** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **
| x                                                                                                                                                                                                                                                 | ** ** | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                        | ** ** | ** **                                                                                    |
| **For the quarterly period ended September 30,  2007**                                                                                                                                                                                       |
| ** **                                                                                                                                                                                                                                        | ** ** | ** **                                                                                    |
| **OR**                                                                                                                                                                                                                                            |
| ** **                                                                                                                                                                                                                                        | ** ** | ** **                                                                                    |
| **o**                                                                                                                                                                                                                                             | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                        | ** ** | ** **                                                                                    |
| **For the transition period  from                 to                 ** |

 

**Commission File Number: 000-50839**

 

**Phase Forward Incorporated**

(Exact name of registrant as 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 markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.

 

Yes   x   No   o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated 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 markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

Yes   o   No   x

 

As of October 31,2007, the registrant had 42,293,282 shares of Common Stock outstanding.

 

 

----

 

**PHASEFORWARD INCORPORATEDQUARTERLY REPORT ON FORM 10-QFor the quarterly period ended September 30, 2007Table of Contents**

** **
| ** **                                  | ** ** | ** **                                                                                                                                                    | ** ** | **Page  Number** |
|---------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|
| **Part I—Financial  Information** |       |                                                                                                                                                          |
| ** **                                  | ** ** | ** **                                                                                                                                                    | ** ** | ** **       |
| Item 1.                                     |       | Condensed Consolidated  Balance Sheets as of December 31, 2006 (unaudited) and September 30,  2007 (unaudited)                                      |       | 3                |
|                                        |       |                                                                                                                                                          |       |             |
|                                        |       | Condensed  Consolidated Statements of Income for the three and nine months ended September 30,  2006 (unaudited) and September 30, 2007 (unaudited) |       | 4                |
|                                        |       |                                                                                                                                                          |       |             |
|                                        |       | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2006 (unaudited) and September 30, 2007 (unaudited)       |       | 5                |
|                                        |       |                                                                                                                                                          |       |             |
|                                        |       | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                                             |       | 6                |
|                                        |       |                                                                                                                                                          |       |             |
| Item 2.                                     |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                   |       | 21               |
|                                        |       |                                                                                                                                                          |       |             |
| Item 3.                                     |       | Quantitative  and Qualitative Disclosures about Market Risk                                                                                                   |       | 38               |
|                                        |       |                                                                                                                                                          |       |             |
| Item 4.                                     |       | Controls and  Procedures                                                                                                                                      |       | 39               |
|                                        |       |                                                                                                                                                          |       |             |
| **Part II—Other  Information**    |       |                                                                                                                                                          |
| ** **                                  | ** ** | ** **                                                                                                                                                    | ** ** | ** **       |
| Item 1.                                     |       | Legal Proceedings                                                                                                                                             |       | 40               |
|                                        |       |                                                                                                                                                          |       |             |
| Item 1A.                                    |       | Risk Factors                                                                                                                                                  |       | 40               |
|                                        |       |                                                                                                                                                          |       |             |
| Item 5.                                     |       | Other Information                                                                                                                                             |       | 40               |
|                                        |       |                                                                                                                                                          |       |             |
| Item 6.                                     |       | Exhibits                                                                                                                                                      |       | 41               |
|                                        |       |                                                                                                                                                          |       |             |
| Signatures                                  |       |                                                                                                                                                          |       | 42               |
|                                        |       |                                                                                                                                                          |       |             |
| Exhibit Index                          |       | 43                                                                                                                                                            |

 

2

----

 

**Part I—Financial Information**

 

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

 

**Phase Forward Incorporated****Condensed Consolidated Balance Sheets**

**(unaudited)****(in thousands, except per share amounts)**

 
| ** **                                                                                              | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                              | ** ** | **2007**                               | ** ** |
| **Assets**                                                                                              | ** ** | ** **                            | ** ** | ** **                             | ** ** |
| Current assets:                                                                                         |       |                                  |       |                                   |       |
| Cash and cash equivalents                                                                               |       | $                                     | 42,169     |                                   | $          | 157,134 |   |
| Short-term investments                                                                                  |       | 27,466                                |       | 29,832                                 |       |
| Accounts receivable, net of allowance of $384 and  $426 in 2006 and 2007, respectively                  |       | 29,652                                |       | 27,990                                 |       |
| Deferred set up costs, current portion                                                                  |       | 1,649                                 |       | 2,201                                  |       |
| Prepaid commissions and royalties, current portion                                                      |       | 3,570                                 |       | 4,865                                  |       |
| Prepaid expenses and other current assets                                                               |       | 2,972                                 |       | 3,691                                  |       |
| Deferred income taxes                                                                                   |       | 5,158                                 |       | 5,150                                  |       |
| Total current assets                                                                                    |       | 112,636                               |       | 230,863                                |       |
| Property and equipment, net                                                                             |       | 8,561                                 |       | 12,023                                 |       |
| Deferred set up costs, net of current portion                                                           |       | 1,000                                 |       | 1,263                                  |       |
| Prepaid commissions and royalties, net of current  portion                                              |       | 2,670                                 |       | 3,205                                  |       |
| Intangible assets, net of accumulated amortization  of $1,176 and $1,814 in 2006 and 2007, respectively |       | 2,724                                 |       | 2,086                                  |       |
| Goodwill                                                                                                |       | 27,820                                |       | 27,268                                 |       |
| Deferred income taxes                                                                                   |       | 4,988                                 |       | 4,569                                  |       |
| Other assets                                                                                            |       | 252                                   |       | 259                                    |       |
| Total assets                                                                                            |       | $                                     | 160,651    |                                   | $          | 281,536 |   |
|                                                                                                    |       |                                  |       |                                   |       |
| **Liabilities and Stockholders’ Equity**                                                           | ** ** | ** **                            | ** ** | ** **                             | ** ** |
| Current liabilities:                                                                                    |       |                                  |       |                                   |       |
| Accounts payable                                                                                        |       | $                                     | 2,893      |                                   | $          | 2,497 |   |
| Accrued expenses                                                                                        |       | 14,183                                |       | 18,070                                 |       |
| Accrued earn-out                                                                                        |       | 3,500                                 |       | 3,500                                  |       |
| Deferred revenues, current portion                                                                      |       | 47,128                                |       | 56,731                                 |       |
| Deferred rent, current portion                                                                          |       | 352                                   |       | 417                                    |       |
| Total current liabilities                                                                               |       | 68,056                                |       | 81,215                                 |       |
|                                                                                                    |       |                                  |       |                                   |       |
| Deferred revenues, net of current portion                                                               |       | 3,527                                 |       | 3,273                                  |       |
| Deferred rent, net of current portion                                                                   |       | 596                                   |       | 70                                     |       |
| Other long-term liabilities                                                                             |       | 451                                   |       | —                                 |       |
| Total liabilities                                                                                       |       | 72,630                                |       | 84,558                                 |       |
|                                                                                                    |       |                                  |       |                                   |       |
| Contingencies (Note 13)                                                                                 |       |                                  |       |                                   |       |
|                                                                                                    |       |                                  |       |                                   |       |
| Stockholders’ equity:                                                                              |       |                                  |       |                                   |       |
| Preferred stock, $0.01 par value:                                                                       |       |                                  |       |                                   |       |
| Authorized—5,000 shares                                                                            |       |                                  |       |                                   |       |
| Issued—0 shares                                                                                    |       | —                                |       | —                                 |       |
| Common stock, $0.01 par value:                                                                          |       |                                  |       |                                   |       |
| Authorized—100,000 shares                                                                          |       |                                  |       |                                   |       |
| Issued—35,529 and 42,319 shares in 2006 and 2007,  respectively                                    |       | 355                                   |       | 423                                    |       |
| Additional paid-in capital                                                                              |       | 176,545                               |       | 271,179                                |       |
| Treasury stock, 37 shares at cost                                                                       |       | (111                                  | )          | (111                                   | )          |
| Accumulated other comprehensive (loss) income                                                           |       | (72                                   | )          | 656                                    |       |
| Accumulated deficit                                                                                     |       | (88,696                               | )          | (75,169                                | )          |
| Total stockholders’ equity                                                                         |       | 88,021                                |       | 196,978                                |       |
| Total liabilities and stockholders’ equity                                                         |       | $                                     | 160,651    |                                   | $          | 281,536 |   |

 

See accompanyingnotes.

 

3

----

 

**PhaseForward Incorporated****CondensedConsolidated Statements of Income**

**(unaudited)****(in thousands,except per share amounts)**

 
| ** **                                                                           | ** ** | **Three Months Ended  September 30****,** | ** ** | **Nine Months Ended  September 30****,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                                                 | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **2007** | ** ** |
| Revenues:                                                                            | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| License                                                                              |       | $                                                        | 11,225     |                                                    | $          | 12,924 |   | $ | 29,633 |   | $ | 35,429 |   |
| Service                                                                              |       | 16,824                                                   |       | 21,952                                                  |       | 46,754 |   | 61,065 |   |
| ** **                                                                           | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenues                                                                       |       | 28,049                                                   |       | 34,876                                                  |       | 76,387 |   | 96,494 |   |
| Costs of revenues:                                                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| License                                                                              |       | 717                                                      |       | 552                                                     |       | 2,020 |   | 1,686 |   |
| Service(1)                                                                           |       | 10,079                                                   |       | 13,561                                                  |       | 27,981 |   | 37,447 |   |
| ** **                                                                           | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total cost of revenues                                                               |       | 10,796                                                   |       | 14,113                                                  |       | 30,001 |   | 39,133 |   |
| Gross margin:                                                                        |       |                                                     |       |                                                    |       |   |   |   |   |
| License                                                                              |       | 10,508                                                   |       | 12,372                                                  |       | 27,613 |   | 33,743 |   |
| Service                                                                              |       | 6,745                                                    |       | 8,391                                                   |       | 18,773 |   | 23,618 |   |
| ** **                                                                           | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total gross margin                                                                   |       | 17,253                                                   |       | 20,763                                                  |       | 46,386 |   | 57,361 |   |
|                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Operating expenses:                                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| Sales and marketing(1)                                                               |       | 5,377                                                    |       | 6,509                                                   |       | 14,798 |   | 17,731 |   |
| Research and development(1)                                                          |       | 4,538                                                    |       | 5,066                                                   |       | 12,022 |   | 14,620 |   |
| General and administrative(1)                                                        |       | 4,551                                                    |       | 5,084                                                   |       | 13,138 |   | 14,509 |   |
| Total operating expenses                                                             |       | 14,466                                                   |       | 16,659                                                  |       | 39,958 |   | 46,860 |   |
| Income from operations                                                               |       | 2,787                                                    |       | 4,104                                                   |       | 6,428 |   | 10,501 |   |
| Other income (expense):                                                              |       |                                                     |       |                                                    |       |   |   |   |   |
| Interest income                                                                      |       | 735                                                      |       | 2,362                                                   |       | 2,010 |   | 4,758 |   |
| Other, net                                                                           |       | 14                                                       |       | (91                                                     | )          | (50 | ) | (153 | ) |
| Total other income                                                                   |       | 749                                                      |       | 2,271                                                   |       | 1,960 |   | 4,605 |   |
| Income before provision for income taxes                                             |       | 3,536                                                    |       | 6,375                                                   |       | 8,388 |   | 15,106 |   |
| Provision for income taxes                                                           |       | 642                                                      |       | 657                                                     |       | 1,520 |   | 1,579 |   |
|                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income                                                                           |       | $                                                        | 2,894      |                                                    | $          | 5,718 |   | $ | 6,868 |   | $ | 13,527 |   |
|                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income per share applicable to common  stockholders:                             | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                |       | $                                                        | 0.08       |                                                    | $          | 0.14 |   | $ | 0.20 |   | $ | 0.36 |   |
|                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Diluted                                                                              |       | $                                                        | 0.08       |                                                    | $          | 0.13 |   | $ | 0.19 |   | $ | 0.34 |   |
|                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average number of common shares used in net  income per share calculations: |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                                                |       | 35,147                                                   |       | 41,238                                                  |       | 34,386 |   | 37,643 |   |
| Diluted                                                                              |       | 36,620                                                   |       | 43,397                                                  |       | 35,921 |   | 39,659 |   |

 

----

(1)             Amounts includestock-based compensation expense, as follows:

 
| Costs of service revenues  |   | $   | 68     |   | $      | 102   |   | $     | 161    |   | $ | 330 |   |
|----------------------------|--------|-----|--------|--------|--------|-------|--------|-------|--------|--------|---|-----|--------|
| Sales and marketing        |   | 143 |   | 201    |   | 351   |   | 570   |   |
| Research and development   |   | 121 |   | 181    |   | 248   |   | 516   |   |
| General and administrative |   | 644 |   | 652    |   | 1,231 |   | 1,917 |   |

 

See accompanyingnotes.

 

4

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**PhaseForward Incorporated****CondensedConsolidated Statements of Cash Flows**

**(unaudited)****(in thousands)**

 
| ** **                                                                          | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                            | ** ** | **2007** | ** ** |
| **Operating activities**                                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net income                                                                          |       | $                                                   | 6,868      |   | $ | 13,527 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:  |       |                                                |       |   |   |
| Depreciation and amortization                                                       |       | 3,809                                               |       | 4,930 |   |
| Stock-based compensation                                                            |       | 1,991                                               |       | 3,333 |   |
| Loss on disposal of fixed assets                                                    |       | 51                                                  |       | — |   |
| Foreign currency exchange loss                                                      |       | 45                                                  |       | 160 |   |
| Provision for allowance for doubtful accounts                                       |       | 79                                                  |       | 75 |   |
| Deferred income taxes                                                               |       | (206                                                | )          | (4,554 | ) |
| Tax benefit related to exercise of stock options                                    |       | (1,027                                              | )          | — |   |
| Non-cash income tax expense                                                         |       | 1,329                                               |       | 5,410 |   |
| Amortization of premiums or discounts on short-term  investments                    |       | 39                                                  |       | 57 |   |
| Changes in assets and liabilities:                                                  |       |                                                |       |   |   |
| Accounts receivable                                                                 |       | 2,361                                               |       | 2,012 |   |
| Deferred costs                                                                      |       | (512                                                | )          | (2,498 | ) |
| Prepaid expenses and other current assets                                           |       | (398                                                | )          | (658 | ) |
| Accounts payable                                                                    |       | (225                                                | )          | (437 | ) |
| Accrued expenses                                                                    |       | 451                                                 |       | 3,337 |   |
| Accrued litigation settlement                                                       |       | (8,500                                              | )          | — |   |
| Deferred revenues                                                                   |       | 1,687                                               |       | 9,359 |   |
| Deferred rent                                                                       |       | (472                                                | )          | (452 | ) |
|                                                                                |       |                                                |       |   |   |
| Net cash provided by operating activities                                           |       | 7,370                                               |       | 33,601 |   |
|                                                                                |       |                                                |       |   |   |
| **Investing activities**                                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Proceeds from maturities of short-term investments                                  |       | 29,163                                              |       | 60,172 |   |
| Purchase of short-term investments                                                  |       | (44,186                                             | )          | (62,594 | ) |
| Purchase of property and equipment                                                  |       | (3,502                                              | )          | (7,707 | ) |
| (Increase) decrease in other assets                                                 |       | (32                                                 | )          | 1 |   |
| Payment on earn-out under acquisition                                               |       | (2,000                                              | )          | — |   |
|                                                                                |       |                                                |       |   |   |
| Net cash used in investing activities                                               |       | (20,557                                             | )          | (10,128 | ) |
|                                                                                |       |                                                |       |   |   |
| **Financing activities**                                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Proceeds from issuance of common stock                                              |       | 2,332                                               |       | 91,369 |   |
| Tax benefit related to exercise of options                                          |       | 1,027                                               |       | — |   |
|                                                                                |       |                                                |       |   |   |
| Net cash provided by financing activities                                           |       | 3,359                                               |       | 91,369 |   |
|                                                                                |       |                                                |       |   |   |
| Effect of exchange rate changes on cash and cash  equivalents                       |       | (174                                                | )          | 123 |   |
|                                                                                |       |                                                |       |   |   |
| Net change in cash and cash equivalents                                             |       | (10,002                                             | )          | 114,965 |   |
| Cash and cash equivalents at beginning of period                                    |       | 51,779                                              |       | 42,169 |   |
|                                                                                |       |                                                |       |   |   |
| Cash and cash equivalents at end of period                                          |       | 41,777                                              |       | 157,134 |   |
| Short-term investments at end of period                                             |       | 23,791                                              |       | 29,832 |   |
| Total cash, cash equivalents and short-term  investments at end of period           |       | $                                                   | 65,568     |   | $ | 186,966 |   |
|                                                                                |       |                                                |       |   |   |
| **Non-cash investing activities**                                                   |       |                                                |       |   |   |
| Accrued earn-out in connection with acquisition of  Lincoln Technologies, Inc. |       | $                                                   | 3,500      |   | $ | — |   |

 

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 informationpresented not 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 of September 30,2007, the results of its operations for the three and nine months ended September 30,2006 and 2007 and its cash flows for the nine months ended September 30,2006 and 2007. These unaudited condensed consolidated financial statements andnotes thereto should be read in conjunction with the audited consolidatedfinancial statements and notes thereto included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2006. The results ofoperations for the interim periods are not necessarily indicative of theresults of operations to be expected for the year ending December 31,2007.

