,B, C, D, and E convertible preferred stock received the Company’s common stock,in the amount of the preferred stock’s common stock equivalent for each shareof Avery preferred stock held on the payment date of the Distribution.

 

•                  Avery redeemed 7,126,894 shares ofits Series G preferred stock from John Faltys, Joseph R. Simrell,David Haynes, Mark J. Nielsen, Arun Anand, Murari Cholappadi, SanjayGupta (collectively the “Old Primal Stockholders”) in consideration of6,207,026 shares of the Company’s common stock, each dated February 9,2001.

 

•                  The Company issued 250,000 shares ofcommon stock to a former executive officer of Avery.

 

*Basis ofPresentation*- The accompanying consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America.

 

*Principlesof Consolidation*- The accompanying consolidated financialstatements include the accounts of Primal Solutions, Inc. and its whollyowned subsidiary, Wireless Billing Systems. Intercompany accounts and transactions have been eliminated.

 

*CashEquivalents*- The Company considers all highly liquid debtinstruments purchased with an original maturity of three months or less to becash equivalents.  Substantially all ofthe Company’s cash and cash equivalents are held at one bank at December 31,2004 and 2003.  As of December 31,2004 and 2003, the Company has $2.6 and $1.0 million on deposit with this bankthat exceeds the federally insured limit.

 

F-7

----

 

*Propertyand Equipment* - Property and equipment are stated atcost.  Depreciation and amortization areprovided on the straight-line method over the following estimated useful lives:

 
| Computer and office equipment |   | 2 to  5 years                                              |
|-------------------------------|--------|------------------------------------------------------------|
| Furniture and fixtures        |   | 7  years                                                   |
| Leasehold improvements        |   | Shorter  of the estimated useful life or life of the lease |

 

Maintenance and repairsare charged to expense as incurred. Renewal and improvements of a major nature are capitalized.

 

*Long-LivedAssets* - In the first quarter of fiscal 2002, the Companyadopted Statement of Financial Accounting Standards (“SFAS”) No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. SFAS No. 144 establishes a single accountingmodel, based on the framework established in SFAS No. 121, *Accounting for the Impairment of Long-Lived Assetsand for Long-Lived Assets to Be Disposed Of*, for long-lived assetsto be disposed of by sale, and resolves implementation issues related to SFASNo. 121.  The adoption of SFAS No. 144did not have a material impact on the Company’s operating results or financialposition.

 

Propertyand equipment, definite life intangible assets, and capitalized software costsare recorded at cost less accumulated depreciation or amortization.  They are amortized using the straight-linemethod over estimated useful lives of three years to seven years.  The determination of useful lives and whetheror not these assets are impaired involves judgment and such assets are reviewedfor impairment whenever events or circumstances indicate that the carryingamount of such assets may not be recoverable. The Company  evaluates thecarrying value of long-lived assets and definite life identifiable intangible assets for impairment of valuebased on undiscounted future cash flows resulting from the use of the asset andits eventual disposition.  While theCompany did not experience impairment of intangible assets in prior periods, itcannot guarantee that there will not be impairment in the future.

 

*Accountingfor Goodwill**and OtherIntangible Assets*– On January 1, 2002 the Company adopted SFASNo. 142, *Goodwill and Other IntangibleAssets*.  SFAS No. 142requires that goodwill and intangible assets with indefinite useful lives nolonger be amortized.  It also establishesa new method of testing goodwill for impairment on an annual basis or on aninterim basis if an event occurs or circumstances change that would reduce thefair value of a reporting unit below its carrying value.  Management has completed a review of each ofthe Company’s reporting units, Systems and Services, and has concluded that thefair value of each reporting unit exceeds its carrying value, indicating nogoodwill impairment is present as of September 30, 2003 and 2004. Management will continue to complete an annual testing of goodwill forimpairment on September 30th of each year.  Such fair value measurements involvesignificant estimates and assumptions, including the future cash flows,comparable market multiples and discount rates. Changes in such estimates and assumptions could significantly affect thefair value and potential impairment.

 

*Software Licenses, Services, andPost-Contract Customer Support* - Revenues from salesof software licenses (systems revenue), which generally contain multipleelements, are recognized upon delivery of the related product if therequirements of Statement of Position (“SOP”) No. 97-2, *Software Revenue Recognition*, as amended,are met.  If the requirements ofSOP No. 97-2, including evidence of an arrangement, clientacceptance, a fixed or determinable fee, collectibility or vendor-specificobjective evidence about the value of an element are not met at the date ofdelivery and passage of title, revenue recognition is deferred until such itemsare known or resolved.  Revenue frompost-contract customer support is deferred and recognized ratably over the termof the contract.  Revenues from servicesare recognized as the services are performed under the agreements. Certainlicensing and services arrangements with our customers are billed monthly and theassociated revenue is recognized monthly.

 

The AICPA and itsSoftware Revenue Recognition Task Force continue to issue interpretations andguidance for applying the relevant standards to a wide range of sales contractterms and business arrangements that are prevalent in the softwareindustry.  Also, the Securities andExchange Commission (“SEC”) has issued Staff Accounting Bulletin No. 101 “*Revenue Recognition in Financial Statements,”* and

 

F-8

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Staff Accounting BulletinNo. 104, which revises or rescinds portions of Staff Accounting Bulletin No.101, which provides guidance related to revenue recognition based oninterpretations and practices followed by the SEC.  Future interpretations of existing accountingstandards or changes in the Company’s business practice could result in futurechanges in the Company’s revenue accounting policies that could have a materialadverse effect on the Company’s business, financial condition and results ofoperations.

 

*SoftwareProgramming and Customization Services* - Revenues arerecognized as services are performed under the agreements and are included insystems revenue in the accompanying consolidated financial statements.

 

*SoftwareDevelopment Costs* - Costs incurred in the research anddevelopment of new software products and enhancements to existing softwareproducts are expensed as incurred until technological feasibility has beenestablished.  After technologicalfeasibility is established, any additional costs would be capitalized inaccordance with SFAS No. 86, *Accounting for the Costsof Computer Software to Be Sold, Leased or Otherwise Marketed*.  Because the Company believes that its currentprocess for developing software is essentially completed concurrently with theestablishment of technological feasibility, no software development costs havebeen capitalized as of December 31, 2004 and 2003.

 

*AdvertisingCosts*- Advertising costs are expensed as incurred.  The Company did not incur any significantadvertising costs for any periods presented.

