Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**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 June 30, 2008** |
|-------------------------------------------------------|

 
| **OR** |
|--------|

 
| o | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|---|-------------------------------------------------------------------------------------------------------------------|

 
| **For the  transition period from                                   to                                  ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**CommissionFile Number: 000-50839**

 

**PhaseForward Incorporated**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**

(State or other  jurisdiction of

incorporation or  organization)                | ** ** | **04-3386549**

(I.R.S. Employer

Identification  No.) |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|
| **880  Winter Street**

**Waltham,  Massachusetts**

(Address of  principal executive offices) | ** ** | **02451**

(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, anon-accelerated filer or a smaller reporting company.  See the definitions of “large acceleratedfiler”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2of the Exchange Act.  (Check one):

 

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

(Do not check if a smaller  reporting company) |   | Smaller reporting company  o |

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

 

Yes    **o**     No   x

 

As of August 1,2008, the registrant had 42,799,937 shares of common stock outstanding.

 

 

** **

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**Table of Contents**

** **

**PHASE FORWARD INCORPORATEDQUARTERLY REPORT ON FORM 10-QFor the quarterly period ended June 30, 2008Table of Contents**

 
| ** **                                 | ** **                                                                                                                                         | ** ** | **Page  Number** |
|--------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|
| **Part I—Financial Information** |                                                                                                                                               |       |
|                                       |                                                                                                                                               |       |             |
| Item 1.                                    | Condensed Consolidated  Balance Sheets as of December 31, 2007 (unaudited) and June 30,  2008 (unaudited)                                | 2          |
|                                       |                                                                                                                                               |       |             |
|                                       | Condensed Consolidated  Statements of Income for the three and six months ended June 30, 2007  (unaudited) and June 30, 2008 (unaudited) | 3          |
|                                       |                                                                                                                                               |       |             |
|                                       | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2007 (unaudited) and June 30, 2008 (unaudited)       | 4          |
|                                       |                                                                                                                                               |       |             |
|                                       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                                  | 5          |
|                                       |                                                                                                                                               |       |             |
| Item 2.                                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                        | 17         |
|                                       |                                                                                                                                               |       |             |
| Item 3.                                    | Quantitative  and Qualitative Disclosures about Market Risk                                                                                        | 35         |
|                                       |                                                                                                                                               |       |             |
| Item 4.                                    | Controls and Procedures                                                                                                                            |       | 37               |
|                                       |                                                                                                                                               |       |             |
| **Part II—Other  Information**   |                                                                                                                                               |       |
|                                       |                                                                                                                                               |       |             |
| Item 1.                                    | Legal Proceedings                                                                                                                                  |       | 37               |
|                                       |                                                                                                                                               |       |             |
| Item 1A.                                   | Risk Factors                                                                                                                                       |       | 37               |
|                                       |                                                                                                                                               |       |             |
| Item 4                                     | Submission of  Matters to a Vote of Security Holders                                                                                               |       | 37               |
|                                       |                                                                                                                                               |       |             |
| Item 5.                                    | Other Information                                                                                                                                  |       | 38               |
|                                       |                                                                                                                                               |       |             |
| Item 6.                                    | Exhibits                                                                                                                                           |       | 39               |
|                                       |                                                                                                                                               |       |             |
| Signatures                                 |                                                                                                                                               |       | 40               |
|                                       |                                                                                                                                               |       |             |
| Exhibit Index                         |                                                                                                                                               |       | 41               |

 

----

Table of Contents

 