 

As of September 30,2007, the Company’s significant accounting policies and estimates, which aredetailed in the Company’s Annual Report on Form 10-K for the year ended December 31,2006, have not changed except for the adoption of Financial AccountingStandards Board Interpretation (FASB) No. (FIN) 48, *Accountingfor Uncertainty in Income Taxes*. See Note 17 for additionalinformation regarding the Company’s adoption of FIN 48.

 

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

 

TheCompany derives revenues from software licenses and services. License revenuesare derived principally from the sale of term licenses for the Company’ssoftware products including: *InFormTM,ClintrialTM,**Clintrace*TM, *WebVDMETM*,*CTSDTM* and *WebSDMTM.*Service revenues arederived principally from the Company’s delivery 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,** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                             | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2007** | ** ** |
| License                      |       | $                                                    | 11,225     |                                                | $          | 12,924 |   | $ | 29,633 |   | $ | 35,429 |   |
| Application hosting services |       | 10,883                                               |       | 14,906                                              |       | 29,210 |   | 40,370 |   |
| Consulting services          |       | 3,048                                                |       | 3,475                                               |       | 8,405 |   | 9,999 |   |
| Customer support             |       | 2,893                                                |       | 3,571                                               |       | 9,139 |   | 10,696 |   |
|                         |       |                                                 |       |                                                |       |   |   |   |   |
| Total                        |       | $                                                    | 28,049     |                                                | $          | 34,876 |   | $ | 76,387 |   | $ | 96,494 |   |
|                              |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

TheCompany recognizes software license revenues in accordance with Statement ofPosition (“SOP”) No. 97-2, *SoftwareRevenue Recognition,* as amended, issued by the American Institute ofCertified Public Accountants (“AICPA”), while revenues resulting fromapplication hosting services are recognized in accordance with Emerging IssuesTask Force (“EITF”) Issue No. 00-3, *Applicationof AICPA Statement of Position 97-2 to Arrangements that include the Right toUse Software Stored on Another Entity’s Hardware*, SEC StaffAccounting Bulletin (“SAB”) No. 104, *RevenueRecognition*, and EITF Issue No. 00-21, *Revenue Arrangements with MultipleDeliverables.*

 

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 be terminatedby either party for material breach of obligations not corrected within30 days after notice of the breach.

 

6

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TheCompany recognizes revenues when all of the following conditions are satisfied:(1) there is persuasive evidence of an arrangement; (2) the productor service has been provided to the customer; (3) the collection of feesis probable; and (4) the amount of fees to be paid by the customer isfixed or determinable.

 

TheCompany typically 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 annual or multi-year terms. These arrangements typicallyinclude multiple elements: software license, consulting services and customersupport. The Company bills its customers in accordance with the terms of theunderlying contract. Generally, the Company bills license fees annually inadvance for each year of the license term. Payment terms are generally net30 days.

 

TheCompany’s software license revenues are earned from the sale of off-the-shelfsoftware requiring no significant modification or customization subsequent todelivery to 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, running test dataand documentation of procedures.

 

TheCompany generally bundles customer support with the software license for theentire term of the arrangement. As a result, the Company generally recognizesrevenues for all elements, including consulting services, ratably over the termof the software license and support arrangement. The Company allocates therevenues recognized for these arrangements to the different elements based onmanagement’s estimate of the relative fair value of each element. For itsterm-based licenses, the Company allocates 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. TheCompany has allocated the estimated fair value to its multiple elementarrangements to provide meaningful disclosures about each of its revenuestreams. The costs associated with the consulting and customer support servicesare expensed as incurred. There are instances in which the Company sellssoftware licenses based on usage levels. These software licenses can be basedon estimated usage, in which case the license fee charged to the customer isfixed based on this estimate. When the fee is fixed, the revenues are generallyrecognized ratably over the contractual term of the arrangement. If the fee isbased on actual usage, and therefore variable, the revenues are recognized inthe period of use. Revenues from certain follow-on consulting services, whichare sold separately to customers with existing software licenses and are notconsidered part of a multiple element arrangement, are recognized as theservices are performed.

 

TheCompany sells perpetual 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.

 

Inaddition to making its software products available to customers throughlicenses, the Company offers its *InForm*,*WebVDME*, *CTSD* and *WebSDM* softwaresolutions through a hosted application solution delivered through a standardweb-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 overthe hosting period. Fees 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

 

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milestones. Fees forapplication hosting and related services in the second stage are generallybilled quarterly in advance. Bundled into this revenue element are revenuesattributable to the software license used by the customer.

 

Revenuesresulting from hosting services for the *WebVDME*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related support services. Servicesfor this offering are charged monthly as a fixed fee. Revenues are recognizedratably over the period of the service.

 

In theevent that an application hosting customer cancels a clinical trial and itsrelated statement of work, all deferred revenues are recognized and alldeferred set up costs are expensed. In addition, certain termination relatedfees may be charged and if so, such fees are recognized in the period oftermination.

 

Onecustomer, GlaxoSmithKline, accounted for approximately 18% and 15% of theCompany’s total revenues in the three months ended September 30, 2006 and2007, and 17% and 16% of the Company’s total revenues in the nine months ended September 30,2006 and 2007, respectively. The same customer accounted for $2,638 and $2,114,or 9% and 8%, of accounts receivable outstanding as of December 31, 2006and September 30, 2007, respectively.

 

TheCompany deferred $483 and $976 of set up costs and amortized $489 and $670 ofset up costs in the three months ended September 30, 2006 and 2007,respectively, and deferred $2,085 and $2,650 of set up costs and amortized$1,517 and $1,835 of set up costs in the nine months ended September 30,2006 and 2007, respectively. The amortization of deferred set up costs is acomponent of cost of services.

 

Deferredrevenues represent amounts billed or cash received in advance of revenuerecognition.

 

Provisionsfor estimated losses on uncompleted contracts are made on acontract-by-contract basis and are recognized in the period in which suchlosses become probable and can be reasonably estimated. To date, the Companyhas not experienced any material losses on uncompleted application hosting orconsulting contracts.

 

Inaccordance with EITF Issue No. 01-14, *IncomeStatement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred,* the Company included $140 and $229 ofout-of-pocket expenses in service revenues and cost of service revenues in thethree months ended September 30, 2006 and 2007, respectively, and included$461 and $526 of out-of-pocket expenses in service revenues and cost of servicerevenues in the nine months ended September 30, 2006 and 2007,respectively.

 

**3.****              PrepaidSales Commissions and Royalties**

 

Forarrangements where revenues are recognized over the relevant contract period,the Company defers related commissions paid to its direct sales force andsoftware license royalties paid to third parties, and amortizes these expensesover the period 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 commissions paid are recoverable by theCompany. The Company deferred $1,122 and $3,233 of commissions and amortized tosales and marketing expense $804 and $2,306 in the three months ended September 30,2006 and 2007, respectively, and deferred $3,998 and $6,859 of commissions andamortized to sales and marketing expense $3,428 and $5,211 in the nine monthsended September 30, 2006 and 2007, respectively.

 

TheCompany’s royalty obligation is based upon the license and customer supportrevenues earned for certain products in an arrangement. The Company has theright to recover the royalties in the event the arrangement is cancelled. TheCompany deferred $99 and $526 of royalties and amortized to cost of revenues$694 and $617 in the three months ended September 30, 2006 and 2007,respectively, and deferred $1,834 and $2,066 of royalties and amortized to costof revenues $2,337 and $1,884 in the nine months ended September 30, 2006and 2007, respectively.

 

**4.****              Warrantiesand Indemnification**

 

The Company’s softwarelicense arrangements and hosting services are typically warranted to perform ina manner consistent with general industry standards that are reasonablyapplicable and substantially in accordance with the Company’s

 

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product documentationunder normal use and circumstances. The Company’s arrangements also includecertain provisions for indemnifying customers against liabilities if itsproducts or services infringe a third party’s intellectual property rights.

 

The Company has enteredinto service level agreements with some of its hosted application customerswarranting certain levels of uptime reliability or other service levels andpermits 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 hasnot incurred any material costs as a result of such indemnifications and hasnot accrued any liabilities related to such obligations in the accompanyingconsolidated financial statements.

 

**5.****              Acquisitionof Lincoln Technologies, Inc.**

 

On August 25,2005, the Company acquired all of the outstanding capital stock of LincolnTechnologies, Inc. (“Lincoln”), a provider of products and services fordrug safety, clinical trial safety signal detection, and applied data standards.The acquired technology and products of Lincoln provide the Company with anexpanded drug safety offering and enhance the Company’s ability to offerinnovative software and services in the drug safety market. The Company paid apremium for Lincoln to enable it to expand its offerings in the drug safetymarket and to obtain a valuable workforce.

 

Theaggregate purchase price was $16,667. The acquisition agreement called foradditional cash consideration to be paid subject to achievement of certainfinancial 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 May 2006.The acquisition agreement was amended in September 2006 to amend the termsof the remaining contingent earn-out payment for which the security holders ofLincoln could be eligible in 2007 under the acquisition agreement. Pursuant tothe amendment, the Company agreed to pay the security holders of Lincoln anaggregate of $3,500 in cash on December 26, 2007 in satisfaction of theCompany’s remaining payment obligations under the acquisition agreement. The$3,500 was accrued as of December 31, 2006 and September 30, 2007.The acquisition of Lincoln was accounted for as a purchase under SFAS No. 141,*Business Combinations*. Accordingly, theresults of Lincoln have been included in the audited consolidated financialstatements since the date of acquisition.

 

**6.****              Net Income Per Share**

 

Basicnet income per common share for all periods presented was determined bydividing net income applicable to common stockholders by the weighted averagenumber of common shares outstanding during the period. Weighted-average commonshares outstanding exclude unvested restricted common stock. Diluted net incomeper share includes the effects of all dilutive, potentially issuable commonshares using the treasury stock method.

 

9

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Thecalculation of basic and diluted net income per share is as follows:

 
| ** **                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                             | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2007** | ** ** |
| Numerator:                                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Net income                                                            |       | $                                                    | 2,894      |                                                | $          | 5,718 |   | $ | 6,868 |   | $ | 13,527 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator:                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted-average common shares outstanding                            |       | 36,085,013                                           |       | 42,173,033                                          |       | 34,789,198 |   | 38,580,618 |   |
| Less weighted-average unvested restricted common  shares outstanding  |       | (938,275                                             | )          | (934,561                                            | )          | (403,494 | ) | (937,702 | ) |
| Basic weighted-average common shares outstanding                      |       | 35,146,738                                           |       | 41,238,472                                          |       | 34,385,704 |   | 37,642,916 |   |
| Dilutive effect of common stock options                               |       | 1,473,252                                            |       | 1,702,967                                           |       | 1,535,732 |   | 1,671,410 |   |
| Dilutive effect of unvested restricted common stock  awards and units |       | —                                               |       | 455,142                                             |       | — |   | 344,514 |   |
| Diluted weighted-average common shares outstanding                    |       | 36,619,990                                           |       | 43,396,581                                          |       | 35,921,436 |   | 39,658,840 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Net income per share applicable to common  stockholders:              |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                 |       | $                                                    | 0.08       |                                                | $          | 0.14 |   | $ | 0.20 |   | $ | 0.36 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Diluted                                                               |       | $                                                    | 0.08       |                                                | $          | 0.13 |   | $ | 0.19 |   | $ | 0.34 |   |

 

In thethree months ended September 30, 2006 and 2007, diluted weighted-averagecommon shares outstanding do not include options outstanding to purchase119,478 and 0 common equivalent shares, respectively, as their effect wouldhave been anti-dilutive.

 

In thenine months ended September 30, 2006 and 2007, diluted weighted-averagecommon shares outstanding do not include options outstanding to purchase115,075 and 3,734 common equivalent shares, respectively, as their effect wouldhave been anti-dilutive.

 

**7.****              Foreign Currency Translation**

 

Thefinancial statements of the Company’s foreign subsidiaries are translated inaccordance with SFAS No. 52, *ForeignCurrency Translation.* The reporting currency for the Company is theU.S. dollar. The functional currency of the Company’s subsidiaries in theUnited Kingdom, France, Belgium, 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 in the period. Gains andlosses 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 $16 and ($98) in the three months ended September 30, 2006 and2007, respectively, and ($45) and ($160) in the nine months ended September 30,2006 and 2007, respectively. Such gains (losses) are included in other income(expense) in the accompanying unaudited condensed consolidated statements ofincome.

 

Foreigncurrency translation adjustments are accumulated as a component of othercomprehensive income as a separate component of stockholders’ equity.

 

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

 

TheCompany accounts 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

 

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fair value, withunrealized gains and losses excluded from earnings and reported in a separatecomponent of stockholders’ equity. The Company considers all highly liquidinvestments with original maturities of 90 days or less at the time of purchaseto be cash equivalents and investments with original maturities of between91 days and one year to be short-term investments. All securities, withthe exception of auction rate securities, are classified as held-to-maturitysecurities. The auction rate securities are debt instruments issued by variousmunicipalities throughout the United States and are classified as available forsale because it is the Company’s intent not to hold them to maturity.

 

Cash,cash equivalents and short-term investments as of December 31, 2006 and September 30,2007 consist of the following:

 
| ** **                      | ** ** | ** **               | ** ** | **As of December 31, 2006** | ** ** |
|---------------------------------|------------|--------------------------|------------|-------------------------------------------------|------------|
| **Description**                 | ** ** | **Contracted  Maturity** | ** ** | **Amortized Cost**                         | ** ** | **Fair Market  Value** | ** ** |
| Cash                            |       | Demand                   |       | $                                               | 15,558     |   | $ | 15,558 |   |
| Certificate of deposit          |       | 78 days                  |       | 1,950                                           |       | 1,950 |   |
| Money market funds              |       | Demand                   |       | 24,661                                          |       | 24,661 |   |
|                            |       |                     |       |                                            |       |   |   |
| Total cash and cash equivalents |       |                     |       | $                                               | 42,169     |   | $ | 42,169 |   |
|                            |       |                     |       |                                            |       |   |   |
| Auction rate securities         |       | 31.4 years               |       | $                                               | 3,200      |   | $ | 3,200 |   |
| Certificate of deposit          |       | 195 days                 |       | 2,550                                           |       | 2,549 |   |
| U.S. agency notes               |       | 297 days                 |       | 7,952                                           |       | 7,952 |   |
| Corporate bonds                 |       | 280 days                 |       | 13,764                                          |       | 13,760 |   |
|                            |       |                     |       |                                            |       |   |   |
| Total short-term investments    |       |                     |       | $                                               | 27,466     |   | $ | 27,461 |   |

 
| ** **                      | ** ** | ** **               | ** ** | **As of September 30, 2007** | ** ** |
|---------------------------------|------------|--------------------------|------------|--------------------------------------------------|------------|
| **Description**                 | ** ** | **Contracted  Maturity** | ** ** | **Amortized Cost**                          | ** ** | **Fair Market  Value** | ** ** |
| Cash                            |       | Demand                   |       | $                                                | 13,300     |   | $ | 13,300 |   |
| Certificates of deposit         |       | 82 days                  |       | 2,000                                            |       | 2,000 |   |
| Money market funds              |       | Demand                   |       | 141,834                                          |       | 141,834 |   |
|                            |       |                     |       |                                             |       |   |   |
| Total cash and cash equivalents |       |                     |       | $                                                | 157,134    |   | $ | 157,134 |   |
|                            |       |                     |       |                                             |       |   |   |
| Auction rate securities         |       | 30 years                 |       | $                                                | 13,375     |   | $ | 13,375 |   |
| Certificate of deposit          |       | 97 days                  |       | 750                                              |       | 750 |   |
| U.S. agency notes               |       | 336 days                 |       | 2,000                                            |       | 2,001 |   |
| Corporate bonds                 |       | 288 days                 |       | 13,707                                           |       | 13,704 |   |
|                            |       |                     |       |                                             |       |   |   |
| Total short-term investments    |       |                     |       | 29,832                                           |       | 29,830 |   |

 

TheCompany has had no realized gains or losses from the sale of cash equivalentsor short-term investments. To date, the Company has not recorded any unrealizedgains or losses in connection with its auction rate securities.

 

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

 

*Stock-Based Compensation Plans*

 

TheCompany currently has one plan under which it may grant stock-basedcompensation awards to its directors, employees and non-employees. The Companyhas two additional plans under which there are awards outstanding, but underwhich no future awards may be made.

 

In2004, the Board of Directors and stockholders approved the Phase ForwardIncorporated 2004 Stock Option and Incentive Plan (the “2004 Plan”) whichbecame effective upon the closing of the Company’s initial public offering. TheCompany had reserved for issuance an aggregate of 1,500,000 shares of commonstock under the 2004 Plan. Under the 2004 Plan, the Board of Directors may grantstock options and other equity interests in the Company to employees of theCompany and non-employees. The exercise price of each option is determined bythe Board of Directors. Stock options may not be granted with an exerciseprice less than the fair market value of the stock on the date of grant, asdefined by the Board of Directors. Options granted under the 2004 Plangenerally vest over a four to seven year period and expire ten years from the

 

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grant date. In February 2005,the Company granted options to certain employees to purchase a total of 419,000shares of common stock that vest upon the earlier of attainment of specifiedmilestones or 7 years from the date of grant. Of these February 2005option grants, 197,000 options have since vested due to the achievement ofmilestones, 37,500 options were forfeited, and 184,500 remain unvested. Generally,the remainder of equity awards granted were service-based and vest over aperiod of four years from the date of grant. On May 3, 2006, the Company’sstockholders approved an amendment to the 2004 Plan to increase the number ofshares available for issuance from 1,500,000 shares to 3,500,000 shares. In2006, the Company issued 1,113,175 unvested restricted stock awards andrestricted stock units under the 2004 Plan. Generally, the balances of theseunvested restricted stock options and units vest 50% in two years; 75% in threeyears and 100% in four years. A total of 400,000 unvested restricted stockawards were granted to the Company’s Chief Executive Officer and vest 25% inthree years; 50% in four years and 100% in five years.