 

*IncomeTaxes* - Income taxes are accounted for in accordance withSFAS No. 109, *Accounting for IncomeTaxes*.  This statementrequires the recognition of deferred tax assets and liabilities to reflect thefuture tax consequences of events that have been recognized in the Company’sfinancial statements or tax returns. Measurement of the deferred items is based on enacted tax laws.  In the event the future consequences ofdifferences between financial reporting bases and tax bases of the Company’sassets and liabilities result in a deferred tax asset, SFAS No. 109requires an evaluation of the probability of being able to realize the futurebenefits indicated by such assets.  Avaluation allowance related to a deferred tax asset is recorded when it is morelikely than not that some portion or all of the deferred tax asset will not berealized.  A full valuation allowance fordeferred tax assets has been provided at December 31, 2004 and 2003.

 

*Accountingfor Stock-Based Compensation*- SFAS No. 123, *Accounting for Stock-Based Compensation,* requires disclosureof the fair value method of accounting for stock options and other equityinstruments.  Under the fair valuemethod, compensation cost is measured at the grant date based on the fair valueof the award and is recognized over the service period which is usually thevesting period.  The Company has chosen,under the provisions of SFAS No. 123, to account for employee stock-basedtransactions under Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees. *Under APB No. 25, no compensation expense is generally recognized aslong as the exercise price of each stock option is at least equal to the marketprice of the underlying stock at the time of the grant. If an entity chooses touse the accounting method described in APB No. 25, SFAS No. 123requires that the pro forma effect of using the fair value method of accountingon its net income be disclosed in a note to the financial statements. TheCompany has chosen to use the accounting method described in APB No. 25.

 

In December 2002, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 148, *Accounting for Stock-Based Compensation Transitionand Disclosure*, an amendment of SFAS No. 123.  This statement amends SFAS No. 123, *Accounting for Stock-Based Compensation*,to provide alternative methods of transition for a voluntary change to the fairvalue based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFASNo. 123 to require prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results.

 

At December 31, 2004, theCompany had one stock-based employee compensation plan, which is described inNote 6.  The Company accounts for stock option grants under this planaccording to  the recognition and measurementprinciples of APB Opinion No. 25, *Accountingfor Stock Issued to Employees,* and related Interpretations.  Nostock-based employee compensation cost is reflected in net loss, as all optionsgranted under those plans had an exercise price equal to the market value ofthe underlying common stock on the

 

F-9

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date of grant.  Thefollowing table illustrates the effect on net loss and loss per share if theCompany had applied the fair value recognition provisions of FASB Statement No.123, *Accounting for Stock-BasedCompensation,* to stock-based employee compensation.

 
| ** **                                                                                                                                    | ** ** | **Year Ended December 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| ** **                                                                                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Net loss, as reported                                                                                                                         |       | $                          | (1,199,815 | ) | $ | (278,582 | ) |
|                                                                                                                                          |       |                       |       |   |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (106,744                   | )          | (69,020 | ) |
|                                                                                                                                          |       |                       |       |   |   |
| Pro Forma net loss                                                                                                                            |       | $                          | (1,306,559 | ) | $ | (347,602 | ) |
|                                                                                                                                          |       |                       |       |   |   |
| Net loss per share:                                                                                                                           |       |                       |       |   |   |
| Basic and Diluted-as reported                                                                                                                 |       | $                          | (0.04      | ) | $ | (0.01 | ) |
|                                                                                                                                          |       |                       |       |   |   |
| Basic and Diluted-pro forma                                                                                                                   |       | $                          | (0.04      | ) | $ | (0.02 | ) |

 

The fair value of eachoption granted was estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions used forgrants in 2004: expected volatility of 150%; risk-free interest rate of 3.5%;and a weighted-average contractual life of 10 years.  The following weighted-average assumptionsused for grants in 2003: expected volatility of 162%; risk-free interest rateof 2.00%; and a weighted-average contractual life of 10 years.

 

*Concentrationof Credit Risk*- The Company sells its products to largecommunications companies, as well as emerging communications carriers.  Credit is extended based on an evaluation ofthe customer’s financial condition, and collateral is generally notrequired.  The Company also evaluates itscredit customers for potential credit losses. The accounts receivable balances at December 31, 2004 and 2003 areprimarily due from the major customers indicated below.

 

In the year ended December 31,2004, the Company had one customer that accounted for greater than 10% of theCompany’s total revenues in the amount of $4.3 million.  In the year ended December 31, 2003, theCompany had one customer that accounted for greater than 10% of the Company’stotal revenues in the amount of $4.5 million. At December 31, 2004, the Company had two customers that accounted forgreater than 10% of the accounts receivable balance in the amount of $269,000.  At December 31, 2003, the Company had threecustomers that accounted for greater than 10% of the accounts receivablebalance in the amount of $628,000.

 

*FairValue of Financial Instruments* - The recorded amounts offinancial assets and liabilities at December 31, 2004 and 2003 approximatefair value, based on the Company’s incremental borrowing rate or due to therelatively short period of time between origination of the instruments andtheir expected realization.

 

*Use ofEstimates* - The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosures of contingentliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

*ComprehensiveLoss* - There was no difference between net loss andcomprehensive loss for any period presented.

 

F-10

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*SegmentInformation* - The Company has adopted SFAS No. 131, *Disclosures About Segments of an Enterprise and Related Information*.  In accordance with SFAS No. 131, theCompany has disclosed in Note 11 the required information about theCompany’s operating segments and geographic areas.

 

**RecentAccounting Pronouncements**

 

In December 2003, the Financial Accounting Standards Board (“FASB”)issued a revision to Interpretation No. 46, *Consolidation of Variable Interest Entities, an Interpretation of ARBNo. 51* (“FIN 46R”). FIN 46R clarifies the application of ARBNo. 51, “Consolidated Financial Statements,” to certain entities in whichequity investors do not have the characteristics of a controlling financialinterest or do not have sufficient equity at risk for the entity to finance itsactivities without additional subordinated financial support provided by anyparties, including the equity holders. FIN 46R requires the consolidation ofthese entities, known as variable interest entities (“VIEs”), by the primarybeneficiary of the entity. The primary beneficiary is the entity, if any, thatwill absorb a majority of the entity’s expected losses, receive a majority ofthe entity’s expected residual returns, or both.

 

Among other changes, the revisions of FIN 46R (a) clarified somerequirements of the original FIN 46, which had been issued inJanuary 2003, (b) eased some implementation problems, and(c) added new scope exceptions. FIN 46R deferred the effective date of theInterpretation for public companies to the end of the first reporting periodending after March 15, 2004, except that all public companies must, at aminimum, apply the unmodified provisions of the Interpretation to entities thatwere previously considered “special-purpose entities” in practice andunder the FASB literature prior to the issuance of FIN 46R by the end of thefirst reporting period ending after December 15, 2003. As ofDecember 31, 2004 and 2003, management believes that the Company is notthe primary beneficiary of any VIE’s.

