**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

** **

**For the quarterly periodended September 30, 2006**

** **

**OR**

** **

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

** **

**For the transition periodfrom                      to                      **

** **

**Commission File Number:000-50839**

** **

**Phase Forward Incorporated**

(Exact name of registrantas specified in its charter)

| **Delaware**                              |   | **04-3386549**       |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer     |
| incorporation or  organization)           |   | Identification  No.) |
|                                      |   |                 |
| **880  Winter Street**                    |   | ** **           |
| **Waltham,  Massachusetts**               |   | **02451**            |
| (Address of  principal executive offices) |   | (Zip Code)           |

 

**(888) 703-1122**(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days.   Yes x   No o

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

| Large accelerated  filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o      No x

Asof October 25, 2006, the registrant had 35,252,366 shares of Common Stockoutstanding.

 

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** **

**PHASEFORWARD INCORPORATEDQUARTERLY REPORT ON FORM 10-QFor the quarterly period ended September 30, 2006**

**Tableof Contents**
|                                             | ** ** | ** **                                                                                                                                          | ** ** | **Page  Number** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| **Part I—Financial  Information** |       |                                                                                                                                                |       |             |       |
| ** **                                  |       | ** **                                                                                                                                          |       |             |       |   |   |
| Item 1.                                     |       | Condensed Consolidated Balance Sheets as of  December 31, 2005 (unaudited) and September 30, 2006 (unaudited)                                  |       |             | 3          |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
|                                        |       | Condensed Consolidated Statements of Income for the  three and nine months ended September 30, 2005 (unaudited) and September 30,  2006 (unaudited) |       |             | 4          |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
|                                        |       | Condensed Consolidated Statements of Cash Flows for  the nine months ended September 30, 2005 (unaudited) and September 30, 2006  (unaudited)       |       |             | 5          |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
|                                        |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                                   |       |             | 6          |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Item 2.                                     |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                                         |       |             | 20         |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Item 3.                                     |       | Quantitative and Qualitative Disclosures about Market  Risk                                                                                         |       |             | 35         |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Item 4.                                     |       | Controls and Procedures                                                                                                                             |       |             | 36         |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| **Part II—Other  Information**    |       |                                                                                                                                                |       |             |       |
| ** **                                  |       | ** **                                                                                                                                          |       |             |       |   |   |
| Item  1.                                    |       | Legal  Proceedings                                                                                                                                  |       |             | 36         |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Item  1A.                                   |       | Risk  Factors                                                                                                                                       |       |             | 36         |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Item  5.                                    |       | Other  Information                                                                                                                                  |       |             | 45         |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Item 6.                                     |       | Exhibits                                                                                                                                            |       |             | 46         |   |   |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Signatures                                  |       |                                                                                                                                                | 47         |             |       |
|                                        |       |                                                                                                                                                |       |             |       |   |   |
| Exhibit Index                          |       |                                                                                                                                                | 48         |             |       |

 

2

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**Part I—Financial Information**

**Item 1.**                          *Condensed Consolidated Financial Statements (unaudited)*

**Phase Forward IncorporatedCondensed Consolidated Balance Sheets(unaudited)(in thousands, except per share amounts)**
| ** **                                                                                          | ** ** | **As of  December 31,** | ** ** | **As of   September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2005**                          | ** ** | **2006**                                 | ** ** |
| **Assets**                                                                                          | ** ** | ** **                        | ** ** | ** **                               | ** ** |
| Current assets:                                                                                     |       |                              |       |                                     |       |
| Cash and cash  equivalents                                                                          |       | $                                 | 51,779     |                                     | $          | 41,777 |   |
| Short-term investments                                                                              |       | 8,807                             |       | 23,791                                   |       |
| Accounts receivable,  net of allowance of $318 and $278 in 2005 and 2006, respectively              |       | 24,923                            |       | 23,184                                   |       |
| Deferred set up costs,  current portion                                                             |       | 1,266                             |       | 1,665                                    |       |
| Prepaid commissions and  royalties, current portion                                                 |       | 3,710                             |       | 3,565                                    |       |
| Prepaid expenses and  other current assets                                                          |       | 2,248                             |       | 2,694                                    |       |
| Deferred income taxes                                                                               |       | 4,025                             |       | 4,264                                    |       |
| Total current assets                                                                                |       | 96,758                            |       | 100,940                                  |       |
|                                                                                                |       |                              |       |                                     |       |
| Property and equipment,  net                                                                        |       | 7,543                             |       | 7,937                                    |       |
| Deferred set up costs,  net of current portion                                                      |       | 782                               |       | 951                                      |       |
| Prepaid commissions and  royalties, net of current portion                                          |       | 2,386                             |       | 2,598                                    |       |
| Intangible assets, net  of accumulated amortization of $306 and $959 in 2005 and 2006, respectively |       | 3,594                             |       | 2,941                                    |       |
| Goodwill                                                                                            |       | 24,960                            |       | 27,722                                   |       |
| Deferred income taxes                                                                               |       | 3,747                             |       | 3,713                                    |       |
| Other assets                                                                                        |       | 174                               |       | 254                                      |       |
| Total assets                                                                                        |       | $                                 | 139,944    |                                     | $          | 147,056 |   |
|                                                                                                |       |                              |       |                                     |       |
| **Liabilities and Stockholders’  Equity**                                                      | ** ** | ** **                        | ** ** | ** **                               | ** ** |
| Current liabilities:                                                                                |       |                              |       |                                     |       |
| Accounts payable                                                                                    |       | $                                 | 2,110      |                                     | $          | 1,948 |   |
| Accrued expenses                                                                                    |       | 12,472                            |       | 12,839                                   |       |
| Accrued earn-out                                                                                    |       | 2,000                             |       | —                                   |       |
| Accrued litigation  settlement                                                                      |       | 8,500                             |       | —                                   |       |
| Deferred revenues,  current portion                                                                 |       | 43,751                            |       | 45,242                                   |       |
| Deferred rent, current  portion                                                                     |       | 394                               |       | 315                                      |       |
| Total current  liabilities                                                                          |       | 69,227                            |       | 60,344                                   |       |
|                                                                                                |       |                              |       |                                     |       |
| Deferred revenues, net  of current portion                                                          |       | 2,743                             |       | 2,817                                    |       |
| Deferred rent, net of  current portion                                                              |       | 1,140                             |       | 746                                      |       |
| Accrued earn-out                                                                                    |       | —                            |       | 3,500                                    |       |
| Other long-term  liabilities                                                                        |       | 117                               |       | 284                                      |       |
| Total liabilities                                                                                   |       | 73,227                            |       | 67,691                                   |       |
|                                                                                                |       |                              |       |                                     |       |
| Contingencies (Note 13)                                                                             |       |                              |       |                                     |       |
|                                                                                                |       |                              |       |                                     |       |
| Stockholders’ equity:                                                                          |       |                              |       |                                     |       |
| Preferred stock, $.01  par value:                                                                   |       |                              |       |                                     |       |
| Authorized—5,000 shares                                                                        |       |                              |       |                                     |       |
| Issued—0 shares                                                                                |       | —                            |       | —                                   |       |
| Common stock, $.01 par  value:                                                                      |       |                              |       |                                     |       |
| Authorized—100,000  shares                                                                     |       |                              |       |                                     |       |
| Issued—33,720 and  35,268 shares in 2005 and 2006, respectively                                |       | 337                               |       | 353                                      |       |
| Additional paid-in  capital                                                                         |       | 168,947                           |       | 173,670                                  |       |
| Deferred stock-based  compensation                                                                  |       | (611                              | )          | —                                   |       |
| Treasury stock, 37  shares at cost                                                                  |       | (111                              | )          | (111                                     | )          |
| Accumulated other  comprehensive loss                                                               |       | (800                              | )          | (370                                     | )          |
| Accumulated deficit                                                                                 |       | (101,045                          | )          | (94,177                                  | )          |
| Total stockholders’  equity                                                                    |       | 66,717                            |       | 79,365                                   |       |
| Total liabilities and  stockholders’ equity                                                    |       | $                                 | 139,944    |                                     | $          | 147,056 |   |

 

See accompanying notes.

3

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**Phase Forward IncorporatedCondensed Consolidated Statements of Income(unaudited)(in thousands, except per share amounts)**
| ** **                                                                           | ** ** | **Three Months Ended  September 30**, | ** ** | **Nine Months Ended  September 30**, | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenues:                                                                            | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| License                                                                              |       | $                                                    | 8,637      |                                                | $          | 11,225 |   | $ | 26,088 |   | $ | 29,633 |   |
| Service                                                                              |       | 13,605                                               |       | 16,824                                              |       | 37,414 |   | 46,754 |   |
| Total revenues                                                                       |       | 22,242                                               |       | 28,049                                              |       | 63,502 |   | 76,387 |   |
| Costs of revenues:                                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| License                                                                              |       | 722                                                  |       | 717                                                 |       | 1,759 |   | 2,020 |   |
| Service(1)                                                                           |       | 7,799                                                |       | 10,079                                              |       | 22,475 |   | 27,981 |   |
| Total cost of revenues                                                               |       | 8,521                                                |       | 10,796                                              |       | 24,234 |   | 30,001 |   |
| Gross margin:                                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| License                                                                              |       | 7,915                                                |       | 10,508                                              |       | 24,329 |   | 27,613 |   |
| Service                                                                              |       | 5,806                                                |       | 6,745                                               |       | 14,939 |   | 18,773 |   |
| Total gross margin                                                                   |       | 13,721                                               |       | 17,253                                              |       | 39,268 |   | 46,386 |   |
|                                                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Operating expenses:                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Sales and  marketing(1)                                                              |       | 3,897                                                |       | 5,377                                               |       | 11,808 |   | 14,798 |   |
| Research and  development(1)                                                         |       | 3,653                                                |       | 4,538                                               |       | 10,423 |   | 12,022 |   |
| General and  administrative(1)                                                       |       | 3,937                                                |       | 4,551                                               |       | 10,959 |   | 13,138 |   |
| Restructuring                                                                        |       | —                                               |       | —                                              |       | (92 | ) | — |   |
| Total operating  expenses                                                            |       | 11,487                                               |       | 14,466                                              |       | 33,098 |   | 39,958 |   |
| Income from operations                                                               |       | 2,234                                                |       | 2,787                                               |       | 6,170 |   | 6,428 |   |
| Other income (expense):                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                                                                      |       | 449                                                  |       | 735                                                 |       | 1,236 |   | 2,010 |   |
| Interest expense                                                                     |       | —                                               |       | —                                              |       | (144 | ) | — |   |
| Other, net                                                                           |       | (79                                                  | )          | 14                                                  |       | (220 | ) | (50 | ) |
| Total other income, net                                                              |       | 370                                                  |       | 749                                                 |       | 872 |   | 1,960 |   |
|                                                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Income before provision  for income taxes                                            |       | 2,604                                                |       | 3,536                                               |       | 7,042 |   | 8,388 |   |
| Provision for income  taxes                                                          |       | 434                                                  |       | 642                                                 |       | 1,566 |   | 1,520 |   |
| Net income                                                                           |       | $                                                    | 2,170      |                                                | $          | 2,894 |   | $ | 5,476 |   | $ | 6,868 |   |
|                                                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Net income per share  applicable to common stockholders:                             | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                |       | $                                                    | 0.07       |                                                | $          | 0.08 |   | $ | 0.17 |   | $ | 0.20 |   |
| Diluted                                                                              |       | $                                                    | 0.06       |                                                | $          | 0.08 |   | $ | 0.16 |   | $ | 0.19 |   |
|                                                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average number  of common shares used in net income per share calculations: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                                |       | 32,241                                               |       | 35,147                                              |       | 32,856 |   | 34,386 |   |
| Diluted                                                                              |       | 35,307                                               |       | 36,620                                              |       | 34,827 |   | 35,921 |   |

----

(1)             Amounts includestock-based compensation expense, as follows:
| Costs of service revenues               |   | $  | 11     |   | $      | 68  |   | $     | 48     |   | $ | 161   |   |
|-----------------------------------------|--------|----|--------|--------|--------|-----|--------|-------|--------|--------|---|-------|--------|
| Sales and  marketing                    |   | 28 |   | 143    |   | 24  |   | 351   |   |
| Research and development                |   | 36 |   | 121    |   | 131 |   | 248   |   |
| General and  administrative             |   | (2 | )      | 644    |   | 227 |   | 1,231 |   |
| Total stock-based  compensation expense |   | $  | 73     |   | $      | 976 |   | $     | 430    |   | $ | 1,991 |   |

 

See accompanying notes.

4

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**Phase Forward IncorporatedCondensed Consolidated Statements of Cash Flows(unaudited)(in thousands)**
| ** **                                                                         | ** ** | **Nine Months Ended   September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                                  | ** ** | **2006** | ** ** |
| **Operating  activities**                                                          | ** ** | ** **                                                | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                                         | 5,476      |   | $ | 6,868 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                      |       |   |   |
| Depreciation and amortization                                                      |       | 2,510                                                     |       | 3,809 |   |
| Stock-based compensation expense                                                   |       | 430                                                       |       | 1,991 |   |
| Loss on disposal of fixed assets                                                   |       | 53                                                        |       | 51 |   |
| Foreign currency exchange loss                                                     |       | 160                                                       |       | 45 |   |
| Provision for allowance for doubtful accounts                                      |       | (1                                                        | )          | 79 |   |
| Deferred income taxes                                                              |       | —                                                    |       | (206 | ) |
| Tax benefit related to exercise of stock options                                   |       | —                                                    |       | (1,027 | ) |
| Non-cash income tax expense                                                        |       | 1,040                                                     |       | 1,329 |   |
| Amortization of premiums or discounts on short-term  investments                   |       | (48                                                       | )          | 39 |   |
| Changes in assets and liabilities:                                                 |       |                                                      |       |   |   |
| Accounts receivable                                                                |       | 1,312                                                     |       | 2,361 |   |
| Deferred costs                                                                     |       | (1,025                                                    | )          | (512 | ) |
| Prepaid expenses and other current assets                                          |       | (350                                                      | )          | (398 | ) |
| Accounts payable                                                                   |       | (377                                                      | )          | (225 | ) |
| Accrued expenses                                                                   |       | 621                                                       |       | 451 |   |
| Accrued litigation settlement                                                      |       | —                                                    |       | (8,500 | ) |
| Deferred revenues                                                                  |       | 2,585                                                     |       | 1,687 |   |
| Deferred rent                                                                      |       | (179                                                      | )          | (472 | ) |
| Net cash  provided by operating activities                                         |       | 12,207                                                    |       | 7,370 |   |
|                                                                               |       |                                                      |       |   |   |
| **Investing  activities**                                                          | ** ** | ** **                                                | ** ** | ** ** | ** ** |
| Proceeds from  maturities of short-term investments                                |       | 3,848                                                     |       | 29,163 |   |
| Purchase of  short-term investments                                                |       | (9,626                                                    | )          | (44,186 | ) |
| Purchase of  property and equipment                                                |       | (2,805                                                    | )          | (3,502 | ) |
| Decrease  (increase) in other assets                                               |       | 9                                                         |       | (32 | ) |
| Cash paid for  acquisition of Lincoln Technologies, Inc., net of cash acquired (1) |       | (10,598                                                   | )          | (2,000 | ) |
| Net cash used in  investing activities                                             |       | (19,172                                                   | )          | (20,557 | ) |
|                                                                               |       |                                                      |       |   |   |
| **Financing  activities**                                                          | ** ** | ** **                                                | ** ** | ** ** | ** ** |
| Payments on  lines of credit and notes payable                                     |       | (4,407                                                    | )          | — |   |
| Proceeds from  issuance of common stock                                            |       | 2,899                                                     |       | 2,332 |   |
| Proceeds from  repayment of subscriptions receivable                               |       | 127                                                       |       | — |   |
| Tax benefit  related to exercise of options                                        |       | —                                                    |       | 1,027 |   |
| Net cash (used  in) provided by financing activities                               |       | (1,381                                                    | )          | 3,359 |   |
| Effect of  exchange rate changes on cash and cash equivalents                      |       | (534                                                      | )          | (174 | ) |
| Net change in  cash and cash equivalents                                           |       | (8,880                                                    | )          | (10,002 | ) |
| Cash and cash  equivalents at beginning of period                                  |       | 53,485                                                    |       | 51,779 |   |
| Cash and cash  equivalents at end of period                                        |       | 44,605                                                    |       | 41,777 |   |
| Short-term  investments at end of period                                           |       | 10,592                                                    |       | 23,791 |   |
| Total cash, cash  equivalents and short-term investments at end of period          |       | $                                                         | 55,197     |   | $ | 65,568 |   |
| ** **                                                                         |       |                                                      |       |   |   |
| **Non-cash  investing activities**                                                 |       |                                                      |       |   |   |
| Accrued earn-out  in connection with acquisition of Lincoln Technologies, Inc.     |       | $                                                         | —     |   | $ | 3,500 |   |

----

(1)             Cash paid foracquisition of Lincoln Technologies, Inc.
| Fair value of assets  acquired                         |   | $      | 1,742  |   | $      | — |   |
|--------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Liabilities assumed, including acquisition costs  paid |   | (898   | )      | — |   |
| Acquired intangible assets                             |   | 3,900  |   | — |   |
| Costs in excess of net assets acquired                 |   | 6,400  |   | 2,000  |   |
| Cash paid                                              |   | 11,144 |   | 2,000  |   |
| Less cash acquired                                     |   | 546    |   | — |   |
| Cash paid for acquisition                              |   | $      | 10,598 |   | $      | 2,000  |   |

 

See accompanyingnotes.

5

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**Phase Forward Incorporated Notes to Condensed Consolidated Financial Statements(unaudited)(in thousands, except share and per share amounts)**

**1.****   Basis ofPresentation**

Theaccompanying unaudited condensed consolidated financial statements includedherein have been prepared by Phase Forward Incorporated (the “Company”)pursuant to the rules and regulations of the Securities and ExchangeCommission (“SEC”). Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles in the United States have been condensed or omittedpursuant to such SEC rules and regulations. Management of the Companybelieves that the disclosures herein are adequate to make the information presentednot misleading. In the opinion of management, the unaudited condensedconsolidated financial statements have been prepared on the same basis as theaudited consolidated financial statements and reflect all material adjustments(consisting only of those of a normal and recurring nature) which are necessaryto present fairly the consolidated financial position of the Company as ofSeptember 30, 2006, the results of its operations for the three and nine monthsended September 30, 2005 and 2006 and its cash flows for the nine months endedSeptember 30, 2005 and 2006. These unaudited condensed consolidated financialstatements and notes thereto should be read in conjunction with the auditedconsolidated financial statements and notes thereto included in the Company’s2005 Annual Report on Form 10-K filed with the SEC on March 13, 2006.The results of operations for the interim periods are not necessarilyindicative of the results of operations to be expected for the year endingDecember 31, 2006.

OnAugust 25, 2005, the Company acquired all of the outstanding capital stock ofLincoln Technologies, Inc. (“Lincoln”), a provider of products and services fordrug safety, including clinical trial safety signal detection and applied datastandards. The results of Lincoln have been included in the unaudited financialstatements since the date of acquisition (see Note 5).

Asof  September 30, 2006, the Company’ssignificant accounting policies and estimates, which are detailed in theCompany’s Annual Report on Form 10-K for the year ended December 31,2005, have not changed except for the adoption of Statement of FinancialAccounting Standard (“SFAS”) No. 123(R), *Share-BasedPayment* (“SFAS No. 123(R)”). See Note 9 for additional information regarding the Company’s adoptionof SFAS No. 123(R).

**2.****   Revenue Recognition andDeferred Set Up Costs**

The Companyderives revenues from software licenses and services. License revenues arederived principally from the sale of term licenses for the Company’s softwareproducts including: *InFormTM, ClintrialTM,**Clintrace*TM, *WebVDMETM*, *CTSDTM* and *WebSDMTM.*  Service revenues are derived from the Company’sdelivery of the hosted solutions of its *InForm, WebVDME*, *CTSD*and *WebSDM* softwareproducts, and consulting services and customer support, including training, forall of the Company’s products.

Thecomponents of revenues are as follows:

|                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                    | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| License                       |       | $                                                    | 8,637      |                                                | $          | 11,225 |   | $ | 26,088 |   | $ | 29,633 |   |
| Application hosting  services |       | 7,998                                                |       | 10,883                                              |       | 22,105 |   | 29,210 |   |
| Consulting services           |       | 2,679                                                |       | 3,048                                               |       | 5,696 |   | 8,405 |   |
| Customer support              |       | 2,928                                                |       | 2,893                                               |       | 9,613 |   | 9,139 |   |
| Total                         |       | $                                                    | 22,242     |                                                | $          | 28,049 |   | $ | 63,502 |   | $ | 76,387 |   |

 

The Companyrecognizes software license revenues in accordance with Statement of Position (“SOP”)No. 97-2, *Software Revenue Recognition,*as amended, issued by the American Institute of Certified Public Accountants (“AICPA”),while revenues resulting from application hosting services are recognized inaccordance with Emerging Issues Task Force (“EITF”) Issue No. 00-3, *Application of AICPA Statement of Position 97-2 toArrangements that include the Right to Use Software Stored on Another Entity’sHardware*, SEC Staff Accounting Bulletin (“SAB”) No. 104, *Revenue Recognition*, and EITF IssueNo. 00-21, *Revenue Arrangements with Multiple Deliverables.*

Customersgenerally have the ability to terminate application hosting, consulting andtraining service agreements upon 30 days notice to the Company. Licenseagreements, multiple element arrangements; including license and serviceagreements and certain application hosting services, can generally beterminated by either party for material breach of obligations not correctedwithin 30 days after notice of the breach.

The Company recognizesrevenues when all of the following conditions are satisfied: (1) there ispersuasive evidence of an 

6

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arrangement; (2) the product or service has beenprovided to the customer; (3) the collection of fees is probable; and(4) the amount of fees to be paid by the customer is fixed ordeterminable.