 

On May 2,2007, the Company’s stockholders approved an amendment to the 2004 Plan toincrease the number of shares available for issuance under the plan by 481,505shares, bringing total shares authorized for issuance under the 2004 Plan to 3,981,505.The increase is equal to the number of shares that were available for issuanceunder the Company’s two other stock plans (the Phase Forward Incorporated 1997Stock Option Plan and the Phase Forward Incorporated 2003 Non-Employee DirectorStock Option Plan) at the date of the amendment. As part of thatamendment, the Company decided that it will no longer issue any further sharesunder its two other plans. As of September 30, 2007, the Company had1,290,098 shares available for grant under the 2004 Plan.

 

In1997, the Company adopted the Phase Forward Incorporated 1997 Stock Option Plan(the “1997 Plan”). On May 2, 2007, the Company’s stockholders approved anamendment to the 2004 Plan to increase the number of shares available forissuance under the plan. As part of that amendment, the Company decidedthat it will no longer issue any further shares under the 1997 Plan. Prior tothe May 2, 2007 amendment to the 2004 Plan, under the 1997 Plan, the Boardof Directors could grant incentive and nonqualified stock options to employeesof the Company and non-employees. The exercise price of each option wasdetermined by the Board of Directors. Incentive stock options could not begranted with an exercise price less than the fair market value of the stock onthe date of grant, as defined by the Board of Directors. Options granted underthe 1997 Plan generally vest over four or five year periods and expire tenyears from the grant date. In January and March 2004, the Companygranted options to certain employees to purchase a total of 205,000 shares ofcommon stock that vest upon the earlier of 7 years from date of grant or theattainment of specified milestones. Options to purchase 178,750 shares havesince either vested upon the attainment of specified milestones in accordancewith the original provisions of the award or been modified to change thevesting provisions to a 4-year service period. Options to purchase 26,250shares were accelerated in December 2004. There was no incrementalstock-based compensation in excess of the amounts that were previously recordedas deferred compensation. There were no shares available for future issuanceunder the 1997 Plan at September 30, 2007.

 

In2003, the Board of Directors and stockholders approved the Phase Forward Incorporated2003 Non-Employee Director Stock Option Plan (the “2003 NED Plan”). On May 2,2007, the Company’s stockholders approved an amendment to the 2004 Plan toincrease the number of shares available for issuance under the plan. As part ofthat amendment, the Company decided that it will no longer issue any furthershares under the 2003 NED Plan. The Company reserved for issuance an aggregateof 362,000 shares of common stock under the 2003 NED Plan. Effective April 20,2004, the 2003 NED Plan was amended to increase the number of shares theCompany could grant under this plan to 562,000 shares. The 2003 NED Planprovided solely for the automatic, one-time grant of a nonqualified stockoption to a non-employee director upon initial election to the Company’s Boardof Directors to purchase 100,000 shares of common stock. On September 23,2005, the 2003 NED Plan was amended to reduce the one-time grant from 100,000to 50,000 stock options. The exercise price of the options could not be lessthan 100% of the fair market value on the grant date. Options vest fully on thefifth anniversary of the date of grant, so long as the non-employee directorhas continuously served on the Board of Directors through such vesting date. Ifthe non-employee director meets certain board attendance criteria, options may vestearlier at a rate of one-sixteenth at the end of each fiscal quarter followingthe date of grant. There were no shares available for future issuance under the2003 Plan at September 30, 2007.

 

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*StockOption Activity*

 

Asummary of stock option activity under the 1997 Plan, the 2004 Plan and the2003 NED Plan as of September 30, 2007, and changes in the nine monthsended September 30, 2007, is as follows:

 
| ** **                                                   | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price  Per Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (2)** | ** ** |
|--------------------------------------------------------------|------------|----------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding as of December 31, 2006                     |       | 3,440,789                  |       | $                                                          | 4.84       |                                                             | 6.75       |                                     | $          | 34,890 |   |
| Granted                                                      |       | —                     |       | —                                                     |       |                                                             |       |                                     |       |
| Exercised                                                    |       | (462,668                   | )          | 4.42                                                       |       |                                                             |       | $                                        | 7,213      |   |
| Canceled                                                     |       | (40,866                    | )          | 7.24                                                       |       |                                                             |       |                                     |       |
|                                                         |       |                       |       |                                                       |       |                                                             |       |                                     |       |
| Outstanding as of September 30, 2007                    |       | 2,937,255                  |       | $                                                          | 4.87       |                                                             | 6.03       |                                     | $          | 44,470 |   |
|                                                         |       |                       |       |                                                       |       |                                                             |       |                                     |       |
| Exercisable as of September 30, 2007                    |       | 2,287,320                  |       | $                                                          | 4.28       |                                                             | 5.63       |                                     | $          | 35,980 |   |
|                                                         |       |                       |       |                                                       |       |                                                             |       |                                     |       |
| Vested or expected to vest as of September 30,  2007(1) |       | 2,775,670                  |       | $                                                          | 4.75       |                                                             | 5.95       |                                     | $          | 42,357 |   |
|                                                              |            |                            |            |                                                            |            |                                                                  |            |                                          |            |  |  |  |

 

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(1)             The vested orexpected to vest options at September 30, 2007 include both the vestedoptions and the number of options expected to vest calculated after applying anestimated forfeiture rate to the unvested options.

 

(2)             The aggregateintrinsic value was calculated based on the positive difference between theestimated fair value per share of the Company’s common stock on September 30,2007 of $20.01 or the date of exercise, as appropriate, and the exercise priceof the underlying options.

 

Asummary of the status of the Company’s unvested stock options and changes inthe nine months ended September 30, 2007, is as follows:

 
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price  Per Share** | ** ** |
|----------------------------------------|------------|------------|------------|------------------------------------------------------------|------------|
| Unvested as of December 31, 2006  |       | 1,017,842  |       | $                                                          | 6.75       |   |
| Granted                                |       | —     |       | —                                                     |       |
| Vested                                 |       | (327,041   | )          | 6.21                                                       |       |
| Forfeited                              |       | (40,866    | )          | 7.24                                                       |       |
|                                   |       |       |       |                                                       |       |
| Unvested as of September 30, 2007 |       | 649,935    |       | $                                                          | 6.99       |   |

 

Thefollowing table summarizes information regarding the Company’s stock optionsoutstanding and exercisable as of September 30, 2007:

 
| **Options Outstanding**            | ** ** | **Options Exercisable** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted  Average  Exercise Price  per Share** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price  per Share** | ** ** |
| $0.10 — 0.60                       |       | 21,834                       |       | 0.64 |   | $ | 0.13 |   | 21,834 |   | $ | 0.13 |   |
| 0.61 — 1.20                        |       | 11,850                       |       | 2.06 |   | 1.00 |   | 11,850 |   | 1.00 |   |
| 1.21 — 3.00                        |       | 1,457,638                    |       | 4.90 |   | 3.00 |   | 1,451,137 |   | 3.00 |   |
| 3.01 — 4.80                        |       | 141,108                      |       | 6.33 |   | 4.50 |   | 106,043 |   | 4.50 |   |
| 4.81 — 5.40                        |       | 26,350                       |       | 2.48 |   | 5.00 |   | 26,350 |   | 5.00 |   |
| 5.41 — 6.00                        |       | 23,140                       |       | 6.49 |   | 6.00 |   | 9,881 |   | 6.00 |   |
| 6.01 — 7.80                        |       | 947,455                      |       | 7.36 |   | 6.71 |   | 509,309 |   | 6.78 |   |
| 7.81 — 9.00                        |       | 212,880                      |       | 7.92 |   | 7.85 |   | 105,916 |   | 7.84 |   |
| 9.01 — 10.29                       |       | 95,000                       |       | 8.15 |   | 10.29 |   | 45,000 |   | 10.29 |   |
|                                    |       |                         |       |   |   |   |   |   |   |   |   |
|                                    |       | 2,937,255                    |       | 6.03 |   | $ | 4.87 |   | 2,287,320 |   | $ | 4.28 |   |

 

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*Restricted Stock Awards and Unit Activity*

 

Asummary of activity related to restricted common stock awards and unit awardsin the nine months ended September 30, 2007, is as follows:

 
| ** **                                | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value  Per Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (2)** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding as of December 31, 2006  |       | 1,081,925                  |       | $                                                                       | 12.43      |                                                             | 3.75       |                                     | $          | 21,649 |   |
| Awarded                                   |       | 234,000                    |       | 13.59                                                                   |       |                                                             |       |                                     |       |
| Exercised                                 |       | —                     |       | —                                                                  |       |                                                             |       |                                     |       |
| Canceled                                  |       | (16,525                    | )          | 12.88                                                                   |       |                                                             |       |                                     |       |
|                                      |       |                       |       |                                                                    |       |                                                             |       |                                     |       |
| Outstanding as of September 30, 2007 |       | 1,299,400                  |       | $                                                                       | 12.63      |                                                             | 3.07       |                                     | $          | 26,001 |   |
|                                      |       |                       |       |                                                                    |       |                                                             |       |                                     |       |
| Expected to be free of restrictions (1)   |       | 950,058                    |       | $                                                                       | 12.63      |                                                             | 3.07       |                                     | $          | 19,011 |   |

 

----

(1)             The expected to befree of restrictions at September 30, 2007 was calculated by applying anestimated forfeiture rate to the unvested shares.

 

(2)             The aggregateintrinsic value is calculated based on the fair value per share of the Company’scommon stock on September 30, 2007 of $20.01.

 

Asummary of the status of the Company’s unvested restricted stock awards andunits and changes in the nine months ended September 30, 2007, is asfollows:

 
| ** **                             | ** ** | **Shares** | ** ** | **Weighted Average  Grant Date  Fair Value  Per Share** | ** ** |
|----------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------|------------|
| Unvested as of December 31, 2006  |       | 1,081,925  |       | $                                                                           | 12.43      |   |
| Granted                                |       | 234,000    |       | 13.59                                                                       |       |
| Vested                                 |       | —     |       | —                                                                      |       |
| Forfeited                              |       | (16,525    | )          | 12.88                                                                       |       |
|                                   |       |       |       |                                                                        |       |
| Unvested as of September 30, 2007 |       | 1,299,400  |       | $                                                                           | 12.63      |   |

 

*EmployeeStock Purchase Plan*

 

In 2004, the Board of Directors and stockholdersapproved the Phase Forward Incorporated 2004 Employee Stock Purchase Plan (the “2004ESPP”). The Company has reserved for issuance under this plan an aggregate of320,000 shares of common stock. The 2004 ESPP allows eligible employees theopportunity to purchase shares of the Company’s common stock through payrolldeductions of up to 10% of a participant’s annual compensation with a maximumof 5,000 shares available per participant during each payment period, subjectto statutory limitations. The first payment period began on September 2,2004 and ended on November 30, 2004. All subsequent payment periodsconsist of six-month periods commencing on December 1 and June 1 andending on the 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).

 

*Stock-BasedCompensation Accounting Policy*

 

On January 1, 2006, the Company adopted theprovisions of SFAS No. 123(R), *Share-basedPayment*, which requires the Company to recognize expense related tothe fair value of stock-based compensation awards. Management elected to use

 

14

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themodified prospective transition method as permitted by SFAS No. 123(R)and therefore has not restated the Company’s financial results for priorperiods. Stock-based compensation expense in the three months ended September 30,2006 and 2007 includes compensation expense for all stock-based compensationawards granted on or after March 15, 2004 (the filing date for the initialregistration statement for the Company’s initial public offering), based on thegrant-date fair value estimated in accordance with the provisions of SFAS No. 123(R).

 

Stockoptions granted prior to March 15, 2004, are minimum value options,pursuant to SFAS No. 123. Under the provisions of SFAS No. 123(R),the value of these options will not be recorded in the statement of operationssubsequent to the adoption of SFAS No. 123(R). Instead, the Companywill continue to account for these options using Accounting Principles Board(APB) Opinion No. 25, *Accounting forStock Issued to Employees*, and related Interpretations.

 

Forservice-based options, accounted for under SFAS No. 123(R), theCompany recognizes compensation expense on a straight-line basis over therequisite service period of the award. For performance-based options, the Companyrecognizes expense on a straight-line basis over the estimated performanceperiod. In addition, SFAS 123(R) requires the benefits of tax deductionsin excess of recognized share-based compensation to be reported as a financingactivity rather than an operating activity in the statements of cash flows.This requirement reduces net operating cash flows and increases net financingcash flows in periods after adoption.

 

Prior to the adoption of SFAS No. 123(R),the Company applied SFAS No. 123, *Accounting for Stock-BasedCompensation*, amended by SFAS No. 148, *Accounting for Stock-based Compensation —Transition and Disclosure*, which allowed companies to apply theexisting accounting rules under APB Opinion No. 25. Pursuant toAPB Opinion No. 25, the Company accounted for its stock-based awardsto employees using the intrinsic-value method, under which compensation expensewas measured on the date of grant as the difference between the fair value ofthe Company’s common stock and the option exercise price multiplied by thenumber of options granted. Generally, the Company granted stock options withexercise prices equal to the estimated fair value of its common stock; however,to the extent that the fair value of the common stock exceeded the exerciseprice of stock options granted to employees on the date of grant, the Companyrecorded deferred compensation and amortized the expense over the vesting schedule ofthe options, generally four years. In accordance with APB Opinion No. 25,the Company recorded deferred stock-based compensation resulting from the grantof employee stock options with an exercise price less than the fair value ofcommon stock. As of September 30, 2007, the Company had $29 of deferredstock-based compensation remaining to be amortized which is expected to beamortized during the remainder of 2007. Upon the adoption of SFAS No. 123(R)on January 1, 2006, the deferred stock-based compensation balance wasnetted against additional paid-in capital on the consolidated balance sheet andstatement of stockholders equity.

 

Foroptions accounted for under SFAS No. 123(R), the fair value of eachoption grant is estimated on the date of grant using the Black-Scholes pricingmodel. No options were granted in the three and nine months ended September 30,2007 or in the three months ended September 30, 2006. In the nine monthsended September 30, 2006, the weighted-average assumptions used todetermine the estimated fair value for grants were as follows:

 
| ** **               | ** ** | **Nine  Months Ended  September 30,  2006** | ** ** |
|--------------------------|------------|-------------------------------------------------------|------------|
| Risk-free interest rate  |       | 4.65                                                  | %          |
| Expected volatility      |       | 53                                                    | %          |
| Expected life (in years) |       | 4.28                                                  |       |
| Expected dividend yield  |       | —                                                |       |

 

For purposes of utilizing the Black-Scholes optionpricing model and because there was a limited trading history for its commonstock, the Company determined the expected life and the volatility for optionsbased on an analysis of reported data for a peer group of companies that haveissued stock options with substantially similar terms. The expected life ofoptions granted by the Company has been determined based on the averageexpected life of the options as reported by this peer group of companies duringa similar reporting period. The expected volatility of options granted has beendetermined using an average of the historical volatility measures of this peergroup of companies as well as the historical volatility of the Company’s commonstock beginning in January 2005. The risk-free interest rate is based on atreasury instrument whose term is consistent with the expected life of thestock options. The Company has not paid and does not anticipate paying cashdividends on its shares of common stock; therefore, the expected dividend yieldis assumed to be zero. In addition, while SFAS No. 123 permitted companiesto record forfeitures based on actual forfeitures, which was the Company’shistorical policy under SFAS No. 123, SFAS No. 123(R) requirescompanies to utilize an estimated forfeiture rate when calculating

 

15

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stock-basedcompensation expense in 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 statements ofincome.

 

In the three months endedSeptember 30, 2006 and 2007, the Company recorded $976 and $1,136 ofaggregate stock-based compensation expense, respectively, of which $813 and$1,107, respectively, was a result of the adoption of SFAS No. 123(R). Theremaining stock-based compensation expense is due to the amortization ofstock-based compensation associated with previously issued stock options whichamounted to $163 and $29, in the three months ended September 30, 2006 and2007, respectively. In the nine months ended September 30, 2006 and 2007,the Company recorded $1,991 and $3,333 of aggregate stock-based compensationexpense, respectively, of which $1,617 and $3,226, respectively, was a resultof the adoption of SFAS No. 123(R). The remaining stock-based compensationexpense is due to the amortization of stock-based compensation associated withpreviously issued stock options which amounted to $374 and $107 in the ninemonths ended September 30, 2006 and 2007, respectively. As of September 30,2007, there was $11,479 of unrecognized stock-based compensation expenserelated to stock-based awards that is expected to be recognized over a weightedaverage period of 2.96****years.