 

In December 2004, the FASB issued Statement of Financial AccountingStandards (SFAS) No. 123 (Revised), *Share-Based Payment*.  This standard revises SFAS No. 123, APBOpinion No. 25 and related accounting interpretations, and eliminates the useof the intrinsic value method for employee stock-based compensation.  SFAS No. 123® requires compensation costsrelated to share based payment transactions to be recognized in the financialstatements over the period that an employee provides service in exchange forthe award.  Currently, the Company usesthe intrinsic value method of APB Opinion No. 25 to value share-based optionsgranted to employees and board members. This standard requires the expensing of all share-based compensation,including options, using the fair value based method.  The effective date of this standard for theCompany will be January 1, 2006. Management is currently assessing the impact that this new standard willhave on the Company’s financial statements.

 

*Net LossPer Share*- The Company has computed net loss per share inaccordance with SFAS No. 128, *Earnings Per Share*.  Basic and diluted net loss per share wascomputed by dividing net loss by the weighted-average number of common sharesoutstanding for the period.

 

The following tablerepresents the computation of basic and diluted loss per common share for theperiods presented:

 
| ** **                                            | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| Numerator:                                            |       |                       |       |   |   |
| Numerator for basic loss per share                    |       |                       |       |   |   |
| Net loss applicable to common stockholders            |       | $                          | (1,199,815 | ) | $ | (278,582 | ) |
| Denominator:                                          |       |                       |       |   |   |
| Denominator for basic and diluted loss per share      |       | —                     |       | — |   |
| Weighted-average shares outstanding during the period |       | 29,238,864                 |       | 20,369,380 |   |
| Net loss per share:                                   |       |                       |       |   |   |
| Basic and Diluted                                     |       | $                          | (.04       | ) | $ | (0.01 | ) |

 

F-11

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Not included in the abovetable is the dilutive effect of options to purchase  2,368,717 and 1,150,982 shares of commonstock for the years ended December 31, 2004 and 2003, respectively becausethey are anti-dilutive.

 

**2.**              PROPERTY AND EQUIPMENT

 

Property and equipmentconsist of the following at December 31:

 
| ** **                                      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Computer and office equipment                   |       | $          | 1,700,306  |       | $          | 1,489,861 |   |
| Furniture and fixtures                          |       | 95,425     |       | 92,511     |       |
| Leasehold improvements                          |       | 50,725     |       | 36,949     |       |
|                                            |       |       |       |       |       |
|                                            |       | 1,846,456  |       | 1,619,321  |       |
| Less accumulated depreciation and  amortization |       | (1,353,391 | )          | (1,125,914 | )          |
|                                            |       |       |       |       |       |
| Property and equipment, net                     |       | $          | 493,065    |       | $          | 493,407 |   |

 

Amortization of equipmentpurchased under capitalized lease obligations is included in depreciationexpense.  There are no property andequipment under capital leases at December 31, 2004 and 2003.

 

F-12

----

 

**3.****             ****NOTESPAYABLE**

 

The following table representsprincipal balances due under the notes payable:

 
| ** **                   | ** ** | **Current** | ** ** | **Non current** | ** ** | **Total** | ** ** |
|------------------------------|------------|-------------|------------|-----------------|------------|-----------|------------|
| **December 31, 2004:**       |       |        |       |            |       |      |       |
| Corsair Communications, Inc. |       | $           | 533,706    |            | $          | 578,001   |       | $ | 1,111,707 |   |
| Spieker Properties, L.P.     |       | —      |       | 276,940         |       | 276,940   |       |
| Sunwest Bank                 |       | 100,000     |       | —          |       | 100,000   |       |
| Total                        |       | $           | 633,706    |            | $          | 854,941   |       | $ | 1,488,647 |   |
|                         |       |        |       |            |       |      |       |
| **December 31, 2003:**       |       |        |       |            |       |      |       |
| Corsair Communications, Inc. |       | $           | 182,256    |            | $          | 1,371,874 |       | $ | 1,554,130 |   |
| Spieker Properties, L.P.     |       | —      |       | 253,452         |       | 253,452   |       |
| Sunwest Bank                 |       | 120,917     |       | —          |       | 120,917   |       |
| Total                        |       | $           | 303,173    |            | $          | 1,625,326 |       | $ | 1,928,499 |   |

 

*NotePayable to Corsair Communication, Inc.*

 

On February 4, 1999,Corsair Communications, Inc. (“Corsair”) and its wholly-owned subsidiary,Subscriber Computing, Inc., sold substantially all of the assets relating toSubscriber’s Communication Resource Manager billing system and IntelligentMessage Router to Wireless Billing Systems, a recently formed and wholly ownedsubsidiary of Primal Systems, Inc. As consideration for the agreement, theCompany paid Corsair $2,238,242 by issuing a note payable to Corsair.  The note payable bears interest at 10% and issecured by substantially all the property and equipment that was acquired fromCorsair.  Principal and interest arepayable monthly with all unpaid principal and interest originally due May2001.  The Company recorded the assets atfair value of $4,581,889 and assumed liabilities of $2,343,647, in addition tothe note payable to Corsair.

 

In January 2001, theCompany amended the terms of and refinanced the Corsair note payable originallydue in May 2001.  Also, certain otherliabilities due to Corsair totaling $50,528 were added to the principal balanceof the amended note.  The interest rateof the amended note increased to 16% starting in May 2001, and the note waspayable in approximately 36 monthly installments, beginning June 2001, and wasdue May 2004.

 

In December 2001, theCompany again amended the terms of the Corsair note payable.  At the time of the amendment, the accruedinterest was $185,903.  As per the termsof the amendment, the Company paid $125,000 of the accrued interest, and theremaining $60,903 was reclassified to the principal balance of the note makingthe principal balance $1,722,418 at December 31, 2001.  The amended terms of the note also extendedthe maturity of the note from May 2004 to December 2004, required no principalpayments to be made in 2002 and adjusted the interest rate of the note to 8%.

 

In December 2002, theCompany signed a letter of intent to amend the terms of the Corsair notepayable.  Per the terms of the letter ofintent, the principal and interest payments scheduled to begin in January 2003have been reduced to $25,000 for 2003 and 2004 with a balloon payment of$1.4 million due at maturity of the note in December 2004.  In July 2003, the Company formally completedthe 2002 Amended and Restated Secured Promissory Note.

 

InJune 2004, the Company made an accelerated principal payment of $250,000 asresult of the closing of the Private Placement (Note 7) in accordance with thenote agreement.

 

InMarch 2004, the Company amended the terms of the note with Corsair whichextended the maturity date to December 2006 and converted the note tofully-amortizing payments of approximately $50,000 per month beginning January2005 with an interest rate of 8%.  At December 31, 2004 the note balanceoutstanding was $1,111,707.

 

F-13

----

 

*NotePayable to Spieker Properties, L.P.*

 

In June 2001, the Companyand its landlord amended its occupancy lease to reduce costs related tounneeded space and corresponding rental payments.  As part of the amendment, the Company agreedto sign a note for $200,000 which carries an interest rate of 9%, and there areno principal or interest payments due until April 2007.