The Companygenerally enters into software term licenses for its *InForm*, *Clintrial*and *Clintrace* products with itscustomers for 3- to 5-year periods. License agreements for its *WebVDME, CTSD*and*WebSDM*productsare generally for one-year terms.  Thesearrangements typically include multiple elements: software license, consultingservices and customer support. The Company bills its customers in accordancewith the terms of the underlying contract. Generally, the Company bills licensefees annually in advance for each year of the license term. Payment terms aregenerally net 30 days.

The Company’ssoftware license revenues are earned from the sale of off-the-shelf softwarerequiring no significant modification or customization subsequent to deliveryto the customer. Consulting services, which can also be performed bythird-party consultants, are deemed to be non-essential to the functionality ofthe software and typically are for trial configuration, implementationplanning, loading of software, building simple interfaces and running test dataand documentation of procedures.

The Companygenerally bundles customer support with the software license for the entireterm of the arrangement. As a result, the Company generally recognizes revenuesfor all elements, including consulting services, ratably over the term of thesoftware license and support arrangement. The Company allocates the revenuesrecognized for these arrangements to the different elements based on management’sestimate of the relative fair value of each element. For its term-basedlicenses, the Company allocates to consulting services the anticipated serviceeffort and value throughout the term of the arrangement at an amount that wouldhave been allocated had those services been sold separately to the customer.The remaining value is allocated to license and support services, with 10% ofthis amount allocated to support services. The Company has allocated theestimated fair value to its multiple element arrangements to provide meaningfuldisclosures about each of its revenue streams. The costs associated with theconsulting and customer support services are expensed as incurred. There areinstances in which the Company sells software licenses based on usage levels.These software licenses can be based on estimated usage, in which case thelicense fee charged to the customer is fixed based on this estimate. When thefee is fixed, the revenues are generally recognized ratably over thecontractual term of the arrangement. If the fee is based on actual usage, andtherefore variable, the revenues are recognized in the period of use. Revenuesfrom certain follow-on consulting services, which are sold separately tocustomers with existing software licenses and are not considered part of amultiple element arrangement, are recognized as the services are performed.

The Company sellsperpetual licenses for the *Clintrial* and *Clintrace* software products in certainsituations to its existing customers with the option to purchase customersupport. The Company has established vendor specific objective evidence of fairvalue for the customer support. Accordingly, license revenues are recognizedupon delivery of the software and when all other revenue recognition criteriaare met. Customer support revenues are recognized ratably over the term of theunderlying support arrangement. The Company continues to generate customersupport and maintenance revenues from its perpetual license customer base.Training revenues are recognized as earned.

In addition tomaking its software products available to customers through licenses, theCompany offers its *InForm*, *WebVDME*, *CTSD* and *WebSDM* software solutions through a hosted applicationsolution delivered through a standard web-browser.  Revenues resulting from *InForm*applicationhosting services consists of three stages for each clinical trial: the firststage involves application set up, including design of electronic case reportforms and edit checks, implementation of the system and server configuration;the second stage involves application hosting and related support services; andthe third stage involves services required to close out, or lock, the databasefor the clinical trial. Services provided for the first and third stages areprovided on a fixed fee basis based upon the complexity of the trial and systemrequirements. Services for the second stage are charged separately as a fixedmonthly fee. The Company recognizes revenues from all stages of the *InForm*hosting service ratably over thehosting period. Fees to be charged and costs incurred for the trial systemdesign, set up and implementation are deferred until the start of the hostingperiod and are amortized and recognized ratably over the estimated hostingperiod. The deferred costs include incremental direct costs with third partiesand certain internal direct costs related to the trial and application set up,as defined under SFAS No. 91, *Accountingfor Nonrefundable Fees and Costs Associated with Originating or Acquiring Loansand Indirect Costs of Leases*. These costs include salary andbenefits associated with direct labor costs incurred during trial set up, aswell as third-party subcontract fees and other contract labor costs. Workperformed outside the original scope of work is contracted for separately as anadditional fee and is generally recognized ratably over the remaining term ofthe hosting period. Fees for the first and third stages of the service arebilled based upon milestones. Fees for application hosting and related servicesin the second stage are generally billed quarterly in advance. Bundled intothis revenue element are revenues attributable to the software license used bythe customer.

Revenues resultingfrom hosting services for the *WebVDME*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related supportservices.  Services for this offering arecharged monthly as a fixed fee.  Revenuesare recognized ratably over the period of the service.

In the event thatan application hosting customer cancels a clinical trial and its relatedstatement of work, all deferred revenues are recognized and all deferred set upcosts are expensed.  In addition, certaintermination related fees may be charged and if so, such fees are recognized inthe period of termination.

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One customer,GlaxoSmithKline, accounted for approximately 16% and 18% of the Company’s totalrevenues in the three months ended September 30, 2005 and 2006, respectively,and 16% and 17% of the Company’s total revenues in the nine months endingSeptember 30, 2005 and 2006, respectively, and $1,725 and $1,924 of accountsreceivable outstanding as of December 31, 2005 and September 30, 2006,respectively.

The Companydeferred $666 and $483 of set up costs and amortized $425 and $489 during thethree months ended September 30, 2005 and 2006, respectively, and deferred$1,841 and $2,085 of set up costs and amortized $1,272 and $1,517 in the ninemonths ended September 30, 2005 and 2006, respectively.   The amortization of deferred set up costs isa component of cost of services.

Deferred revenuesrepresent amounts billed or cash received in advance of revenue recognition.

Provisions forestimated losses on uncompleted contracts are made on a contract-by-contractbasis and are recognized in the period in which such losses become probable andcan be reasonably estimated. To date, the Company has not experienced anymaterial losses on uncompleted application hosting or consulting contracts.

In accordance withEITF Issue No. 01-14, *Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” ExpensesIncurred,* the Company included $162 and $140 of out-of-pocketexpenses in service revenues and cost of service revenues in the three monthsended September 30, 2005 and 2006, respectively, and included $552 and $461 ofout-of-pocket expenses in service revenues and cost of service revenues in thenine months ended September 30, 2005 and 2006, respectively.

**3.   Prepaid SalesCommissions and Royalties**

For arrangementswhere revenues are recognized over the relevant contract period, the Companycapitalizes related commissions paid to its direct sales force and softwarelicense royalties paid to third parties, and amortizes these expenses over theperiod in which the related revenues are recognized.

Commissionpayments are nonrefundable unless amounts due from a customer are determined tobe uncollectible or if the customer subsequently changes or terminates thelevel of service, in which case the commissions paid are recoverable by theCompany. The Company deferred $989 and $1,122 of commissions and amortized tosales and marketing expense $1,003 and $804 in the three months ended September30, 2005 and 2006, respectively, and deferred $2,312 and $3,998 of commissionsand amortized to sales and marketing expense $2,738 and $3,428 in the ninemonths ended September 30, 2005 and 2006, respectively.

The Company’sroyalty obligation is based upon the license and customer support revenuesearned for certain products in an arrangement. The Company has the right torecover the royalties in the event the arrangement is cancelled. The Companydeferred $645 and $99 of royalties and amortized to cost of revenues $803 and$694 in the three months ended September 30, 2005 and 2006, respectively, anddeferred $2,879 and $1,834 of royalties and amortized to cost of revenues$2,102 and $2,337 in the nine months ended September 30, 2005 and 2006,respectively.

**4.   Warranties andIndemnification**

The Company’ssoftware license arrangements and hosting services are typically warranted toperform in a manner consistent with general industry standards that arereasonably applicable and substantially in accordance with the Company’sproduct documentation under normal use and circumstances. The Company’sarrangements also include certain provisions for indemnifying customers againstliabilities if its products or services infringe a third party’s intellectualproperty rights.

The Company hasentered into service level agreements with some of its hosted applicationsolution customers warranting certain levels of uptime reliability andpermitting those customers to receive credits against monthly hosting fees orterminate their agreements in the event that the Company fails to meet thoselevels.  To date, the Company has notincurred any material costs as a result of such indemnifications and has notaccrued any liabilities related to such obligations in the accompanying consolidatedfinancial statements.

**5.   Acquisition of LincolnTechnologies, Inc.**

        On August 25, 2005, the Companyacquired all of the outstanding capital stock of Lincoln, a provider ofproducts and services for drug safety including clinical trial safety signaldetection and applied data standards. The acquired technology and products of Lincoln provide the Company withan expanded drug safety offering and enhance the Company’s ability to offerinnovative software and services in the drug safety market.  The Company paid a premium for Lincoln toenable it to expand its offerings in the drug safety market and to obtain avaluable workforce.

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The aggregatepurchase price was $16,667.  Theacquisition agreement called for additional cash consideration to be paidsubject to achievement of certain financial targets in 2005 and 2006, of up to$2,000 and $4,000, respectively.  Thedefined 2005 financial targets were achieved and, accordingly, the Companyaccrued additional consideration of $2,000 in 2005 which was paid in May2006.  The acquisition agreement wasamended in September 2006 to amend the terms of the remaining contingentearnout payment for which the securityholders of Lincoln could be eligible in2007 under the acquisition agreement.  Pursuant to the amendment, theCompany agreed to pay the securityholders of Lincoln an aggregate of $3,500 incash on December 26, 2007 in satisfaction of the Company’s remaining paymentobligations under the acquisition agreement. The $3,500 has been accrued as of September 30, 2006.   The acquisition of Lincoln was accounted foras a purchase under SFAS No. 141, *Business Combinations*.  Accordingly, the results of Lincoln have beenincluded in the audited consolidated financial statements since the date ofacquisition.

Thecomponents of the consideration were as follows:

|                                                                                 | ** ** | **Amount** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|
| Cash paid                                                                       |       | $11,000    |       |
| Acquisition costs                                                               |       | 167        |       |
| Payment of earn-out                                                             |       | 2,000      |       |
| Accrued earn-out                                                                |       | 3,500      |       |
| Total purchase price to  be allocated to acquired asset subject to amortization |       | $16,667    |       |

 

Thefollowing table summarizes the allocation of the purchase price to the fairvalue of the assets acquired and liabilities assumed at the date of acquisitionand the additional cash consideration of $2,000 in 2005 and $3,500 in 2006:

|                                                         | ** ** | ** ** | ** ** | **Amount** | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|
| Current assets                                          |       |       |       | $          | 1,486      |   |
| Property, plant  and equipment                          |       |       |       | 263        |       |
| Intangible  assets subject to amortization:             |       |       |       |       |       |
| Developed technology (five year useful life)            |       | $          | 1,800      |       |       |   |
| Customer base (five year useful life)                   |       | 1,600      |       |       |       |
| Other intangible assets (two to five year useful  life) |       | 500        |       | 3,900      |       |
| Goodwill                                                |       |       |       | 11,930     |       |
| Total assets  acquired                                  |       |       |       | 17,579     |       |
| Current  liabilities                                    |       |       |       | (912       | )          |
| Net assets  acquired                                    |       |       |       | $          | 16,667     |   |
|                                                         |            |            |            |            |            |  |  |

 

Included inliabilities assumed is a provision for lease abandonment costs of approximately$270 relating to the leased facilities of Lincoln.

Arollforward of the liability for lease abandonment costs is as follows:

|                                                                         | ** ** | **Amount** | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|
| Provision for  lease abandonment costs as of August 25, 2005            |       | $          | 270        |   |
| Payments made during the year ended December 31,  2005                  |       | (48        | )          |
| Balance as of  December 31, 2005                                        |       | $          | 222        |   |
| Reduction to provision during the nine months ended  September 30, 2006 |       | (116       | )          |
| Payments made during the nine months ended September  30, 2006          |       | (73        | )          |
| Balance as of  September 30, 2006                                       |       | $          | 33         |   |

 

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Thefollowing table presents selected unaudited financial information of theCompany and Lincoln as if the acquisition had occurred on January 1, 2005.  The unaudited pro forma results are notnecessarily indicative of the results that would have occurred had theacquisition been consummated on January 1, 2005.

|                                                                    | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Pro forma  revenues                                                |       | $                                                              | 22,711     |                                                          | $          | 66,443 |   |
| Pro forma income  from operations                                  |       | 1,606                                                          |       | 5,312                                                         |       |
| Pro forma net  income applicable to common stockholders            |       | 1,685                                                          |       | 4,821                                                         |       |
| Pro forma net  income per share applicable to common stockholders: |       |                                                           |       |                                                          |       |
| Basic                                                              |       | $                                                              | 0.05       |                                                          | $          | 0.15 |   |
| Diluted                                                            |       | $                                                              | 0.05       |                                                          | $          | 0.14 |   |

 

**6.   Net Income Per Share**

Basic net incomeper common share for all periods presented was determined by dividing netincome applicable to common stockholders by the weighted average number ofcommon shares outstanding during the period. Dilutive net income per shareincludes the effects of all dilutive, potentially issuable common shares.

Areconciliation of basic and diluted shares for the three and nine months endedSeptember 30, is as follows:

|                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| Basic weighted average  common shares outstanding  |       | 33,241,245                                           |       | 35,146,738                                          |       | 32,855,642 |   | 34,385,704 |   |
| Weighted average common  equivalent shares         |       | 2,065,700                                            |       | 1,473,252                                           |       | 1,971,780 |   | 1,535,732 |   |
| Diluted weighted average common shares outstanding |       | 35,306,945                                           |       | 36,619,990                                          |       | 34,827,422 |   | 35,921,436 |   |

 

For the threemonths ended September 30, 2006, diluted weighted average shares outstanding donot include options outstanding to purchase 119,478 common equivalent shares astheir effect would have been anti-dilutive.

For the ninemonths ended September 30, 2005 and 2006, diluted weighted average sharesoutstanding do not include options outstanding to purchase 321,000 and 115,075common equivalent shares, respectively, as their effect would have beenanti-dilutive.

**7.   Foreign Currency Translation**

The financialstatements of the Company’s foreign subsidiaries are translated in accordancewith SFAS No. 52, *Foreign CurrencyTranslation.* The reporting currency for the Company is the U.S.dollar. The functional currency of the Company’s subsidiaries in the UnitedKingdom, France, Belgium, Germany, Japan and Australia are the local currenciesof those countries. Accordingly, the assets and liabilities of the Company’sforeign subsidiaries are translated into U.S. dollars using the exchange ratein effect at each balance sheet date. Revenues and expense accounts aretranslated generally using an average rate of exchange during the period. Gainsand losses arising from transactions denominated in foreign currencies areprimarily related to intercompany accounts that have been determined to betemporary in nature and cash and accounts receivable denominated innon-functional currencies. The Company has recorded foreign currency gains(losses) of ($38) and $16 for the three months ended September 30, 2005 and2006, respectively, and ($169) and ($45) for the nine months ended September30, 2005 and 2006, respectively.  Suchgains (losses) are included in other income (expense) in the accompanyingunaudited condensed consolidated statements of operations.

Foreign currencytranslation adjustments are accumulated as a component of other comprehensiveincome (loss) as a separate component of stockholders’ equity.

**8.   Cash, Cash Equivalents and Short-termInvestments**

The Companyaccounts for its investments in accordance with SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*. Under SFAS No. 115, securities that the Company hasthe intent and ability to hold to maturity are reported at amortized cost,which approximates market value, and are classified as held-to-maturity, whilethose securities for which it is not the Company’s intent to hold to maturityare classified as available-for-sale securities and are reported at fair value,with unrealized gains 

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and (losses) excluded from earnings and reported in aseparate component of stockholders’ equity. The Company considers all highlyliquid investments with original maturities of 90 days or less at the timeof purchase to be cash equivalents and investments with original maturities ofbetween 91 days and one year to be short-term investments.  All securities, with the exception of auctionrate securities, are classified as held-to-maturity securities.  The auction rate securities are debtinstruments issued by various municipalities throughout the United States andare classified as available for sale because it is the Company’s intent not tohold them to maturity.

Cash, cashequivalents and short-term investments as of December 31, 2005 andSeptember 30, 2006 consist of the following:

|                                  | ** ** | ** **               | ** ** | **December 31, 2005** | ** ** |
|----------------------------------|------------|--------------------------|------------|---------------------------------|------------|
| **Description**                  | ** ** | **Contracted  Maturity** | ** ** | **Amortized Cost**         | ** ** | **Fair Market  Value** | ** ** |
| Cash                             |       | Demand                   |       | $                               | 20,108     |   | $ | 20,108 |   |
| U.S. agency notes                |       | 50 days                  |       | 4,716                           |       | 4,717 |   |
| Money market funds               |       | Demand                   |       | 26,955                          |       | 26,955 |   |
| Total cash and cash  equivalents |       |                     |       | $                               | 51,779     |   | $ | 51,780 |   |
|                             |       |                     |       |                            |       |   |   |
| Banker’s acceptance         |       | 139 days                 |       | $                               | 420        |   | $ | 420 |   |
| Certificate of deposit           |       | 298 days                 |       | 400                             |       | 400 |   |
| U.S. agency notes                |       | 153 days                 |       | 3,639                           |       | 3,639 |   |
| Corporate bonds                  |       | 302 days                 |       | 4,348                           |       | 4,338 |   |
| Total short-term  investments    |       |                     |       | $                               | 8,807      |   | $ | 8,797 |   |

 

|                                  | ** ** | ** **               | ** ** | **September 30, 2006** | ** ** |
|----------------------------------|------------|--------------------------|------------|----------------------------------|------------|
| **Description**                  | ** ** | **Contracted  Maturity** | ** ** | **Amortized Cost**          | ** ** | **Fair Market  Value** | ** ** |
| Cash                             |       | Demand                   |       | $                                | 16,024     |   | $ | 16,024 |   |
| U.S. agency notes                |       | 50 days                  |       | 4,432                            |       | 4,431 |   |
| Certificate of deposit           |       | 49 days                  |       | 400                              |       | 400 |   |
| Money market funds               |       | Demand                   |       | 20,921                           |       | 20,921 |   |
| Total cash and cash  equivalents |       |                     |       | $                                | 41,777     |   | $ | 41,776 |   |
|                             |       |                     |       |                             |       |   |   |
| Auction rate securities          |       | 30.1 years               |       | $                                | 4,900      |   | $ | 4,900 |   |
| Certificate of deposit           |       | 151 days                 |       | 1,699                            |       | 1,699 |   |
| U.S. agency notes                |       | 162 days                 |       | 6,113                            |       | 6,114 |   |
| Corporate bonds                  |       | 270 days                 |       | 11,079                           |       | 11,076 |   |
| Total short-term  investments    |       |                     |       | $                                | 23,791     |   | $ | 23,789 |   |

 

The Company hashad no realized gains or losses to date from the sale of money market funds orshort-term investments.

**9.****   Stock-Based Compensation**

The Companycurrently has four plans under which it may grant stock-based compensationawards to its employees and non-employees.

**Stock-BasedCompensation Plans**

In 1997, the Companyadopted the Phase Forward Incorporated 1997 Stock Option Plan (the “1997 Plan”).  Under the 1997 Plan, the Board of Directorsmay grant incentive and nonqualified stock options to employees of the Companyand non-employees. The exercise price of each option is determined by the Boardof Directors. Incentive stock options may not be granted with an exercise priceless than the fair market value of the stock on the date of grant, as definedby the Board of Directors. Options granted under the 1997 Plan generally vestover four or five year periods and expire ten years from the grant date. InJanuary and March 2004, the Company granted options to certain employeesto purchase a total of 205,000 shares of common stock that vest upon theearlier of 7 years from date of grant or the attainment of specifiedmilestones. Options to purchase 178,750 shares have since either vested uponthe attainment of specified milestones in accordance with the originalprovisons of the awards or been modified to change the vesting provisions to a4-year service period vesting. Options to purchase 26,250 shares wereaccelerated in December 2004. There was no incremental stock-based compensationin excess of the amounts that were previously recorded as deferredcompensation. As of September 30, 2006, the Company had 236,358 share optionsavailable for grants under this plan. The Company has not issued options under this plan since its July 2004initial public offering, but may do so in the future.

In 2004, the Boardof Directors and stockholders approved the Phase Forward Incorporated 2004Stock Option and Incentive Plan (the “2004 Plan”) which became effective uponthe closing of the Company’s initial public offering. The Company had reservedfor issuance an aggregate of 1.5 million shares of common stock under the 2004Plan.  Under the 2004 Plan, the Board ofDirectors may 

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grant stock options and other equity interests in theCompany to employees of the Company and non-employees. The exercise price ofeach option is determined by the Board of Directors. Incentive stock optionsmay not be granted with an exercise price less than the fair market value ofthe stock on the date of grant, as defined by the Board of Directors. Optionsgranted under the 2004 Plan generally vest over a four to seven year period andexpire ten years from the grant date. In February 2005, the Company grantedoptions to certain employees to purchase a total of 419,000 shares of commonstock that vest upon the earlier of attainment of specified milestones or 7years from the date of grant.  Of theseFebruary 2005 option grants, 64,750 options have since vested due to theachievement of milestones, 25,000 options were forfeited and the balanceremains unvested.  Generally, theremainder of equity awards granted were service-based and vest over a period offour years from the date of grant.  OnMay 3, 2006, the Company’s stockholders approved an amendment to the 2004 Planto increase the number of shares available for issuance from 1.5 million sharesto 3.5 million shares.  As of September30, 2006, the Company had 1,142,105 share options available for grants underthis plan.

In 2003, the Boardof Directors and stockholders approved the Phase Forward Incorporated 2003Non-Employee Director Stock Option Plan (the “2003 NED Plan”).  The Company reserved for issuance anaggregate of 362,000 shares of common stock under this plan.  Effective April 20, 2004, the 2003 NEDPlan was amended to increase the number of shares the Company may grant underthis plan to 562,000 shares. The 2003 NED Plan provided solely for theautomatic, one-time grant of a nonqualified stock option to a non-employeedirector upon initial election to the Company’s Board of Directors to purchase100,000 shares of common stock.  OnSeptember 23, 2005, the 2003 NED Plan was amended to reduce the one-time grantfrom 100,000 to 50,000 stock options. The exercise price of the options must not be less than 100% of the fairmarket value on the grant date. Options vest fully on the fifth anniversary ofthe date of grant, so long as the non-employee director has continuously servedon the Board of Directors through such vesting date. If the non-employee directormeets certain board attendance criteria, options may vest earlier at a rate ofone-sixteenth at the end of each fiscal quarter following the date of grant. Asof September 30, 2006, the Company had 234,875 share options available forfuture grants under this plan.