 

Stock-based compensation expense is allocated asfollows:

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                             | ** ** | **2007**                                                  | ** ** | **2006** | ** ** | **2007** | ** ** |
| Cost of service revenues   |       | $                                                    | 68         |                                                      | $          | 102 |   | $ | 161 |   | $ | 330 |   |
| Sales and marketing        |       | 143                                                  |       | 201                                                       |       | 351 |   | 570 |   |
| Research and development   |       | 121                                                  |       | 181                                                       |       | 248 |   | 516 |   |
| General and administrative |       | 644                                                  |       | 652                                                       |       | 1,231 |   | 1,917 |   |
|                       |       |                                                 |       |                                                      |       |   |   |   |   |
| Total                      |       | $                                                    | 976        |                                                      | $          | 1,136 |   | $ | 1,991 |   | $ | 3,333 |   |

 

**10.****       Goodwill and Intangible Assets**

 

Goodwilland intangible 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.

 

Thegoodwill resulting from acquisitions is reviewed for impairment on an annualbasis in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets.*Consistent with prioryears, the Company conducted its annual impairment test of goodwill in thefourth quarter of 2006. Based on the results of the first step of the goodwillimpairment test, the Company has determined that no impairment of goodwillexisted at December 31, 2006, as the carrying amount of goodwill of thereporting unit was less than its fair value and therefore, the second step ofthe goodwill impairment test was not necessary.

 

Arollforward of the net carrying amount of goodwill is as follows:

 
| ** **                                                               | ** ** | **Amount** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|
|                                                                     |       |       |       |
| Balance as of December 31,  2006                                    |       | $          | 27,820     |   |
| Release of valuation allowance related to acquired  net operating losses |       | (430       | )          |
| Decrease associated with the acquisition of Lincoln                      |       | (122       | )          |
|                                                                     |       |       |       |
| Balance as of September 30,  2007                                   |       | $          | 27,268     |   |

 

Theutilization of or release of the valuation allowance related to acquired netoperating losses reflects an actual or anticipated reduction in cash paymentsto local taxing authorities for income taxes that are not reflected as abenefit in the income tax provision for financial statement purposes but ratheras a reduction to goodwill. In the nine months ended September 30, 2007,the Company determined that it is more likely than not that the Company willrealize a portion of its deferred tax assets and therefore reduced thevaluation allowance by $4,873. This benefit of the release in valuationallowance was realized through reductions to income tax expense of $4,443 andto goodwill of $430.

 

16

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Intangibleassets, all of which relate to the acquisition of Lincoln, consist of thefollowing:

 
| ** **                        | ** ** | ** **                      | ** ** | **As of December 31, 2006** | ** ** | **As of September 30, 2007** | ** ** |
|-----------------------------------|------------|---------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| **Description**                   | ** ** | **Estimated  Useful Life** | ** ** | **Gross  Carrying  Value**                      | ** ** | **Accumulated  Amortization**                    | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed technology and know-how |       | 5 years                         |       | $                                               | 1,800      |                                             | $          | 487 |   | $ | 1,800 |   | $ | 757 |   |
| Customer relationships            |       | 5 years                         |       | 1,600                                           |       | 432                                              |       | 1,600 |   | 673 |   |
| Non-compete agreements            |       | 2 years                         |       | 300                                             |       | 203                                              |       | 300 |   | 300 |   |
| Tradename                         |       | 5 years                         |       | 200                                             |       | 54                                               |       | 200 |   | 84 |   |
|                              |       |                            |       |                                            |       |                                             |       |   |   |   |   |
| Total                             |       |                            |       | $                                               | 3,900      |                                             | $          | 1,176 |   | $ | 3,900 |   | $ | 1,814 |   |

 

Amortizationexpense related to intangible assets in the three months ended September 30,2006 and 2007 was $217 and 202, respectively, and $653 and $637 in the ninemonths ended September 30, 2006 and 2007, respectively.

 

Theestimated remaining amortization expense for each of the four succeeding yearsis as follows:

 
| **Year Ended December 31,** | ** ** | **Amount** | ** ** |
|--------------------------------------------|------------|------------|------------|
| 2007 (1)                                   |       | $          | 180        |   |
| 2008                                       |       | 720        |       |
| 2009                                       |       | 720        |       |
| 2010                                       |       | 466        |       |
|                                       |       |       |       |
| Total                                      |       | $          | 2,086      |   |

 

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(1)             This amount reflectsamortization expense that the Company anticipates recognizing from October 1,2007 through December 31, 2007.

 

**11.****       Accrued Expenses**

 

Accruedexpenses consist of the following:

 
| ** **                           | ** ** | **As of  December 31,** | ** ** | **As of  September 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|
| ** **                           | ** ** | **2006**                          | ** ** | **2007**                           | ** ** |
| Accrued payroll and related benefits |       | $                                 | 8,338      |                               | $          | 10,409 |   |
| Accrued other expenses               |       | 3,720                             |       | 5,075                              |       |
| Accrued royalties                    |       | 1,553                             |       | 1,705                              |       |
| Accrued income taxes                 |       | 572                               |       | 881                                |       |
|                                 |       |                              |       |                               |       |
| Total                                |       | $                                 | 14,183     |                               | $          | 18,070 |   |

 

**12.****       Debt**

 

Priorto August 2005, all borrowings under the Company’s $5,000 working capitalline of credit were secured by substantially all assets of the Company. Under arelated negative pledge agreement, the Company was generally prohibited from pledgingits intellectual property to others, subject to certain exceptions. In August 2005,the working capital line of credit was amended to eliminate the securityinterest in the Company’s assets and the negative pledge on the Company’sintellectual property. The amendment also removed or modified the financialcovenants. Effective March 31, 2006, the working capital line of creditwas reduced from $5,000 to $2,000. As of December 31, 2006 and September 30,2007, there were no amounts outstanding under the working capital line ofcredit. At September 30, 2007, there was $1,500 available under the lineof credit, and $500 reserved under a letter of credit associated with theCompany’s leased facility. At September 30, 2007, the Company was incompliance with all financial covenants.

 

**13.****       Contingencies**

 

Fromtime to time and in the ordinary course of business, the Company is subject tovarious claims, charges and litigation. Intellectual property disputes oftenhave a risk of injunctive relief which, if imposed against the Company, could

 

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materially and adverselyaffect its financial condition, or results of operations. Although the outcomeof litigation cannot be predicted with certainty and some lawsuits, claims orproceedings may be disposed of unfavorably to the Company, which couldmaterially and adversely affect its financial condition or results ofoperations, the Company does not believe that it is currently a party to anymaterial legal proceedings. From time to time, third parties have asserted and may inthe future assert intellectual property rights to technologies that areimportant to the Company’s business and have demanded and may in thefuture demand that the Company license their technology.

 

For example, the Company entered into a SettlementAgreement and related License Agreement with Dr. Mark L. Kozam d/b/a MLKSoftware and Datasci, LLC. The Settlement Agreement relates to a lawsuit filedby Datasci in 2004 alleging that certain of the Company’s products and servicesand certain products and services of one of the Company’s customers, 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 and obtain a perpetual, irrevocable, fully paid worldwide, non-exclusivelicense to the patent that was the subject of the claim by Datasci. Theconfidential settlement, in which neither party admits liability, provides formutual releases and dismissal of all actions between the parties.

 

Pursuantto SFAS No. 142, *Goodwill and OtherIntangible Assets,*the Company reviewed the attributes of thelicense obtained and estimated that the license obtained had no value or usefullife and that the license would not contribute to the Company’s future cashflows, either directly or indirectly. In addition, theCompany does not anticipate changing any of its products as a result ofthe license to this patent. As such, the settlement amount was recorded as acharge to operations. Since the contingency existed as of December 31,2005 and the settlement was concluded prior to the issuance of the 2005 auditedconsolidated financial statements, in accordance with SFAS No. 5, theCompany recorded the impact of the settlement in 2005 as a charge to operations.The settlement was paid in the first quarter of 2006.

 

**14.**       Stockholders’ Equity

** **

In thenine months ended September 30, 2007, the Company issued 462,668 shares ofcommon stock in connection with the exercise of stock options resulting inproceeds of $2,047, and 11,042 shares of common stock under the 2004 ESPPresulting in proceeds of $172.

 

On May 29,2007, the Company sold 5,500,000 shares of common stock at $15.00 per share ina public offering, resulting in proceeds of $77,455 after deductingunderwriters’ discounts and offering related expenses. The Company also grantedthe underwriters an option for 30 days to purchase up to an additional 825,000shares to cover over-allotments, if any, which was exercised in full on June 1,2007, resulting in net proceeds of $11,695 after deducting underwriters’discounts.

 

**15.**       Comprehensive Income

** **

The Company’sother comprehensive income relates to foreign currency translation adjustmentsand is presented separately on the balance sheet as required.

 

Comprehensiveincome consists of the following:

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                             | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2007** | ** ** |
| Net income                        |       | $                                                    | 2,894      |                                                | $          | 5,718 |   | $ | 6,868 |   | $ | 13,527 |   |
| Cumulative translation adjustment |       | (2                                                   | )          | 482                                                 |       | 429 |   | 728 |   |
|                              |       |                                                 |       |                                                |       |   |   |   |   |
| Comprehensive income              |       | $                                                    | 2,892      |                                                | $          | 6,200 |   | $ | 7,297 |   | $ | 14,255 |   |

 

**16.****       Forward Foreign Exchange Contracts**

 

TheCompany enters into transactions in currencies other than the U.S. dollar andholds cash in foreign currencies which expose the Company to transactions gainsand losses as foreign currency exchange rates fluctuate against the U.S.dollar. The Company from time to time enters into forward foreign exchangecontracts to hedge the foreign currency exposure of non-U.S. dollar denominatedthird-party and intercompany receivables and cash balances. The contracts,which relate to the British pound, euro, and the Japanese yen, generally haveterms of one month. These hedges are deemed fair value hedges

 

18

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and have not beendesignated for hedge accounting. The gains or losses on the forward foreignexchange contracts along with the associated losses and gains on therevaluation and settlement of the intercompany balances, accounts receivableand cash balances are recorded in current operations.

 

Thefollowing table summarizes the outstanding forward foreign exchange contractsheld by the Company as of December 31, 2006 and September 30, 2007:

 
| ** **    | ** ** | ** **          | ** ** | **As of December 31, 2006** | ** ** | **As of September 30, 2007** | ** ** |
|---------------|------------|---------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| **Currency**  | ** ** | **Hedge Type** | ** ** | **Local  Currency  Amount**                     | ** ** | **Approximate  U.S. Dollar  Equivalent**    | ** ** | **Local  Currency  Amount** | ** ** | **Approximate  U.S. Dollar  Equivalent** | ** ** |
| British pound |       | Sale                |       | 6,000                                           |       | $                                                | 11,752     |   | 500 |   | $ | 1,022 |   |
| Euro          |       | Sale                |       | 2,000                                           |       | 2,639                                            |       | — |   | — |   |
| Japanese yen  |       | Sale                |       | 59,000                                          |       | 496                                              |       | 21,000 |   | 184 |   |
|          |       |                |       |                                            |       | $                                                | 14,887     |   |   |   | $ | 1,206 |   |

 

Theforward foreign exchange contracts are short-term and mature within 35 days oforigination.

 

Due tothe short period of time between entering into the forward foreign exchangecontracts and September 30, 2007, the forward foreign exchange contractsrate approximates the exchange rate as of the end of the reporting period.

 

Realizedand unrealized foreign currency gains (losses), net of hedging are accountedfor in non-operating income (expense). Foreign currency gains (losses), net ofhedging, were $16 and ($98) in the three months ended September 30, 2006and 2007, respectively, and ($45) and ($160) in the nine months ended September 30,2006 and 2007, respectively. The Company settles forward foreign exchangecontacts in cash.

 

**17.**                               Income Taxes

** **

TheCompany adopted the provisions of FIN 48, an interpretation of SFAS 109, *Accounting for Income Taxes*, on January 1, 2007. As aresult of the implementation of FIN 48, the Company recognized no materialadjustment in the liability for unrecognized income tax benefits. At theadoption date of January 1, 2007 and September 30, 2007, the Companyhad $388 of unrecognized tax benefits, all of which would affect the Company’seffective tax rate if recognized.

 

TheCompany recognizes interest and penalties related to uncertain tax positions inthe provision for income taxes. At the adoption date of January 1, 2007,the Company had $107 of accrued interest and penalties related to uncertain taxprovisions. As of September 30, 2007, the Company had $118 of accruedinterest and penalties related to uncertain tax positions.

 

Thetax years 2004 through 2006 remain open to examination by federal and state taxjurisdictions.

 

**TheCompany has various foreign subsidiaries for which tax years 2000 through 2006remain open to examination in certain foreign tax jurisdictions.**

** **

TheCompany’s provision for taxes includes foreign and alternative minimum tax. TheCompany has utilized available U.S. net operating losses to offset its primaryfederal obligations resulting in an effective tax rate of 18% and 10% in thethree and nine months ended September 30, 2006 and 2007, respectively. Inthe nine months ended September 30, 2007, the Company determined that itis more likely than not that it will realize an additional portion of deferredtax assets and therefore reduced the valuation allowance by $4,873. Thisbenefit of the release in valuation allowance was realized through reductionsto income tax expense of $4,443 and to goodwill of $430. The Company currentlyexpects to realize recorded deferred tax assets as of September 30, 2007of $9,719. The Company’s conclusion that such assets will be recovered is basedupon its expectation that future earnings of the Company will providesufficient taxable income to realize recorded tax assets. While the realizationof the Company’s net recorded deferred tax assets cannot be assured, to theextent that future taxable income against which these tax assets may beapplied is not sufficient, some or all of the Company’s net recorded deferredtax assets would not be realizable.

 

19

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Areconciliation of the federal statutory rate to the Company’s effective taxrate is as follows:

 
| ** **                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                       | ** ** | **2006**                         | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2007** | ** ** |
| Federal statutory rate           |       | 34                               | %          | 34                              | %          | 34 | % | 34 | % |
| State tax                        |       | 3                                |       | 3                               |       | 3 |   | 3 |   |
| Alternative minimum tax          |       | 1                                |       | 2                               |       | 1 |   | 2 |   |
| Stock-based compensation expense |       | 7                                |       | 1                               |       | 7 |   | 1 |   |
| Other                            |       | 1                                |       | —                          |       | 1 |   | — |   |
| Decrease in valuation allowance  |       | (28                              | )          | (30                             | )          | (28 | ) | (30 | ) |
|                             |       |                             |       |                            |       |   |   |   |   |
| Effective tax rate               |       | 18                               | %          | 10                              | %          | 18 | % | 10 | % |

 

**18.****       RecentlyIssued Accounting Pronouncements**

 

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, whichdefines fair value, establishes a framework for measuring fair value undergenerally accepted accounting principles, and expands disclosures about fairvalue measurements. SFAS No. 157 applies to other accountingpronouncements that require or permit fair value measurements. The new guidanceis effective for financial statements issued for fiscal years beginning after November 15,2007, and for interim periods within those fiscal years. The Company iscurrently analyzing the effect, if any, SFAS No. 157 will have on itsconsolidated financial position and results of operations.

 

In February 2007, the FASB released SFAS No. 159,*The Fair Value Option for Financial Assetsand Financial Liabilities,*whichis effective for fiscal years beginning after November 15, 2007. ThisStatement permits entities to choose to measure many financial instruments andcertain other items at fair value. The objective is to improve financialreporting by providing entities with the opportunity to mitigate volatility inreported earnings caused by measuring related assets and liabilitiesdifferently without having to apply complex hedge accounting provisions. TheCompany is currently analyzing the effect, if any, SFAS No. 159 will haveon its consolidated financial position and results of operations.

 

**19.****       SubsequentEvents**

 

**On October 30,2007, the Company acquired all of the outstanding capital stock of GreenMountain Logic, Inc. (“GML”), a process automation software company thatprovides targeted solutions for the life sciences industry, including LabPas CTautomation software for Phase I clinical trials.  The acquired technologyand products of GML provide the Company with a solution targeted for Phase Iclinical trials. The aggregate purchase price was $5,250 in cash.**

 

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**Item 2. *Management’s Discussionand Analysis of Financial Condition and Results of Operations.***

** **

*The following discussion of thefinancial condition and results of operations of**Phase Forward Incorporated**should be read inconjunction with the condensed consolidated financial statements and therelated notes thereto included elsewhere in this Quarterly Report on Form 10-Qand the audited financial statements and notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operationsincluded in our Annual Report on Form 10-K for the year ended December 31,2006, which has been filed with the Securities and Exchange Commission (the “SEC”).*

 

**Overview**

 

We are a provider of integrated enterprise-levelsoftware products, services and hosted solutions for use in our customers’global clinical trial data management and safety evaluation and monitoringactivities.

 

Our customers include pharmaceutical, biotechnology,and medical device companies, clinical research organizations, or CROs, as wellas academic institutions, governmental regulatory agencies, and other entitiesengaged in clinical trial and safety evaluation and monitoring activities. Ourproducts automate essential elements of the clinical trial data management andsafety evaluation and monitoring process for both clinical trials andpost-approval therapeutic products. We believe our products allow our customersto accelerate the market introduction of new medical therapies, reduce overallresearch and development expenditures, enhance existing data quality controlefforts, facilitate proactive safety assessments, enable increased safetycompliance and reduce clinical and economic risk.