 

*NotePayable to Sunwest Bank*

 

In May 2002, the Companyentered into two loan agreements with Sunwest Bank.  One loan agreement is structured as anequipment line of credit facility for $100,000. The second loan agreement is structured as a $100,000 operating line ofcredit.  Any borrowings under theequipment line of credit are to be repaid with amortizing payments at anadjustable interest rate of prime plus 2.25% (6.5%, at December 31, 2004)due in October 2004, and any borrowings under the operating line of credit areto be repaid at maturity, August 2004, with accrued interest paid monthly at arate of prime plus 2.0% (6.5%, at December 31, 2004).  The loan agreement does not include anyspecific financial covenants that the Company is required to meet, however theCompany is required to inform Sunwest Bank of 1) all material adverse changesto the Company’s financial condition and 2) all existing and threatenedlitigation or claims that could materially affect the financial condition ofthe Company.

 

In May 2002, the Companydrew down on the equipment line of credit to finance a $60,704 purchase ofcomputer equipment.    AtDecember 31, 2004 and 2003, the balance of the loan was $ 0 and $20,916,respectively.

 

Any borrowings under theoperating line of credit were to be repaid at maturity (April 2005), withaccrued interest paid monthly at a rate of prime plus 2.00% with a floor rateof 6.50%.  In February 2003, the Company drew down the full amount tofinance a portion of the annual premium for an insurance policy.  On March15, 2004, Sunwest Bank extended the April 2004 maturity date of the operatingline of credit to August 2004, and on August 12, 2004 extended the maturitydate to December 2004.  On December 3, 2004 Sunwest extended the maturitydate to April 2005.  At December 31,2004 and 2003, the balance of the note was $100,000.  During the fist quarter of 2005 the Companychanged banks from Sunwest to First Regional Bank.  The existing line of credit with Sunwest Bankwas paid off through a new line of credit with First Regional Bank in theamount of $100,000.  As part of thistransaction a certificate of deposit (CD) in the amount of $100,000 wasestablished as collateral on the First Regional LOC.  This is an interest bearing account whichearns 1.90% annually and matures in February 2006.  The new LOC with First Regional Bank maturesin February 2006 and has an interest rate of 4.9%, or 3 percent over the CDrate.

 

The following tablerepresents the contractual payments associated with the notes payable as ofDecember 31, 2004:

 
| ** **               | ** ** | **Interest  Payments** | ** ** | **Principal  Payments** | ** ** | **Total  Payments** | ** ** |
|--------------------------|------------|------------------------|------------|-------------------------|------------|---------------------|------------|
| Year ending December 31: |       |                   |       |                    |       |                |       |
| 2005                     |       | $                      | 69,643     |                    | 633,706    |                | 703,349    |   |
| 2006                     |       | 25,347                 |       | 578,001                 |       | 603,348             |       |
| 2007                     |       | 0                      |       | 0                       |       | 0                   |       |
| 2008                     |       | 137,430                |       | 200,000                 |       | 337,430             |       |
| 2009                     |       | 0                      |       | 0                       |       | 0                   |       |
|                     |       |                   |       |                    |       |                |       |
| Total                    |       | $                      | 232,420    |                    | $          | 1,411,707           |       | $ | 1,644,127 |   |
|                          |            |                        |            |                         |            |                     |            |  |  |  |

 

F-14

----

 

 

**4.****              COMMITMENTS AND CONTINGENCIES**

 

The Company leases officespace and certain equipment under various non-cancelable operating leases.  Future minimum lease payments required underoperating leases, net of sublease income, as of December 31, 2004 are asfollows:

 
| ** **                   | ** ** | **Sublease  (Income)** | ** ** | **Operating  Leases** | ** ** | **Net**   | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|-----------|------------|
| Year ending December 31:     |       |                   |       |                  |       |      |       |
| 2005                         |       | (43,656                | )          | $                     | 545,458    |      | $          | 501,802 |   |
| 2006                         |       | (15,515                | )          | 508,460               |       | 492,945   |       |
| 2007                         |       | 0                      |       | 165,660               |       | 165,660   |       |
| 2008                         |       | 0                      |       | 20,868                |       | 20,868    |       |
| 2009                         |       | 0                      |       | 43,475                |       | 43,475    |       |
|                         |       |                   |       |                  |       |      |       |
| Total minimum lease payments |       | $                      | 59,171     |                  | $          | 1,283,921 |       | $ | 1,224,750 |   |
|                              |            |                        |            |                       |            |           |            |  |  |  |

 

Rent expense under suchoperating leases was $450,363 and $382,627 for the years endedDecember 31, 2004 and 2003, respectively.  TheCompany’s leased office space includes approximately 13,500 square feet ofgeneral and administrative office space in Irvine, California through May2006.  In addition, the Company leasesapproximately 7,000 square feet of office space in Irvine California throughApril 2007.

 

The Company is subject tovarious legal proceedings from time to time as part of its business. The Companydoes not believe that it is currently party to any legal proceedings orthreatened legal proceedings, the adverse outcome of which, individually or inthe aggregate, would have a material adverse effect on its business, financialcondition and results of operations.

 

**5.**              GUARANTEES ANDINDEMNIFICATIONS

 

The Company has madeguarantees and indemnities, under which it may be required to make payments toa third-party, in relation to certain transactions.  In connection with the sales of its products,the Company provides intellectual property indemnities to its customers.  Guarantees and indemnities to customers inconnection with product sales generally are subject to limits based on theamount of the related product sales.  TheCompany also indemnifies its directors and officers to the maximum extentpermitted under applicable law in effect. The Company has not recorded any liability for these guarantees andindemnities in the accompanying consolidated balance sheets.  The Company considers such factors as thedegree of probability of an unfavorable outcome and the ability to make areasonable estimate of the amount of loss. To date, the Company has not encountered material costs as a result ofsuch obligations and have not accrued any liabilities related to suchindemnification in its financial statements.

 

The Company generallywarrants its products for a period of three months from the date of acceptanceof the product by its customers. Warranty costs have historically been minimal.

 

F-15

----

 

**6.**              STOCK-BASEDCOMPENSATION

 

*StockOptions*

 

2001 FlexibleIncentive Plan

 

In February 2001, theBoard of Directors approved the Company’s 2001 Flexible Incentive Plan (the “StockOption Plan”) and authorized approximately 3,900,000 shares to be reserved forissuance pursuant to the Stock Option Plan. In October 2001, upon the approval of the Stock Option Plan by theDepartment of Corporations of the State of California, the Board of Directorsapproved the Company’s Stock Option Plan, as amended.  Under the terms of the Stock Option Plan, asamended, employees and directors are eligible to receive a grant of incentivestock options to purchase shares of the Company’s common stock at their fairmarket value on the date of grant. Options granted under the Stock Option Planvest at the minimum rate of 20% per year from the grant date, but could vest atan accelerated rate.  Options to purchasean aggregate of 2,180,964 shares at prices ranging from $0.06 to $0.07 pershare were granted with exercise price at fair value on the date of the grantduring the year ended December 31, 2003. At December 31, 2004 and2003, options to purchase 2,278,528 and 1,714,897 shares, respectively, ofcommon stock were exercisable under the Stock Option Plan.