In 2004, the Board of Directors and stockholdersapproved the Phase Forward Incorporated 2004 Employee Stock Purchase Plan (the “2004ESPP”), which became effective after the completion of the Company’s initialpublic offering on July 20, 2004. The Company has reserved for issuanceunder this plan an aggregate of 320,000 shares of common stock. The 2004 ESPPallows eligible employees the opportunity to purchase shares of the Company’scommon stock through payroll deductions of up to 10% of a participant’s annualcompensation with a maximum of 5,000 shares available per participant duringeach payment period, subject to statutory limitations. The first payment periodbegan on September 2, 2004 and ended on November 30, 2004.  All subsequent payment periods consist ofsix-month periods commencing on December 1 and June 1 and ending onthe last day of May and November.

Prior to December 1, 2005, the price per shareunder the 2004 ESPP for each payment period was the lesser of (1) 85% ofthe last reported sale price of the Company’s common stock on the firstbusiness day of the payment period and (2) 85% of the last reported saleprice of the common stock on the last business day of the payment period.Effective December 1, 2005, the Company amended the price provision of the2004 ESPP such that the option price is now set at 95% of the last reportedsale price of the common stock on the last business day of the payment period.Accordingly, the 2004 ESPP is considered a non-compensatory plan under SFAS No.123(R).

**Accountingfor Stock-Based Compensation**

OnDecember 16, 2004, the Financial Accounting Standards Board, or FASB,issued SFAS No. 123(R), which is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*. SFAS No. 123(R)supersedes Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*, and amends SFASNo. 95, *Statement of Cash Flows*.Generally, the approach under SFAS No. 123(R) is similar to the approachdescribed in SFAS No. 123. However, SFAS No. 123(R) requires all share-basedpayments to employees to be recognized in the income statement based on theirfair value. Pro forma disclosure is no longer an alternative.

SFAS No. 123(R)required adoption for fiscal years starting after June 15, 2005. As aresult, the Company adopted SFAS No. 123(R) starting in its fiscal firstquarter of 2006, which began on January 1, 2006.   The Company’s results of operations andfinancial position for prior periods have not been restated as a result of itsadoption of SFAS No. 123(R).

The Companyadopted the “modified prospective” method outlined in SFAS No. 123(R). Underthe “modified prospective” method, compensation cost is recognized in theincome statement beginning on the adoption date of SFAS No. 123(R) as follows:(a) based on the requirements of SFAS No. 123(R) for all share-basedpayments granted on or after the adoption date; (b) based on therequirements of SFAS No. 123 for all share-based payments that are unvested asof December 31, 2005, and (c) excludes those stock options issued by theCompany prior to it becoming a public entity which were valued using the “minimumvalue” method. Therefore commencing January 1, 2006, in accordance with themodified prospective method, the Company is amortizing the fair value,calculated utilizing a Black-Scholes option pricing model, as stock-basedcompensation expense as of December 31, 2005.

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For purposes ofutilizing the Black-Scholes option pricing model and because there was alimited trading history for its common stock, the Company determined theexpected life and the volatility for options based on an analysis of reporteddata for a peer group of companies that have issued stock options withsubstantially similar terms. The expected life of options granted by theCompany has been determined based on the average expected life of the optionsas reported by this peer group of companies during a similar reporting period.The expected volatility of options granted has been determined using an averageof the historical volatility measures of this peer group of companies as wellas the historical volatility of the Company’s common stock beginning in January2005. The risk-free interest rate is based on a treasury instrument whose termis consistent with the expected life of the stock options. The Company has notpaid and does not anticipate paying cash dividends on its shares of commonstock; therefore, the expected dividend yield is assumed to be zero. Inaddition, while SFAS No. 123 permitted companies to record forfeitures based onactual forfeitures, which was the Company’s historical policy under SFAS No.123, SFAS No. 123(R) requires companies to utilize an estimated forfeiture ratewhen calculating stock-based compensation expense for the period.  As a result, the Company has applied aforfeiture rate of 8%, derived from an analysis of its historical data, indetermining the expense recorded in the Company’s consolidated statement ofincome.

TheCompany determines the weighted average fair value of options granted under theBlack-Scholes option pricing model.  TheCompany did not issue stock options during the three months ended September 30,2006.   The weighted average assumptionsutilized to determine fair value for the periods reported are indicated in thefollowing table:

|                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| Risk-free interest rate                        |       | 4.15                                                 | %          | —                                              |       | 4.03 | % | 4.65 | % |
| Expected volatility                            |       | 55                                                   | %          | —                                              |       | 59 | % | 53 | % |
| Expected life (in  years)                      |       | 4.07                                                 |       | —                                              |       | 4.10 |   | 4.28 |   |
| Expected dividend yield                        |       | —                                               |       | —                                              |       | — |   | — |   |
| Weighted average fair value of options granted |       | $                                                    | 3.61       |                                                | $          | — |   | $ | 3.36 |   | $ | 4.21 |   |
|                                                |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |

 

Prior to theadoption of SFAS No. 123(R) and as permitted by SFAS No. 123, the Companyhistorically accounted for share-based payments to employees using the APBOpinion No. 25 intrinsic value method and, as such, generally recognized nocompensation cost for employee share-based payments other than the stock-basedcompensation expense associated with stock options granted at a discount fromthe deemed fair market value.  Thisstock-based compensation expense is based on the amount by which the exerciseprice of an option is less than the deemed fair value of the Company’s commonstock at the date of grant. Because there had been no public market for theCompany’s stock prior to the July 2004 initial public offering, the Company’sBoard of Directors had determined the fair value of the common stock based uponseveral factors, including, but not limited to, the Company’s operating andfinancial performance, issuance of convertible preferred stock, the rights andpreferences of all securities senior to common stock and the anticipatedoffering price of the Company’s common stock in connection with the initialpublic offering.

During the ninemonths ended September 30, 2005 and 2006, the Company recorded stock-basedcompensation expense of $430 and $374, respectively, related to such stockoptions granted at a discount.

As of September30, 2006, there was an aggregate of $213 of stock-based compensation remainingto be expensed in connection with previously granted discounted stockoptions.  This expense will be recordedas follows: $73 in the remaining quarter of 2006; $134 in 2007; and $6 in2008.  The Company amortizes the deferredcompensation charges over the vesting period of the underlying option awards inaccordance with FASB Interpretation No. 28, *Accounting for StockAppreciation Rights and Other Variable Stock Option or Award Plans*.

**Stock-BasedCompensation Expense**

During the threemonths ended September 30, 2006, the Company recorded $976 of stock-basedcompensation expense, $813 of which resulted from adoption of SFAS No. 123(R).The remaining $163 of stock-based compensation expense is due to theamortization of stock-based compensation associated with previously issuedstock options granted at a discount from the deemed fair market value prior tothe Company’s initial public offering. The expense is allocated asfollows:  $68 to cost of revenues, $121to research and development, $143 to sales and marketing and $644 to generaland administrative.  For the three monthsended September 30, 2005 and 2006, stock-based compensation expense reducedbasic and diluted earnings per share by $0.00 and $0.03, respectively.  For the nine months ended September 30, 2005and 2006, stock-based compensation expense reduced basic and diluted earningsper share by $0.01 and $0.06, respectively. As of September 30, 2006, there was $11,643 of unrecognized stock-basedcompensation expense related to market-based share awards that is expected tobe recognized over a weighted average period of 3.3 years.

13

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Prior to adoptingSFAS No. 123(R), the Company accounted for stock-based compensation under APBOpinion No. 25. The following table illustrates the effect on net income andearnings per share if the fair value based method had been applied to theyear-ago period. 
| ** **                                                                                                  | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | ** **                                             | ** ** | ** **                                            | ** ** |
| Net income as reported                                                                                      |       | $                                                      | 2,170      |                                                  | $          | 5,476 |   |
| Stock-based  compensation expense included in reported net income                                           |       | 73                                                     |       | 430                                                   |       |
| Stock-based  compensation expense determined under the fair value based method, net of  related tax effects |       | (848                                                   | )          | (2,152                                                | )          |
|                                                                                                        |       |                                                   |       |                                                  |       |
| Net income — pro forma                                                                                 |       | $                                                      | 1,395      |                                                  | $          | 3,754 |   |
|                                                                                                        |       |                                                   |       |                                                  |       |
| Income per common  equivalent share:                                                                        |       |                                                   |       |                                                  |       |
| Basic — as  reported                                                                                   |       | $                                                      | 0.07       |                                                  | $          | 0.17 |   |
|                                                                                                        |       |                                                   |       |                                                  |       |
| Diluted — as  reported                                                                                 |       | $                                                      | 0.06       |                                                  | $          | 0.16 |   |
|                                                                                                        |       |                                                   |       |                                                  |       |
| Basic — pro  forma                                                                                     |       | $                                                      | 0.04       |                                                  | $          | 0.11 |   |
|                                                                                                        |       |                                                   |       |                                                  |       |
| Diluted — pro  forma                                                                                   |       | $                                                      | 0.04       |                                                  | $          | 0.11 |   |

 

The 2004 ESPP was amended effective December 1, 2005such that the plan is a non-compensatory plan under SFAS No. 123(R) in 2006.The assumptions used to calculate the SFAS No. 148, *Accountingfor Stock-Based Compensation — Transition and Disclosures,*pro formadisclosure for shares purchased under the 2004 ESPP under the Black-Scholesoption pricing model were as follows: 
| ** **                       | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|----------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Average risk-free  interest rate |       | 3.12                                                           | %          | 2.74                                                          | %          |
| Expected volatility              |       | 60                                                             | %          | 60                                                            | %          |
| Expected life (in  years)        |       | 0.5                                                            |       | 0.5                                                           |       |
| Expected dividend yield          |       | —                                                         |       | —                                                        |       |

 

**Stock Option Activity**

A summary of stock optionactivity under the 1997 Plan, the 2004 Plan and the 2003 NED Plan as ofSeptember 30, 2006, and changes during the nine months ended September 30,2006, is as follows:
| **Options**                                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Term  (years)** | ** ** | **Aggregate  Intrinsic  Value (2)** | ** ** |
|-------------------------------------------------------|------------|------------|------------|--------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding at December  31, 2005                     |       | 4,331,775  |       | $                                          | 4.64       |                                                             |       |                                     |       |   |
| Granted                                               |       | 13,500     |       | 8.90                                       |       |                                                             |       |                                     |       |
| Exercised                                             |       | (602,581   | )          | 3.59                                       |       |                                                             |       |                                     |       |
| Cancelled                                             |       | (33,043    | )          | 5.72                                       |       |                                                             |       |                                     |       |
| Outstanding at  September 30, 2006                    |       | 3,709,651  |       | $                                          | 4.82       |                                                             | 6.99       |                                     | $          | 26,424 |   |
|                                                  |       |       |       |                                       |       |                                                             |       |                                     |       |
| Exercisable at  September 30, 2006                    |       | 2,355,505  |       | $                                          | 3.85       |                                                             | 6.28       |                                     | $          | 19,049 |   |
|                                                  |       |       |       |                                       |       |                                                             |       |                                     |       |
| Vested or expected to  vest at September 30, 2006 (1) |       | 3,500,208  |       | $                                          | 4.71       |                                                             | 6.91       |                                     | $          | 25,319 |   |

----

(1)             Thevested or expected to vest options at September 30, 2006 include both thevested options and the number of options expected to vest calculated afterapplying an estimated forfeiture rate to the unvested options.

(2)             Theaggregate intrinsic value is calculated based on the positive differencebetween the estimated fair value per share of the Company’s common stock onSeptember 30, 2006 of $11.94 and the exercise price of the underlying options.

14

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A summary of the statusof the Company’s unvested stock options as of September 30, 2006, and changesduring the nine months ended September 30, 2006, is as follows:
| **Unvested Shares**        | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|---------------------------------|------------|------------|------------|--------------------------------------------|------------|
| Unvested at  December 31, 2005  |       | 2,055,245  |       | $                                          | 5.98       |   |
| Granted                         |       | 13,500     |       | 8.90                                       |       |
| Vested                          |       | (681,556   | )          | 5.03                                       |       |
| Forfeited                       |       | (33,043    | )          | 5.72                                       |       |
| Unvested at September  30, 2006 |       | 1,354,146  |       | $                                          | 6.49       |   |

 

Thefollowing table summarizes information regarding the Company’s stock optionsoutstanding and exercisable at September 30, 2006:
| **Options Outstanding**                | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $0.10 - 0.60                                |       | 22,334                       |       | 1.66 |   | $ | 0.13 |   | 22,334 |   | $ | 0.13 |   |
| 0.61 - 1.20                                 |       | 25,350                       |       | 3.05 |   | 1.00 |   | 25,350 |   | 1.00 |   |
| 2.41 - 3.00                                 |       | 1,865,404                    |       | 5.91 |   | 3.00 |   | 1,718,799 |   | 3.00 |   |
| 3.01 - 4.80                                 |       | 165,960                      |       | 7.33 |   | 4.50 |   | 87,894 |   | 4.50 |   |
| 4.81 - 5.40                                 |       | 43,850                       |       | 3.48 |   | 5.00 |   | 43,850 |   | 5.00 |   |
| 5.41 - 6.00                                 |       | 74,180                       |       | 7.45 |   | 6.00 |   | 31,408 |   | 6.00 |   |
| 6.01 - 7.80                                 |       | 1,171,573                    |       | 8.38 |   | 6.75 |   | 339,260 |   | 6.92 |   |
| 7.81 - 9.00                                 |       | 241,000                      |       | 8.93 |   | 7.87 |   | 61,610 |   | 7.81 |   |
| 9.01 - 10.29                                |       | 100,000                      |       | 9.15 |   | 10.29 |   | 25,000 |   | 10.29 |   |
|                                        |       | 3,709,651                    |       | 6.99 |   | $ | 4.82 |   | 2,355,505 |   | $ | 3.85 |   |

 

**Restricted Stock Awards Activity**

In June 2006, the Company awarded 942,250 shares ofrestricted stock under the 2004 Plan to its Chief Executive Officer, members ofthe Company’s senior management team and other key employees. The restrictedstock award to the Chief Executive Officer vests 25% after three years ofservice, 50% after four years and 100% after five years. The remaining restrictedstock awards generally vest 50% after two years of service, 75% after threeyears and 100% after four years. The Company calculated restricted stock awardexpense using the fair value on the date of the grant. This expense isamortized on a straight-line basis over the service period. The stock-basedcompensation expense associated with the 942,250 restricted stock awards isweighted based on the period of time the awards were outstanding during thethree and nine month period ended September 30, 2006.  Generally, employees will forfeit awardedrestricted shares if their employment is terminated prior to vesting.  The Company is applying an estimated annualforfeiture rate of 8% in determining the expense recorded in the Company’sconsolidated statements of income.  Therestricted stock awards have also been reflected in the calculation of basicand diluted earnings per share.

A summary of restrictedstock awards activity during the nine months ended September 30, 2006, is asfollows:
| **Restricted Stock Awards**    | ** ** | **Shares** | ** ** | **Weighted  Average Fair  Value Per Share** | ** ** | **Weighted Average  Remaining  Contractual Term  (years)** | ** ** | **Aggregate  Intrinsic Value (2)** | ** ** |
|------------------------------------------|------------|------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------|------------|
| Outstanding at December  31, 2005        |       | —     |       | $                                                          | —     |                                                                 |       |                                         |       |   |
| Awarded                                  |       | 942,250    |       | 12.12                                                      |       |                                                                 |       |                                         |       |
| Forfeited                                |       | (11,250    | )          | 12.12                                                      |       |                                                                 |       |                                         |       |
| Outstanding at  September 30, 2006       |       | 931,000    |       | $                                                          | 12.12      |                                                                 | 3.98       |                                         | $          | 11,116 |   |
|                                     |       |       |       |                                                       |       |                                                                 |       |                                         |       |
| Expected to be free of  restrictions (1) |       | 718,557    |       | $                                                          | 12.12      |                                                                 | 3.98       |                                         | $          | 8,580 |   |

----

(1)             Theexpected to be free of restrictions at September 30, 2006 was calculated byapplying an estimated forfeiture rate to the unvested shares.

(2)             Theaggregate intrinsic value is calculated based on the fair value per share ofthe Company’s common stock on September 30, 2006 of $11.94.

15

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**10.     Goodwilland Intangible Assets**

Goodwill andintangible assets that have indefinite lives are not amortized but areevaluated for impairment annually or whenever events or changes incircumstances indicate the carrying value may not be recoverable. Intangibleassets that have finite lives are amortized over their useful lives.

The goodwillresulting from acquisitions is reviewed for impairment on an annual basis inaccordance with SFAS No. 142,*Goodwill and Other Intangible Assets.*  Consistent with prior years, the Companyconducted its annual impairment test of goodwill during the fourth quarter of2005 and determined that no impairment of goodwill existed at December 31,2005.

A rollforward ofthe net carrying amount of goodwill is as follows:
| ** **                                                                               | ** ** | **Amount** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------|------------|
| Balance as of December 31, 2004                                                     |       | $          | 21,817     |   |
| Utilization of acquired net  operating losses — Clinsoft                            |       | (2,057     | )          |
| Increase associated with the  acquisition of Lincoln                                     |       | 8,430      |       |
| Release of valuation  allowance related to acquired net operating losses — Clinsoft |       | (3,230     | )          |
| Balance as of December 31, 2005                                                     |       | $          | 24,960     |   |
| Increase associated with the  acquisition of Lincoln                                     |       | 3,066      |       |
| Release of valuation  allowance related to acquired net operating losses — Clinsoft |       | (304       | )          |
| Balance as of September 30, 2006                                                         |       | $          | 27,722     |   |

 

The utilization ofor release of the valuation allowance related to acquired net operating lossesreflects an actual or anticipated reduction in cash payments to local taxingauthorities for income taxes that are not reflected as a benefit in the incometax provision for financial statement purposes but rather as a reduction togoodwill.  In the year ended December 31,2005, the Company determined that it is more likely than not that the Companywill realize a portion of its deferred tax assets and therefore reduced thevaluation allowance by $7,772 in December 2005. This benefit of the release in valuation allowance was realized throughreductions to income tax expense of $4,542 and to goodwill of $3,230.

During the ninemonths ended September 30, 2006, adjustments totaling $3,066 were recorded togoodwill associated with the acquisition of Lincoln.  Goodwill wasincreased by the earn-out accrual of $3,500 (see Note 5) and reduced by thefollowing: ($194) receipts of previously written-off accounts receivable;($123) reduction to deferred revenues due to the completion of two servicesengagements; and ($117) associated with a sublease of the abandoned formerLincoln facility.

Intangible assets,all of which relate to the acquisition of Lincoln, consist of the following:
| ** **                         | ** ** | ** **                          | ** ** | **As of December 31, 2005** | ** ** | **As of September 30, 2006** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| **Description**                    | ** ** | **Estimated Useful Life** | ** ** | **Gross  Carrying  Value**                      | ** ** | **Accumulated  Amortization**                    | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed technology and  know-how |       | 5 years                             |       | $                                               | 1,800      |                                             | $          | 127 |   | $ | 1,800 |   | $ | 397 |   |
| Customer relationships             |       | 5 years                             |       | 1,600                                           |       | 112                                              |       | 1,600 |   | 353 |   |
| Non-compete agreements             |       | 2 years                             |       | 300                                             |       | 53                                               |       | 300 |   | 165 |   |
| Tradename                          |       | 5 years                             |       | 200                                             |       | 14                                               |       | 200 |   | 44 |   |
| Total                              |       |                                |       | $                                               | 3,900      |                                             | $          | 306 |   | $ | 3,900 |   | $ | 959 |   |

 

Amortizationexpense related to intangible assets for the three months ended September 30,2005 and 2006 was $89 and $218, respectively, and $89 and $653 for the ninemonths ended September 30, 2005 and 2006, respectively.

The estimatedremaining amortization expense for each of the five succeeding fiscal years isas follows:
| **Year ended December 31,** | ** ** | **Amount** | ** ** |
|--------------------------------------------|------------|------------|------------|
| 2006                                       |       | $          | 218        |   |
| 2007                                       |       | 817        |       |
| 2008                                       |       | 720        |       |
| 2009                                       |       | 720        |       |
| 2010                                       |       | 466        |       |
| Total                                      |       | $          | 2,941      |   |

 

16

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**11.     AccruedExpenses**

Accrued expensesconsist of the following:
| ** **                            | ** ** | **As of  December 31,  2005** | ** ** | **As of  September 30,  2006** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|
| Accrued payroll  and related benefits |       | $                                       | 5,327      |                                     | $          | 6,318 |   |
| Accrued other  expenses               |       | 4,037                                   |       | 3,947                                    |       |
| Accrued  royalties                    |       | 2,411                                   |       | 1,895                                    |       |
| Accrued income  taxes                 |       | 697                                     |       | 679                                      |       |
| Total                                 |       | $                                       | 12,472     |                                     | $          | 12,839 |   |

 

**12.     Debt**

Prior to August2005, all borrowings under the Company’s $5,000 working capital line of creditwere secured by substantially all assets of the Company.  Under a related negative pledge agreement,the Company was generally prohibited from pledging its intellectual property toothers, subject to certain exceptions.  In August 2005, the workingcapital line of credit was amended to eliminate the security interest in theCompany’s assets and the negative pledge on the Company’s intellectualproperty. The amendment also removed or modified the financial covenants. Effective March 31, 2006, the working capital line of credit was reduced from$5,000 to $2,000.  As of December 31, 2005 and September 30, 2006,there were no amounts outstanding under the working capital line ofcredit.  At September 30, 2006, there was$1,500 available under the line of credit, and $500 reserved under a letter ofcredit associated with the Company’s leased facility.  At September 30, 2006, the Company was incompliance with all financial covenants.

**13.     Contingencies**

        From time to time and in the ordinarycourse of business, the Company is subject to various claims, charges andlitigation. Intellectual property disputes often have a risk of injunctiverelief which, if imposed against the Company, could materially and adverselyaffect its financial condition, or results of operations. From time to time,third parties have asserted and may in the future assert intellectual propertyrights to technologies that are important to the Company’s business and havedemanded and may in the future demand that the Company license their technology.The outcome of litigation cannot be predicted with certainty and some lawsuits,claims or proceedings may be disposed of unfavorably to the Company, whichcould materially and adversely affect its financial condition or results ofoperations.