 

**Acquisitions**

 

Fromtime to time we have expanded our product and service offerings through theacquisition of other businesses or technologies. The most significant of thesetransactions are the acquisitions of Clinsoft Corporation and LincolnTechnologies, Inc.

 

*LincolnTechnologies, Inc.*

 

On August 25,2005, we acquired all of the outstanding capital stock of Lincoln Technologies, Inc.(“Lincoln”), a provider of products and services for drug safety, clinicaltrial safety signal detection, and applied data standards. Lincoln’s productsconsisted of *WebVDME, CTSD*and*WebSDM*. The aggregate purchase price wasapproximately $16.7 million. The acquisition agreement called for additionalcash consideration to be paid subject to achievement of certain financialtargets in 2005 and 2006, of up to $2.0 million and $4.0 million, respectively.The defined 2005 financial targets were achieved and, accordingly, we accruedadditional consideration of $2.0 million in 2005 which was paid in May 2006.The acquisition agreement was amended in September 2006 to amend the termsof the remaining contingent earn-out payment for which the security holders ofLincoln could be eligible in 2007 under the acquisition agreement. Pursuant tothe amendment, we agreed to pay the security holders of Lincoln an aggregate of$3.5 million in cash on December 26, 2007 in satisfaction of our remainingpayment obligations under the acquisition agreement. The $3.5 million wasaccrued as of September 30, 2006. The acquisition of Lincoln was accountedfor as a purchase under Statement of Financial Accounting Standards (SFAS) No. 141,*Business Combinations*. Accordingly, theresults of Lincoln have been included in our consolidated financial statementssince the date of acquisition.

 

*Clinsoft Corporation*

 

On August 14,2001, we acquired Clinsoft Corporation (“Clinsoft”), a developer, marketer andprovider of clinical data management and adverse event reporting and trackingproducts and services. Clinsoft’s products consisted of *Clintrial*and *Clintrace*. The aggregate purchase price was approximately$44.1 million, which consisted of the issuance of 3.9 million sharesof our Series D redeemable convertible preferred stock, the assumption ofliabilities and direct acquisition costs. The acquisition of the Clinsoftbusiness was accounted for as a purchase under SFAS No. 141. Accordingly,the results of Clinsoft have been included in our consolidated financialstatements since the date of acquisition.

 

** Litigation Settlement**

 

In February 2006, we entered into a SettlementAgreement and related License Agreement with Dr. Mark L. Kozam d/b/a MLKSoftware and Datasci, LLC. The Settlement Agreement relates to a lawsuit filedby Datasci in 2004 alleging that certain of our products and services andcertain products and services of one of our customers, Quintiles, Inc.,infringe a

 

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UnitedStates patent claimed to be owned by Datasci. Under the Settlement Agreementand related License Agreement, we agreed to make a one-time, lump-sum paymentto Datasci in the amount of $8.5 million to settle the claim and obtain aperpetual, irrevocable, fully paid worldwide, non-exclusive license to thepatent that was the subject of the claim by Datasci. The confidentialsettlement, in which neither party admits liability, provides for mutualreleases and dismissal of all actions between the parties. Pursuantto SFAS No. 142, *Goodwill and OtherIntangible Assets,*we reviewed the attributes of the licenseobtained and estimated that the license obtained had no value or useful lifeand that the license would not contribute to our future cash flows, eitherdirectly or indirectly. In addition, we do not anticipatechanging any of our products as a result of the license to this patent. Assuch, the settlement amount was recorded as a charge to operations. Since the contingency existed as of December 31, 2005 andthe settlement was concluded prior to the issuance of our 2005 auditedconsolidated financial statements, in accordance with SFAS No. 5, *Accounting for Contingencies,* we recorded the impact of thesettlement in 2005 as a charge to operations. The settlement was paid in thethree months ended March 31, 2006.

 

**Sourcesof Revenues**

 

Wederive our revenues from software licenses and services. License revenues arederived principally from the sale of term licenses for our software productsincluding; *InForm, Clintrial,**Clintrace,**WebVDME,**CTSD* and *WebSDM.*Service revenues are derived principally from our delivery ofthe hosted solution of our *InForm,**WebVDME*, *CTSD* and *WebSDM* software products, andconsulting services and customer support, including training, for all of ourproducts. We generally recognize revenues ratably over the life of a license orservice contract. This allows us to maintain a backlog that provides multi-yearvisibility in revenues.

 

Onecustomer, GlaxoSmithKline, accounted for approximately 18% and 15% of our totalrevenues in the three months ended September 30, 2006 and 2007,respectively, and 17% and 16% of our total revenues in the nine months ended September 30,2006 and 2007 respectively. The same customer accounted for $2.6 million and$2.1 million, or 9% and 8%, of accounts receivable outstanding as of December 31,2006 and September 30, 2007, respectively. Our top 20 customers accountedfor approximately 73% and 69% of our total revenues, net of reimburseableout-of-pocket expenses in the three months ended September 30, 2006 and2007, respectively, and 69% and 68% of our total revenues, net of reimburseableout-of-pocket expenses in the nine months ended September 30, 2006 and2007, respectively.

 

* License Revenues*

 

Wederive our license revenues from the following products: *InForm*, our Internet-based electronic datacapture, or EDC, solution; *Clintrial*,our clinical data management solution; and our drug safety solutions, includingour *Clintrace*, *WebVDME*,*CTSD*, and *WebSDM*products. Although each of our software solutions is available as a stand-aloneenterprise application, we offer integrated enterprise solutions incorporatingcertain of our electronic data capture, data management and drug safetyproducts.

 

Licenserevenues for our *InForm *electronicdata capture software solution, either on a stand-alone or integrated basis,are determined 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 or multi-year withpayment terms generally annually in advance. License revenues are recognizedratably over the duration of the software term license agreement, to the extentthat amounts are fixed or determinable and collectable.

 

Followingour acquisition 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 may inthe 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 continueto provide and charge for maintenance and support on our products to thosecustomers who do not convert to our software term license arrangements. Wegenerally charge 18% of the perpetual license fee for customer support. We willcontinue our efforts to convert the remaining former Clinsoft customer base tosoftware term license arrangements. However, we anticipate that some customerswill not convert and instead will continue to make annual customer supportpayments.

 

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*ServiceRevenues*

 

*Application Hosting Services.*  Inaddition to making our software products available to customers throughlicenses, we offer our *InForm*,*WebVDME, CTSD*and*WebSDM* software as hosted applicationsolutions delivered through a standard web-browser, with customer support andtraining services. Service revenues from application hosting services arederived principally from our *InForm *hostedsolution.

 

Revenuesresulting from the *InForm *hostingservice consist 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.

 

Servicesprovided for the first and third stages are provided on a fixed fee basisdepending upon the complexity of the trial and system requirements. Servicesfor the second stage are charged separately as a fixed monthly fee. Werecognize revenues from all stages of the hosting service ratably over thehosting period. Fees charged and costs incurred for the trial system design,set up and implementation are deferred until the start of the hosting periodand are amortized 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 theevent that an application hosting customer cancels a clinical trial and itsrelated statement of work, all deferred revenues are recognized and alldeferred set up costs are expensed. In addition, certain termination-relatedfees may be charged and if so, such fees are recognized in the period oftermination.

 

Revenuesresulting from hosting services for our *WebVDME*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related support services. Servicesfor this offering are charged monthly as a fixed fee. Revenues are recognizedratably over the period of the service.

 

Inaddition, application hosting service revenues include hosting servicesassociated with term license customers and reimbursable out-of-pocket expenses.

 

*Consulting Services.*  Consultingservices include the design and documentation of the processes related to ourcustomers’ use of our products and services in their clinical trials.Consulting services also include project planning and management services,guidance on best practices in using our software products, data management andconfiguration services for data mining and reporting, as well as implementationservices consisting of application 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.

 

*Customer Support.*  We have amultinational services organization to support our software products and hostedsolutions worldwide. Customer support includes telephone support, softwaremaintenance and training. We bundle customer support in our software termlicenses and allocate 10% of the value of the license to customer supportrevenues. Our customer support revenues also consist of customer support feespaid by perpetual license customers. Customer support revenues are recognizedratably over the period of the customer support or term license agreement, withpayment terms generally annually in advance.

 

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**Costof Revenues and Operating Expenses**

 

Weallocate overhead expenses such as rent and occupancy charges and employeebenefit costs to all departments based on headcount. As such, general overheadexpenses are reflected in cost of service revenues and in the sales andmarketing, research and development, and general and administrative expensecategories.

 

*Cost of Revenues.*  Cost oflicense revenues consists primarily of the amortization of royalties paid forcertain modules within our *Clintrial*software product as well as our *InForm *softwareproduct. In addition, costs of revenues include expense for the amortization ofacquired technologies associated with the acquisition of Lincoln. The cost oflicense revenues vary based upon the mix of revenues from software licenses forour products. We operate our service organization on a global basis as onedistinct unit, and do 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 alsoincludes hosting costs that primarily consist of hosting facility fees andserver depreciation.

 

Thecost of service revenues varies based upon the number of employees in theservice organization, the type of work performed, and royalties associated withrevenues derived from providing customer support, as well as costs associatedwith the flexible 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.

 

*Gross Margin.*  Our gross marginon license revenues varies based on the mix of royalty- and non-royalty-bearinglicense revenues and the amount of amortization of acquired technologies. Ourgross margin 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 ourcosts associated with delivery of the services are recognized as the servicesare performed, which is typically in the first 6 to 12 months of thecontract period. Accordingly, our gross margin on service revenues will varysignificantly over the life of a contract due to the timing, amount and type ofservice required in delivering certain projects. In addition, consolidatedgross margin will vary depending upon the mix of license and service revenues.

 

*Sales and Marketing.*  Sales andmarketing expenses consist primarily of employee-related expenses, includingtravel, marketing programs which include product marketing expenses such astrade shows, workshops and seminars, corporate communications, other brandbuilding and advertising, allocated overhead and the amortization ofcommissions. In addition, sales and marketing include expense for theamortization of acquired technologies associated with the acquisition ofLincoln. We expect that sales and marketing expenses will continue to increasein absolute 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 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 continue to add features and functionalityto our products, introduce additional integrated software solutions to ourproduct suite and expand our product and service offering.

 

*General and Administrative.*  Generaland administrative expenses consist primarily of employee-related expenses,professional fees, such as expenses for accounting, compliance with theSarbanes-Oxley Act of 2002, and legal services, including litigation,information technology and other corporate expenses and allocated overhead. Weexpect that in the future our general and administrative expenses will increasein absolute dollars as we add personnel and incur additional costs related tothe growth of our business and operations.

 

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*Stock-BasedCompensation Expenses.*  Our cost of servicerevenues, sales and marketing, research and development, and general andadministrative expenses include stock-based compensation expense. Stock-basedcompensation expense consists of the fair value of outstanding stock optionsand restricted stock awards and is recognized over the respective stock optionand award service periods. It also includes amortization of the excess of thedeemed fair market value over the exercise price of stock options granted priorto when we became a public company. In the years 2004, 2005 and 2006, werecorded $2.1 million, $607,000 and $3.0 million of aggregate stock-basedcompensation expense, respectively.

 

**ForeignCurrency Translation**

 

Withregard to our international operations, we frequently enter into transactionsin currencies other than the U.S. dollar. As a result, our revenues, expensesand cash flows are subject to fluctuations due to changes in foreign currencyexchange rates, particularly changes in the euro, British pound, Australiandollar and Japanese yen. In the three months ended September 30, 2006 and2007, approximately 48% of our revenues were generated in locations outside theUnited States. In the nine months ended September 30, 2006 and 2007, approximately49% and 50%, respectively, of our revenues were generated in locations outsidethe United States. The majority of these revenues are in currencies other thanthe U.S. dollar, as are many of the associated expenses. In periods when theU.S. dollar declines in value as compared to the foreign currencies in which weconduct business, our foreign currency-based revenues and expenses generallyincrease in value when translated 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 in the reporting periods. On an ongoing basis,we evaluate our estimates and assumptions with our audit committee, includingthose related to revenue recognition, deferred set up costs, commissions androyalties, accounts receivable reserves, stock-based compensation expenses,long-lived assets, intangibles assets and goodwill, income taxes,restructuring, contingencies and litigation. We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basisfor making judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. There have been no materialchanges to these estimates for the periods presented in this Quarterly Reporton Form 10-Q. Our actual results may differ from these estimatesunder different assumptions or conditions.

 

We believe that of oursignificant accounting policies, which are described in Note 2 of thenotes to our consolidated financial statements included in our Annual Report onForm 10-K for the year ended December 31, 2006 and the Notes to ourunaudited condensed consolidated financial statements included in thisQuarterly Report on Form 10-Q, the following accounting policies involve agreater degree of judgment and complexity. Accordingly, these are the policieswe believe are the most critical to aid in fully understanding and evaluatingour consolidated financial condition and results of operations.

 

*Revenue Recognition 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,* SEC Staff AccountingBulletin (SAB) No. 104, *RevenueRecognition*and EITFIssue No. 00-21, *Revenue Arrangementswith Multiple Deliverables.*

 

Customersgenerally have the ability to terminate application hosting, consulting andtraining service agreements upon 30 days notice. 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.

 

Werecognize revenues when all of the following conditions are satisfied: (1) thereis persuasive evidence of an arrangement; (2) the product or service hasbeen provided 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.

 

Wegenerally enter into software term licenses for our *InForm*, *Clintrial*and *Clintrace* products with ourcustomers for 3 to 5 year periods. License agreements for our *WebVDME, CTSD*and*WebSDM*products are generally annual or multi-year

 

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terms. These arrangementstypically include multiple elements: software license, consulting services andcustomer support. We bill our customers in accordance with the terms of theunderlying contract. Generally, we bill license fees annually in advance foreach year of the license term. Our payment terms are generally net30 days.

 

Oursoftware 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.

 

Wegenerally bundle customer support with the software license for the entire termof the arrangement. As a result, we generally recognize revenues for allelements, including consulting services, ratably over the term of the softwarelicense and support arrangement. We allocate the revenues recognized for thesearrangements to the different elements based on management’s estimate of therelative fair value of each element. For our term-based licenses, we allocateto consulting services the anticipated service effort and value throughout theterm of the arrangement at an amount that would have been allocated had thoseservices been sold separately to the customer. The remaining value is allocatedto license and support services, with 10% of this amount allocated to supportservices. We have allocated the estimated fair value to our multiple elementarrangements to provide meaningful disclosures about each of our revenuestreams. The costs associated with the consulting and customer support servicesare expensed as incurred. There are instances in which we sell softwarelicenses based on usage levels. These software licenses can be based onestimated usage, in which case the license fee charged to the customer is fixedbased on this estimate. When the fee is fixed, the revenues are generallyrecognized ratably over the contractual term of the arrangement. If the fee isbased on actual usage, and therefore variable, the revenues are recognized inthe period of use. Revenues from certain follow-on consulting services, whichare sold separately to customers with existing software licenses and are notconsidered part of a multiple element arrangement, are recognized as theservices are performed.

 

Wecontinue to sell 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 recognizedratably over the term of the underlying support arrangement. We continue togenerate customer support and maintenance revenues from our perpetual licensecustomer base. Training revenues are recognized as earned.

 

Inaddition to making our software products available to customers throughlicenses, we offer our *InForm*, *WebVDME*, *CTSD* and *WebSDM* software solutions through a hosted applicationsolution delivered through a standard web-browser.

 

Revenuesresulting from *InForm *application hostingservices consists of three stages for each clinical trial: the first stageinvolves application set up, including design of electronic case report formsand edit checks, implementation of the system and server configuration; thesecond stage involves application hosting and related support services; and thethird stage involves services required to close out, or lock, the database forthe 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. We recognize revenues from all stages of the *InForm *hosting service ratably overthe hosting period. Fees charged and costs incurred for the trial systemdesign, set up and implementation are deferred as applicable, until the startof the hosting period and then amortized and recognized, as applicable, ratablyover the estimated hosting period. The deferred costs include incrementaldirect costs with third parties and certain internal direct costs related tothe trial and application set up, as defined under SFAS No. 91, *Accounting for Nonrefundable Fees and CostsAssociated with Originating or Acquiring Loans and Indirect Costs of Leases*.These costs include salary and benefits associated with direct labor costsincurred during trial set up, as well as third-party subcontract fees and othercontract labor costs. Work performed outside the original scope of work iscontracted for separately as an additional fee and is generally recognizedratably over the remaining term of the hosting period. Fees for the first andthird stages of the services are billed based upon milestones. Fees for applicationhosting and related services in the second stage are billed quarterly inadvance. Bundled into this revenue element are the revenues attributable to thesoftware license used by the customer.

 

Revenuesresulting from hosting services for our *WebVDME*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related support services. Servicesfor this offering are charged monthly as a fixed fee. Revenues are recognizedratably over the period of the service.

 

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In theevent that an application hosting customer cancels a clinical trial and itsrelated statement of work, all deferred revenues are recognized and alldeferred set up costs are expensed. In addition, certain termination relatedfees may be charged and if so, such fees are recognized in the period oftermination.