 

During 2003, the Companyissued 2,180,964 options to purchase commons stock at a weighted-average priceof $0.06 per share, fair market value at the time of the grant.  Options to purchase 1,000,000 shares vestproportionately every three months over a two-year period from the date of thegrant and the remaining 1,180,964 options vest proportionately every threemonths over a three-year period from the date of the grant.

 

The Company’sStockholders approved the adoption of Primal’s 2004 Flexible Incentive Plan atthe Company’s 2004 Annual Meeting of Stockholders held November 12, 2004.  Pursuant to the 2004 Flexible Incentive Plan,the Company may issue up to an aggregate of 5,451,073 shares of the Company’scommon stock, $0.01 par value per share. The Company’s 2004 Flexible Incentive Plan provides that the Company’sBoard of Directors or such appropriately appointed committee, as the case maybe, may refrain from issuing awards under the 2004 Flexible Incentive Planuntil the Board of Directors or other such committee has determined that suchissuance of awards under the 2004 Flexible Incentive Plan will not violateapplicable federal or state securities laws.

 

Options Issued Outside the Stock Option Plan

 

InJanuary 2004, the Company issued 360,000 options to purchase common stock to anofficer of the Company.  The options, which were issued at an exerciseprice equal to 85% of the fair market value of the Company’s common stock onthe date of grant, have a ten-year term and vest over a three years and expirein ten year period.  Because the exercise price of the options were issuedat less than the fair market value of the Company’s stock on the date of thegrant, the Company records an expense from the options issued ratably over thevesting period, in accordance with APB Opinion No. 25.

 

Warrants

 

•                  In April 2003, the Company issued250,000 warrants to each of the four non-employee Board members under Section4(2) of the Securities Act of 1933, as amended. The warrants were issued at an exercise price equal to the fair marketvalue of the Company’s common stock on the date of grant, vest over two yearsand expire in ten years.   As thewarrants were issued at the fair market value, the Company did not record anyexpense from the warrants issued, in accordance with APB Opinion No. 25 andrelated interpretations.

 

•                  InJune 2004, pursuant to the Private Placement, the Company issued warrants topurchase 7,142,393 shares of the Company’s common stock to the InstitutionalInvestors and the Accredited Investors (Note 7).  The warrants had anestimated fair value of $1,776,000 based on the Black-Scholes valuationmodel.  In addition, the Company issued warrants to purchase 652,174shares of the Company’s common stock to its investment banking firm for servicesrendered, with a weighted-average exercise price of $0.25 expiring June2009.  The estimated fair value of the investment banking warrants was$163,000 based on the Black-Scholes valuation model.

 

F-16

----

 

•                  InAugust 2004, the Company issued warrants to purchase 25,000 shares of commonstock at $0.22, with an exercise price set at the fair market value of theCompany’s common stock on the date of grant.  The warrants, which wereissued to a principal of one of the Company’s investment advisors, vest inequal proportions every three months over a two-year period and have a ten-yearterm.

 

•                  Inaccordance with the provisions of Accounting Principles Board Opinion No. 14,the Company allocated the gross proceeds received in the Private Placement tothe common stock and warrants issued based on their relative estimated fairvalues.  As a result of this analysis, the Company has allocated proceedsof $1,036,000 to the warrants (Note 7).  Such amount is presented in the “Warrants”line item on the Company’s December 31, 2004 consolidated balance sheet, alongwith the estimated fair value of the investment banking warrants issued inconnection with the Private Placement as described above.

 

At December 31, 2004 andDecember 31, 2003, options / warrants to purchase 8,689,566 and 759,312 shares,respectively, of common stock were exercisable from grants outside the StockOption Plan.

 

Information regarding allstock options / warrants issued is as follows:

 
| ** **                                      | ** ** | **Number of  Options  /Warrants** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|-------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------------|------------|
| Balances, December 31, 2002                     |       | 3,278,930                         |       | $                                       | 0.06       |   |
| Granted (weighted-average fair value of  $0.06) |       | 2,180,964                         |       | 0.06                                    |       |
| Exercised                                       |       | (113,636                          | )          | 0.07                                    |       |
| Canceled                                        |       | (566,103                          | )          | 0.07                                    |       |
| Balances, December 31, 2003                     |       | 4,780,155                         |       | $                                       | 0.06       |   |
| Granted (weighted-average fair value of  $0.27) |       | 8,895,567                         |       | 0.27                                    |       |
| Exercised                                       |       | (925,576                          | )          | 0.04                                    |       |
| Canceled                                        |       | (181,515                          | )          | 0.07                                    |       |
| Balances, December 31, 2004                     |       | 12,568,631                        |       | $                                       | 0.21       |   |

 

The following tablesummarizes information concerning currently outstanding and exercisableoptions:

 
| ** **                   | ** ** | **Options/Warrants Outstanding** | ** ** | **Options/Warrants  Exercisable**                    | ** ** |
|------------------------------|------------|----------------------------------|------------|------------------------------------------------------|------------|
| **Range of  Exercise Price** | ** ** | **Number  Outstanding**          | ** ** | **Weighted-  Average  Remaining  Contractual  Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|                         |       |                             |       |                                                 |       |   |   |   |   |   |   |
| $0.03                        |       | 524,450                          |       | 7.86                                                 |       | $ | 0.03 |   | 349,630 |   | $ | 0.03 |   |
| $0.05                        |       | 815,000                          |       | 7.57                                                 |       | $ | 0.05 |   | 806,667 |   | $ | 0.05 |   |
| $0.06                        |       | 636,965                          |       | 8.55                                                 |       | $ | 0.06 |   | 265,398 |   | $ | 0.06 |   |
| $0.07                        |       | 1,350,899                        |       | 6.85                                                 |       | $ | 0.07 |   | 1,350,899 |   | $ | 0.07 |   |
| $0.08                        |       | 360,000                          |       | 8.62                                                 |       | $ | 0.08 |   | 149,998 |   | $ | 0.08 |   |
| $0.17                        |       | 48,000                           |       | 9.84                                                 |       | $ | 0.17 |   | 0 |   | $ | 0.17 |   |
| $0.18                        |       | 230,000                          |       | 9.78                                                 |       | $ | 0.18 |   | 0 |   | $ | 0.18 |   |
| $0.20                        |       | 360,000                          |       | 9.01                                                 |       | $ | 0.20 |   | 119,999 |   | $ | 0.20 |   |
| $0.22                        |       | 25,000                           |       | 0.58                                                 |       | $ | 0.22 |   | 25,000 |   | $ | 0.22 |   |
| $0.23                        |       | 434,782                          |       | 4.47                                                 |       | $ | 0.23 |   | 434,782 |   | $ | 0.23 |   |
| $0.25                        |       | 423,750                          |       | 9.05                                                 |       | $ | 0.25 |   | 105,938 |   | $ | 0.25 |   |
| $0.28                        |       | 7,359,785                        |       | 4.47                                                 |       | $ | 0.28 |   | 7,359,785 |   | $ | 0.28 |   |
| $0.03 to $0.28               |       | 12,568,631                       |       | 5.79                                                 |       | $ | 0.21 |   | 10,968,094 |   | $ | 0.20 |   |