**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 June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                               | ** ** | **2007**                              | ** ** | **2008**                          | ** ** |
| **Assets**                                                                                               | ** ** | ** **                            | ** ** | ** **                        | ** ** |
| Current assets:                                                                                          |       |                                  |       |                              |       |
| Cash and cash  equivalents                                                                               |       | $                                     | 133,401    |                              | $          | 171,601 |   |
| Restricted cash,  current portion                                                                        |       | —                                |       | 500                               |       |
| Short-term  investments                                                                                  |       | 25,171                                |       | 21,043                            |       |
| Accounts receivable,  net of allowance of $270 and $387 in 2007 and 2008, respectively                   |       | 35,515                                |       | 28,993                            |       |
| Deferred set up  costs, current portion                                                                  |       | 2,062                                 |       | 2,370                             |       |
| Prepaid  commissions and royalties, current portion                                                      |       | 4,458                                 |       | 4,584                             |       |
| Prepaid expenses  and other current assets                                                               |       | 4,513                                 |       | 4,018                             |       |
| Deferred income  taxes, current portion                                                                  |       | 10,061                                |       | 11,185                            |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total current  assets                                                                                    |       | 215,181                               |       | 244,294                           |       |
|                                                                                                     |       |                                  |       |                              |       |
| Long-term  investments                                                                                   |       | 24,050                                |       | 23,292                            |       |
| Property and  equipment, net                                                                             |       | 15,967                                |       | 17,585                            |       |
| Deferred set up  costs, net of current portion                                                           |       | 1,347                                 |       | 1,635                             |       |
| Prepaid  commissions and royalties, net of current portion                                               |       | 3,614                                 |       | 4,279                             |       |
| Intangible  assets, net of accumulated amortization of $2,044 and $2,554 in 2007 and  2008, respectively |       | 3,356                                 |       | 2,846                             |       |
| Goodwill                                                                                                 |       | 25,511                                |       | 25,486                            |       |
| Deferred income  taxes, net of current portion                                                           |       | 16,576                                |       | 11,606                            |       |
| Restricted cash,  non-current portion                                                                    |       | —                                |       | 962                               |       |
| Other assets                                                                                             |       | 267                                   |       | 499                               |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total assets                                                                                             |       | $                                     | 305,869    |                              | $          | 332,484 |   |
|                                                                                                     |       |                                  |       |                              |       |
| **Liabilities  and Stockholders’ Equity**                                                           | ** ** | ** **                            | ** ** | ** **                        | ** ** |
| Current  liabilities:                                                                                    |       |                                  |       |                              |       |
| Accounts payable                                                                                         |       | $                                     | 1,222      |                              | $          | 2,629 |   |
| Accrued expenses                                                                                         |       | 19,447                                |       | 17,210                            |       |
| Deferred  revenues, current portion                                                                      |       | 61,750                                |       | 71,921                            |       |
| Deferred rent,  current portion                                                                          |       | 240                                   |       | 34                                |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total current  liabilities                                                                               |       | 82,659                                |       | 91,794                            |       |
|                                                                                                     |       |                                  |       |                              |       |
| Deferred  revenues, net of current portion                                                               |       | 5,380                                 |       | 10,793                            |       |
| Deferred rent,  net of current portion                                                                   |       | 116                                   |       | —                            |       |
| Other long-term  liabilities                                                                             |       | 1,277                                 |       | 2,178                             |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total  liabilities                                                                                       |       | 89,432                                |       | 104,765                           |       |
|                                                                                                     |       |                                  |       |                              |       |
| Commitments and  contingencies (Note 12)                                                                 |       |                                  |       |                              |       |
|                                                                                                     |       |                                  |       |                              |       |
| 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—42,724  and 42,832 shares in 2007 and 2008, respectively                                     |       | 428                                   |       | 428                               |       |
| Additional  paid-in capital                                                                              |       | 274,869                               |       | 278,735                           |       |
| Treasury stock,  37 shares at cost                                                                       |       | (111                                  | )          | (111                              | )          |
| Accumulated  other comprehensive income                                                                  |       | 746                                   |       | 466                               |       |
| Accumulated  deficit                                                                                     |       | (59,495                               | )          | (51,799                           | )          |
|                                                                                                     |       |                                  |       |                              |       |
| Total  stockholders’ equity                                                                         |       | 216,437                               |       | 227,719                           |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total  liabilities and stockholders’ equity                                                         |       | $                                     | 305,869    |                              | $          | 332,484 |   |

 

See accompanying notes.