OnFebruary 15, 2006, the Company entered into a Settlement Agreement andrelated License Agreement with Dr. Mark L. Kozam d/b/a MLK Software andDatasci, LLC.  The Settlement Agreement relates to a lawsuit filed byDatasci in 2004 alleging that certain of the Company’s products and servicesand certain products and services of the Company’s customer, Quintiles, Inc.,infringe a United States patent claimed to be owned by Datasci. Under theSettlement Agreement and related License Agreement, the Company agreed to makea one-time, lump sum payment to Datasci in the amount of $8,500 to settle theclaim. The confidential settlement, in which neither party admits liability,provides for mutual releases and dismissal of all actions between the parties.

Pursuant to SFASNo. 142, *Goodwill and Other Intangible Assets*,the Company reviewed the attributes of the license obtained and estimated thatthe license obtained had no value or useful life and that the license would notcontribute to the future cash flows of the Company, either directly orindirectly. The Company does not anticipate changing any of its products as aresult of the license to this patent.  Assuch, the settlement amount was recorded as a charge to operations. Since thecontingency existed as of December 31, 2005 and the settlement was concludedprior to the issuance of the Company’s 2005 audited consolidated financialstatements, in accordance with SFAS No. 5, *Accounting forContingencies*, the Company recorded the impact of the settlement in2005 as a charge to operations.   Thesettlement was paid during the three months ending March 31, 2006.

**14.    Stockholders’ Equity**

During the ninemonths ended September 30, 2006, the Company issued 602,581 shares of commonstock in connection with the exercise of stock options resulting in proceeds of$2,174 and 14,137 shares of common stock under the 2004 ESPP resulting inproceeds of $171.

17

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**15.   Comprehensive Income**

The Company’s othercomprehensive income relates to foreign currency translation adjustments and ispresented separately on the balance sheet as required.

Comprehensive incomeconsists of the following:
| ** **                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| Net income                         |       | $                                                    | 2,170      |                                                | $          | 2,894 |   | $ | 5,476 |   | $ | 6,868 |   |
| Cumulative translation  adjustment |       | 14                                                   |       | (2                                                  | )          | (520 | ) | 429 |   |
| Comprehensive income               |       | $                                                    | 2,184      |                                                | $          | 2,892 |   | $ | 4,956 |   | $ | 7,297 |   |

 

**16.   Forward Foreign Exchange Contracts**

The Company entersinto transactions in currencies other than the U.S. dollar and holds cash inforeign currencies which expose the Company to transactions gains and losses asforeign currency exchange rates fluctuate against the U.S. dollar. The Companyfrom time to time enters into forward foreign exchange contracts to hedge theforeign currency exposure of non-U.S. dollar denominated third-party andintercompany receivables and cash balances. The contracts which relate to theBritish pound, euro, and the Japanese yen, generally have terms of one month.These hedges are deemed fair value hedges and have not been designated forhedge accounting. The gains or losses on the forward foreign exchange contractsalong with the associated gains and losses on the revaluation and settlement ofthe intercompany balances, accounts receivable and cash balances are recordedin the period incurred.

Thefollowing table summarizes the outstanding forward foreign exchange contractsheld by the Company:
| ** **    | ** ** | ** **          | ** ** | **As of December 31, 2005** | ** ** | **As of September 30, 2006**  | ** ** |
|---------------|------------|---------------------|------------|-------------------------------------------------|------------|---------------------------------------------------|------------|
| **Currency**  | ** ** | **Hedge Type** | ** ** | **Local Currency  Amount**                 | ** ** | **Approximate U.S.  Dollar Equivalent** | ** ** | **Local Currency  Amount** | ** ** | **Approximate U.S.  Dollar Equivalent** | ** ** |
| British pound |       | Sale                |       | 6,000                                           |       | $                                                 | 10,303     |   | 1,500 |   | $ | 2,807 |   |
| Euro          |       | Purchase            |       | (500                                            | )          | (592                                              | )          | — |   | — |   |
| Euro          |       | Sale                |       | —                                          |       | —                                            |       | 150 |   | 190 |   |
| Japanese yen  |       | Sale                |       | 156,000                                         |       | 1,317                                             |       | 60,000 |   | 509 |   |
|          |       |                |       |                                            |       | $                                                 | 11,028     |   |   |   | $ | 3,506 |   |

 

As of December 31,2005 and September 30, 2006, the forward foreign exchange contracts areshort-term and mature within 35 days of origination.

Due to the shortperiod of time between entering into the forward foreign exchange contracts andSeptember 30, 2006, the forward foreign exchange contract rate approximates theexchange rate as of the end of the reporting period.

Realized andunrealized foreign currency gains (losses), net of hedging, are accounted forin non-operating income (expense). Foreign currency gains (losses), net ofhedging, were ($38) and $16 for the three months ended September 30, 2005 and2006, respectively, and ($169) and ($45) for the nine months ended September30, 2005 and 2006, respectively.   TheCompany settles forward foreign exchange contracts in cash.

**17.**       Income Taxes

**The Company’s effective taxrates for the three months ended September 30, 2005 and 2006****were 17% and 18%, respectively, and 22%and 18% for the nine months ended September 30, 2005 and 2006, respectively.  The Company’s effective tax rates were lowerthan the Company’s statutory federal and state rate of 40% due to the estimatedutilization of previously unrecognized net operating losses. The Companycurrently expects to realize recorded deferred tax assets as of September 30,2006 of $7,977. The Company’s conclusion that such assets will be recovered isbased upon its expectation that future earnings of the Company will providesufficient taxable income to realize recorded tax assets. Such tax strategiesinclude estimates and involve judgment. While the realization of the Company’snet recorded deferred tax assets cannot be assured, to the extent that futuretaxable income against which these tax assets may be applied is not sufficient,some or all of the Company’s net recorded deferred tax assets would not berealizable.

18

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** **

**18.****       Recently Issued AccountingPronouncement**

In July 2006, theFASB issued FASB Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes* (“FIN 48”), which is an interpretation of SFAS No.109, *Accounting for Income Taxes*. FIN 48clarifies the accounting for income taxes by prescribing the minimumrecognition threshold a tax position is required to meet before beingrecognized in the financial statements. FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. In addition, FIN 48 clearlyscopes out income taxes from FASB Statement No. 5, *Accountingfor Contingencies*. FIN 48 is effective for fiscal years beginningafter December 15, 2006. The Company will implement this interpretation in thefiscal year starting January 1, 2007. The Company is currently analyzing theeffect, if any, FIN 48 will have on the Company’s consolidated financialposition and results of operations.

In September 2006,the FASB issued SFAS No. 157, *FairValue Measurements*, which defines fair value, establishes aframework for measuring fair value under generally accepted accountingprinciples, and expands disclosures about fair value measurements. SFASNo. 157 applies to other accounting pronouncements that require or permitfair value measurements. The new guidance is effective for financial statementsissued for fiscal years beginning after November 15, 2007, and for interimperiods within those fiscal years. The Company is currently analyzing theeffect, if any, SFAS No. 157 will have on the Company’s consolidatedfinancial position and results of operations.

19

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**Item2.  *Management’s Discussionand Analysis of Financial Condition and Results of Operations.***

*The followingdiscussion and analysis of our financial condition and results of operationsshould be read in conjunction with our unaudited condensed consolidatedfinancial statements and related notes that appear elsewhere in this QuarterlyReport on Form 10-Q. In addition to historical consolidatedfinancial information, the following discussion contains forward-lookingstatements***within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities and ExchangeAct of 1934, as amended, and are intended to be covered by the “safe harbor”created by those sections. Forward-looking statements, which are based oncertain assumptions and**reflectour plans, estimates and beliefs**,*can generally be identified by the use of forward-looking terms such as “believes,”“expects,” “may,” “will,” “should,” “could,” “seek,” “intends,” “plans,” “estimates,”“anticipates” or other comparable terms*. Ouractual results could differ materially from those discussed in theforward-looking statements. Factors that could cause or contribute to thesedifferences include those discussed below and elsewhere in this QuarterlyReport on Form 10-Q.  **We urge you toconsider the risks and uncertainties described in Item 1A of this******QuarterlyReport onForm 10-Q**in evaluatingour forward-looking statements.  Wecaution readers not to place undue reliance upon any such forward-lookingstatements, which speak only as of the date made. Except as otherwise requiredby the federal securities laws, we disclaim any obligation or undertaking topublicly release any updates or revisions to any forward-looking statementcontained herein (or elsewhere) to reflect any change in our expectations withregard thereto or any change in events, conditions or circumstances on which*****anysuch statement is based.*

**Overview**

        PhaseForward Incorporated is a provider of integrated enterprise-level softwareproducts, services and hosted solutions for use in our customers’ globalclinical trial and drug safety monitoring activities. Our customers includepharmaceutical, biotechnology and medical device companies, as well as academicinstitutions, governmental regulatory agencies, clinical researchorganizations, or CROs, and other entities engaged in clinical trial and drugsafety monitoring activities. By automating essential elements of the clinicaltrial and drug safety monitoring processes, we believe our products allow our customersto accelerate the market introduction of new medical therapies andcorresponding revenues, reduce overall research and development expenditures,enhance existing data quality control efforts, increase drug safety complianceand reduce clinical and economic risk.

**Acquisitions**

From time to timewe have expanded our product and service offerings through the acquisition ofother businesses or technologies.  Themost significant of these transactions are the acquisitions of ClinsoftCorporation (“Clinsoft”) and Lincoln Technologies, Inc. (“Lincoln”), which aredescribed below.

*LincolnTechnologies, Inc.*

        On August 25, 2005, we acquiredall of the outstanding capital stock of Lincoln, a provider of products andservices for drug safety, including clinical trial safety signal detection, andapplied data standards.  Lincoln’sproducts consisted of *WebVDME, CTSD*and*WebSDM.*The aggregate purchase price wasapproximately $16.7 million.  Theacquisition agreement called for additional cash consideration to be paidsubject to achievement of certain financial targets in 2005 and 2006, of up to$2.0 million and $4.0 million, respectively. The defined 2005 financial targets were achieved and, accordingly, weaccrued additional consideration of $2.0 million in 2005 which was paid in May2006.  The acquisition agreement wasamended in September 2006 to amend the terms of the remaining contingentearnout payment for which the securityholders of Lincoln could be eligible in 2007under the acquisition agreement.  Pursuant to the amendment, we agreed topay the securityholders of Lincoln an aggregate of $3.5 million in cash onDecember 26, 2007 in satisfaction of our remaining payment obligations underthe acquisition agreement.  The $3.5million has been accrued as of September 30, 2006.  The acquisition of Lincoln was accounted foras a purchase under Statement of Financial Accounting Standards (SFAS) No. 141,*Business Combinations*.  Accordingly, the results of Lincoln have beenincluded in our audited consolidated financial statements since the date ofacquisition.

*Clinsoft Corporation*

On August 14, 2001, weacquired Clinsoft, a developer, marketer and provider of clinical data managementand adverse event reporting and tracking products and services.  Clinsoft’s products consisted of *Clintrial*and *Clintrace. *The aggregate purchase price wasapproximately $44.1 million, which consisted of the issuance of 3.9 millionshares of our Series D redeemable convertible preferred stock, the assumptionof liabilities and direct acquisition costs. The acquisition of the Clinsoft business was accounted for as a purchaseunder SFAS No. 141.  Accordingly, theresults of Clinsoft have been included in our consolidated financial statementssince the date of acquisition.

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**LitigationSettlement**

OnFebruary 15, 2006, we entered into a Settlement Agreement and relatedLicense Agreement with Dr. Mark L. Kozam d/b/a MLK Software and Datasci, LLC.The Settlement Agreement relates to a lawsuit filed by Datasci in 2004 allegingthat certain of our products and services and certain products and services ofone of our customers, Quintiles, Inc., infringe a United States patentclaimed to be owned by Datasci. Under the Settlement Agreement and relatedLicense Agreement, we agreed to make a one-time, lump-sum payment to Datasci inthe amount of $8.5 million to settle the claim. The confidential settlement, inwhich neither party admits liability, provides for mutual releases anddismissal of all actions between the parties.

Pursuant to SFASNo. 142, *Goodwill and Other Intangible Assets,*wereviewed the attributes of the license obtained and estimated that the licenseobtained had no value or useful life and that the license would not contributeto our future cash flows, either directly or indirectly.  In addition, we donot anticipate changing any of our products as a result of the license to thispatent.  As such, the settlement amountwas recorded as a charge to operations.  Since the contingency existed as of December 31, 2005 and thesettlement was concluded prior to the issuance of our 2005 audited consolidatedfinancial statements, in accordance with SFAS No. 5, *Accountingfor Contingencies,* we recorded the impact of the settlement in 2005as a charge to operations.  Thesettlement was paid during the three months ended March 31, 2006.  During the nine months ended September30, 2006, we incurred expense of $373,000 relating to our defense in this suit,which is included in general and administrative expenses.

**Sourcesof Revenues**

We derive ourrevenues from software licenses and services. License revenues are derived principally from the sale of term licensesfor our software products including; *InForm,Clintrial,**Clintrace,**WebVDME,**CTSD* and *WebSDM.*  Service revenues are derived principally fromour delivery of the hosted solution of our *InForm,**WebVDME*, *CTSD* and *WebSDM* software products, andconsulting services and customer support, including training, for all of ourproducts.  We generally recognizerevenues ratably over the life of a license or service contract. This allows usto maintain a backlog that provides multi-year visibility in revenues.

One customer,GlaxoSmithKline, accounted for approximately 16% and 18% of our total revenuesin the three months ended September 30, 2005 and 2006, respectively, and 16%and 17% of our total revenues in the nine months ending September 30, 2005 and2006 respectively, and $1.7 million and $1.9 million of accounts receivableoutstanding as of December 31, 2005 and September 30, 2006, respectively.  Our top 20 customers accounted forapproximately 67% and 73% of our total revenues, net of reimburseableout-of-pocket expenses in the three months ended September 30, 2005 and 2006,respectively, and 67% and 69% of our total revenues, net of reimburseableout-of-pocket expenses in the nine months ended September 30, 2005 and 2006,respectively.

* License Revenues*

We derive ourlicense revenues from the following products: *InForm*,our Internet based electronic data capture solution; *Clintrial*, our clinical data management solution; and ourdrug safety solutions, including *Clintrace*, andour recently acquired *WebVDME*, *CTSD*, and *WebSDM*products. Although each of our software solutions are available as stand-aloneenterprise applications, we offer integrated enterprise solutions incorporatingcertain of our electronic data capture, data management and drug safetyproducts.

License revenuesfor our *InForm* electronic datacapture software solution, either on a stand-alone or integrated basis, aredetermined primarily by the number, complexity and duration of the clinicaltrials and the number of participants in each clinical trial. License revenuesfor our *Clintrial,**Clintrace,**WebVDME*,*CTSD* and *WebSDM*software solutions are determined primarily by the number of users accessingthe software solution. Except as discussed below, we enter into softwarelicense agreements for our *InForm*,*Clintrial* and *Clintrace* products**withterms generally of three to five years with payment terms generally annually inadvance. License agreements for our *WebVDME, CTSD*and*WebSDM* products are generally annual with payment termsgenerally in advance.  License revenuesare recognized ratably over the duration of the software term licenseagreement, to the extent that amounts are fixed or determinable andcollectable.

Following ouracquisition of Clinsoft in August 2001, we began converting holders ofClinsoft perpetual software licenses to our software term license arrangements.We continue to sell perpetual licenses of these products in certain situationsto our existing customers with the option to purchase customer support, and mayin the future do so for new customers based on customer requirements or marketconditions. We recognize revenues on the perpetual licenses upon delivery ofthe software when all other revenue recognition criteria are met.  We continue to provide and charge formaintenance and support on our products to those customers who do not convertto our software term license arrangements. We generally charge 18% of theperpetual license fee for customer support. We will continue our efforts toconvert the remaining former Clinsoft customer base to software term licensearrangements.  However, we anticipatethat some customers will not convert and instead will continue to make annualcustomer support payments.

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*ServiceRevenues*

*ApplicationHosting Services.*    In addition tomaking our software products available to customers through licenses, we offerour *InForm*,*WebVDME, CTSD*and*WebSDM* software as hosted applicationsolutions delivered through a standard web-browser, with customer support andtraining services.  Service revenues fromapplication hosting services are derived principally from our *InForm* hosted solution.

Revenues resultingfrom the *InForm*hosting serviceconsist of three stages for each clinical trial:

·                  *First stage—*trial and application set up,including design of electronic case report forms and edit checks, installationand server configuration of the system;

·                  *Second stage—*application hosting andrelated support services; and

·                  *Third stage—*services required to closeout, or lock, the database for the clinical trial.

Services providedfor the first and third stages are provided on a fixed fee basis depending uponthe complexity of the trial and system requirements. Services for the secondstage are charged separately as a fixed monthly fee. We recognize revenues fromall stages of the hosting service ratably over the hosting period. Fees to becharged and costs incurred for the trial system design, set up andimplementation, are deferred until the start of the hosting period and areamortized and recognized ratably over the estimated hosting period. Thedeferred costs include direct costs related to the trial and application setup. Fees for the first and third stages of the services are billed based uponmilestones. Fees for application hosting and related services in the secondstage are generally billed quarterly in advance. Bundled into this revenueelement are the revenues attributable to the software license used by thecustomer.

In the event thatan application hosting customer cancels a clinical trial and its relatedstatement of work, all deferred revenues are recognized and all deferred set upcosts are expensed.  In addition, certaintermination-related fees may be charged and if so, such fees are recognized inthe period of termination.

Revenues resultingfrom hosting services for our *WebVDME*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related supportservices.  Services for this offering arecharged monthly as a fixed fee.  Revenuesare recognized ratably over the period of the service.

In addition,application hosting service revenues include hosting services associated withterm license customers and reimbursable out-of-pocket expenses.

*ConsultingServices.*    Consulting services includethe design and documentation of the processes related to our customers’ use ofour products and services in their clinical trials. Consulting services alsoinclude project planning and management services, guidance on best practices inusing our software products, data management and configuration services fordata mining and reporting, as well as implementation services consisting ofapplication architecture design, systems integration, installation and validation.  Revenues from consulting services included ineither a multiple element software license agreement or in an applicationhosting agreement are recognized ratably over the term of the arrangement. Theassociated costs are expensed as incurred. Revenues from consulting servicesthat are not included in a multiple element software license arrangement arerecognized as services are performed. Fixed priced arrangements are billedbased upon contractual milestones, and time-and-materials arrangements arebilled monthly.

*CustomerSupport.*    We have a multinationalservices organization to support our software products and hosted solutionsworldwide. Customer support includes telephone support, software maintenanceand training. We bundle customer support in our software term licenses andallocate 10% of the value of the license to customer support revenues. Ourcustomer support revenues also consist of customer support fees paid byperpetual license customers. Customer support revenues are recognized ratablyover the period of the customer support or term license agreement, with paymentterms generally annually in advance.

**Costof Revenues and Operating Expenses**

We allocateoverhead expenses such as rent and occupancy charges and employee benefit coststo all departments based on headcount. As such, general overhead expenses arereflected in cost of service revenues and in the sales and marketing, researchand development, and general and administrative expense categories.

*Costof Revenues.*    Cost of license revenuesconsists primarily of the amortization of royalties paid for certain moduleswithin our *Clintrial* softwareproduct as well as our *InForm*software product. In addition, costs of revenues include expense for theamortization of acquired technologies associated with the acquisition ofLincoln. The cost of license revenues vary based upon the mix of revenues fromsoftware licenses for our products. We operate our service organization on aglobal basis as one distinct unit, and do

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not segment costs for our various service revenueelements. These services include performing application hosting, consulting andcustomer support services. Costs for these services consist primarily ofemployee-related costs associated with these services, amortization of thedeferred clinical trial set up costs, allocated overhead, outside contractors,royalties associated with providing customer support for use with the *Clintrial* and *InForm*softwareproducts and reimbursable out-of-pocket expenses. Cost of services also includeshosting costs that primarily consist of hosting facility fees and serverdepreciation.

The cost ofservice revenues vary based upon the number of employees in the serviceorganization, the type of work performed, and royalties associated with revenuesderived from providing customer support, as well as costs associated with theflexible use of outside contractors to support internal resources. Wesupplement the trial design and set up activity for our *InForm*application hosting servicesthrough the use of outside contractors. This allows us to utilize outsidecontractors in those periods where trial design and set up activity is highestwhile reducing the use of outside contractors in those periods where trialactivity lessens, allowing for a more flexible delivery model. The percentageof the services workforce represented by outside contractors varies from periodto period depending on the volume of specific support required. The cost ofservices is significantly higher as a percentage of revenues as compared to ourcost of license revenues primarily due to the employee-related and outsidecontractor expenses associated with providing services.

*GrossMargin.*    Our gross margin on licenserevenues varies based on the mix of royalty- and non-royalty-bearing licenserevenues and the amount of amortization of acquired technologies. Our grossmargin on service revenues varies primarily due to variations in theutilization levels of the professional service team and the timing of expenseand revenue recognition under our service arrangements. In situations where theservice revenues are recognized ratably over the software license term  our costs associated with delivery of theservices are recognized as the services are performed, which is typically duringthe first 6 to 12 months of the contract period. Accordingly, our grossmargin on service revenues will vary significantly over the life of a contractdue to the timing, amount and type of service required in delivering certainprojects. In addition, consolidated gross margin will vary depending upon themix of license and service revenues.

*Salesand Marketing.*    Sales and marketingexpenses consist primarily of employee-related expenses, including travel,marketing programs which include product marketing expenses such as tradeshows, workshops and seminars, corporate communications, other brand buildingand advertising, allocated overhead and the amortization of commissions. Weexpect that sales and marketing expenses will continue to increase in absolutedollars as commission expense increases with our revenues and as we continue toexpand sales coverage and to build brand awareness through what we believe arethe most cost effective channels available, but may fluctuate quarter overquarter due to the timing of marketing programs.