 

F-17

----

 

**7.****             ****PRIVATE PLACEMENT**

 

OnJune 15, 2004, the Company completed a private placement of its common stockand warrants to Special Situations Private Equity Fund, L.P., SpecialSituations Technology Fund, L.P., and Special Situations Technology Fund II,L.P. (collectively, the “Special Situations Funds” or the “InstitutionalInvestors”).  In connection with the private placement, the Company alsosold shares of its common stock and warrants to other accredited investors (“AccreditedInvestors”), including but not limited to each member of the Company’s Board ofDirectors, Chief Executive Officer, and Chief Financial Officer.  (ThoseAccredited Investors who are members of the Company’s management are hereafterreferred to as “Management Accredited Investors,” and those accreditedinvestors who are not members of the Company’s management are hereafterreferred to as “Non-Management Accredited Investors.”)  Pursuant to theprivate placement with the Institutional Investors and the Accredited Investors(the “Private Placement”), the Company issued an aggregate of 14,284,782 sharesof its common stock (the “Shares”) and warrants to purchase 7,142,393 shares ofthe Company’s common stock (the “Warrants”; together with the Shares, the “PrivatePlacement Securities”) for total cash proceeds of $3.3 million. The sharesunderlying the Warrants may be referred to hereinafter as “Warrant Shares.”

 

Additionally,investors participating in the Private Placement received a Warrant to purchaseone share of common stock for each two Shares purchased. The effective price inthe Private Placement was $0.23 for each unit.  The Warrants areexercisable in cash, representing a potential $2.0 million in additionalproceeds bringing the total gross proceeds of the Private Placement toapproximately $5.3 million upon full exercise of the Warrants.  There canbe no assurance that any or all of the Warrants will be exercised.

 

Inaccordance with the provisions of Accounting Principles Board Opinion No. 14,the Company allocated the gross proceeds received in the Private Placement tothe common stock and warrants issued based on their relative estimated fairvalues.  As a result of this analysis, the Company has allocated proceedsof $1,036,000 to the warrants along with the estimated fair value of theinvestment banking warrants issued in connection with the Private Placement.

 

Pursuantto the Private Placement purchase agreement (“Purchase Agreement”), the Companyissued an aggregate of 13,043,478 Shares at a price of $0.23 per share to theInstitutional Investors and received gross proceeds of $3.0 million****in cash from the InstitutionalInvestors.  The Company also issued Warrants to the InstitutionalInvestors to purchase an aggregate of 6,521,739 shares of our common stock atan exercise price of $0.28 per share for a five-year period. Additionally, the Company and the Institutional Investors entered into aRegistration Rights Agreement, whereby, among other things, the Company agreedto file, and did file on July 30, 2004 and on March 10, 2005, a “resale”registration statement with the Securities and Exchange Commission (“SEC”),covering the Shares and the Warrant Shares in connection with the PrivatePlacement. As a condition precedent to closing the Private Placement with theInstitutional Investors under the Institutional Investor Agreements, theCompany was required to have received gross proceeds from the sale of itscommon stock and warrants of not less than $250,000 from accredited investorson terms no more favorable than those offered to the InstitutionalInvestors.  The Institutional Investors also required that the accreditedinvestors be comprised of at least, but not limited to, each member of theCompany’s Board of Directors, Chief Executive Officer, and Chief FinancialOfficer.  Accordingly, the Management Accredited Investors contributedgross proceeds of $125,500****in cash****to purchase an aggregate of 545,653 Sharesat a price of $0.23 per share and Warrants to purchase an aggregate of 272,827shares of the Company’s common stock exercisable at $0.28 per share for fiveyears.  Additionally, the Non-Management Accredited Investors contributedgross proceeds of $160,000****in cash****to purchase an aggregate of 695,651 Sharesat a price of $0.23 per share and Warrants to purchase an aggregate of 347,827shares of the Company’s common  stockexercisable at $0.28 per share for five years.

 

F-18

----

 

Inconnection therewith, the Non-Management Accredited Investors entered into theInstitutional Investor Agreements.  The Company and each of the ManagementAccredited Investors executed a Purchase Agreement and a Registration RightsAgreement, and the Company issued Warrants on terms no more favorable than asoffered to the Institutional Investors.  Additionally, each of theManagement Accredited Investors was required by the Institutional Investors toexecute a Lock-Up Agreement providing for certain restrictions on the transferof shares of the Company’s common stock owned by such person as set forth inthe Lock-Up Agreement.

 

*Registration Rights Agreements*

 

Underthe terms of the Private Placement, the Company granted the InstitutionalInvestors and the Non-Management Accredited Investors****the following registration rights as to their Shares,including Warrant Shares issuable upon the exercise of the Warrants:

 

•                  The Company filed a registration statement onForm SB-2 under the Securities Act of 1933, as amended (the “Securities Act”),with the SEC on July 30, 2004 and on March 10, 2005, to enable shares to beresold thereunder.  If such registration statements had not been filedwith the SEC on or before such time, the Company would have been required topay liquidated damages to each investor in an amount equal to 1.5% of theaggregate amount invested by such investor for each 30-day period, or pro ratafor any portion thereof, that the registration statement is not filed (“LiquidatedDamages”).

 

•                  Upon demand by any investor and upon anychange in the price of the Warrants such that additional shares of common stockbecome issuable upon the exercise of the Warrants (“Additional Shares”), theCompany is obligated to file a registration statement on Form SB-2 covering theresale of the Additional Shares.  If the Company does not file suchregistration statement within five days of an investor’s demand, the Companywill pay Liquidated Damages to each investor.

 

•                  Within ten days of the Company becomingeligible to use a registration statement on Form S-3, the Company is obligatedto file a registration statement on Form S-3.  If such registrationstatement is not filed with the SEC on or before such time, the Company willpay Liquidated Damages to each investor.