 

2

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**PhaseForward Incorporated****Condensed Consolidated Statements of Income**

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

 
| ** **                                                                           | ** ** | **Three Months Ended   June 30****,** | ** ** | **Six Months Ended  June 30****,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2007**                                                  | ** ** | **2008**                                          | ** ** | **2007** | ** ** | **2008** | ** ** |
| Revenues:                                                                            | ** ** | ** **                                                | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| License                                                                              |       | $                                                         | 11,469     |                                              | $          | 13,087 |   | $ | 22,505 |   | $ | 25,701 |   |
| Service                                                                              |       | 20,065                                                    |       | 27,764                                            |       | 39,113 |   | 53,170 |   |
| ** **                                                                           | ** ** | ** **                                                | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenues                                                                       |       | 31,534                                                    |       | 40,851                                            |       | 61,618 |   | 78,871 |   |
| Costs of  revenues:                                                                  |       |                                                      |       |                                              |       |   |   |   |   |
| License                                                                              |       | 529                                                       |       | 626                                               |       | 1,134 |   | 1,281 |   |
| Service(1)                                                                           |       | 12,359                                                    |       | 17,191                                            |       | 23,886 |   | 32,719 |   |
| ** **                                                                           | ** ** | ** **                                                | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total cost of  revenues                                                              |       | 12,888                                                    |       | 17,817                                            |       | 25,020 |   | 34,000 |   |
| Gross margin:                                                                        |       |                                                      |       |                                              |       |   |   |   |   |
| License                                                                              |       | 10,940                                                    |       | 12,461                                            |       | 21,371 |   | 24,420 |   |
| Service                                                                              |       | 7,706                                                     |       | 10,573                                            |       | 15,227 |   | 20,451 |   |
| ** **                                                                           | ** ** | ** **                                                | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total gross  margin                                                                  |       | 18,646                                                    |       | 23,034                                            |       | 36,598 |   | 44,871 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Operating  expenses:                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Sales and  marketing(1)                                                              |       | 5,775                                                     |       | 6,783                                             |       | 11,222 |   | 12,934 |   |
| Research and  development(1)                                                         |       | 4,922                                                     |       | 6,021                                             |       | 9,554 |   | 11,579 |   |
| General and  administrative(1)                                                       |       | 4,787                                                     |       | 6,045                                             |       | 9,425 |   | 11,745 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Total operating  expenses                                                            |       | 15,484                                                    |       | 18,849                                            |       | 30,201 |   | 36,258 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Income from  operations                                                              |       | 3,162                                                     |       | 4,185                                             |       | 6,397 |   | 8,613 |   |
| Other income  (expense):                                                             |       |                                                      |       |                                              |       |   |   |   |   |
| Interest income                                                                      |       | 1,532                                                     |       | 1,386                                             |       | 2,396 |   | 3,287 |   |
| Other expense                                                                        |       | 4                                                         |       | 115                                               |       | (62 | ) | 249 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Total other  income                                                                  |       | 1,536                                                     |       | 1,501                                             |       | 2,334 |   | 3,536 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Income before  provision for income taxes                                            |       | 4,698                                                     |       | 5,686                                             |       | 8,731 |   | 12,149 |   |
| Provision for  income taxes                                                          |       | 370                                                       |       | 1,992                                             |       | 922 |   | 4,453 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Net income                                                                           |       | $                                                         | 4,328      |                                              | $          | 3,694 |   | $ | 7,809 |   | $ | 7,696 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Net income per  share applicable to common stockholders:                             | ** ** | ** **                                                | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                |       | $                                                         | 0.12       |                                              | $          | 0.09 |   | $ | 0.22 |   | $ | 0.18 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Diluted                                                                              |       | $                                                         | 0.11       |                                              | $          | 0.08 |   | $ | 0.21 |   | $ | 0.18 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Weighted average  number of common shares used in net income per share calculations: |       |                                                      |       |                                              |       |   |   |   |   |
| Basic                                                                                |       | 36,991                                                    |       | 42,007                                            |       | 35,815 |   | 41,933 |   |
|                                                                                 |       |                                                      |       |                                              |       |   |   |   |   |
| Diluted                                                                              |       | 38,997                                                    |       | 43,859                                            |       | 37,727 |   | 43,798 |   |

 

----

(1)             Amountsinclude stock-based compensation expense, as follows:

 
| Costs of service revenues  |   | $   | 118    |   | $      | 448   |   | $     | 228    |   | $ | 841 |   |
|----------------------------|--------|-----|--------|--------|--------|-------|--------|-------|--------|--------|---|-----|--------|
| Sales and marketing        |   | 203 |   | 368    |   | 369   |   | 682   |   |
| Research and development   |   | 179 |   | 323    |   | 335   |   | 602   |   |
| General and administrative |   | 665 |   | 853    |   | 1,265 |   | 1,613 |   |

 

See accompanying notes.