 

Wedeferred $483,000 and $976,000 of set up costs and amortized $489,000 and$670,000 in the three months ended September 30, 2006 and 2007, respectively,and deferred $2.1 million and $2.7 million of set up costs and amortized $1.5million and $1.8 million in the nine months ended September 30, 2006 and2007, respectively. The amortization of deferred set up costs is a component ofcost of services.

 

Deferredrevenues represents amounts billed or cash received in advance of revenuerecognition.

 

Provisionsfor estimated losses on uncompleted contracts are made on acontract-by-contract basis and are recognized in the period in which suchlosses become probable and can be reasonably estimated. To date, we have notexperienced any material losses on uncompleted application hosting contracts.

 

*Accounting for 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$1.1 million and $3.2 million of commissions and amortized to sales andmarketing expense $804,000 and $2.3 million of commissions in the three monthsended September 30, 2006 and 2007, respectively, and deferred $4.0 millionand $6.9 million of commissions and amortized to sales and marketing expense$3.4 million and $5.2 million of commissions in the nine months ended September 30,2006 and 2007, respectively. Royalties are paid on a percentage of billingsbasis for certain of our products, and we have the right to recover royaltiesin the event an arrangement is cancelled. We deferred $99,000 and $526,000 ofroyalties and amortized to cost of revenues $694,000 and $617,000 of royaltiesin the three months ended September 30, 2006 and 2007, respectively, anddeferred $1.8 million and $2.1 million of royalties and amortized to cost ofrevenues $2.3 million and $1.9 million of royalties in the nine months ended September 30,2006 and 2007, respectively.

 

*Accounts Receivable Reserves.*  Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. We regularly evaluatethe collectibility of our trade receivables based on a combination of factors,which may include dialogue with the customer to determine the cause ofnon-payment, the use of collection agencies, and/or the use of litigation. Inthe event it is determined that the customer may not be able to meet itsfull obligation to us, we record a specific allowance to reduce the relatedreceivable to the amount that we expect to recover given all informationavailable to us. We continuously monitor collections from our customers andmaintain a provision for estimated credit losses based upon our historicalexperience and any specific customer collection issues that we have identified.While such credit losses have historically been within our expectations and theprovisions established, we cannot guarantee that we will continue to experiencethe same credit loss rates in the future. If the financial condition of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required. Our accountsreceivable reserves were $384,000 and $426,000 as of December 31, 2006 andSeptember 30, 2007, respectively.

 

*Accounting for Income Taxes.*  Inconnection with preparing our financial statements, we are required to computeincome tax expense in each jurisdiction in which we operate. This processrequires that we project our current tax liability and estimate our deferredtax assets and liabilities, including net operating loss and tax creditcarryforwards. In assessing the need for a valuation allowance, we haveconsidered our recent operating results, future taxable income projections andall prudent and feasible tax planning strategies. Based upon theseprojections, if it is determined that it is more likely than not that we wouldrealize a portion of our deferred tax assets, we would recognize the benefit,through the release of the portion of the deferred tax asset valuationallowance, that we are reasonably confident will be utilized. In 2005, we determined that it was more likelythan not that we would realize a portion of our deferred tax assets andtherefore reduced the valuation allowance by $7.8 million in December 2005.This benefit of the release in valuation allowance was realized throughreductions to income tax expense of $4.5 million and to goodwill of$3.2 million for the realization of acquired net operating losscarryforwards in the Clinsoft acquisition. In 2006, we determined that it wasmore likely than not that we would realize an additional portion of ourdeferred tax assets and therefore reduced the valuation allowance by$5.6 million. This benefit of the release in valuation allowance wasrealized through reductions to income tax expense of $5.4 million and togoodwill of $207,000. Also in 2006, we utilized $3.2 million of ourdeferred tax assets to offset 2006 taxable income. In the nine months ended September 30,2007, we determined that it is more likely than not that we will realize anadditional portion of deferred

 

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tax assets and thereforereduced the valuation allowance by $4.9 million. This benefit of therelease in valuation allowance was realized through reductions to income taxexpense of $4.4 million and to goodwill of $430,000.

 

If ourcurrent assumptions underlying the future taxable income projections and taxplanning strategies do not turn out to be substantially accurate, therealization of our remaining deferred tax assets which are currently subject toa full valuation allowance could be accelerated, which would result in areduction to income tax expense in the period when realization of this deferredtax asset is more likely than not to occur. However, this will be highlydependent upon our year-end projection of future income streams. After fullrealization of these benefits, we would expect our reported tax rate to revertto a more normal tax rate, in the range of 37% to 39%.

 

*Accounting for Stock-Based Awards.* On January 1, 2006, we adopted theprovisions of SFAS No. 123(R), *Share-basedPayment*, which requires us to recognize expense related to the fairvalue of stock-based compensation awards. We elected to use the modifiedprospective transition method as permitted by SFAS No. 123(R) andtherefore have not restated our financial results for prior periods. Under thistransition method, stock-based compensation expense for 2006 includescompensation expense for all stock-based compensation awards granted on orafter March 15, 2004 (the filing date for the initial registrationstatement for our initial public offering), based on the grant-date fair valueestimated in accordance with the provisions of SFAS No. 123(R).

 

Prior to the adoption of SFAS No. 123(R), weapplied SFAS No. 123, amended by SFAS No. 148, *Accounting for Stock-based Compensation —Transition and Disclosure*, which allowed companies to apply theexisting accounting rules under APB Opinion No. 25. Pursuant toAPB Opinion No. 25, we accounted for our stock-based awards toemployees using the intrinsic-value method, under which compensation expensewas measured on the date of grant as the difference between the fair value ofour common stock and the option exercise price multiplied by the number ofoptions granted. Generally, we granted stock options with exercise prices equalto the estimated fair value of our common stock; however, to the extent thatthe fair value of the common stock exceeded the exercise price of stock optionsgranted to employees on the date of grant, we recorded deferred compensationand amortized the expense over the vesting schedule of the options,generally four years. During 2003 and 2004, in accordance with APB OpinionNo. 25, we recorded deferred stock-based compensation resulting from thegrant of employee stock options with an exercise price less than the fair valueof common stock. As of September 30, 2007, we had $29,000 of deferredstock-based compensation remaining to be amortized which we expect to beamortized in the remainder of 2007**.**

 

Forall stock options granted prior to March 15, 2004, we used the minimumvalue method, pursuant to SFAS No. 123, *Accountingfor Stock-Based Compensation* for pro forma disclosure. Under theprovisions of SFAS No. 123(R), the value of these options will not berecorded in the statement of operations subsequent to the date of our adoptionof SFAS No. 123(R). Instead, we will continue to account for theseoptions using Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*,and related Interpretations.

 

Forservice-based options, accounted for under SFAS No. 123(R), werecognize compensation expense on a straight-line basis over the requisiteservice period of the award. For performance-based options, we recognizeexpense on a straight-line basis over the estimated performance period. Inaddition, SFAS 123(R) requires the benefits of tax deductions in excess ofrecognized share-based compensation to be reported as a financing activityrather than an operating activity in the statements of cash flows. Thisrequirement can have the effect of reducing our net operating cash flows andincreasing our net financing cash flows in certain periods.

 

Effective with the adoption of SFAS No. 123(R),we have elected to use the Black-Scholes option pricing model to determine theweighted average fair value of options granted.

 

In thethree and nine months ended September 30, 2007, we recorded $1.1 millionand $3.3 million of aggregate stock-based compensation expense, of which $1.1million and $3.2 million were a result of the adoption of SFAS No. 123(R).The remaining stock-based compensation expense is due to the amortization ofstock-based compensation associated with previously issued stock options whichamounted to $29,000 and $107,000, in the three and nine months ended September 30,2007, respectively. In the three months ended September 30, 2007,stock-based compensation expense included $102,000 in cost of revenues,$181,000 in research and development, $201,000 in sales and marketing and$652,000 in general and administrative expense. In the nine months ended September 30,2007, stock-based compensation expense included $330,000 in cost of revenues,$516,000 in research and development, $570,000 in sales and marketing and $1.9million in general and administrative expense. In the three months ended September 30,2006 and 2007, stock-based compensation expense reduced basic and dilutedearnings per share by $0.03. In the nine months ended September 30, 2006and 2007,

 

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stock-based compensationexpense reduced diluted earnings per share by $0.07 and $0.09, respectively. Asof September 30, 2007, we had $11.5 million of unrecognizedstock-based compensation expense related to market-based share awards that weexpect to recognize over a weighted average period of 2.96 years.

 

*Goodwill and 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 may differmaterially from these estimates. The timing and size of impairment charges, ifany, involves the application of management’s judgment regarding the estimatesand could significantly affect our operating results.

 

**Overviewof Results of Operations in the Three Months Ended September 30, 2006 and2007**

 

Totalrevenues increased by 24% or $6.8 million in the three months ended September 30,2007 compared to the same period in 2006 due to an increase in both service andlicense revenues.

 

Ourgross margin increased by 20% or $3.5 million in the three months ended September 30,2007 compared to the same period in 2006, primarily due to the increase inservices and license revenues.

 

Operatingincome in the three months ended September 30, 2007 of $4.1 millionincreased 47% or $1.3 million compared to the same period in 2006. Theoperating income in the three months ended September 30, 2006 and 2007also included $976,000 and $1.1 million of stock-based compensation expense,respectively.

 

Theresults in the three months ended September 30, 2007 were impacted byforeign exchange rate fluctuations, resulting in an approximately 3% increasein revenues and a 2% increase in expenses in the period.

 

As of September 30,2007, we had $187.0 million of cash, cash equivalents and short-terminvestments, an increase of $117.4 million from $69.6 million at December 31,2006. The increase was primarily due to net proceeds of approximately $89.2million, after deducting underwriters’ discounts, from our sale of 5,500,000shares of common stock in an underwritten public offering on May 29, 2007and an additional 825,000 shares pursuant to the exercise in full of theunderwriters’ over allotment option on June 1, 2007, each at $15.00 pershare. As of September 30, 2007, we had no outstanding debt.

 

*Revenues*

 
| ** **                   | ** ** | **Three Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|------------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                   | ** ** | **2006**                                                 | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** **                                               | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues**                 | ** ** | **Amount**                                               | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                   | ** ** | **(in thousands)**                                  | ** ** |
| License                      |       | $                                                        | 11,225     |                 | 40         | %          | $          | 12,924 |   | 37 | % | $ | 1,699 |   | 15 | % |
| Application hosting services |       | 10,883                                                   |       | 39                   |       | 14,906     |       | 43 |   | 4,023 |   | 37 |   |
| Consulting services          |       | 3,048                                                    |       | 11                   |       | 3,475      |       | 10 |   | 427 |   | 14 |   |
| Customer support             |       | 2,893                                                    |       | 10                   |       | 3,571      |       | 10 |   | 678 |   | 23 |   |
| Total                        |       | $                                                        | 28,049     |                 | 100        | %          | $          | 34,876 |   | 100 | % | $ | 6,827 |   | 24 | % |

 

Totalrevenues increased in the three months ended September 30, 2007 ascompared to the same period in 2006, primarily due to increases in applicationhosting and license revenues. The increase in revenues associated with ourapplication hosting services was due to an increase in trials under management,which include both application hosting services trials as well as trials hostedfor our *InForm *license customers. Theincrease in license revenues was primarily the result of additional *InForm *revenues from new and existing customers and, toa lesser extent, growth in sales relating to our safety products. The increasein consulting revenues was primarily attributable to additional revenues whichwere related to our *WebVDME, CTSD,*and*Clintrace* products. The increase in customer supportrevenues in the three months ended September 30, 2007 was due primarily toincreases in *InForm *customer support andtraining revenues. Our revenues were not significantly impacted by priceincreases or decreases. Inflation had only a nominal impact on our revenues.

 

29

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| ** **                          | ** ** | **Three Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                          | ** ** | **2006**                                                 | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                          | ** ** | ** **                                               | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                               | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                  | ** ** |
| United States                       |       | $                                                        | 14,586     |                 | 52         | %          | $          | 18,126 |   | 52 | % | $ | 3,540 |   | 24 | % |
|                                |       |                                                     |       |                 |       |       |       |   |   |   |   |   |   |
| United Kingdom                      |       | 9,316                                                    |       | 33                   |       | 11,329     |       | 32 |   | 2,013 |   | 22 |   |
| France/Belgium                      |       | 2,577                                                    |       | 9                    |       | 3,595      |       | 10 |   | 1,018 |   | 40 |   |
| Asia Pacific                        |       | 1,570                                                    |       | 6                    |       | 1,826      |       | 6 |   | 256 |   | 16 |   |
| International subtotal              |       | 13,463                                                   |       | 48                   |       | 16,750     |       | 48 |   | 3,287 |   | 24 |   |
| Total                               |       | $                                                        | 28,049     |                 | 100        | %          | $          | 34,876 |   | 100 | % | $ | 6,827 |   | 24 | % |

 

The increasein revenues worldwide was due to the increase in application hosting servicesand license revenues primarily associated with our *InForm *product. The increase in both U.S. andinternational revenues is primarily related to an increase in application hostingservices and *InForm *license**revenues from both new and existing customers.

 

*Costof Revenues*

 
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** | ** **          | ** ** | ** ** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                      | ** ** | **2006**                                                 | ** ** | **2007**            | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                               | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                               | ** ** | **of Related** | ** ** | ** ** | ** ** | **of Related** | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                               | ** ** | **Revenues**        | ** ** | **Amount** | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                                  | ** ** |
| License                         |       | $                                                        | 717        |                | 6          | %          | $          | 552 |   | 4 | % | $ | (165 | ) | (23 | )% |
| Services                        |       | 10,079                                                   |       | 60                  |       | 13,561     |       | 62 |   | 3,482 |   | 35 |   |
| Total                           |       | $                                                        | 10,796     |                | 38         | %          | $          | 14,113 |   | 40 | % | $ | 3,317 |   | 31 | % |

 

The cost of license revenues decreased in the threemonths ended September 30, 2007 primarily due to a $183,000 decreasein cost of royalties associated with our *InForm *softwareproduct. The increase in cost of services in the three months ended September 30,2007 was due primarily to increases in employee-related and contractor expensesof $1.5 million and $1.1 million, respectively, associated with a headcountincrease of 40 people and the delivery of increased services revenues. We alsohad increases in depreciation, telephone and travel expense of $403,000,$126,000 and $124,000, respectively. In addition, there were increases infacilities expense and computer related expenses of $113,000 and $183,000,respectively, which includes hardware and software support agreements, computeraccessories and equipment rentals for our training classes. These expenseincreases were partially offset by an increased benefit of labor capitalization(net of amortization) of $312,000 associated with work required for the trialbuild or set up phase for application hosting service arrangements, due to anincrease in trials in the set up phase.

 

*GrossMargin*

 
| ** **            | ** ** | **Three Months Ended September 30,** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------|------------|----------------------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                                 | ** ** | **2007**            | ** ** | ** ** | ** ** |
| ** **            | ** ** | ** **                                               | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **            | ** ** | ** **                                               | ** ** | **of Related** | ** ** | ** ** | ** ** | **of Related** | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                               | ** ** | **Revenues**        | ** ** | **Amount** | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                                  | ** ** |
| License               |       | $                                                        | 10,508     |                | 94         | %          | $          | 12,372 |   | 96 | % | $ | 1,864 |   | 18 | % |
| Services              |       | 6,745                                                    |       | 40                  |       | 8,391      |       | 38 |   | 1,646 |   | 24 |   |
| Total                 |       | $                                                        | 17,253     |                | 62         | %          | $          | 20,763 |   | 60 | % | $ | 3,510 |   | 20 | % |

 

Thelicense gross margin percentage increased in the three months ended September 30,2007 due to a decrease in royalty expense relating to our *InForm *software.The services gross margin percentage decreased in the three months ended September 30,2007, as our expense increase outpaced our revenues growth. The overall grossmargin percentage decreased in the three months ended September 30, 2007due to the decline in license revenues as a percentage of total revenues andthe decrease in services gross margin. It is likely that gross margin, as apercentage of revenues will fluctuate quarter by quarter due to the timing andmix of license and service revenues, and the type, amount and timing of servicerequired in delivering certain projects. For example, when services areperformed on a time and material basis, the timing of expense and revenuerecognition is more closely aligned than when services are performed underbundled arrangements, where the revenues are recognized ratably over thelicense period, while the expenses are recognized as incurred.

 

30

----

 

*OperatingExpenses*

 
| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|-----------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                                 | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                               | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                               | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                  | ** ** |
| Sales and marketing         |       | $                                                        | 5,377      |                 | 19         | %          | $          | 6,509 |   | 19 | % | $ | 1,132 |   | 21 | % |
| Research and development    |       | 4,538                                                    |       | 16                   |       | 5,066      |       | 14 |   | 528 |   | 12 |   |
| General and administrative  |       | 4,551                                                    |       | 16                   |       | 5,084      |       | 15 |   | 533 |   | 12 |   |
| Total                       |       | $                                                        | 14,466     |                 | 51         | %          | $          | 16,659 |   | 48 | % | $ | 2,193 |   | 15 | % |

 

 

*Sales and Marketing.*  Sales andmarketing expenses increased in the three months ended September 30, 2007primarily due to a $905,000 increase in commission expense due to an increasein orders and revenues. We also experienced additional employee-relatedexpenses in the amount of $194,000. We expect that our sales and marketingexpense will continue to increase in absolute dollars as commission expenseincreases with our revenues and as we continue to expand sales coverage and tobuild brand awareness through what we believe are the most cost effectivechannels available, but may fluctuate quarter over quarter due to thetiming of marketing programs.