 

Theregistration statements filed with the SEC on July 30, 2004 and on March 10,2005 were declared effective by the SEC on September 10, 2004 and  March 10, 2005, respectively.  Subject to certain conditions, the Companywill use commercially reasonable efforts to cause the registration statement(s)to remain effective until the earlier of (i) the date on which all registrablesecurities covered by such registration statement have been sold, or (ii) thedate on which all registrable securities covered by such registration statementmay be sold pursuant to Rule 144(k). Further, the Company will use commerciallyreasonable efforts to register or qualify or cooperate with the investors inconnection with the registration or qualification of their shares in any publicoffering under the blue sky laws of the following states: New York, New Jersey,Connecticut, Massachusetts, Pennsylvania, Texas, California, and Nevada.

 

Allexpenses of filing and causing each such registration statement to become andremain effective shall be borne by the Company.

 

TheCompany granted the Management Accredited Investors registration rights thatare no more favorable than the terms described above.

 

F-19

----

 

*Warrants*

 

TheCompany issued to the Institutional Investors and the Non-Management AccreditedInvestors Warrants that may be exercised at a price of $0.28 per share, subjectto certain anti-dilutive adjustments.  The Warrants expire on June 15,2009.  The Warrants may be called by the Company at the price of $0.01 perWarrant Share if the closing bid price as reported by Bloomberg equals orexceeds $0.56 per share (subject to adjustment) for 30 consecutive trading dayscommencing after June 15, 2006 and after the registration statement has beendeclared effective by the SEC.

 

Warrantholders do not have any of the rights or privileges of the Company’sstockholders, including voting rights, prior to exercise of the Warrants. TheCompany has reserved sufficient shares of authorized common stock to cover theissuance of common stock subject to the Warrants.

 

TheWarrants issued to the Management Accredited Investors contain terms that nomore favorable than those described above.

 

**8.**              GOODWILL

 

The Company merged withAvery on October 1, 1999.  Inconnection with the merger and subsequent spin-off on February 9, 2001,the Company recorded a total of $8.3 million in goodwill representing thedifference between the purchase price Avery paid over the estimated fair marketvalue of the net assets of the Company. On February 9, 2001, the Company was spun-off as a separate companyby Avery.  However, the goodwill, whichwas pushed-down to the Company’s balance sheet by the parent, Avery, at thetime of the merger, remained on the Company’s balance sheet at the time it wasspun-off.

 

F-20

----

 

Since the spin-off fromAvery on February 9, 2001, the economic condition of the communicationsindustry in particular, and the economy in general, has continued todeteriorate.  The Company hassignificantly reduced personnel and expenses during 2001, and the current cashflow forecasts have been reduced significantly as compared to the forecast usedat the time of the Avery transactions. Also, the Company’s market capitalization has decreased significantlyfrom the spin-off date. As a result, during the quarter endedSeptember 30, 2001, goodwill was deemed impaired, and the Company recordeda charge of $5.6 million to reflect the write down of goodwill to its estimatedrecoverable value.

 

In 2001, the Companyadopted SFAS No. 141, *BusinessCombinations*, and on January 1, 2002 the Company adopted SFASNo. 142, *Goodwill and Other IntangibleAssets*.  SFAS No. 141requires use of the purchase method of accounting for business combinationsinitiated after June 30, 2001.  Theadoption of SFAS No. 141 did not have a material impact on the Company’sconsolidated financial statements.  SFASNo. 142 requires that goodwill and intangible assets with indefiniteuseful lives no longer be amortized.  Italso establishes a new method of testing goodwill for impairment on an annualbasis or on an interim basis if an event occurs or circumstances change thatwould reduce the fair value of a reporting unit below its carrying value, andrequired the testing of goodwill for impairment under the new standard by June30, 2002.  Management completed reviewsof each of the Company’s reporting units, Systems and Services, and hasconcluded that the fair value of each reporting unit exceeds its carryingvalue, indicating no goodwill impairment is present as of January 1, 2002,September 30, 2002, 2003 and 2004. Management will continue to complete an annual testing of goodwill forimpairment on September 30th of each year.  Such fair value measurements involvesignificant estimates and assumptions, including the future cash flows,comparable market multiples and discount rates. Changes in such estimates and assumptions could significantly affect thefair value and potential impairment.

 

**9.****              EMPLOYEE BENEFITS**

 

The Company has aqualified 401(k) retirement plan (the “Plan”) for its full-time employeesand makes contributions at the discretion of the Board of Directors.  Total contributions to the Plan were $25,130for the year ended December 31, 2004.

 

**10.****       INCOME TAXES**

 

For each of the yearsended December 31, 2004 and 2003, the expense for income taxes was$1,600.  The expense for income taxes forthe years ended December 31, 2004 and 2003 reflects the minimum tax due inCalifornia.

 

A reconciliation of theprovision for the income taxes to the amount of income tax expense that wouldresult from applying the federal statutory rate of 34% to income beforeprovision for income taxes is as follows:

 
| ** **                                                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                     |       |     |       |     |       |
| Benefit at statutory rate                                                |       | $        | (407,936   | )        | $          | (94,270 | ) |
| State taxes, net of federal benefit                                      |       | 28,721   |       | 5,298    |       |
| Adjustment of net operating loss, credit  carryforwards and depreciation |       | 133,705  |       | 30,041   |       |
| Change in valuation allowance                                            |       | 242,881  |       | 65,579   |       |
| Other                                                                    |       | 4,229    |       | (5,048   | )          |
|                                                                     |       |     |       |     |       |
|                                                                     |       | $        | 1,600      |     | $          | 1,600 |   |

 

F-21

----

 

The tax effects oftemporary differences used in determining the Company’s deferred tax assets andliabilities are presented below at December 31, 2004 and 2003:

 
| ** **                       | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|
| Deferred tax assets:             |       |       |       |       |       |
|                             |       |       |       |       |       |
| Net operating loss carryforwards |       | $          | 1,005,851  |       | $          | 576,474 |   |
| Accruals                         |       | 250,256    |       | 209,524    |       |
| Credits                          |       | 314,920    |       | 316,829    |       |
| State taxes                      |       | 544        |       | 2,730      |       |
| Other                            |       | 5,549      |       | 27,091     |       |
|                             |       |       |       |       |       |
| Total deferred tax assets        |       | 1,577,120  |       | 1,132,648  |       |
| Less valuation allowance         |       | (1,263,801 | )          | (1,020,920 | )          |
|                             |       |       |       |       |       |
| Net deferred tax assets          |       | 313,319    |       | 111,728    |       |
|                                  |            |            |            |            |            |  |  |

 

 
| Deferred tax liabilities:        |   |     |   |     |   |
|----------------------------------|--------|----------|--------|----------|--------|
| Basis difference in fixed assets |   | (313,319 | )      | (111,728 | )      |
| State taxes                      |   | —   |   | —   |   |
|                             |   |     |   |     |   |
| Total deferred tax liabilities   |   | (313,319 | )      | (111,728 | )      |
|                             |   |     |   |     |   |
| Net deferred tax assets          |   | $        | — |     | $      | — |   |
|                                  |        |          |        |          |        |  |  |

 

Based upon uncertaintiesrelated to the Company’s ability to generate sufficient taxable income in thefuture to realize its deferred tax assets, a full valuation allowance has beenprovided for the years ended December 31, 2004 and December 31, 2003,as it is more likely than not that the Company’s deferred tax asset will not berealized.