 

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**PhaseForward Incorporated****Condensed Consolidated Statements of Cash Flows**

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

 
| ** **                                                                              | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                              | ** ** | **2007**                                      | ** ** | **2008** | ** ** |
| **Operating  activities**                                                               | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net income                                                                              |       | $                                             | 7,809      |   | $ | 7,696 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:      |       |                                          |       |   |   |
| Depreciation and  amortization                                                          |       | 3,172                                         |       | 4,492 |   |
| Stock-based  compensation expense                                                       |       | 2,197                                         |       | 3,738 |   |
| Loss on disposal  of fixed assets                                                       |       | —                                        |       | 317 |   |
| Foreign currency  exchange loss (gain)                                                  |       | 62                                            |       | (14 | ) |
| Provision for  allowance for doubtful accounts                                          |       | 100                                           |       | 71 |   |
| Deferred income  taxes                                                                  |       | (2,592                                        | )          | 4,328 |   |
| Non-cash income  tax expense                                                            |       | 3,023                                         |       | — |   |
| Amortization of  premiums or discounts on investments                                   |       | 40                                            |       | (125 | ) |
| Changes in  assets and liabilities:                                                     |       |                                          |       |   |   |
| Accounts  receivable                                                                    |       | 3,641                                         |       | 7,235 |   |
| Deferred costs                                                                          |       | (1,448                                        | )          | (1,271 | ) |
| Prepaid expenses  and other current assets                                              |       | (561                                          | )          | 295 |   |
| Accounts payable                                                                        |       | 349                                           |       | 1,396 |   |
| Accrued expenses                                                                        |       | (629                                          | )          | (1,594 | ) |
| Deferred  revenues                                                                      |       | 11,043                                        |       | 15,417 |   |
| Deferred rent                                                                           |       | (293                                          | )          | (321 | ) |
|                                                                                    |       |                                          |       |   |   |
| Net cash  provided by operating activities                                              |       | 25,913                                        |       | 41,660 |   |
|                                                                                    |       |                                          |       |   |   |
| **Investing  activities**                                                               | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Increase in  restricted cash                                                            |       | —                                        |       | (1,462 | ) |
| Proceeds from  maturities of short-term investments                                     |       | 45,422                                        |       | 39,825 |   |
| Purchase of  short-term and long-term investments                                       |       | (51,919                                       | )          | (36,091 | ) |
| Purchase of  property and equipment                                                     |       | (6,105                                        | )          | (5,895 | ) |
|                                                                                    |       |                                          |       |   |   |
| Net cash used in  investing activities                                                  |       | (12,602                                       | )          | (3,623 | ) |
|                                                                                    |       |                                          |       |   |   |
| **Financing  activities**                                                               | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Proceeds from  issuance of common stock                                                 |       | 90,078                                        |       | 1,373 |   |
| Withholding  taxes in connection with vesting of restricted stock awards                |       | —                                        |       | (1,247 | ) |
|                                                                                    |       |                                          |       |   |   |
| Net cash  provided by financing activities                                              |       | 90,078                                        |       | 126 |   |
|                                                                                    |       |                                          |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                           |       | (90                                           | )          | 37 |   |
|                                                                                    |       |                                          |       |   |   |
| Net increase in  cash and cash equivalents                                              |       | 103,299                                       |       | 38,200 |   |
| Cash and cash  equivalents at beginning of period                                       |       | 42,169                                        |       | 133,401 |   |
|                                                                                    |       |                                          |       |   |   |
| Cash and cash  equivalents at end of period                                             |       | 145,468                                       |       | 171,601 |   |
| Short-term and  long-term investments at end of period                                  |       | 33,924                                        |       | 44,335 |   |
| Total cash, cash  equivalents and short-term and long-term investments at end of period |       | $                                             | 179,392    |   | $ | 215,936 |   |

 

See accompanying notes.