*Researchand Development.*    Research anddevelopment expenses consist primarily of employee-related expenses, allocatedoverhead and outside contractors. We focus our research and development effortson increasing the functionality, performance and integration of our softwareproducts. We expect that in the future, research and development expenses willincrease in absolute dollars as we introduce additional integrated softwaresolutions to our product suite.

*        Generaland Administrative.*    General andadministrative expenses consist primarily of employee-related expenses,professional fees, primarily consisting of expenses for accounting, compliancewith the Sarbanes-Oxley Act of 2002, and legal services, including litigation,information technology and other corporate expenses and allocated overhead. Weexpect that in the future, general and administrative expenses will fluctuatequarter by quarter due to the timing of outside contractor and professionalfees associated with Sarbanes-Oxley compliance, as well as legal services.

*Restructuring.*    Werecorded a $4.5 million restructuring charge in 2003 which related to therelocation of our corporate headquarters. This charge includes approximately$2.5 million relating to the estimated future obligation under thenon-cancelable lease and an approximate $2.0 million write-off of therelated abandoned leasehold improvements and fixed assets. As of September 30,2005, payments for all remaining expenses were completed and as a result werecorded a restructuring benefit of $92,000 representing the elimination ofaccrued expenses associated with the restructuring charge.

*Stock-BasedCompensation Expenses.*    Our cost ofservice revenues, sales and marketing, research and development, and generaland administrative expenses include stock-based compensation expense sinceJanuary 1, 2006.  Stock-basedcompensation expense is the fair value of outstanding stock options andrestricted stock awards which is recognized over the respective stock optionand award service periods.  It alsoincludes amortization of the excess of the deemed fair market value over theexercise price of stock options granted prior to when we became a publiccompany.

**ForeignCurrency Translation**

With regard to ourinternational operations, we frequently enter into transactions in currenciesother than the U.S. dollar. As a result, our revenues, expenses and cash flowsare subject to fluctuations due to changes in foreign currency exchange rates,particularly changes in the euro, British pound, Australian dollar and Japaneseyen. In the three months ended September 30, 2005 and 2006, approximately 45%and 48%, respectively, of our revenues were generated in locations outside theUnited States.  In the nine

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months ended September 30, 2005 and 2006,approximately 47% and 49%, respectively, of our revenues were generated inlocations outside the United States.  Themajority of these revenues are in currencies other than the U.S. dollar, as aremany of the associated expenses. In periods when the U.S. dollar declines invalue as compared to the foreign currencies in which we conduct business, ourforeign currency-based revenues and expenses generally increase in value whentranslated into U.S. dollars.

**CriticalAccounting Policies and Estimates**

Our unaudited condensedconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of thesefinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. On an ongoingbasis, we evaluate our estimates and assumptions with our audit committee,including those related to revenue recognition, deferred set up costs,commissions and royalties, accounts receivable reserves, stock-basedcompensation expenses, long-lived assets, intangibles assets and goodwill,income taxes, restructuring, contingencies and litigation. We base ourestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. There have beenno material changes to these estimates for the periods presented in thisQuarterly Report on Form 10-Q. Our actual results may differ fromthese estimates under different assumptions or conditions.

We believe that of oursignificant accounting policies, which are described in Note 2 of thenotes to our 2005 consolidated financial statements included in our AnnualReport on Form 10-K and in the Notes to our unaudited condensed consolidatedfinancial statements included in this Quarterly Report on Form 10-Q,the following accounting policies involve a greater degree of judgment andcomplexity. Accordingly, these are the policies we believe are the mostcritical to aid in fully understanding and evaluating our consolidatedfinancial condition and results of operations.

* RevenueRecognition and Deferred Set Up Costs.*    Werecognize software license revenues in accordance with Statement of Position(SOP) No. 97-2, *Software RevenueRecognition,* as amended, issued by the American Institute ofCertified Public Accountants, while revenues resulting from applicationservices are recognized in accordance with Emerging Issues Task Force (EITF)Issue No. 00-3, *Application of AICPAStatement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware* and Securities andExchange Commission’s (SEC) Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition*. On August 1,2003, we adopted EITF Issue No. 00-21, *RevenueArrangements with Multiple Deliverables.* The adoption of EITF IssueNo. 00-21 did not have a material impact on our financial position orresults of operations.

Customersgenerally have the ability to terminate application hosting, consulting andtraining service agreements upon 30 days notice to us. License agreements,multiple element arrangements, including license and services agreements, andcertain application hosting services can generally be terminated by eitherparty for material breach of obligations not corrected within 30 daysafter notice of the breach.

We recognizerevenues when all of the following conditions are satisfied: (1) there ispersuasive evidence of an arrangement; (2) the product or service has beenprovided to the customer; (3) the collection of our fees is probable; and(4) the amount of fees to be paid by the customer is fixed ordeterminable.

We generally enterinto software term licenses for our *InForm*,*Clintrial* and *Clintrace* products with our customers for3- to 5-year periods. License agreements for our *WebVDME,CTSD*and*WebSDM*products are generally for one-year terms. These arrangements typically include multiple elements: software license,consulting services and customer support. We bill our customers in accordancewith the terms of the underlying contract. Generally, we bill license feesannually in advance for each year of the license term. Our payment terms aregenerally net 30 days.

Our softwarelicense revenues are earned from the sale of off-the-shelf software requiringno significant modification or customization subsequent to delivery to thecustomer. Consulting services, which can also be performed by third-partyconsultants, are deemed to be non-essential to the functionality of thesoftware and typically are for trial configuration, implementation planning,loading of software, building simple interfaces and running test data anddocumentation of procedures.

We generally bundle customer support with thesoftware license for the entire term of the arrangement. As a result, wegenerally recognize revenues for all elements, including consulting services,ratably over the term of the software license and support arrangement. Weallocate the revenues recognized for these arrangements to the differentelements based on management’s estimate of the relative fair value of eachelement. For our term-based licenses, we allocate to consulting services theanticipated service effort and value throughout the term of the arrangement atan amount that would have been allocated had those services been soldseparately to the customer. The remaining value is allocated to license andsupport services, with 10% of this amount allocated to support services. Wehave allocated the estimated fair value to our multiple element arrangements toprovide meaningful disclosures about 

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each of our revenue streams. The costs associated withthe consulting and customer support services are expensed as incurred. Thereare instances in which we sell software licenses based on usage levels. Thesesoftware licenses can be based on estimated usage, in which case the licensefee charged to the customer is fixed based on this estimate. When the fee isfixed, the revenues are generally recognized ratably over the contractual termof the arrangement. If the fee is based on actual usage, and thereforevariable, the revenues are recognized in the period of use. Revenues fromcertain follow-on consulting services, which are sold separately to customerswith existing software licenses and are not considered part of a multipleelement arrangement, are recognized as the services are performed.

We continue tosell perpetual licenses for the *Clintrial*and *Clintrace* software productsin certain situations to our existing customers with the option to purchasecustomer support and may in the future do so for new customers based oncustomer requirements or market conditions. We have established vendor specificobjective evidence of fair value for the customer support. Accordingly, licenserevenues are recognized upon delivery of the software and when all otherrevenue recognition criteria are met.  Customer support revenues are recognized ratably over the term of theunderlying support arrangement. We continue to generate customer support andmaintenance revenues from our perpetual license customer base. Trainingrevenues are recognized as earned.

In addition tomaking our software products available to customers through licenses, we offerour *InForm*, *WebVDME*, *CTSD* and *WebSDM*software solutions through a hosted application solution delivered through astandard web-browser.

Revenues resultingfrom *InForm*application hosting servicesconsists of three stages for each clinical trial: the first stage involvesapplication set up, including design of electronic case report forms and editchecks, implementation of the system and server configuration; the second stageinvolves application hosting and related support services; and the third stageinvolves services required to close out, or lock, the database for the clinicaltrial. Services provided for the first and third stages are provided on a fixedfee basis based upon the complexity of the trial and system requirements.Services for the second stage are charged separately as a fixed monthly fee. Werecognize revenues from all stages of the *InForm*hosting service ratably over the hosting period. Fees charged andcosts incurred for the trial system design, set up and implementation are deferredas applicable, until the start of the hosting period and then amortized andrecognized, as applicable, ratably over the estimated hosting period. Thedeferred costs include incremental direct costs with third parties and certaininternal direct costs related to the trial and application set up, as definedunder SFAS No. 91, *Accounting forNonrefundable Fees and Costs Associated with Originating or Acquiring Loans andIndirect Costs of Leases*. These costs include salary and benefitsassociated with direct labor costs incurred during trial set up, as well asthird-party subcontract fees and other contract labor costs. Work performedoutside the original scope of work is contracted for separately as anadditional fee and is generally recognized ratably over the remaining term ofthe hosting period. Fees for the first and third stages of the services arebilled based upon milestones. Fees for application hosting and related servicesin the second stage are billed quarterly in advance. Bundled into this revenueelement are the revenues attributable to the software license used by thecustomer.

Revenues resultingfrom hosting services for our *WebVDME*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related supportservices.  Services for this offering arecharged monthly as a fixed fee.  Revenuesare recognized ratably over the period of the service.

In the event thatan application hosting customer cancels a clinical trial and its relatedstatement of work, all deferred revenues are recognized, all deferred set upcosts are expensed and certain termination related fees may be charged.

We deferred$666,000 and $483,000 of set up costs and amortized $425,000 and $489,000during the three months ended September 30, 2005 and 2006, respectively anddeferred $1.8 million and $2.1 million of set up costs and amortized $1.3million and $1.5 million in the nine months ended September 30, 2005 and 2006,respectively.  The amortization ofdeferred set up costs is a component of cost of services.

Deferred revenuesrepresent amounts billed or cash received in advance of revenue recognition.

Provisions forestimated losses on uncompleted contracts are made on a contract-by-contractbasis and are recognized in the period in which such losses become probable andcan be reasonably estimated. To date, we have not experienced any materiallosses on uncompleted application hosting contracts.

*Accountingfor Prepaid Sales Commissions and Royalties.*    Forarrangements where we recognize revenues over the relevant contract period, wedefer related commission payments to our direct sales force and softwarelicense royalties paid to third parties and amortize these amounts over thesame period that the related revenues are recognized. This is done to bettermatch commission and royalty expenses with the related revenues. We deferred$989,000 and $1.1 million of commissions and amortized to sales and marketingexpense $1.0 million and $804,000 in the three months ended September 30, 2005and 2006, respectively, and deferred $2.3 million and $4.0 million ofcommissions and amortized to sales and marketing expense $2.7 million and $3.4million in the nine months ended September 30, 2005 and 2006,respectively.  Royalties are paid on apercentage of billings basis for certain of our products. We deferred $645,000and $99,000 of royalties and amortized to cost of revenues $803,000 and$694,000 in the three 

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months ended September 30, 2005 and 2006,respectively, and deferred $2.9 million and $1.8 million of royalties andamortized to cost of revenues $2.1 million and $2.3 million in the nine monthsended September 30, 2005 and 2006, respectively.

*        AccountsReceivable Reserves.*    We maintainallowances for doubtful accounts for estimated losses resulting from theinability of our customers to make required payments. We regularly evaluate thecollectibility of our trade receivables based on a combination of factors,which may include dialogue with the customer to determine the cause of non-payment,the use of collection agencies, and/or the use of litigation. In the event itis determined that the customer may not be able to meet its full obligation tous, we record a specific allowance to reduce the related receivable to theamount that we expect to recover given all information available to us. Wecontinuously monitor collections 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 cannot guarantee that we will continue to experience the samecredit loss rates in the future. If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required. Our accounts receivablereserves were $318,000 and $278,000 as of December 31, 2005 and September30, 2006, respectively.

*Accountingfor Income Taxes.*    In connection withpreparing our financial statements, we are required to estimate income taxexpense in each jurisdiction in which we operate.  This process requires that we project ourcurrent tax liability and estimate our deferred tax assets and liabilities,including net operating loss and tax credit carryforwards.  In assessing the need for a valuationallowance, we have considered our recent operating results, future taxableincome projections and all prudent and feasible tax planning strategies.  In the year ended December 31, 2005, wedetermined that it is more likely than not that we will realize a portion ofour deferred tax assets and reduced the valuation allowance by $7.8 million in December2005.  This benefit of the release invaluation allowance was realized through reductions to income tax expense of$4.5 million and to goodwill of $3.2 million. During the three months and nine months ended September 30, 2006 theCompany released a portion of its valuation allowance, resulting in a reductionin income tax expense of $857,000 and $2.3 million, respectively.

*Accountingfor Stock-Based Awards. *   On December 16, 2004, the FinancialAccounting Standards Board (FASB) issued SFAS No. 123(R), *Share-Based Payment*, which is a revision of SFASNo. 123, *Accounting for Stock-Based Compensation*.SFAS No. 123(R) supersedes Accounting Principles Board (APB) OpinionNo. 25, *Accounting for Stock Issued to Employees*,and amends SFAS No. 95, *Statement of Cash Flows*.Generally, the approach under SFAS No. 123(R) is similar to the approachdescribed in SFAS No. 123. However, SFAS No. 123(R) requires all share-basedpayments to employees, including grants of stock options, to be recognized inthe income statement based on their fair values.  Pro forma disclosure is no longer analternative.

As prescribed, weadopted SFAS No. 123(R) starting in our fiscal first quarter of 2006, whichbegan on January 1, 2006.

As permitted bySFAS No. 123, we historically accounted for share-based payments to employeesusing the APB Opinion No. 25 intrinsic value method and, as such, generallyrecognized no compensation cost for employee stock options other than theamortization of deferred stock-based compensation cost associated with stockoptions granted at a discount from the deemed fair market value.  Under our adoption of SFAS No. 123(R) and asoutlined therein, we utilized the “modified prospective” method to beginrecognizing stock-based compensation expenses. Under the “modified prospective”method, stock-based compensation is recognized in the income statementbeginning on the adoption date of SFAS No. 123(R) as follows:  (a) based on the requirements of SFASNo. 123(R) for all share-based payments granted on or after the adoptiondate;  (b) based on the requirementsof SFAS No. 123 for all share-based payments that are un-vested as of December31, 2005; and (c) excludes those options issued prior to the Phase Forwardbecoming a public entity which were valued using the “minimum value method”.

In accordance with the modified prospective method ofadoption, our results of operations and financial position for prior periodshave not been restated.

Effective with theadoption of SFAS No. 123(R), we have elected to use the Black-Scholes optionpricing model to determine the weighted average fair value of options granted.

We had a limitedtrading history for our common stock as it began trading on the NASDAQ NationalMarket on July 15, 2004. Accordingly, we have determined the expected lifeand the volatility for options granted based on an analysis of reported datafor a peer group of companies that issued options with substantially similarterms. The expected life of options we granted has been determined based on theaverage expected life of the options as reported by this peer group ofcompanies during a similar reporting period. The expected volatility of options granted has been determined using anaverage of the historical volatility measures of this peer group of companiesas well as the weighted average historical volatility of our own common stockbeginning in January 2005.  The risk-freeinterest rate is based on a treasury instrument whose term is consistent withthe expected life of the stock options. We have not paid and do not anticipatepaying cash dividends on our shares of common stock; therefore, the expecteddividend yield is assumed to be zero. In addition, SFAS No. 123(R) requirescompanies to utilize an estimated forfeiture rate when calculating the expensefor the period. We have applied an estimated forfeiture rate based onhistorical experience.

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On June 6, 2006, we granted 942,250 shares ofrestricted stock awards to our Chief Executive Officer, members of our seniormanagement team and other key employees. We determine restricted stock awardexpense based on the closing market price of our common stock on the day beforethe date of grant. This expense is amortized on a straight-line basis over theservice period.

Prior to theadoption of SFAS No. 123(R), we recorded deferred stock-based compensation inthe amount by which the exercise price of an option is less than the deemedfair value of our common stock at the date of grant. Because there had been nopublic market for the our stock prior to the July 2004 initial public offering,our Board of Directors had determined the fair value of the common stock basedupon several factors, including, but not limited to, our operating andfinancial performance, issuance of convertible preferred stock, the rights andpreferences of all securities senior to common stock and the anticipatedoffering price of our common stock in connection with the initial publicoffering.  We amortize the deferredcompensation charges over the vesting period of the underlying option awards inaccordance with FASB Interpretation No. 28, *Accounting for StockAppreciation Rights and Other Variable Stock Option or Award Plans*.

During the threeand nine months ended September 30, 2006, we recorded $976,000 and $2.0 millionof aggregate stock-based compensation expense, of which $813,000 and $1.6million were a result of the adoption of SFAS No. 123(R). The remainingstock-based compensation expense is due to the amortization of stock-basedcompensation associated with previously issued stock options which amounted to$163,000 and $374,000, respectively. For the three months ended September 30,2006 stock-based compensation expense was allocated as follows: $68,000 to costof revenues; $121,000 to research and development; $143,000 to sales andmarketing; and $644,000 to general and administrative.  For the nine months ended September 30, 2006stock-based compensation expense included $161,000 in cost of revenues,$248,000 in research and development, $351,000 in sales and marketing and $1.2million in general and administrative expense. For the three months ending September 30, 2005 and 2006, stock-basedcompensation expense reduced basic and diluted earnings per share by $0.00 and$0.03, respectively.  For the nine monthsended September 30, 2005 and 2006, stock-based compensation expense reducedbasic and diluted earnings per share by $0.01 and $0.06, respectively.  As of September 30, 2006, there was $11.6million of unrecognized stock-based compensation expense related tomarket-based share awards that is expected to be recognized over a weightedaverage period of 3.3 years.

*OtherSignificant Estimates*

*Goodwilland Intangible Assets Impairment.*    Wereview the carrying value of goodwill and intangible assets periodically basedupon the expected future discounted operating cash flows of our business. Ourcash flow estimates are based on historical results adjusted to reflect ourbest estimate of our operating results in future periods. Actual results maydiffer materially from these estimates. The timing and size of impairment charges,if any, involves the application of management’s judgment regarding theestimates and could significantly affect our operating results.

**Overviewof Results of Operations for the Three Months Ended September 30, 2005 and 2006**

        Totalrevenues increased by 26% or $5.8 million in the three months ended September30, 2006 compared to the same period in 2005 due to increases in bothapplication hosting services and license revenues of 36% and 30%, respectively.

        Ourgross margin increased by 26% or $3.5 million in the three months endedSeptember 30, 2006 compared to the same period in 2005, primarily due to theincrease in revenues.

Operating incomefor the three months ended September 30, 2006 of $2.8 million increased$553,000 or 25% compared to the same period in 2005.  The operating income for the three monthsended September 30, 2005 and 2006 included $73,000 and $976,000 of stock-basedcompensation expense, respectively.

The results forthe three months ended September 30, 2006 were impacted by foreign exchangerate fluctuations, resulting in approximately 2% decrease in revenues and anapproximately 1% increase in expenses for the period.

        As of September 30, 2006, we had$65.6 million of cash, cash equivalents and short-term investments, anincrease of $5.0 million from $60.6 million at December 31,2005.  As of September 30, 2006, we hadno outstanding debt.

27

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*Revenues*
| ** **                    | ** ** | **Three Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                    | ** ** | **2005**                                                 | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                               | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                                  | ** ** |
| License                       |       | $                                                        | 8,637      |                             | 39         | %          | $          | 11,225 |   | 40 | % | $ | 2,588 |   | 30 | % |
| Application hosting  services |       | 7,998                                                    |       | 36                               |       | 10,883     |       | 39 |   | 2,885 |   | 36 |   |
| Consulting services           |       | 2,679                                                    |       | 12                               |       | 3,048      |       | 11 |   | 369 |   | 14 |   |
| Customer support              |       | 2,928                                                    |       | 13                               |       | 2,893      |       | 10 |   | (35 | ) | (1 | ) |
| Total                         |       | $                                                        | 22,242     |                             | 100        | %          | $          | 28,049 |   | 100 | % | $ | 5,807 |   | 26 | % |
|                          |       |                                                     |       |                             |       |       |       |   |   |   |   |   |   |

 

Total revenues increased in the three months ended September30, 2006 primarily due to increases in application hosting service and licenserevenues.  The increase in revenuesassociated with our application hosting services in the three months endedSeptember 30, 2006 was due to an increase in trials under management, whichinclude both application hosting services trials as well as trials hosted forour *InForm* license customers.  The increase in license revenues wasprimarily the result of additional *InForm*revenuefrom new and existing customers and to a lesser extent increased growth insales related to our *Clintrial* andsafety products. The increase in consulting revenues was attributable to servicesrelating to additional *InForm* and *Clintrial* consulting revenues which were provided to both newand existing customers. Our revenues were not significantly impacted byprice increases or decreases.  Inflationhad only a nominal impact on our revenues. Revenues were impacted by foreign exchange rate fluctuations, resultingin a decrease in revenues for the period of 2%. In the future, we anticipate that the percentage oflicense revenues and service revenues will fluctuate quarter over quarter as apercentage of total revenues, primarily due to changes in the type, amounts anddelivery schedules of license and service orders, which are based on therequirements of our customers.
| ** **                          | ** ** | **Three Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2005**                                                 | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                               | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                  | ** ** |
| United States                       |       | $                                                        | 12,225     |                             | 55         | %          | $          | 14,586 |   | 52 | % | $ | 2,361 |   | 19 | % |
| United Kingdom                      |       | 6,271                                                    |       | 28                               |       | 9,316      |       | 33 |   | 3,045 |   | 49 |   |
| France                              |       | 2,179                                                    |       | 10                               |       | 2,577      |       | 9 |   | 398 |   | 18 |   |
| Asia Pacific                        |       | 1,567                                                    |       | 7                                |       | 1,570      |       | 6 |   | 3 |   | — |   |
| International subtotal              |       | 10,017                                                   |       | 45                               |       | 13,463     |       | 48 |   | 3,446 |   | 34 |   |
| Total                               |       | $                                                        | 22,242     |                             | 100        | %          | $          | 28,049 |   | 100 | % | $ | 5,807 |   | 26 | % |

 

The increase inrevenues worldwide was primarily due to increases in application hostingservice and license revenues associated with our *InForm*product. The increase in U.S. revenues is primarily related to a new businessrelationship with an *InForm*customer,while the increase in international revenues is primarily the result ofadditional *InForm*application hosting servicesrevenues with both new and existing customers.