 

*Research and Development.*  Researchand development expenses increased in the three months ended September 30,2007 primarily due to employee-related expenses of $417,000. We alsoexperienced additional expenses related to outside contractors, depreciationexpense and stock-based compensation of $133,000, $73,000 and $61,000,respectively. These expense increases were partially offset by a reduction inrecruiting expenses in the amount of $183,000. We expect that our research anddevelopment costs will continue to increase in absolute dollars as we continueto add features and functionality to our products and expand our product andservice offerings.

 

*General and Administrative.*  Generaland administrative expenses increased in the three months ended September 30,2007 primarily due to an increase in employee-related expenses of $190,000 relatedto a headcount increase of 4 people. In addition, outside contractor expenseand  taxes and fees increased by $128,000and $32,000, respectively. We also had increases in employee development,depreciation and computer related expense of $63,000, $36,000 and $33,000,respectively. We expect that in the future our general and administrativeexpenses will increase in absolute dollars as we add personnel and incuradditional costs related to the growth of our business and operations.

 

*OperatingIncome*
| ** **       | ** ** | **Three Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|------------------|------------|----------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **       | ** ** | **2006**                                                 | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **       | ** ** | ** **                                               | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Amount**                                               | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                                  | ** ** |
| Operating income |       | $                                                        | 2,787      |                 | 10         | %          | $          | 4,104 |   | 12 | % | $ | 1,317 |   | 47 | % |
|                  |            |                                                          |            |                      |            |            |            |  |  |  |  |  |  |  |  |  |

 

 

*Operating Income.* The increase inoperating income in the three months ended September 30, 2007 wasprimarily due to an increase in gross margin and the reduction in operatingexpenses as a percentage of revenues.

 

*OtherIncome (Expense)*

 
| ** **              | ** ** | **Three Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|-------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **              | ** ** | **2006**                                                 | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **                                               | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                               | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                                  | ** ** |
| Other income (expense): |       |                                                     |       |                 |       |       |       |   |   |   |   |   |   |
| Interest income         |       | $                                                        | 735        |                 | 3          | %          | $          | 2,362 |   | 7 | % | $ | 1,627 |   | 221 | % |
| Other, net              |       | 14                                                       |       | —               |       | (91        | )          | — |   | (105 | ) | NM |   |
| Total other income      |       | $                                                        | 749        |                 | 3          | %          | $          | 2,271 |   | 7 | % | $ | 1,522 |   | 203 | % |

 

*Other Income (Expense).*  Theincrease in interest income in the three months ended September 30, 2007was primarily due to an increase in the amount of cash, cash equivalents andshort-term investments which were interest bearing.

 

31

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*Provisionfor Income Taxes*

 
| ** **                 | ** ** | **Three Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|----------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                 | ** ** | **2006**                                                 | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                 | ** ** | ** **                                               | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **                 | ** ** | **Amount**                                               | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | **(in thousands)**                                  | ** ** |
| Provision for income taxes |       | $                                                        | 642        |                 | 2          | %          | $          | 657 |   | 2 | % | $ | 15 |   | 2 | % |
|                            |            |                                                          |            |                      |            |            |            |  |  |  |  |  |  |  |  |  |

 

*Provisionfor Income Taxes.  * Our provision for taxes includesforeign and alternative minimum tax. We have utilized available U.S. netoperating loss (NOL) carryforwards to offset our primary federal obligationsresulting in an effective tax rate of 18% and 10% in the three months ended September 30,2006 and 2007, respectively. In the three months ended September 30, 2007,we determined that it is more likely than not that we will realize additionalamounts of our NOL carryforwards and therefore reduced the valuation allowanceby $2.1 million. This benefit of the release in valuation allowance wasrealized through reductions to income tax expense of $1.9 million and togoodwill of $237,000. We currently expect to realize recorded deferred taxassets as of September 30, 2007 of approximately $9.7 million.

 

Inassessing the need for a valuation allowance, we have considered our recentoperating results, future taxable income projections and all prudent andfeasible tax planning strategies. Based upon these projections, if it isdetermined that it is more likely than not that we would realize a portion ofour deferred tax assets, we would recognize the benefit, through the release ofthe portion of the deferred tax asset valuation allowance, that we arereasonably confident will be utilized.

 

If ourcurrent assumptions underlying the future taxable income projections and taxplanning strategies do not turn out to be substantially accurate, therealization of our remaining deferred tax assets which are currently subject toa full valuation allowance could be accelerated, which would result in areduction to income tax expense in the period when realization of this deferredtax asset is more likely than not to occur. However, this will be highlydependent upon our year-end projection of future income streams. After fullrealization of these benefits, we would expect our reported tax rate to revertto a more normal tax rate, in the range of 37% to 39%.

 

**Overviewof Results of Operations in the Nine Months Ended September 30, 2006 and2007**

 

Totalrevenues increased by 26% or $20.1 million in the nine months ended September 30,2007 compared to the same period in 2006 due to an increase in both service andlicense revenues.

 

Ourgross margin increased by 24% or $11.0 million in the nine months ended September 30,2007 compared to the same period in 2006, primarily due to the increase inservices revenues and the combination of additional license revenues thatgenerate a higher gross margin.

 

Operatingincome in the nine months ended September 30, 2007 of $10.5 millionincreased 63% or $4.1 million compared to the same period in 2006. The operatingincome in the nine months ended September 30, 2006 and 2007 also included$2.0 million and $3.3 million of stock-based compensation expense,respectively.

 

Theresults in the nine months ended September 30, 2007 were impacted byforeign exchange rate fluctuations, resulting in an approximately 3% increasein revenues and expenses in the period.

 

*Revenues*

 
| ** **                   | ** ** | **Nine Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|------------------------------|------------|---------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                   | ** ** | **2006**                                                | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** **                                              | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues**                 | ** ** | **Amount**                                              | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                   | ** ** | **(in thousands)**                                 | ** ** |
| License                      |       | $                                                       | 29,633     |                 | 39         | %          | $          | 35,429 |   | 37 | % | $ | 5,796 |   | 20 | % |
| Application hosting services |       | 29,210                                                  |       | 38                   |       | 40,370     |       | 42 |   | 11,160 |   | 38 |   |
| Consulting services          |       | 8,405                                                   |       | 11                   |       | 9,999      |       | 10 |   | 1,594 |   | 19 |   |
| Customer support             |       | 9,139                                                   |       | 12                   |       | 10,696     |       | 11 |   | 1,557 |   | 17 |   |
| Total                        |       | $                                                       | 76,387     |                 | 100        | %          | $          | 96,494 |   | 100 | % | $ | 20,107 |   | 26 | % |

 

32

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Totalrevenues increased in the nine months ended September 30, 2007 as comparedto the same period in 2006, primarily due to increases in application hostingand license revenues. The increase in revenues associated with our applicationhosting services in the nine months ended September 30, 2007 was due to anincrease in trials under management, which include both application hostingservices trials as well as trials hosted for our *InForm *licensecustomers. The increase in license revenues was primarily the result ofadditional *InForm *revenues to both new andexisting customers and, to a lesser extent, growth in sales relating to our *WebVDME, CTSD,*and *Clintrace*products. The increase in consulting revenues was attributable to additional *InForm *and safety related revenues. The increase incustomer support revenues in the nine months ended September 30, 2007 wasdue primarily to increases in *InForm *trainingand customer support revenues. Our revenues were not significantly impacted byprice increases or decreases. Inflation had only a nominal impact on ourrevenues.

 
| ** **                          | ** ** | **Nine Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                          | ** ** | **2006**                                                | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                          | ** ** | ** **                                              | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                              | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                 | ** ** |
| United States                       |       | $                                                       | 39,093     |                 | 51         | %          | $          | 47,852 |   | 50 | % | $ | 8,759 |   | 22 | % |
|                                |       |                                                    |       |                 |       |       |       |   |   |   |   |   |   |
| United Kingdom                      |       | 24,775                                                  |       | 32                   |       | 34,249     |       | 35 |   | 9,474 |   | 38 |   |
| France/Belgium                      |       | 7,433                                                   |       | 10                   |       | 8,957      |       | 9 |   | 1,524 |   | 20 |   |
| Asia Pacific                        |       | 5,086                                                   |       | 7                    |       | 5,436      |       | 6 |   | 350 |   | 7 |   |
| International subtotal              |       | 37,294                                                  |       | 49                   |       | 48,642     |       | 50 |   | 11,348 |   | 30 |   |
| Total                               |       | $                                                       | 76,387     |                 | 100        | %          | $          | 96,494 |   | 100 | % | $ | 20,107 |   | 26 | % |

 

Theincrease in revenues worldwide was due to the increase in application hostingservices and license revenues associated with our *InForm *product. The increase in U.S. revenues isprimarily related to an increase in *InForm *revenuesacross all of our categories.

 

*Costsof Revenues*

 
| ** **                      | ** ** | **Nine Months Ended September 30,** | ** ** | ** **          | ** ** | ** ** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                      | ** ** | **2006**                                                | ** ** | **2007**            | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                              | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                              | ** ** | **of Related** | ** ** | ** ** | ** ** | **of Related** | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                              | ** ** | **Revenues**        | ** ** | **Amount** | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                                 | ** ** |
| License                         |       | $                                                       | 2,020      |                | 7          | %          | $          | 1,686 |   | 5 | % | $ | (334 | ) | (17 | )% |
| Services                        |       | 27,981                                                  |       | 60                  |       | 37,447     |       | 61 |   | 9,466 |   | 34 |   |
| Total                           |       | $                                                       | 30,001     |                | 39         | %          | $          | 39,133 |   | 41 | % | $ | 9,132 |   | 30 | % |

 

The costs of license revenuesdecreased in the nine months ended September 30, 2007 primarily dueto a $396,000 decrease in the cost of royalties associated with our *InForm *software product. Theincrease in cost of services in the nine months ended September 30, 2007was primarily due to increases in employee-related and contractor expenses of$4.0 million and $2.5 million, respectively, associated with deliveringincreased services revenues. We also had expense increases for depreciation,facilities and computer related expenses of $772,000, $422,000 and $952,000,respectively. Computer related expenses include hardware and software supportagreements as well as computer accessories. In addition, there were alsoincreases in travel and recruiting expense of $329,000 and $264,000,respectively. Further expense increases included telephone andstock-based compensation of  $298,000 and$169,000, respectively. These expense increases were partially offset by anincreased benefit of labor capitalization (net of amortization) of $247,000associated with the work required for trial build or set up phase forapplication hosting service arrangements, due to an increase in trials in theset up phase.

 

33

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*GrossMargin*

 
| ** **            | ** ** | **Nine Months Ended September 30,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                                | ** ** | **2007**                        | ** ** | ** ** | ** ** |
| ** **            | ** ** | ** **                                              | ** ** | **Percentage  of Related** | ** ** | ** ** | ** ** | **Percentage  of Related** | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                              | ** ** | **Revenues**                    | ** ** | **Amount** | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                                 | ** ** |
| License               |       | $                                                       | 27,613     |                            | 93         | %          | $          | 33,743 |   | 95 | % | $ | 6,130 |   | 22 | % |
| Services              |       | 18,773                                                  |       | 40                              |       | 23,618     |       | 39 |   | 4,845 |   | 26 |   |
| Total                 |       | $                                                       | 46,386     |                            | 61         | %          | $          | 57,361 |   | 59 | % | $ | 10,975 |   | 24 | % |

 

Thelicense gross margin percentage increased in the nine months ended September 30,2007 due to a decrease in royalty expense primarily relating to our *InForm *software. The services gross margin percentagedecreased slightly in the nine months ended September 30, 2007, as ourexpense increase outpaced our revenues growth. The overall gross margin percentagedecreased in the nine months ended September 30, 2007 due to the declinein license revenue as a percentage of total revenues and the decrease inservices gross margin.

 

*OperatingExpenses*

 
| ** **                  | ** ** | **Nine Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                                | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                              | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                              | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                 | ** ** |
| Sales and marketing         |       | $                                                       | 14,798     |                 | 19         | %          | $          | 17,731 |   | 18 | % | $ | 2,933 |   | 20 | % |
| Research and development    |       | 12,022                                                  |       | 16                   |       | 14,620     |       | 15 |   | 2,598 |   | 22 |   |
| General and administrative  |       | 13,138                                                  |       | 17                   |       | 14,509     |       | 15 |   | 1,371 |   | 10 |   |
| Total                       |       | $                                                       | 39,958     |                 | 52         | %          | $          | 46,860 |   | 48 | % | $ | 6,902 |   | 17 | % |

 

*Sales and Marketing.*Sales and marketingexpenses increased in the nine months ended September 30, 2007 primarilydue to a $1.8 million increase in commission expense due to an increase inrevenues, an increase in the effective commission rate and a $342,000 increasein employee-related expenses. We also experienced increases in travel,stock-based compensation expense and outside contractor expense of $325,000,$219,000 and $102,000, respectively. In addition, there was an increase intelephone expense of $76,000.

 

* Research and Development.*  Research and development expenses increased inthe nine months ended September 30, 2007 primarily due to employee-relatedexpenses of $1.3 million. In addition, outside contractors, stock-basedcompensation and depreciation expense increased $675,000, $268,000 and $263,000respectively. Further, there was an increase in facilities and telephoneexpense of $112,000 and $86,000, respectively. These expense increases werepartially offset by a reduction in recruiting expenses in the amount of$169,000.

 

*General and Administrative.*  Generaland administrative expenses increased in the nine months ended September 30,2007 primarily due to an increase in stock-based compensation expense of$686,000 and employee-related expenses of $582,000 related to a headcountincrease of 4 people. Further, computer relatedexpenses, taxes and fees and depreciation expense increased $159,000, $116,000and $124,000, respectively. Additionally, we experienced expense increases inemployee development, telephone and recruiting in the amounts of $123,000,$52,000 and $69,000, respectively. These expense increases werepartially offset by a decrease in professional fees of $669,000 which includedan elimination of expense related to an acquisition opportunity that wasevaluated in the nine months ended September 30, 2006.

 

*OperatingIncome*

 
| ** **       | ** ** | **Nine Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|------------------|------------|---------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **       | ** ** | **2006**                                                | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **       | ** ** | ** **                                              | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Amount**                                              | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                                 | ** ** |
| Operating income |       | $                                                       | 6,428      |                 | 8          | %          | $          | 10,501 |   | 11 | % | $ | 4,073 |   | 63 | % |
|                  |            |                                                         |            |                      |            |            |            |  |  |  |  |  |  |  |  |  |

 

34

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*Operating Income.* The increase inoperating income in the nine months ended September 30, 2007 was primarilydue to the reduction in operating expenses as a percentage of revenues.

 

*OtherIncome (Expense)*

 
| ** **              | ** ** | **Nine Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|-------------------------|------------|---------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **              | ** ** | **2006**                                                | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **                                              | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                              | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                                 | ** ** |
| Other income (expense): |       |                                                    |       |                 |       |       |       |   |   |   |   |   |   |
| Interest income         |       | $                                                       | 2,010      |                 | 3          | %          | $          | 4,758 |   | 5 | % | $ | 2,748 |   | 137 | % |
| Other, net              |       | (50                                                     | )          | —               |       | (153       | )          | — |   | (103 | ) | (206 | ) |
| Total other income      |       | $                                                       | 1,960      |                 | 3          | %          | $          | 4,605 |   | 5 | % | $ | 2,645 |   | 135 | % |

 

*Other Income (Expense).*  Theincrease in interest income in the nine months ended September 30, 2007was primarily due to an increase in the amount of cash, cash equivalents andshort-term investments which was interest bearing.

 

*Provisionfor Income Taxes*

 
| ** **                 | ** ** | **Nine Months Ended September 30,** | ** ** | ** **           | ** ** | ** ** | ** ** |
|----------------------------|------------|---------------------------------------------------------|------------|----------------------|------------|------------|------------|
| ** **                 | ** ** | **2006**                                                | ** ** | **2007**             | ** ** | ** ** | ** ** |
| ** **                 | ** ** | ** **                                              | ** ** | **Percentage**       | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **                 | ** ** | **Amount**                                              | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | **(in thousands)**                                 | ** ** | ** **           | ** ** |
| Provision for income taxes |       | $                                                       | 1,520      |                 | 2          | %          | $          | 1,579 |   | 2 | % | $ | 59 |   | 4 | % |
|                            |            |                                                         |            |                      |            |            |            |  |  |  |  |  |  |  |  |  |

 

* Provisionfor Income Taxes.  *Our provision for taxes includes foreign andalternative minimum tax. We have utilized available U.S. net operating loss(NOL) carryforwards to offset our primary federal obligations resulting in aneffective tax rate of 18% and 10% in the nine months ended September 30,2006 and 2007, respectively. In the nine months ended September 30, 2007,we determined that it is more likely than not that we will realize additionalamounts of our NOL carryforwards and therefore reduced the valuation allowanceby $4.9 million. This benefit of the release in valuation allowance wasrealized through reductions to income tax expense of $4.4 million and togoodwill of $430,000. We currently expect to realize recorded deferred taxassets as of September 30, 2007 of approximately $9.7 million.