 

At December 31,2004, the Company’s federal and state loss carryforwards are $2,654,780 and$1,896,426 and will begin to expire in 2019 and 2006, respectively.  The Company’s research and development creditcarryforward is $291,382 and will begin to expire in 2019.  However, the net operating loss and researchand development credit may change due to utilization within the Avery consolidatedgroup.

 

As a result of the mergerof Primal Systems, Inc. with and into Avery (see Note 1), the Company’s annualuse of Primal Systems, Inc.’s net operating losses were limited underSection 382 of the Internal Revenue Code to approximately $160,000annually.

 

In2001, an adjustment was made to eliminate approximately $2 million of federalnet operating loss carryforwards, previously accounted for by the Company on aseparate return basis and used by Avery, that are not available to the Companyafter the spin-off.  In 2002, anadditional adjustment was made to eliminate approximately $640,000 of federalnet operating loss carryforwards.  Anoffsetting adjustment was made to the valuation allowance with no effect on theincome tax provision or net income.

 

**11.**       SEGMENT ANDGEOGRAPHIC INFORMATION

 

Operating segments aredefined as components of an enterprise about which separate financialinformation is available that is evaluated regularly by the Company’s chiefoperating decision maker, or decision-making group, in deciding how to allocateresources and in assessing performance. The operating segments of the Company are managed separately becauseeach segment represents a strategic business unit that offers differentproducts or services.

 

F-22

----

 

The Company’s reportableoperating segments include Systems and Services.  The Systems operating segment develops andmarkets the Company’s integrated suite of client/server and browser-basedsoftware solutions.  The Services segmentprovides after-sale support for software products, programming, maintenance,customization, consulting and application management and hosting servicesrelated to the Company’s products and a variety of software languages andplatforms.

 

The Company does notseparately allocate operating expenses to these segments, nor does it allocatespecific assets to these segments. Therefore, segment information reported includes only revenues, cost ofrevenues, and gross margin, as this information is the only segment-relatedinformation provided to the chief operating decision maker.

 

Operating segment datafor years ended December 31, 2004 and 2003 were as follows:.

 
| ** **                       | ** ** | **Systems** | ** ** | **Services** | ** ** | **Total** | ** ** |
|----------------------------------|------------|-------------|------------|--------------|------------|-----------|------------|
|                             |       |        |       |         |       |      |       |
| **Year ended December 31, 2004** |       |        |       |         |       |      |       |
| Revenues                         |       | $           | 2,441,978  |         | 5,166,908  |      | 7,608,886  |   |
| Cost of Revenues                 |       | 96,357      |       | 3,620,193    |       | 3,716,550 |       |
| Gross Profit                     |       | $           | 2,345,621  |         | 1,546,715  |      | 3,892,336  |   |
|                             |       |        |       |         |       |      |       |
| **Year ended December 31, 2003** |       |        |       |         |       |      |       |
| Revenues                         |       | $           | 2,548,980  |         | $          | 3,967,685 |       | $ | 6,516,665 |   |
| Cost of Revenues                 |       | 244,107     |       | 2,692,041    |       | 2,936,148 |       |
| Gross Profit                     |       | $           | 2,304,873  |         | $          | 1,275,644 |       | $ | 3,580,517 |   |
|                                  |            |             |            |              |            |           |            |  |  |  |  |

 

Revenues are attributedto geographic areas based on the location of the entity to which the productsor services were sold.  Revenues, grossprofit, loss from operations, and long-lived assets concerning principalgeographic areas in which the Company operates are as follows:

 
| ** **                       | ** ** | **North America** | ** ** | **Asia / Pacific** | ** ** | **Europe** | ** ** | **Total**  | ** ** |
|----------------------------------|------------|-------------------|------------|--------------------|------------|------------|------------|------------|------------|
|                             |       |              |       |               |       |       |       |       |       |
| **Year ended December 31, 2004** |       |              |       |               |       |       |       |       |       |
| Revenues                         |       | $                 | 6,511,940  |               | $          | 610,673    |       | $          | 486,273    |   | $ | 7,608,886 |   |
| Gross Profit                     |       | 3,331,913         |       | 311,989            |       | 248,434    |       | 3,892,336  |       |
| Net Loss                         |       | (1,026,842        | )          | (96,295            | )          | (76,678    | )          | (1,199,815 | )          |
| Property and Equipment, net      |       | 493,065           |       |               |       |       |       | 493,065    |       |
|                             |       |              |       |               |       |       |       |       |       |
| **Year ended December 31, 2003** |       |              |       |               |       |       |       |       |       |
| Revenues                         |       | $                 | 5,492,439  |               | $          | 609,055    |       | $          | 415,171    |   | $ | 6,516,665 |   |
| Gross Profit                     |       | 3,017,776         |       | 334,639            |       | 228,112    |       | 3,580,517  |       |
| Net Loss                         |       | (234,797          | )          | (26,037            | )          | (17,748    | )          | (278,582   | )          |
| Property and Equipment, net      |       | 493,407           |       |               |       |       |       | 493,407    |       |

 

F-23

----

 

**12.**       RELATED PARTYTRANSACTION

 

InSeptember 2003, the Board of Directors approved and completed the sale of688,235 shares of our common stock to members of the Board of Directors at aprice equal to fair market value.

** **

**13.**       SUBSEQUENT EVENTS

 

Following the completion of its merger with anotherwireless telecommunications company in November 2004, our largest customernotified us of its intention not to renew its license and services agreementwith us upon its expiration in accordance with its terms in December 2005.  Based upon our conversations with thiscustomer, it is our understanding that our customer’s election not to renew itsagreement with us was a result of a previous significant investment by itsmerger partner in an existing billing system in place prior to the merger, andon which most of the combined company’s customers already reside.  As a result of this event, the Company hasincurred a liability for one time termination benefits to be paid to itsemployees, provided that related employees fulfill their contractualobligations, and announced the terms of such termination benefits to itsemployees in January 2005.  In accordancewith SFAS 146 the Company has measured the liability estimated to be approximately$155,000 and will record the charge pro-rata throughout 2005.  In accordance with SFAS 146 the estimatedliability will be re-measured throughout 2005.

 

F-24

----