*Cost ofRevenues*
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** | ** **                                | ** ** | ** ** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2005**                                                 | ** ** | **2006**                                  | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                               | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                                  | ** ** |
| License                         |       | $                                                        | 722        |                                      | 8          | %          | $          | 717 |   | 6 | % | $ | (5 | ) | (1 | )% |
| Services                        |       | 7,799                                                    |       | 57                                        |       | 10,079     |       | 60 |   | 2,280 |   | 29 |   |
| Total                           |       | $                                                        | 8,521      |                                      | 38         | %          | $          | 10,796 |   | 38 | % | $ | 2,275 |   | 27 | % |

 

The cost oflicense revenues remained consistent in the three months ended September 30,2006.  The increase in cost of servicesin the three months ended September 30, 2006 was primarily due to increases inemployee-related and contractor expenses of $1.2 million and $425,000,respectively, associated with a headcount increase of 35 people and thedelivery of  increased services revenues.  We also had an expense increase of $248,000relating to an increase in the number of arrangements in the hostingphase.  Expenses in the hosting phaseinclude actual costs incurred as well as the amortization of costs that werepreviously deferred during the set up phase. In addition, there were expense increases in facilities and travel of$129,000 and $122,000, respectively.

28

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*GrossMargin*
| ** **            | ** ** | **Three Months Ended September 30,** | ** ** | ** **                                | ** ** | ** ** | ** ** |
|-----------------------|------------|----------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2005**                                                 | ** ** | **2006**                                  | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                               | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                                  | ** ** |
| License               |       | $                                                        | 7,915      |                                      | 92         | %          | $          | 10,508 |   | 94 | % | $ | 2,593 |   | 33 | % |
| Services              |       | 5,806                                                    |       | 43                                        |       | 6,745      |       | 40 |   | 939 |   | 16 |   |
| Total                 |       | $                                                        | 13,721     |                                      | 62         | %          | $          | 17,253 |   | 62 | % | $ | 3,532 |   | 26 | % |

 

Thelicense gross margin percentage increased in the three months ended September 30,2006 due to an increase in license revenues for all of our products. Theservices gross margin percentage decreased during the three months endedSeptember 30, 2006, as our expense increase outpaced our revenue growth.The overall gross margin percentage was unchanged in the three months endedSeptember 30, 2006.  It is likely thatgross margin, as a percentage of revenues will fluctuate quarter by quarter dueto the timing and mix of license and service revenues, and the type, amount andtiming of service required in delivering certain projects.  For example, when services are performed on atime and material basis, the timing of expense and revenue recognition is moreclosely aligned than when services are performed under bundled arrangements,where the revenues are recognized ratably over the license period, while theexpenses are recognized as incurred.

*OperatingExpenses*
| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-----------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2005**                                                 | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                               | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                  | ** ** |
| Sales and marketing         |       | $                                                        | 3,897      |                             | 18         | %          | $          | 5,377 |   | 19 | % | $ | 1,480 |   | 38 | % |
| Research and  development   |       | 3,653                                                    |       | 16                               |       | 4,538      |       | 16 |   | 885 |   | 24 |   |
| General and  administrative |       | 3,937                                                    |       | 18                               |       | 4,551      |       | 16 |   | 614 |   | 16 |   |
| Restructuring               |       | —                                                   |       | —                           |       | —     |       | — |   | — |   | — |   |
| Total                       |       | $                                                        | 11,487     |                             | 52         | %          | $          | 14,466 |   | 51 | % | $ | 2,979 |   | 26 | % |

 

* Sales and Marketing.*    Salesand marketing expenses increased in the three months ended September 30, 2006primarily due to a $536,000 increase in employee-related expenses related to aheadcount increase of 8 people and a $462,000 increase in commission expensedue to both an increase in revenues and an increase in the effective commissionrate.  We also experienced increases inamortization expense of $128,000 associated with our purchase of Lincoln inAugust 2005 as well as stock-based compensation expense and travel expenses of$115,000 and $103,000, respectively.  Weexpect that our sales and marketing expense will continue to increase inabsolute dollars as commission expense increases with our revenues and as wecontinue to expand sales coverage and to build brand awareness through what webelieve are the most cost effective channels available, but may fluctuatequarter over quarter due to the timing of marketing programs.

* Research and Development.*    Researchand development expenses increased in the three months ended September 30, 2006primarily due to employee-related expenses of $368,000.   In addition, there were expense increases inrecruiting and outside contractor expense of $177,000 and $137,000,respectively. Further expense increases included stock-based compensation anddepreciation of $84,000 and $52,000, respectively.  We expect that our research and developmentcosts will continue to increase in absolute dollars as we continue to addfeatures and functionality to our products and expand our product and serviceofferings.

* General and Administrative.*    General and administrativeexpenses increased in the three months ended September 30, 2006 primarily dueto a $646,000 increase in stock-based compensation expense.  In addition, there were expense increases inemployee related, depreciation and computer related of $142,000, $86,000 and$89,000, respectively.  Computer relatedexpenses include hardware and software support agreements as well as computeraccessories.  These expense increaseswere partially offset by a decrease in professional fees of $330,000 primarilyassociated with legal fees related to defending our intellectualproperty.

29

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*OperatingIncome, Other Income (Expense)*
| ** **              | ** ** | **Three Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **              | ** ** | **2005**                                                 | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                               | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                                  | ** ** |
| Operating income        |       | $                                                        | 2,234      |                             | 10         | %          | $          | 2,787 |   | 10 | % | $ | 553 |   | 25 | % |
| Other income (expense): |       |                                                     |       |                             |       |       |       |   |   |   |   |   |   |
| Interest income         |       | 449                                                      |       | 2                                | %          | 735        |       | 3 |   | 286 |   | 64 |   |
| Other, net              |       | (79                                                      | )          | —                           |       | 14         |       | — |   | 93 |   | 118 |   |
| Total other income      |       | $                                                        | 370        |                             | 2          | %          | $          | 749 |   | 3 | % | $ | 379 |   | 102 | % |

 

* Operating Income.*   Theincrease in operating income in the three months ended September 30, 2006 wasprimarily due to the increase in revenues and reduction in operating expensesas a percentage of revenues.

* Other Income (Expense).*    Theincrease in interest income in the three months ended September 30, 2006 wasprimarily due to an increase in cash and cash equivalents available forinvestment, short term investments and an increase in the yield on investment.

*Provisionfor Income Taxes*
| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-----------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2005**                                                 | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                               | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                  | ** ** |
| Provision for income  taxes |       | $                                                        | 434        |                             | 2          | %          | $          | 642 |   | 2 | % | $ | 208 |   | 48 | % |
|                             |            |                                                          |            |                                  |            |            |            |  |  |  |  |  |  |  |  |  |

 

*Provisionfor Income Taxes.* The provision for income taxes in 2005and 2006 represents income taxes payable in both our U.S. and foreignoperations that cannot be offset through loss carryforwards.  In utilizing our net operating losscarryforwards, we are required to use our net operating losses in the order inwhich they were incurred.  Theutilization of the acquired net operating losses reduces the amount of incometaxes payable to local tax authorities, but does not reduce the amount ofincome tax expense for financial reporting purposes as it is recorded as areduction to goodwill. The effective tax rate for 2006 increased to 18%compared to an effective tax rate of 17% for 2005.  The increase in our effective tax rate isprimarily due to a one time benefit realized in 2005 associated withadjustments to previous estimates compared to our U.S. tax return for the yearended December 31, 2004 filed in the third quarter of 2005.

**Overviewof Results of Operations for the Nine Months Ended September 30, 2005 and 2006**

Totalrevenues increased by 20% or $12.9 million in the nine months ended September30, 2006 compared to the same period in 2005 primarily due to an increase inservice revenues of 25%.

Ourgross margin increased by 18% or $7.1 million in the nine months endedSeptember 30, 2006 compared to the same period in 2005, primarily due to theincrease in revenues.

Operatingincome for the nine months ended September 30, 2006 of $6.4 million increased4% or $258,000 compared to the same period in 2005.  The operating income for the nine monthsended September 30, 2005 and 2006 also included $430,000 and $2.0 million ofstock-based compensation expense, respectively.

Theresults for the nine months ended September 30, 2006 were impacted by foreignexchange rate fluctuations, resulting in decreases in both revenues andexpenses for the period of 2% and 1%, respectively.

30

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*Revenues*
| ** **                    | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                    | ** ** | **2005**                                                | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                              | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                                 | ** ** |
| License                       |       | $                                                       | 26,088     |                             | 41         | %          | $          | 29,633 |   | 39 | % | $ | 3,545 |   | 14 | % |
| Application hosting  services |       | 22,105                                                  |       | 35                               |       | 29,210     |       | 38 |   | 7,105 |   | 32 |   |
| Consulting services           |       | 5,696                                                   |       | 9                                |       | 8,405      |       | 11 |   | 2,709 |   | 48 |   |
| Customer support              |       | 9,613                                                   |       | 15                               |       | 9,139      |       | 12 |   | (474 | ) | (5 | ) |
| Total                         |       | $                                                       | 63,502     |                             | 100        | %          | $          | 76,387 |   | 100 | % | $ | 12,885 |   | 20 | % |

 

Total revenues increased in the ninemonths ended September 30, 2006 as compared to the same period in 2005,primarily due to increases in application hosting and license revenues.  The increase in revenues associated with ourapplication hosting services in the nine months ended September 30, 2006 wasprimarily due to an increase in trials under management, which include bothapplication hosting services trials as well as trials hosted for our *InForm* license customers. The increase in license revenues was primarily the result ofadditional *InForm*revenue from new and existingcustomers and to a lesser extent increased growth in sales related to our *Clintrial* and safety products.The increase in consulting revenues was primarily attributable to servicesrelating to new business relationships relating to the *WebVDME* product we began offering afterthe August 2005 acquisition of Lincoln as well as additional *InForm* consulting revenues which was primarily related toour existing customer base.  The decreasein customer support revenues in the nine months ended September 30, 2006 wasprimarily due to a reduction in *Clintrace*and *Clintrial*customer support revenues.  Our revenues were not significantly impactedby price increases or decreases. Inflation had only a nominal impact on our revenues.   Revenues were impacted by foreign exchangerate fluctuations, resulting in a decrease in revenues for the period of 2%.
| ** **                          | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2005**                                                | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                              | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                 | ** ** | ** **                       | ** ** |
| United States                       |       | $                                                       | 33,750     |                             | 53         | %          | $          | 39,093 |   | 51 | % | $ | 5,343 |   | 16 | % |
| United Kingdom                      |       | 18,747                                                  |       | 30                               |       | 24,775     |       | 32 |   | 6,028 |   | 32 |   |
| France                              |       | 6,396                                                   |       | 10                               |       | 7,433      |       | 10 |   | 1,037 |   | 16 |   |
| Asia Pacific                        |       | 4,609                                                   |       | 7                                |       | 5,086      |       | 7 |   | 477 |   | 10 |   |
| International subtotal              |       | 29,752                                                  |       | 47                               |       | 37,294     |       | 49 |   | 7,542 |   | 25 |   |
| Total                               |       | $                                                       | 63,502     |                             | 100        | %          | $          | 76,387 |   | 100 | % | $ | 12,885 |   | 20 | % |

 

The increase in revenues worldwide was primarily due to anincrease in application hosting service and license revenues. The increase inU.S. revenues is primarily related to additional license revenue across all ofour products as well as growth in application hosting services, while theincrease in international revenues is primarily the result of additional*InForm*application hosting servicesrevenues with both new and existing customers.

*Cost ofRevenues*
| ** **                      | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                                | ** ** | ** ** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2005**                                                | ** ** | **2006**                                  | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                              | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                                 | ** ** |
| License                         |       | $                                                       | 1,759      |                                      | 7          | %          | $          | 2,020 |   | 7 | % | $ | 261 |   | 15 | % |
| Services                        |       | 22,475                                                  |       | 60                                        |       | 27,981     |       | 60 |   | 5,506 |   | 24 |   |
| Total                           |       | $                                                       | 24,234     |                                      | 38         | %          | $          | 30,001 |   | 39 | % | $ | 5,767 |   | 24 | % |

 

        Thecost of license revenues increased in the nine months ended September 30, 2006primarily due to amortization expense from acquired technologies relating toour recent acquisition of Lincoln of $237,000. The increase in cost of servicesin the nine months ended September 30, 2006 was primarily due to increases inemployee-related and contractor expenses of $2.5 million and $1.5 million,respectively, associated with a headcount increase of 35 people and the delivery of increased services revenues.  We also had expense increases fordepreciation, hosting and computer related expenses of $403,000, $121,000 and$299,000, respectively, which were the result of an increase in trials undermanagement in the nine months ended September 30, 2006 as compared to the sameperiod in 2005.  Computer relatedexpenses include hardware and software support agreements as well as computeraccessories.  In addition, there werealso increases in travel and royalty expense of $324,000 and $191,000,respectively.  Furthermore, we hadexpense increases in facilities and stock-based compensation of $160,000 and$114,000.

31

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*GrossMargin*
| ** **            | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                                | ** ** | ** ** | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2005**                                                | ** ** | **2006**                                  | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                              | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                                 | ** ** |
| License               |       | $                                                       | 24,329     |                                      | 93         | %          | $          | 27,613 |   | 93 | % | $ | 3,284 |   | 13 | % |
| Services              |       | 14,939                                                  |       | 40                                        |       | 18,773     |       | 40 |   | 3,834 |   | 26 |   |
| Total                 |       | $                                                       | 39,268     |                                      | 62         | %          | $          | 46,386 |   | 61 | % | $ | 7,118 |   | 18 | % |

 

The license and services gross margin percentages wereunchanged during the nine months ended September 30, 2006, as revenues grew atapproximately the same rate as expenses.

*OperatingExpenses*
| ** **                  | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2005**                                                | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                              | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                 | ** ** |
| Sales and marketing         |       | $                                                       | 11,808     |                             | 19         | %          | $          | 14,798 |   | 19 | % | $ | 2,990 |   | 25 | % |
| Research and  development   |       | 10,423                                                  |       | 16                               |       | 12,022     |       | 16 |   | 1,599 |   | 15 |   |
| General and  administrative |       | 10,959                                                  |       | 17                               |       | 13,138     |       | 17 |   | 2,179 |   | 20 |   |
| Restructuring               |       | (92                                                     | )          | —                           |       | —     |       | — |   | 92 |   | 100 |   |
| Total                       |       | $                                                       | 33,098     |                             | 52         | %          | $          | 39,958 |   | 52 | % | $ | 6,860 |   | 21 | % |

 

* Salesand Marketing.*    Salesand marketing expenses increased in the nine months ended September 30, 2006primarily due to a $1.2 million increase in employee-related expenses relatedto a headcount increase of 8 people and a $690,000 increase in commissionexpense due to both an increase in revenues and an increase in the effectivecommission rate.  We also experiencedincreases in amortization expense of $383,000 associated with our purchase ofLincoln in August 2005, as well as travel and marketing programs of $217,000and $180,000, respectively.  In addition,stock-based compensation expense increased by $327,000.

* Researchand Development.*    Research anddevelopment expenses increased in the nine months ended September 30, 2006primarily due to employee-related expenses of $1.0 million.  In addition, there were also expense increasesfor recruiting, stock-based compensation and depreciation of $186,000, $117,000and $83,000, respectively.

* Generaland Administrative.*    General andadministrative expenses increased in the nine months ended September 30, 2006primarily due to an increase in stock-based compensation expense of $1.0million.  In addition, there were alsoexpense increases in employee-related expenses of $177,000 related to aheadcount increase of 6 people as well as additional outside contractorexpenses of $428,000.  Furthermore,expenses increased in depreciation and computer related by $244,000 and$233,000, respectively.  Computer related expenses include hardware andsoftware support agreements as well as computer accessories.  These expense increases were partially offsetby an overall decrease in professional fees of $287,000, which included$575,000 in savings relating to defending our intellectual property and$438,000 of additional expense related to an acquisition opportunity that wasevaluated during the period, but which we decided not to pursue.

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*OperatingIncome, Other Income (Expense)*

|                         | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **              | ** ** | **2005**                                                | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                              | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                                 | ** ** |
| Operating income        |       | $                                                       | 6,170      |                             | 10         | %          | $          | 6,428 |   | 8 | % | $ | 258 |   | 4 | % |
| Other income (expense): |       |                                                    |       |                             |       |       |       |   |   |   |   |   |   |
| Interest income         |       | $                                                       | 1,236      |                             | 2          | %          | 2,010      |   | 3 |   | 774 |   | 63 |   |
| Interest expense        |       | (144                                                    | )          | —                           |       | 0          |       | — |   | 144 |   | 100 |   |
| Other, net              |       | (220                                                    | )          | —                           |       | (50        | )          | — |   | 170 |   | 77 |   |
| Total other income      |       | $                                                       | 872        |                             | 1          | %          | $          | 1,960 |   | 3 | % | $ | 1,088 |   | 125 | % |

 

*Operating Income.*   Theincrease in operating income in the nine months ended September 30, 2006 wasprimarily due to an increase in revenues.

*Other Income (Expense).*   Theincrease in interest income in the nine months ended September 30, 2006 wasprimarily due to an increase in cash and cash equivalents available forinvestment, short term investments and an increase in the yield oninvestment.  The decrease in interestexpense was due to the pay off of our debt in the quarter ended September 30,2005.  Other, net expense decreasedprimarily due to a decrease in foreign exchange losses compared to the sameperiod in 2005.

*Provisionfor Income Taxes*

|                             | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2005**                                                | ** ** | **2006**                         | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                              | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                 | ** ** |
| Provision for income  taxes |       | $                                                       | 1,566      |                             | 2          | %          | $          | 1,520 |   | 2 | % | $ | (46 | ) | (3 | )% |
|                             |            |                                                         |            |                                  |            |            |            |  |  |  |  |  |  |  |  |  |

 

*Provisionfor Income Taxes.   *The provision for incometaxes in 2005 and 2006 represents income taxes payable in both our U.S. andforeign operations that cannot be offset through loss carryforwards.  In utilizing our net operating losscarryforwards, we are required to use our net operating losses in the order in whichthey were incurred.  The utilization ofthe acquired net operating losses reduces the amount of income taxes payable tolocal tax authorities, but does not reduce the amount of income tax expense forfinancial reporting purposes as it is recorded as a reduction to goodwill. Theeffective tax rate for 2006 decreased to 18% compared to an effective tax rateof 22% for 2005. The decrease in our effective tax rate associated with U.S.income taxes is primarily due to the release of a portion of our deferred taxasset valuation allowance of $2.3 million, which was recognized through areduction to income tax expense partially offset by a one time benefit realizedin 2005 associated with adjustments to previous estimates compared to our U.S.tax return for the year ended December 31, 2004 filed in the third quarter of2005.

**Liquidityand Capital Resources**

Our principalsources of liquidity were cash, cash equivalents, and short-term investmentstotaling $60.6 million and $65.6 million at December 31, 2005 andSeptember 30, 2006, respectively, and accounts receivable of $24.9 millionand $23.2 million, respectively.

Cash provided byand used in operating activities has historically been affected by changes inworking capital accounts, primarily deferred revenues, accounts receivable andaccrued expenses, and add-backs of non-cash expense items such as depreciationand amortization and stock-based compensation. Fluctuations within accountsreceivable and deferred revenues are primarily related to the timing ofbillings of our term license customers and the associated revenue recognition.Movements in deferred costs are related to the volume and stages of hostedclinical trials and movements in accrued expenses and accounts payable are dueto the timing of certain transactions.

Net cash providedby operating activities was $7.4 million in the nine months endedSeptember 30, 2006, which was greater than net income of $6.9 million.This difference is primarily due to $3.8 million of non-cash depreciationand amortization, $2.0 million of stock-based compensation, $1.3 million ofnon-cash income tax expense, an increase in deferred revenues of $1.7 million,and a decrease in accounts receivable of $2.4 million, partially offset by $1.0million of tax benefit related to exercise of options, the payment of accruedlitigation settlement of $8.5 million, a reduction of accrued expenses of$512,000 and a reduction to deferred rent of $472,000.

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Net cash used byinvesting activities was $20.6 million during the nine months endingSeptember 30, 2006, which was primarily due to the purchase of short-terminvestments of $44.2 million, capital expenditures associated withexpansion of our hosting facility and purchase of computer equipment to supportour work force of $3.5 million and the payment of accrued earn-out of $2.0million, partially offset by $29.2 million of proceeds from maturities ofshort-term investments.

Net cash providedby financing activities was $3.4 million in the nine months ended September 30,2006, consisting primarily of  $2.3million of proceeds from the exercise of stock options and sales of commonstock under our employee stock purchase plan and $1.0 million from the taxbenefit associated with the exercise of options.

At December 31,2005 and September 30, 2006, we had a $1.3 million and $500,000, respectively,outstanding letter of credit related to our facility.  The letter of credit reduces the amountavailable under our line of credit with a bank.

Substantially allof our long-lived assets as December 31, 2005 and September 30, 2006 arelocated in the United States.

We generally donot enter into long-term binding purchase commitments. Our principalcommitments consist of obligations under non-cancelable operating leases foroffice space.

Thefollowing table of our material contractual obligations as of September 30,2006 summarizes the aggregate effect that these obligations are expected tohave on our cash flows in the periods indicated:

|                                  | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **1 year  or less** | ** ** | **2-3 years** | ** ** | **4-5 years** | ** ** | **More than  5 years** | ** ** |
| ** **                       | ** ** | **(in thousands)**                   | ** ** |
| Operating lease  obligations     |       | $                                         | 6,943      |   | $ | 3,305 |   | $ | 3,638 |   | $ | — |   | $ | — |   |
| Total                            |       | $                                         | 6,943      |   | $ | 3,305 |   | $ | 3,638 |   | $ | — |   | $ | — |   |

 

Prior to August2005, all borrowings under our $5.0 million working capital line of credit weresecured by substantially all our assets. Under a related negative pledge agreement we were generally prohibitedfrom pledging our intellectual property to others, subject to certainexceptions.  In August 2005, the working capital line of credit wasamended to eliminate the security interest in our assets and the negativepledge on our intellectual property.  Theamendment also removed or modified the financial covenants.  EffectiveMarch 31, 2006, the working capital line of credit was reduced from $5.0million to $2.0 million. As of December 31, 2005 and September 30, 2006,there were no amounts outstanding under the working capital line ofcredit.  At September 30, 2006, there was$1.5 million available under the line of credit and $500,000 reserved under aletter of credit associated with our leased facilities.  At September 30, 2006, we were in compliancewith all financial covenants.