 

Inassessing the need for a valuation allowance, we have considered our recentoperating results, future taxable income projections and all prudent andfeasible tax planning strategies. Based upon these projections, if it isdetermined that it is more likely than not that we would realize a portion ofour deferred tax assets, we would recognize the benefit, through the release ofthe portion of the deferred tax asset valuation allowance, which we arereasonably confident will be utilized.

 

If ourcurrent assumptions underlying the future taxable income projections and taxplanning strategies do not turn out to be substantially accurate, therealization of our remaining deferred tax assets which are currently subject toa full valuation allowance could be accelerated, which would result in a reductionto income tax expense in the period when realization of this deferred tax assetis more likely than not to occur. However, this will be highly dependent uponour year-end projection of future income streams. After full realization ofthese benefits, we would expect our reported tax rate to revert to a morenormal tax rate, in the range of 37% to39%.

 

**Liquidityand Capital Resources**

 

Ourprincipal sources of liquidity were cash, cash equivalents and short-terminvestments totaling $69.6 million and $187.0 million at December 31,2006 and September 30, 2007, respectively, and accounts receivable of$29.7 million and $28.0 million, respectively.

 

On May 29,2007, we sold 5,500,000 shares of common stock at $15.00 per share in a publicoffering resulting in proceeds of $77.5 million after deducting underwriters’discounts and offering related expenses. We also granted the underwriters anoption for 30 days to purchase up to an additional 825,000 shares to coverover-allotments, if any, which was exercised in full on June 1, 2007,resulting in net proceeds of $11.7 million after deducting underwriters’discounts.

 

35

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Cashprovided by and used in operating activities has historically been affected bychanges in working capital accounts, primarily deferred revenue, accountsreceivable and accrued expenses, and add-backs of non-cash expense items suchas depreciation and amortization and stock-based compensation. Fluctuationswithin accounts receivable and deferred revenues are primarily related to thetiming of billings of our term license customers and the associated revenuerecognition. Movements in deferred costs are related to the volume and stagesof hosted clinical trials and movements in accrued expenses and accountspayable are due to the timing of certain transactions.

 

Netcash provided by operating activities was $33.6 million in the nine monthsended September 30, 2007, which was greater than net income of$13.5 million. This difference is primarily due to $4.9 million ofnon-cash depreciation and amortization, $3.3 million of stock-basedcompensation, $5.4 million of non-cash income tax expense, a decrease inaccounts receivable of $2.0 million, an increase in accrued expenses of $3.3million, an increase in deferred revenues of $9.4 million, partially offset bydecreases in deferred income tax of $4.6 million, increases in deferred costsof $2.5 million and increases in prepaid expense and other current assets of$658,000.

 

Netcash used by investing activities was $10.1 million in the nine monthsended September 30, 2007, which was primarily due to the purchase ofshort-term investments of $62.6 million and capital expendituresassociated with the expansion of our hosting facility of $7.7 million partiallyoffset by $60.1 million of proceeds from maturities of short-terminvestments.

 

Netcash provided by financing activities was $91.4 million in the nine monthsended September 30, 2007, consisting of net proceeds from the issuance ofcommon stock. Net proceeds of approximately $89.2 million, after deductingunderwriters’ discounts, were received from our sales of 5,500,000 shares ofcommon stock in an underwritten public offering on May 29, 2007 and anadditional 825,000 shares pursuant to the exercise in full of the underwriters’over allotment option on June 1, 2007, each at $15.00 per share. Proceedsof $2.0 million were received from the exercise of stock options.

 

At December 31,2006 and September 30, 2007, we had a $500,000 outstanding letter ofcredit related to our facility. The letter of credit reduces the amountavailable under our line of credit with a bank.

 

Substantiallyall of our long-lived assets at December 31, 2006 and September 30,2007 are located in the United States and in the United Kingdom.

 

Wegenerally do not enter into long-term binding purchase commitments. Ourprincipal commitments consist of obligations under non-cancelable operatingleases for office space.

 

Thefollowing table of our material contractual obligations as of December 31,2006 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      |       | $                                         | 10,138     |   | $ | 3,474 |   | $ | 4,664 |   | $ | 1,659 |   | $ | 341 |   |
| Income tax liabilities           |       | 499                                       |       | 499 |   | — |   | — |   | — |   |
| Total                            |       | $                                         | 10,637     |   | $ | 3,973 |   | $ | 4,664 |   | $ | 1,659 |   | $ | 341 |   |

 

Priorto August 2005, all borrowings under our $5.0 million working capital lineof credit were secured by substantially all our assets. Under a relatednegative pledge agreement we were generally prohibited from pledging ourintellectual property to others, subject to certain exceptions. In August 2005,the working capital line of credit was amended to eliminate the securityinterest in our assets and the negative pledge on our intellectual property. Theamendment also removed or modified the financial covenants. Effective March 31,2006, the working capital line of credit was reduced from $5.0 million to $2.0million. As of December 31, 2006 and September 30, 2007, there wereno amounts outstanding under the working capital line of credit. At September 30,2007, there was $1.5 million available under the line of credit and $500,000reserved under a letter of credit associated with our leased facilities. At September 30,2007, we were in compliance with all financial covenants.

 

At December 31,2006, we had $76.1 million of net operating loss carryforwards that may beused to offset future U.S. federal taxable income of which approximately $18.6million of net operating loss carryforwards were acquired in the Clinsoftacquisition.

 

36

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These attributes may reduceour future cash tax liability. Approximately $51.1 million of these netoperating losses are subject to a full valuation allowance. When realization ofthis deferred tax asset is more likely than not to occur, the benefit willresult in a reduction of income tax expense of $13.1 million and a reduction togoodwill of $5.9 million. In addition, we had approximately $3.3 million of netoperating losses resulting from excess tax deductions related to stock-basedcompensation. We will realize the benefit of these losses through increases tostockholder’s equity in the periods in which the losses are utilized to reducetax payments. In addition, we had approximately $6.2 million of federalresearch and development tax credit carryforwards that may be used to offsetfuture U.S. federal taxable income of which approximately $2.8 million wereacquired in the Clinsoft acquisition and have an unlimited carryforward period.The net operating loss and tax credit carryforward period extends through 2023and 2026, respectively, and both are subject to review and possible adjustmentby the taxing authorities. Also, the Internal Revenue Code contains provisionsthat may limit the net operating loss and tax credit carryforwardsavailable in any given year in the event of certain changes in the ownershipinterests of significant stockholders. In addition, we also had $2.8 million offoreign net operating loss carryforwards that may be used to offset futureforeign taxable income. These foreign net operating loss carryforwards have anunlimited carryforward period. We currently expect to realize recorded deferredtax assets as of September 30, 2007 of $9.7 million. Our conclusion thatsuch assets will be recovered is based upon our expectation that our futureearnings will provide sufficient taxable income to realize recorded tax assets.

 

Webelieve our existing cash, cash equivalents, short-term investments, togetherwith funds generated by operations, should be sufficient to meet our operatingrequirements. 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 andenhancements to existing products and services and the continuing marketacceptance of our products and services. To the extent that existing cash andsecurities and cash from operations are insufficient to fund our futureactivities, we may need to raise additional funds through public orprivate equity or debt financing. From time to time, we may also enterinto agreements with respect to potential investments in, or acquisitions of,businesses, services or technologies, which could also require us to seekadditional equity or debt financing.

 

**RecentlyIssued Accounting Pronouncements**

 

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, whichdefines fair value, establishes a framework for measuring fair value undergenerally accepted accounting principles, and expands disclosures about fairvalue measurements. SFAS No. 157 applies to other accountingpronouncements that require or permit fair value measurements. The new guidanceis effective for financial statements issued for fiscal years beginning after November 15,2007, and for interim periods within those fiscal years. We are currentlyanalyzing the effect, if any, SFAS No. 157 will have on our consolidatedfinancial position and results of operations.

 

In February 2007,the FASB released SFAS No. 159, *TheFair Value Option for Financial Assets and Financial Liabilities,*which is effective for fiscal yearsbeginning after November 15, 2007. This Statement permits entities tochoose to measure many financial instruments and certain other items at fairvalue. The objective is to improve financial reporting by providing entitieswith the opportunity to mitigate volatility in reported earnings caused bymeasuring related assets and liabilities differently without having to applycomplex hedge accounting provisions. We are currently analyzing the effect, ifany, SFAS No. 159 will have on our consolidated financial position andresults of operations.

 

**Off-BalanceSheet Arrangements**

 

We donot have any special purpose entities or off-balance sheet arrangements.

 

**SpecialNote Regarding Forward-Looking Statements**

 

In addition to historical consolidated financialinformation, this Quarterly Report on Form 10-Q contains forward-lookingstatements **withinthe meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities and Exchange Act of 1934, as amended, and are intended to becovered by the “safe harbor” created by those sections.**Allstatements, other than statements of historical facts, included in thisQuarterly Report on From 10-Q regarding our strategy, future operations, futurefinancial position, future net sales, projected costs, projected expenses,prospects and plans and objectives of management are forward-lookingstatements. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,”“may,” “plans,” “projects,” “will,” “would” and similar expressions areintended to identify forward-looking statements, although not allforward-looking statements contain these identifying words.

 

37

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We may not actually achieve the plans, intentionsor expectations disclosed in our forward-looking statements and you should notplace undue reliance on our forward-looking statements. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. Although we believe that the expectations underlying any of ourforward-looking statements are reasonable, these expectations may prove tobe incorrect, and all of these statements are subject to risks anduncertainties. We discuss many of the risks that we believe could cause actualresults or events to differ materially from these forward-looking statements ingreater detail in the section entitled “Risk Factors” in **our Annual**Reporton**Form 10-K for the year ended December 31,2006. **We urge you to considerthe risks and uncertainties described in Item 1A of our Annual**Reporton**Form 10-K for the year ended December 31,2006, as updated in this Quarterly Report on Form 10-Q,**in evaluating ourforward-looking statements.**Should one or more of theserisks and uncertainties materialize, or should underlying assumptions,projections or expectations prove incorrect, actual results, performance orfinancial condition may vary materially and adversely from thoseanticipated, estimated or expected. Our forward-looking statements do notreflect the potential impact of any future acquisitions, mergers, dispositions,joint ventures or investments we may make.

 

**We caution readers not to place undue reliance uponany such forward-looking statements, which speak only as of the date made.Except as otherwise required by the federal securities laws, we disclaim anyobligation or undertaking to publicly release any updates or revisions to anyforward-looking statement contained herein (or elsewhere) to reflect any changein our expectations with regard thereto or any change in events, conditions orcircumstances on which********any suchstatement is based.**

 

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

 

*Foreign CurrencyExchange Risk*

* *

Ourresults of operations and cash flows are subject to fluctuations due to changesin foreign currency exchange rates, particularly changes in the euro, Britishpound, Australian dollar and Japanese yen. In the nine months ended September 30,2006 and 2007, 49% and 50%, respectively, of our revenues were generated inlocations outside the United States. The majority of these revenues aredenominated in currencies other than the U.S. dollar, as are many of theassociated expenses. Except for revenue transactions in Japan, we enter intotransactions directly with substantially all of our foreign customers. Thiscreates a foreign currency exchange risk for us.

 

As of September 30,2007, we had $7.3 million, of receivables denominated in currencies other thanthe U.S. dollar. We also maintain cash accounts denominated in currencies otherthan the local currency which expose us to foreign exchange rate movements. 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, as they are considered part ofour net investment and hence do not give rise to gains or losses. We alsomaintain cash accounts denominated in currencies other than the local currencywhich expose us to foreign exchange rate movements.

 

Wehave implemented a risk management program under which we measure foreigncurrency exchange risk monthly and manage those exposures through the use ofvarious operating strategies. As more fully described in Note 2 of the notes toour consolidated financial statements included in our Annual Report on Form 10-K,we regularly hedge our non-U.S. dollar-based exposures by entering intoshort-term forward foreign exchange contracts. This process is designed tominimize foreign currency translation exposures that could otherwise affectconsolidated results of operations. The terms of these contracts are forperiods generally ranging from one to two months. The short-term nature ofthese contracts has resulted in these instruments having insignificant fairvalues at December 31, 2006 and September 30, 2007.

 

Relativeto foreign currency exposures existing at December 31, 2006 and September 30,2007, a 10% unfavorable movement in foreign currency exchange rates would notexpose us to significant losses in earnings or cash flows or significantlydiminish the fair value of our foreign currency financial instruments. This isprimarily due to the short lives of the affected financial instruments thateffectively hedge substantially all of our December 31, 2006 and September 30,2007 exposures against fluctuations in foreign currency exchange rates. Thecalculation assumes that each exchange rate would change in the same directionrelative to the U.S. dollar.

 

As of September 30,2006 and 2007 we entered into contracts to hedge approximately $3.5 million and$1.2 million, respectively, of receivables, intercompany accounts and cashbalances denominated in currencies other than the U.S. dollar.

 

38

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*InterestRate Sensitivity*

 

We hadunrestricted cash, cash equivalents and short-term investments totaling $187.0million at September 30, 2007. Investments in securities are investedprimarily in high quality securities of a short duration and are not materiallyaffected by fluctuations in interest rates. The unrestricted cash and cashequivalents are held for working capital purposes. We do not enter intoinvestments for trading or speculative purposes. Due to the short-term natureof these investments, we believe that we do not have any material exposure tochanges in the fair value of our investment portfolio as a result of changes ininterest rates. Declines in interest rates, however, would reduce futureinvestment income.

 

Wehave a working capital line of credit which bears interest based upon the primerate. At December 31, 2006 and September 30, 2007, there were noamounts outstanding under our working capital line of credit. At September 30,2007, there was $1.5 million available under the line of credit and $500,000reserved under a letter of credit associated with our leased facilities.

 

**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’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognized that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desired controlobjectives, as ours are designed to do, and management necessarily was requiredto apply its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

 

As of September 30,2007, we carried out an evaluation, under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures, as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934. Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective in enabling us torecord, process, summarize and report information required to be included inour periodic SEC filings 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.

 

39

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**Part II—Other Information**

** **

**Item 1.****                                   *Legal Proceedings***

 

Fromtime to time and in the ordinary course of business, we are subject to variousclaims, charges and litigation. The outcome of litigation cannot be predictedwith certainty and some lawsuits, claims or proceedings may be disposed ofunfavorably to us, which could materially affect our financial condition or resultsof operations.

 

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

 

**Certain FactorsWhich May Affect Future Results**

** **

*From time to time we update, revise and supplement therisk factors described under the title “Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2006. Except with respect to a change inour risk factor entitled “Our operating results may fluctuate and couldcause the market price of our common stock to fall rapidly and without notice.”as set forth in our Quarterly Report on Form 10-Q for the period ended June 30,2007, there are no material changes to the risk factors described in the “RiskFactors” section in our Annual Report on Form 10-K for the year endedDecember 31, 2006.*

* *

*We operate in a rapidly changing environment that involves a number ofrisks, some of which are beyond our control. The risks and uncertainties thatwe believe are most important for you to consider are described under the title“Risk Factors” in our Annual Report on Form 10-K for the year ended December 31,2006. Additional risks and uncertainties not presently known to us, which wecurrently deem immaterial or which are similar to those faced by othercompanies in our industry or business in general, may also impair ourbusiness operations. If any of the foregoing risks or uncertainties actuallyoccurs, our business, financial condition and operating results would likelysuffer.*

* *

**Item 5.****                                   *Other Information***

 

Ourpolicy governing transactions in our securities by directors, officers andemployees permits our officers, directors and certain other persons to enterinto trading plans complying with Rule 10b5-1 under the SecuritiesExchange Act of 1934, as amended. We have been advised that our Vice President,Human Resources, Victor P. Becker; our Senior Vice President, Steve Rosenberg;our Vice President , Corporate Development, Martin Young; our Vice President,Quality & Regulatory Compliance, Michael Owings; our Senior VicePresident of Worldwide Sales, Stephen J. Powell;  and our Senior Vice President and Chief FinancialOfficer, Rodger Weismann****have eachentered into a trading plan covering periods after the date of this QuarterlyReport in accordance with Rule 10b5-1 and our policy governingtransactions in our securities. Generally, under these trading plans, theindividual relinquishes control over the transactions once the trading plan isput into place. Accordingly, sales under these plans may occur at anytime, including possibly before, simultaneously with, or immediately aftersignificant events involving our company.

 

**Weanticipate that, as permitted by Rule 10b5-1 and our policy governingtransactions in our securities, some or all of our officers, directors andemployees may establish trading plans in the future. We intend to disclosethe names of executive officers and directors who establish a trading plan incompliance with Rule 10b5-1 and the requirements of our policy governingtransactions in our securities in our future quarterly and annual reports on Form 10-Qand 10-K filed with the Securities and Exchange Commission. However, weundertake no obligation to update or revise the information provided herein,including for revision or termination of an established trading plan, otherthan in such quarterly and annual reports.**

 

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**Item 6.****                                   *Exhibits*.**

 
| **Exhibit** | ** ** | ** **                                                                                                                    |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------|
| **No.**     | ** ** | **Description**                                                                                                               |
| 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. |

** **

**41**

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** **

**Signatures**

** **

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                              | ** ** | **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 8,  2007 |       |                           |   |

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | ** **                                                                                                                    |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------|
| **No.**     | ** ** | **Description**                                                                                                               |
| 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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