        AtDecember 31, 2005, we had $81.8 million of net operating losscarryforwards and $6.0 million of federal research and development tax creditcarryforwards that may be used to offset future U.S. federal taxable income.Approximately $17.2 million and $3.0 million of net operating loss and taxcredit carryforwards were acquired in the Clinsoft acquisition. Theseattributes may reduce our future cash tax liability; however this benefit willbe reflected through reductions to goodwill and not as reductions to income taxexpense. Additionally, we had $3.9 million of foreign net operating losscarryforwards. The net operating loss and tax credit carryforward periodextends through 2024 and both are subject to review and possible adjustment bythe taxing authorities. Also, the Internal Revenue Code contains provisionsthat may limit the net operating loss and tax credit carryforwards available inany given year in the event of certain changes in the ownership interests ofsignificant stockholders.** **We currently expect to realizerecorded deferred tax assets as of September 30, 2006 of approximately $8.0million.  Our conclusion that such assetswill be recovered is based upon our expectation that our future earningscombined with tax planning strategies available to us will provide sufficienttaxable income to realize recorded tax assets.

        Webelieve our existing cash, cash equivalents, short-term investments and cashprovided by operating activities and our debt facility will be sufficient tomeet our working capital and capital expenditure needs over the next12 months. Our future capital requirements will depend on many factors,including our rate of revenue growth, the expansion of our marketing and salesactivities, the timing and extent of spending to support product developmentefforts, the timing of introductions of new products and services and enhancementsto existing products and services, and the continuing market acceptance of ourproducts and services.  To the extentthat existing cash and securities and cash from operations are insufficient tofund our future activities, we may need to raise additional funds throughpublic or private equity or debt financing. From time to time, we may also enter into agreements with respect topotential investments in, or acquisitions of, businesses, services ortechnologies, which could also require us to seek additional equity or debtfinancing.

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**Recently Issued AccountingPronouncements**

In July 2006, theFASB issued FASB Interpretation No. 48 (“FIN 48”), *Accountingfor Uncertainty in Income Taxes*, which is an interpretation of SFASNo. 109*, Accounting for Income Taxes*. FIN 48clarifies the accounting for income taxes by prescribing the minimumrecognition threshold a tax position is required to meet before beingrecognized in the financial statements. FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. In addition, FIN 48 clearlyscopes out income taxes from FASB Statement No. 5, *Accountingfor Contingencies*. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. We will implement this interpretation in the fiscal yearstarting January 1, 2007. We are currently analyzing the effect, if any, FIN 48will have on our consolidated financial position and results of operations.

InSeptember 2006, FASB issued SFAS No. 157, *FairValue Measurements*, which defines fair value, establishes aframework for measuring fair value under generally accepted accountingprinciples, and expands disclosures about fair value measurements. SFASNo. 157 applies to other accounting pronouncements that require or permitfair value measurements. The new guidance is effective for financial statementsissued for fiscal years beginning after November 15, 2007, and for interimperiods within those fiscal years. We are currently analyzing the effect, ifany, SFAS No. 157 will have on our consolidated financial position andresults of operations.

**Off-Balance Sheet Arrangements**

We do not have anyspecial purpose entities or off-balance sheet arrangements.

**Item 3.**                          *Quantitative and Qualitative Disclosures about Market Risk*

*ForeignCurrency Exchange Risk*

Our results ofoperations and cash flows are subject to fluctuations due to changes in foreigncurrency exchange rates, particularly changes in the euro, British pound,Australian dollar and Japanese yen. During the nine months ended September 30, 2005 and 2006, 47% and 49%,respectively, of our revenues were generated in locations outside the UnitedStates. The majority of these revenues are denominated in currencies other thanthe U.S. dollar, as are many of the associated expenses. Except for revenuetransactions in Japan, we enter into transactions directly with substantiallyall of our foreign customers. This creates a foreign currency exchange risk forus.

As of September30, 2006, we had $7.1 million of receivables denominated in currencies otherthan the U.S. dollar. If the foreign exchange rates fluctuated by 10% as ofSeptember 30, 2006, our foreign exchange receivable exposure would havefluctuated by approximately $710,000.  Inaddition, although our foreign subsidiaries have intercompany accounts thateliminate upon consolidation, such accounts expose us to foreign currency ratemovements. Exchange rate fluctuations on short-term intercompany accounts arerecorded in our consolidated statements of operations under “other income(expense)”, while exchange rate fluctuations on long-term intercompany accountsare recorded in our consolidated balance sheets under “accumulated othercomprehensive loss” in stockholders’ equity. We also maintain cash accountsdenominated in currencies other than the local currency which expose us toforeign exchange rate movements.

We haveimplemented a risk management program under which we measure foreign currencyexchange risk monthly and manage those exposures through the use of variousinternal controls and the use of forward foreign exchange contracts. Thisprocess is designed to minimize foreign currency translation exposures thatcould otherwise affect consolidated results of operations. As of September 30,2006, we entered into contracts to hedge approximately $3.5 million ofreceivables, intercompany accounts and cash balances denominated in currenciesother than the U.S. dollar.

*InterestRate Sensitivity*

We hadunrestricted cash, cash equivalents and short term investments totaling $65.6million at September 30, 2006. Investments in securities are invested primarily in high qualitysecurities of a short duration and are not materially affected by fluctuationsin interest rates. The unrestricted cash and cash equivalents are held forworking capital purposes. We do not enter into investments for trading orspeculative purposes. Due to the short-term nature of these investments, webelieve that we do not have any material exposure to changes in the fair valueof our investment portfolio as a result of changes in interest rates. Declinesin interest rates, however, would reduce future investment income.

We have a workingcapital line of credit which bears interest based upon the prime rate. AtDecember 31, 2005 and September 30, 2006, there were no amountsoutstanding under our working capital line of credit. At September 30, 2006,there was $1.5 million available under the line of credit and $500,000 reservedunder a letter of credit associated with our leased facilities.

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**Item 4.**                          *Controls and Procedures*

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our Securities Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the SEC’srules and forms, and that such information is accumulated and communicatedto our management, including our Chief Executive Officer and Chief FinancialOfficer, as appropriate, to allow timely decisions regarding requireddisclosure. In designing and evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, as ours are designed to do, and managementnecessarily was required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

As of September 30, 2006,we carried out an evaluation, under the supervision and with the participationof our management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in enabling us to record, process,summarize and report information required to be included in our periodic SECfilings within the required time period.

There have been nochanges in our internal control over financial reporting that occurred duringthe period covered by this report that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

**Part II—OtherInformation**

**Item 1.**                          *Legal Proceedings*

From time to timeand in the ordinary course of business, we are subject to various claims, chargesand litigation.  The outcome oflitigation cannot be predicted with certainty and some lawsuits, claims orproceedings may be disposed of unfavorably to us, which could materially affectour financial condition or results of operations.

**Item 1A.**                 *Risk Factors*

**Certain Factors WhichMay Affect Future Results**

*From time to time we update, revise and supplement therisk factors described under the title “Risk Factors” in our Annual Report onForm 10-K for the fiscal year ended December 31, 2005.  There are no material changes to the riskfactors described in the “Risk Factors” section in our Annual Report on Form10-K for the fiscal year ended December 31, 2005 other than the inclusionherein of an additional Risk Factor below entitled “Consolidation among ourclients could cause us to lose clients, decrease the market for our productsand result in a reduction of our revenues.”*

*We operate in a rapidly changing environment thatinvolves a number of risks, some of which are beyond our control.  This discussion highlights some of the riskswhich may affect future operating results. These are the risks and uncertainties we believe are most important foryou to consider.  Additional risks anduncertainties not presently known to us, which we currently deem immaterial orwhich are similar to those faced by other companies in our industry or businessin general, may also impair our business operations.  If any of the following risks oruncertainties actually occurs, our business, financial condition and operatingresults would likely suffer.*

**RisksRelated to Our Industry**

***We depend primarily on the pharmaceutical, biotechnology andmedical device industries and are therefore subject to risks relating tochanges in these industries.***

Our businessdepends on the clinical trial, post approval and safety monitoring activitiesconducted or sponsored by pharmaceutical, biotechnology and medical devicecompanies and other entities engaged in these activities. General economicdownturns, increased consolidation or decreased competition in the industriesin which these companies operate could result in fewer products underdevelopment or decreased pressure to accelerate product approval which, inturn, could materially adversely impact our revenues. Our operating results mayalso be adversely impacted by other developments that affect these industriesgenerally, including:

·                  thediscovery of safety issues with approved products or products in clinicaldevelopment;

·                  theassertion of product liability claims;

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·                  changesin third-party reimbursement practices;

·                  changesin medical practices; and

·                  changesin the purchasing patterns of entities conducting clinical research andmonitoring safety.

Any decrease inresearch and development expenditures or in the size, scope or frequency ofclinical trial, post approval and safety monitoring activities conducted orsponsored by pharmaceutical, biotechnology or medical device companies or otherentities as a result of the foregoing or other factors could materiallyadversely affect our operations or financial condition.

***We operate in a highly competitive industry and if we arenot able to compete effectively, our business and operating results will beharmed.***

The market for oursoftware products, services and hosted solutions is characterized by rapidlychanging technologies, evolving industry standards and frequent new product andservice introductions and enhancements that may render existing products andservices obsolete. Accordingly, we are susceptible to rapid and significantdeclines in market share due to unforeseen changes in the features, functionsor pricing of competing products. Barriers to entry are relatively low and,with the introduction of new technologies and new market entrants, we expectthat competition will increase. Increased competition is likely to result inpricing pressures, which could negatively impact our sales, gross margins ormarket share. Our failure to compete effectively could materially adverselyaffect our business, financial condition or results of operations.

Some of ourcurrent competitors, as well as many of our potential competitors, have greatername recognition, longer operating histories and significantly greaterresources. As a result, our competitors may be able to respond more quickly andeffectively than we can to new or changing opportunities, technologies,standards or customer requirements. In addition, current and potentialcompetitors have established, and may in the future establish, cooperativerelationships with vendors of complementary products, technologies or servicesto increase the availability of their products to the marketplace. Accordingly,new competitors or alliances may emerge that have greater market share, largercustomer bases, more widely adopted proprietary technologies, greater marketingexpertise and larger sales forces than we have, which could put us at acompetitive disadvantage. Further, in light of these advantages, even if ourproducts and services are more effective than the product or service offeringsof our competitors, current or potential customers might accept competitiveproducts and services in lieu of purchasing our software products, services andhosted solutions. We cannot assure you that we can maintain or enhance ourcompetitive position against current and future competitors.

***Consolidation among our clients could cause us to loseclients, decrease the market for our products and result in a reduction of ourrevenues.***

Our customer base coulddecline because of consolidation, and we may not be able to expand sales of ourproducts and services to new clients. Consolidation in the pharmaceutical,biotechnology and medical device industries and among CROs has accelerated inrecent years, and we expect this trend to continue. In addition, new companiesor organizations that result from such consolidation may decide that ourproducts and services are no longer needed because of their own internalprocesses or the use of alternative systems. As these entities consolidate,competition to provide products and services to industry participants willbecome more intense and the importance of establishing relationships with largeindustry participants will become greater. These industry participants may tryto use their market power to negotiate price reductions for our products andservices. Also, if consolidation of larger current customers occur, thecombined organization may represent a larger percentage of business for us and,as a result, we are likely to rely more significantly on the combinedorganization’s revenues to continue to achieve growth.

***Changing customer or prospective customerrequirements could decrease the demand for our products and services, whichwould adversely affect our revenues and operating results.***

Our future successwill depend in large part on our ability to enhance and broaden our softwareproducts, services and hosted solutions to meet the evolving needs of ourcustomers and prospective customers. To achieve our goals, we need toeffectively respond to our customers’ and prospective customers’ needs,technological changes and new industry standards and developments in a timelymanner. If we are unable to enhance our existing product and service offeringsor develop new products and services to meet changing requirements, demand forour software products, services and hosted solutions could suffer and ourrevenues and operating results could be materially adversely affected. We couldalso incur substantial costs if we need to modify our products or services, orinformation technology infrastructure, to adapt to technological changes or newindustry standards or developments.

***Changes in regulations and regulatory guidance applicable toour customers or potential customers and the approval process for theirproducts may result in our inability to continue to do business.***

Demand for oursoftware products, services and hosted solutions is largely a function ofregulation and regulatory guidance associated with the approval and safetytracking of drugs, biological products and medical devices imposed upon theclinical trial process and post-approval activities by the U.S. federalgovernment and related regulatory authorities such as the FDA and by foreigngovernments. In recent years, efforts have been made to streamline the FDAapproval process and coordinate U.S. standards with those of other developedcountries. Any change in the scope of applicable regulations and regulatoryguidance could alter the type or amount of clinical trial or safety monitoringspending or negatively impact interest in our software products, services andhosted solutions. Any regulatory reform that limits or reduces the research anddevelopment or safety spending of our customers or potential customers uponwhich our business depends could have a material adverse effect on our revenuesor gross margins.

In addition, anyfailure to conform our software products, services and hosted solutions todomestic or international changes in regulations and regulatory guidanceapplicable to our customers or potential customers and the approval process fortheir products may result in our inability to continue to do business. Changingour software products, services and hosted solutions to allow our customers tocomply with future changes in regulation or regulatory guidance, either domesticallyor internationally, could cause us to incur substantial costs. We cannot assureyou that our product and service offerings will allow our customers andpotential customers 

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to stay in compliancewith regulations and regulatory guidance as they develop. If our product andservice offerings fail to allow our customers and potential customers tooperate in a manner that is compliant with applicable regulations andregulatory guidance, clinical trial sponsors and other entities engaged inclinical trial and safety monitoring activities may be unwilling to use oursoftware products, services and hosted solutions.

***Ifentities engaged in clinical trials do not shift from traditional paper-basedmethods of collecting clinical trial data to electronic system, we may notachieve the market penetration necessary to maintain profitability.***

If entitiesengaged in clinical trials are unwilling to use our electronic data capturesolutions or to change the way of collecting clinical trial data, our future growthand market share may be limited.  Mostclinical trials today rely on pre-printed, three-part paper case report formsfor data collection.  Our efforts toestablish an electronic process to capture clinical trial data are asignificant departure from the traditional paper-based methods of collectingclinical trial data.  As is typical fornew and rapidly evolving industries, customer demand for recently introducedtechnology is highly uncertain.  We maynot be successful in persuading entities engaged in clinical trials to changethe manner in which they have traditionally collected clinical trial data andto accept our software products, services and hosted solutions.  If we fail to convince entities engaged in clinicaltrials to use our methods of capturing clinical trial data, our revenues may belimited and we may fail to maintain profitability.

**RisksRelated to Our Company**

***Oursoftware products and hosted solutions are at varying stages of marketacceptance and the failure of any of our products to achieve or maintain wideacceptance would harm our operating results.***

*** ***We began offering our*InForm *electronic data capturesoftware solution for clinical trials in December 1998. Although the*Clintrial* and*Clintrace* products were introduced over 10 years ago,we did not begin offering these products until after our acquisition ofClinsoft Corporation in 2001.  We onlybegan begin offering our *WebVDME, CTSD*and*WedSDM* products after our August 2005acquisition of Lincoln. Continued use of our *InForm*,*Clintrial* and*Clintrace* software products, and broad and timelyacceptance of our*WebVDME, CTSD*and*WebSDM*products, as well as integratedsolutions combining one or more of our software products, is critical to ourfuture success and is subject to a number of significant risks, some of whichare outside our control. These risks include:

·                  ourcustomers’ and prospective customers’ desire for and acceptance of ourelectronic data capture, management and safety software solutions;

·                  ourability to meet product development and release schedules;

·                  oursoftware products and hosted solutions’ ability to support large numbers ofusers and manage vast amounts of data;

·                  ourcustomers’ ability to use our software products and hosted solutions, traintheir employees and successfully deploy our technology in their clinical trialand safety monitoring activities; and

·                  ourability to significantly expand our internal resources and increase our capitaland operating expenses to support the anticipated growth and continued integrationof our software products, services and hosted solutions.

Our failure toaddress, mitigate or manage these risks would seriously harm our business,particularly if the failure of any or all of our software products or hostedsolutions to achieve market acceptance negatively affects our sales of ourother products and services.

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***Our operating results may fluctuate and could cause themarket price of our common stock to fall rapidly and without notice.***

Our revenues andoperating results are difficult to predict and may fluctuate from quarter toquarter, particularly because of the evolving market in which we operate andour term license model. Our results of operations in any given quarter will bebased on a number of factors, including:

·                  thetiming and mix of license and services revenues, and the amount and type ofservice required in delivering certain projects;

·                  changesin and timing of our operating expenses;

·                  theextent to which our software products, services and hosted solutions achieve ormaintain market acceptance;

·                  ourability to introduce new products and services and enhancements to our existingproducts and services on a timely basis;

·                  thecompetitive environment in which we operate;

·                  ourability to hire and retain qualified personnel;

·                  changesin the regulatory environment related to the clinical trial and safetymonitoring market;

·                  changesin our customers’ purchasing patterns;

·                  thefinancial condition of our current and potential customers; and

·                  thetiming, size and integration success of potential future acquisitions.

A significantportion of our operating expense is relatively fixed in nature and plannedexpenditures are based in part on expectations regarding future revenues.Accordingly, unexpected revenue shortfalls or operating expenses may decreaseour gross margins and could cause significant changes in our operating resultsfrom quarter to quarter. Results of operations in any quarterly period shouldnot be considered indicative of the results to be expected for any futureperiod. In addition, our future quarterly operating results may fluctuate andmay not meet the expectations of securities analysts or investors. If thisoccurs, the trading price of our common stock could fall substantially eithersuddenly or over time.

***The loss of one or more major customers could materially andadversely affect our results of operations and financial condition.***

Our top fivecustomers accounted for approximately 39% of our revenues during the ninemonths ended September 30, 2006. One customer, GlaxoSmithKline, accounted forapproximately 17% of our total revenues for the same period. The loss of any ofour major customers could have a material adverse effect on our results ofoperations or financial condition. We may not be able to maintain our customerrelationships, and our customers may not renew their agreements with us, whichcould adversely affect our results of operations or financial condition. Asignificant change in the liquidity or financial position of any of thesecustomers could also have a material adverse effect on the collect ability ofour accounts receivables, our liquidity and our future operating results.

***We may acquire or make investments in companies ortechnologies that could cause disruption of our business and loss of value ordilution to our stockholders.***

*** ***From time to time, we evaluatepotential investments in, and acquisitions of, complimentary technologies,services and businesses. We have made in the past, and may make in the future,acquisitions or significant investments in other businesses. For example, weacquired Clinsoft Corporation in 2001 and Lincoln in 2005.  Entering into an acquisition entails manyrisks, any of which could harm our business, including:

·                  difficultiesin integrating the operations, technologies, products, existing contracts andpersonnel of the target company and realizing the anticipated synergies of thecombined businesses;

·                  theprice we pay or other resources that we devote may exceed the value weeventually realize or the value we could have realized if we had allocated thepurchase price or other resources to another opportunity;

·                  potentialloss of key employees, customers and strategic alliances from either ourcurrent business or the target company’s business;

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·                  managingthe risks of entering markets or types of businesses in which we have limitedor no direct experience;

·                  thediversion of management’s attention from other business concerns; and

·                  assumptionof unanticipated problems or latent liabilities, such as problems with thequality of the target company’s products.

In addition, if wefinance any future acquisitions by issuing equity securities or convertibledebt, our existing stockholders may be diluted or the market price of our stockmay be adversely affected. The failure to successfully evaluate and executeacquisitions or investments or otherwise adequately address these risks couldmaterially harm our business and financial results.

***If we are unable to retain our personnel and hire additionalskilled personnel, we may be unable to achieve our goals.***

Our future successdepends upon our ability to attract, train and retain highly skilled employeesand contract workers, particularly our management team, sales and marketingpersonnel, professional services personnel and software engineers. Each of ourexecutive officers and other employees could terminate his or her relationshipwith us at any time. The loss of any member of our management team mightsignificantly delay or prevent the achievement of our business or developmentobjectives and could materially harm our business. In addition, because of thetechnical nature of our software products, services and hosted solutions andthe dynamic market in which we compete, any failure to attract and retain qualifieddirect sales, professional services and product development personnel, as wellas our contract workers, could have a material adverse affect on our ability togenerate sales, successfully develop new software products, services and hostedsolutions or software enhancements or deliver services and solutions asrequested by our customers.

***As a result of long sales cycles and our business model, wemay be required to spend substantial time and expense before we recognize asignificant portion of the revenues, if any, attributable to our customercontracts.***

The sales cyclefor some of our software solutions frequently takes in excess of nine monthsfrom initial customer contact to contract execution. During this time, we mayexpend substantial time, effort and financial resources without realizing anyrevenues with respect to the potential sale. In addition, while we generallybegin recognizing revenues upon the execution of our agreements for softwareterm licenses and related services, it may be difficult for us to rapidlyincrease our revenues through additional sales in any period, as licenserevenues and, when applicable, related services revenues, from new customersare recognized over the applicable license term, typically one to five years.As a result, we may not recognize significant revenues, if any, from somecustomers despite incurring considerable expense related to our sales,implementation, and service delivery processes. Even if we do realize revenuesfrom a contract, our term license pricing model may keep us from recognizing asignificant portion of these revenues (including revenues for related services)during the same period in which sales, implementation, and service deliveryexpenses were incurred. For example, pursuant to our contract withGlaxoSmithKline, we incurred significant up-front implementation and otherservice expenses associated with delivery of services for the initial ordersunder the contract, whereas the revenues for these initial orders are beingrecognized ratably over an approximately 5-year period from July 2004. Timingdifferences of this nature could cause our service gross margins andprofitability to fluctuate significantly from quarter to quarter. Similarly, adecline in new or renewed software term licenses in any one quarter will notnecessarily be fully reflected in the revenues in that quarter and maynegatively affect our revenues in future quarters. This could also cause ouroperating results to fluctuate from quarter to quarter.

***Failure to manage our rapid growth effectively could harmour business.***

We have beenexperiencing a period of rapid growth that is placing a significant strain onour operational and financial resources and our personnel. From January 1,1999 to March 31, 2006, the number of our employees increased from 35 to421.  To manage our anticipated future growth effectively, we mustcontinue to maintain and may need to enhance our information technologyinfrastructure, financial and accounting systems and controls and manageexpanded operations in geographically distributed locations. We will also berequired to attract, integrate, train and retain a significant number ofqualified sales and marketing personnel, professional services personnel,software engineers and other management personnel. Our failure to manage ourrapid growth effectively could have a material adverse effect on our business,operating results or financial condition.

***Claims that we or our technologies infringe upon theintellectual property or other proprietary rights of a third party may requireus to incur significant costs, to enter into royalty or licensing agreements orto develop or license substitute technology.***

We have been, andmay in the future be, subject to claims that our technologies infringe upon theintellectual property or other proprietary rights of a third party. Forinstance, we recently settled a lawsuit filed in 2004 by Dr. Mark L.Kozam, doing business under the name MLK Software and Datasci, LLC against usand one of our customers which alleged that we infringed a patent claimed to beowned by them. We incurred substantial professional fees in connection withthis claim and agreed to make a one-time payment of $8.5 million to Datasci inorder to settle this litigation. In addition, the vendors who provide us withtechnology that we use in our technology could become subject to similarinfringement claims. Although we believe that our software solutions do not 

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infringe the patents of any third party, we cannotassure you that our technology does not infringe patents held by others or thatthey will not in the future. Any future claims of infringement could cause usto incur substantial costs defending against the claim, even if the claim iswithout merit, and could distract our management from our business. Moreover,any settlement or adverse judgment resulting from the claim could require us topay substantial amounts or obtain a license to continue to use the technologythat is the subject of the claim, or otherwise restrict or prohibit our use ofthe technology. There can be no assurance that we would be able to obtain alicense from the third party asserting the claim on commercially reasonableterms, if at all, that we would be able to successfully develop alternativetechnology on a timely basis, if at all, or that we would be able to obtain alicense from another provider of suitable alternative technology to permit usto continue offering, and our customers to continue using, the applicabletechnology. In addition, we generally provide in our customer agreements thatwe will indemnify our customers against third-party infringement claimsrelating to our technology provided to the customer, which could obligate us tofund significant amounts. Infringement claims asserted against us or our vendorsmay have a material adverse effect on our business, results of operations orfinancial condition.

***We may be unable to adequately protect, and we may incursignificant costs in defending, our intellectual property and other proprietaryrights.***

Our success dependson our ability to protect our intellectual property and other proprietaryrights. We rely upon a combination of trademark, trade secret, copyright,patent and unfair competition laws, as well as license agreements and othercontractual provisions, to protect our intellectual property and otherproprietary rights. In addition, we attempt to protect our intellectualproperty and proprietary information by requiring our employees and consultantsto enter into confidentiality, non-competition and assignment of inventionsagreements. To the extent that our intellectual property and other proprietaryrights are not adequately protected, third parties might gain access to ourproprietary information, develop and market products or services similar toours, or use trademarks similar to ours, each of which could materially harmour business. Existing U.S. federal and state intellectual property laws offeronly limited protection. Moreover, the laws of other countries in which wemarket our software products, services and hosted solutions may afford littleor no effective protection of our intellectual property. If we resort to legalproceedings to enforce our intellectual property rights or to determine thevalidity and scope of the intellectual property or other proprietary rights ofothers, the proceedings could be burdensome and expensive, even if we were toprevail. The failure to adequately protect our intellectual property and otherproprietary rights may have a material adverse effect on our business, resultsof operations or financial condition.

***Interruptions or delays in service from our third-partyproviders could impair the delivery of our hosted solutions and harm ourbusiness.***

*** ***We host some of our softwaresolutions, primarily our *InForm*hostedsolution, at third-party facilities. Consequently, the occurrence of a naturaldisaster, technical or service lapses, or other unanticipated problems at thefacilities of our third-party providers could result in unanticipatedinterruptions in our customers’ access to our hosted**solutions. Our hosted services may also be subject tosabotage, intentional acts of malfeasance and similar misconduct due to thenature of the Internet. In the past, Internet users have occasionallyexperienced difficulties with Internet and online services due to system orsecurity failures. We cannot assure you that our business interruptioninsurance will adequately compensate our customers or us for losses that mayoccur. Even if covered by insurance, any failure or breach of security of oursystems could damage our reputation and cause us to lose customers. Further,certain of our hosted*InForm *electronicdata capture solutions are subject to service level agreements that guarantee95% to 99% server availability. In the event that we fail to meet those levels,whether resulting from an interruption in service caused by our technology orthat of a third-party provider, we could be subject to customer credits ortermination of these customer contracts.

***Failure of our technology and products could harm ourbusiness and operating results.***

The technologyunderlying our software products and hosted solutions processes vast amounts ofclinical and safety data. Customers relying on our products to collect, tomanage and report clinical and safety information may have a greatersensitivity to product errors and security vulnerabilities than customers ofsoftware products in general. In the past, failures of our technology and humanerror have negatively impacted the data capture, management or reportingcapabilities of our products, and new errors may be detected in the future. Anydelay or failure of our technology may result in the disruption of ourcustomers’ clinical trial or safety monitoring processes and could harm ourbusiness and operating results. Product or service errors could materially andadversely affect our reputation, result in significant costs to us and impairour ability to sell our products and services in the future. The costs incurredin correcting any defects or errors may be substantial and could adverselyaffect our operating margins. In addition, security breaches, whetherintentional or accidental, could expose us to a risk of loss of data,litigation and possible liability.

 ***We have incurred substantial lossesin the past and may not continue to be profitable in the future.***

We incurredsignificant losses in each year from our inception in September 1997through 2003 and we may incur significant operating losses in the future. As aresult of our operating losses and accretion of preferred dividends, we had anaccumulated deficit of $94.2 million at September 30, 2006. You should notconsider recent revenue growth as indicative of our future performance as our 

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operating results may fluctuate significantly fromquarter to quarter. In addition, we expect our development, sales and otheroperating expenses to increase in the future. If our revenues do not grow tooffset these expected increased expenses, we may not continue to be profitable.In fact, in future quarters we may not have any revenue growth and our revenuescould decline. Furthermore, if our operating expenses exceed our expectations,our financial performance will be adversely affected.

***The global nature of our business exposes us to multiplerisks.***

For the nine months ended September 30, 2006,approximately 49% of our revenues were derived from internationaloperations.  We expect that ourinternational operations will continue to account for a significant portion ofour revenues.  As a result of ourinternational operations, we are exposed to many risks and uncertainties,including:

·                  difficultiesin staffing, managing and supporting operations in multiple countries;

·                  tariffand international trade barriers;

·                  fewerlegal protections for intellectual property and contract rights abroad;

·                  differentand changing legal and regulatory requirements in the jurisdictions in which wecurrently operate or may operate in the future;

·                  governmentcurrency control and restrictions on repatriation of earnings;

·                  fluctuationsin foreign currency exchange and interest rates; and

·                  politicaland economic changes, hostilities and other disruptions in regions where wecurrently operate or may operate in the future.

Negativedevelopments in any of these areas in one or more countries could result in areduction in demand for our software products, services and hosted solutions,the cancellation or delay of orders already placed, threats to our intellectualproperty, difficulty in collecting receivables, and a higher cost of doing business,any of which could adversely affect our business, results of operations orfinancial condition. Moreover, with regard to our international operations, wefrequently enter into transactions in currencies other than the U.S. dollar andwe incur operating expenses in currencies other than the U.S. dollar. Thiscreates a foreign currency exchange risk for us that could have a materialadverse effect on our results of operations and financial condition.

***We may lose or delay revenues related to our hostedsolutions and consulting services if our customers terminate or delay theircontracts with us.***

Certain of ourhosted electronic data capture and other service and consulting contracts aresubject to cancellation by our customers at any time with limited notice.Entities engaged in clinical trials may terminate or delay a clinical trial forvarious reasons including the failure of the tested product to satisfy safetyor efficacy requirements, unexpected or undesired clinical results, decisionsto de-emphasize a particular product or forego a particular clinical trial,decisions to downsize clinical development programs, insufficient patientenrollment or investigator recruitment and production problems resulting inshortages of required clinical supplies. In the case of our hosted solutions,any termination or delay in the clinical trials would likely result in aconsequential delay or termination in those customers’ service contracts. Wehave experienced terminations and delays of our customer service contracts inthe past and expect to experience additional terminations and delays in thefuture. Because we do not recognize any portion of a hosted service contract’srevenues until the implementation cycle is complete, the termination or delayof our customers’ clinical trials could result in decreased or delayed revenuesunder these contracts which could materially harm our business.

***In the course of conducting our business, we possess orcould be deemed to possess personal medical information in connection with theconduct of clinical trials, which if we fail to keep properly protected, couldsubject us to significant liability.***

*** ***Our software solutions are usedto collect, manage and report information in connection with the conduct ofclinical trial and safety monitoring activities. This information is or couldbe considered to be personal medical information of the clinical trialparticipants or patients. Regulation of the use and disclosure of personalmedical information is complex and growing. Increased focus on individuals’rights to confidentiality of their personal information, including personalmedical information, could lead to an increase of existing and futurelegislative or regulatory initiatives giving direct legal remedies toindividuals, including rights to damages, against entities deemed responsiblefor not adequately securing such personal information. In addition, courts maylook to regulatory standards in identifying or applying a common law theory ofliability, whether or not that law affords a private right of action. Since wereceive and process personal information of clinical trial participants andpatients from customers utilizing our hosted solutions, there is a risk that wecould be liable if there were a breach of any obligation to a protected personunder contract, standard 

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of practice or regulatory requirement. If we fail toproperly protect this personal information that is in our possession or deemedto be in our possession, we could be subjected to significant liability.

***We could incur substantial costs resulting from productliability claims relating to our products or services or our customers’ use ofour products or services.***

Any failure orerrors in a customer’s clinical trial, post approval or adverse event reportingobligations caused or allegedly caused by our products or services could resultin a claim for substantial damages against us by our customers or the clinicaltrial participants, regardless of our responsibility for the failure. Althoughwe are generally entitled to indemnification under our customer contractsagainst claims brought against us by third parties arising out of our customers’use of our products, we might find ourselves entangled in lawsuits against usthat, even if unsuccessful, divert our resources and energy and adverselyaffect our business. Further, in the event we seek indemnification from acustomer, we cannot assure you that a court will enforce our indemnificationright if challenged by the customer obligated to indemnify us or that the customerwill be able to fund any amounts for indemnification owed to us. We also cannotassure you that our existing general liability insurance coverage will continueto be available on reasonable terms or will be available in amounts sufficientto cover one or more large claims, or that the insurer will not disclaimcoverage as to any future claim.

***We and our products and services could be subjected togovernmental regulation, requiring us to incur significant compliance costs orto cease offering our products and services.***

The clinical trialprocess is subject to extensive and strict regulation by the FDA, as well asother regulatory authorities worldwide. Our electronic data capture, managementand safety products and services could be subjected to state, federal andforeign regulations. We cannot assure you that our products and serviceofferings will comply with applicable regulations and regulatory guidelines asthey develop. If our products or services fail to comply with any applicablegovernment regulations or guidelines, we could incur significant liability orbe forced to cease offering our applicable products or services. Also,conforming our products and services to any applicable regulations andguidelines could substantially increase our operating expenses.

***Our business could be seriously harmed by our dependence ona limited number of suppliers.***

We depend upon alimited number of suppliers for specific components of our software productsand hosted solutions. We may increase our dependence on certain suppliers as wecontinue to develop and enhance our software and service solutions. Ourdependence on a limited number of suppliers leaves us vulnerable to having aninadequate supply of required components, price increases, delayed supplierperformance and poor component quality. For instance, we rely on OracleCorporation to supply the database component of our software solutions and onEquinix, Inc. to provide server facilities for our hosting services.Oracle Corporation also offers a software package that is competitive with ourproducts and services. If we are unable to obtain components for our softwaresolutions from third-party suppliers in the quantities and of the quality thatwe need, on a timely basis or at acceptable prices, we may not be able todeliver our software products, services and hosted solutions on a timely orcost-effective basis to our customers, and our business, results of operationsand financial condition could be seriously harmed. Moreover, delays orinterruptions in our service, including without limitation delays orinterruptions resulting from a change in suppliers, may reduce our revenues,cause customers to terminate their contracts and adversely affect our customerrenewals.

***We may not be able to obtain capital when desired onfavorable terms, if at all, or without dilution to our stockholders.***

We anticipate thatour current cash and cash equivalents will be sufficient to meet our currentneeds for general corporate purposes. However, we may need additional financingto execute on our current or future business strategies, including to:

·                  hireadditional personnel;

·                  developnew or enhance existing software products, services and hosted solutions;

·                  enhanceour operating infrastructure;

·                  acquirebusinesses or technologies; or

·                  otherwiserespond to competitive pressures.

If we raiseadditional funds through the issuance of equity or convertible debt securities,the percentage ownership of our stockholders could be significantly diluted,and these newly issued securities may have rights, preferences or privilegessenior to those of existing stockholders. We cannot assure you that additionalfinancing will be available on terms favorable to us, or at all. If adequatefunds are not available or are not available on acceptable terms, when wedesire them, our ability to fund our operations, take 

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advantage of unanticipated opportunities, develop orenhance our software products, services and hosted solutions, or otherwiserespond to competitive pressures would be significantly limited.

**RisksRelated to our Common Stock**

***The market price of our common stock may be volatile, whichcould result in substantial losses for investors purchasing shares in thepublic markets and subject us to securities class action litigation. The currentmarket price of our common stock may not be indicative of future market pricesand we may be unable to sustain or increase the value of an investment in ourcommon stock.***

Market prices forsecurities of software, technology and health care companies have beenvolatile. The trading price of our common stock may fluctuate significantlyand, accordingly, may not be indicative of future trading prices and we may beunable to sustain or increase the value of an investment in our common stock.Some of the factors that may cause the market price of our common stock tofluctuate include:

·                  changesin estimates of our financial results or recommendations by securitiesanalysts;

·                  financialresults that are below estimate of such results;

·                  period-to-periodfluctuations in our financial results or those of companies that are perceivedto be similar to us;

·                  changesin market valuations of similar companies;

·                  announcementsby us or our competitors of significant products, contracts, acquisitions orstrategic alliances;

·                  litigationinvolving our company or our general industry or both;

·                  thefailure of any of our software products, services and hosted solutions toachieve or maintain commercial success;

·                  successof competitive products and technologies;

·                  salesor transfers of large blocks of stock by existing investors;

·                  futureissuances of securities or the incurrence of debt by us, or other changes inour capital structure;

·                  regulatorydevelopments in the United States and foreign countries;

·                  additionsor departures of key personnel;

·                  investors’general perception of us; and

·                  changesin general economic, industry and market conditions.

In addition, ifthe market for software, technology or health care stocks or the stock marketin general experiences a loss of investor confidence, the trading price of ourcommon stock could decline for reasons unrelated to our business, operatingresults or financial condition. If any of the foregoing occurs, it could causeour stock price to fall and may expose us to class action lawsuits that, evenif unsuccessful, could be costly to defend and a distraction to management.

***Ownership of our common stock is concentrated among a smallnumber of stockholders and sales of a large block of which could cause themarket price of our common stock to drop significantly, even if our business isdoing well.***

A relatively smallnumber of our stockholders own large blocks of shares. We cannot predict theeffect, if any, that public sales of these shares or the availability of theseshares for sale will have on the market price of our common stock. If ourstockholders, and particularly our directors and officers, sell substantialamounts of our common stock in the public market, or if the public perceivesthat such sales could occur, this could have an adverse impact on the marketprice of our common stock, even if there is no relationship between such salesand the performance of our business.

***Our directors and management may be able to exercisesignificant control over our company.***

At September 30,2006, our directors and executive officers and their affiliates beneficiallycontrolled approximately 17% of our outstanding common stock. As a result,these stockholders, if they act together, are able to influence our managementand affairs and 

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all matters requiring stockholder approval, includingthe election of directors and approval of significant corporate transactions.This concentration of ownership may have the effect of delaying or preventing achange in control of our company and might affect the market price of ourcommon stock.

***Delaware law and our corporate documents may prevent orfrustrate a change in control or a change in management that stockholdersbelieve is desirable.***

Provisions of ourcertificate of incorporation and bylaws and Delaware law may discourage, delayor prevent a merger, acquisition or other change in control that stockholdersmay consider favorable, including transactions in which you might otherwisereceive a premium for your shares. These provisions may also prevent orfrustrate attempts by our stockholders to replace or remove our management.These provisions include:

·                  limitationson the removal of directors;

·                  advancenotice requirements for stockholder proposals and nominations;

·                  theinability of stockholders to act by written consent or to call specialmeetings; and

·                  theability of our board of directors to designate the terms of and issue newseries of preferred stock without stockholder approval, which could be used toinstitute a rights plan, or a poison pill, that would work to dilute the stockownership of a potential hostile acquirer, likely preventing acquisitions thathave not been approved by our board of directors.

The affirmativevote of the holders of at least 75% of our shares of capital stock entitled tovote is necessary to amend or repeal the above provisions of our certificate ofincorporation. In addition, absent approval of our board of directors, ourbylaws may only be amended or repealed by the affirmative vote of the holdersof at least 75% of our shares of capital stock entitled to vote.

In addition,Section 203 of the Delaware General Corporation Law prohibits a publiclyheld Delaware corporation from engaging in a business combination with aninterested stockholder, generally a person which together with its affiliatesowns, or within the last three years has owned, 15% of our voting stock, for aperiod of three years after the date of the transaction in which the personbecame an interested stockholder, unless the business combination is approvedin a prescribed manner.

The existence ofthe foregoing provisions could limit the price that investors might be willingto pay in the future for shares of our common stock.

**Item 5.**                          *Other Information*

Our policygoverning transactions in our securities by directors, officers and employeespermits our officers, directors and certain other persons to enter into tradingplans complying with Rule 10b5-1 under the Securities Exchange Act of1934, as amended. We have been advised that our Vice President, HumanResources, Victor P. Becker; our Chairman and Chief Strategy Officer, Paul A.Bleicher; our Vice President, General Counsel and Secretary, D. Ari Buchler;our Vice President of Worldwide Sales, Stephen J. Powell; our Senior VicePresident, Steven J. Rosenberg; and our President and Chief Executive Officer,Robert K. Weiler have each entered into a trading plan covering periods afterthe date of this Quarterly Report in accordance with Rule 10b5-1 and our policygoverning transactions in our securities. Generally, under these trading plans, the individual relinquishescontrol over the transactions once the trading plan is put into place.  Accordingly, sales under these plans mayoccur at any time, including possibly before, simultaneously with, or immediatelyafter significant events involving our company.

**We anticipate that, as permitted byRule 10b5-1 and our policy governing transactions in our securities, someor all of our officers, directors and employees may establish trading plans inthe future. We intend to disclose the names of executive officers and directorswho establish a trading plan in compliance with Rule 10b5-1 and therequirements of our policy governing transactions in our securities in ourfuture quarterly and annual reports on Form 10-Q and 10-K filed with theSecurities and Exchange Commission. However, we undertake no obligation toupdate or revise the information provided herein, including for revision ortermination of an established trading plan, other than in such quarterly andannual reports.**

 

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**Item 6.  *Exhibits.***
| Exhibit | ** ** | ** **                                                                                                                    | ** ** |
|---------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| **No.** | ** ** | **Description**                                                                                                               | ** ** |
| 10.1    |       | Amendment No. 1 to  Agreement and Plan of Merger by and among Phase Forward, Lincoln and Lincoln  SR dated                    |       |
|    |       | as of  September 13, 2006 (Incorporated by reference herein to Exhibit 10.1 to  the Company’s Current Report on     |       |
|    |       | Form 8-K filed with the  SEC on September 15, 2006).                                                                          |       |
| 31.1    |       | Certification of  CEO pursuant to Rule 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934.     |       |
| 31.2    |       | Certification of  CFO pursuant to rules 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934.    |       |
| 32.1    |       | Certification of  CEO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |       |
| 32.2    |       | Certification of  CFO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |       |
|    |       |                                                                                                                          |       |

 

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**SIGNATURES**

Pursuant to the requirement of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned there unto duly authorized.
|                             | **PHASE FORWARD  INCORPORATED** |
|-----------------------------|---------------------------------|
|                        | By:                             | /s/ ROBERT K. WEILER |
|                        |                            | Robert K. Weiler  Chief Executive Officer  (Duly authorized officer) |
|                        | By:                             | /s/ RODGER WEISMANN |
|                        |                            | Rodger Weismann  Chief Financial Officer  (Duly authorized officer and  principal financial officer) |
| Date: November 1, 2006 |                            |   |

 

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** **

**EXHIBIT INDEX**
| Exhibit | ** ** | ** **                                                                                                                    | ** ** |
|---------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| **No.** | ** ** | **Description**                                                                                                               | ** ** |
| 10.1    |       | Amendment No. 1 to  Agreement and Plan of Merger by and among Phase Forward, Lincoln and Lincoln  SR dated                    |       |
|    |       | as of  September 13, 2006 (Incorporated by reference herein to Exhibit 10.1 to  the Company’s Current Report on     |       |
|    |       | Form 8-K filed with the  SEC on September 15, 2006).                                                                          |       |
| 31.1    |       | Certification of  CEO pursuant to Rule 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934.     |       |
| 31.2    |       | Certification of  CFO pursuant to rules 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934.    |       |
| 32.1    |       | Certification of  CEO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |       |
| 32.2    |       | Certification of  CFO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |       |

 

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