 

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**PhaseForward Incorporated**

**Notes to Condensed Consolidated FinancialStatements**

**(unaudited)**

**(inthousands, except share and per share amounts)**

 

**1.****              Basisof Presentation**

 

The accompanyingunaudited condensed consolidated financial statements included herein have beenprepared by Phase Forward Incorporated (the “Company”) pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”). Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles in theUnited States have been condensed or omitted pursuant to such SEC rules andregulations. Management of the Company believes that the disclosures herein areadequate to make the information presented not misleading. In the opinion ofmanagement, the unaudited condensed consolidated financial statements have beenprepared on the same basis as the audited consolidated financial statements andreflect all material adjustments (consisting only of those of a normal andrecurring nature) which are necessary to present fairly the consolidatedfinancial position of the Company as of June 30, 2008, the results of itsoperations for the three and six months ended June 30, 2007 and 2008 andits cash flows for the six months ended June 30, 2007 and 2008. Theseunaudited condensed consolidated financial statements and notes thereto shouldbe read in conjunction with the audited consolidated financial statements andnotes thereto included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2007. The results of operations for the interimperiods are not necessarily indicative of the results of operations to beexpected for the year ending December 31, 2008.

 

As of June 30,2008, 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 31,2007, have not changed except for the adoption of Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair Value Measurements*and SFAS No. 159, *The Fair Value Option forFinancial Assets and Liabilities*. See Note 17 for additional information regarding the Company’sadoption of these pronouncements.

 

Certain amounts inthe prior year’s financial statements have been reclassified to conform to thecurrent year’s presentation.

 

**2.****             ****Revenue Recognition and DeferredSet Up Costs**

 

The Company derivesrevenues from software licenses and services. License revenues are derivedprincipally from the sale of term licenses for the Company’s software productsincluding: *InFormTM, ClintrialTM,**WebSDMTM*, *Empirica*TM*Trace*(formerly *Clintrace*TM), *Empirica Signal* (formerly *WebVDMETM*)and *CTSDTM*.  Service revenues are derivedprincipally from the Company’s delivery of the hosted solutions of its *InForm, Empirica Signal*, *CTSD*and *WebSDM* softwareproducts, and consulting services and customer support, including training, forall of the Company’s products.

 

The components of revenueare as follows:

 
| ** **                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                        | ** ** | **2008**                                      | ** ** | **2007** | ** ** | **2008** | ** ** |
| License                       |       | $                                               | 11,469     |                                          | $          | 13,087 |   | $ | 22,505 |   | $ | 25,701 |   |
| Application  hosting services |       | 13,412                                          |       | 21,235                                        |       | 25,464 |   | 40,420 |   |
| Consulting  services          |       | 3,098                                           |       | 3,604                                         |       | 6,524 |   | 7,170 |   |
| Customer support              |       | 3,555                                           |       | 2,925                                         |       | 7,125 |   | 5,580 |   |
|                          |       |                                            |       |                                          |       |   |   |   |   |
| Total                         |       | $                                               | 31,534     |                                          | $          | 40,851 |   | $ | 61,618 |   | $ | 78,871 |   |

 

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

 

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Customers generally havethe ability to terminate application hosting, consulting and training serviceagreements upon 30 days notice to the Company. License agreements,multiple element arrangements, including license and service 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.

 

The Company recognizesrevenues when all of the following conditions are satisfied: (1) there ispersuasive evidence of an arrangement; (2) the product or service has beenprovided to the customer; (3) the collection of fees is probable; and (4) theamount of fees to be paid by the customer is fixed or determinable.

 

The Company generallyenters into software term licenses for its *InForm*,*Clintrial* and *Empirica Trace*products with its customersfor 3- to 5-year periods. License agreements for other**productsare generally for annual or multi-year terms. These arrangements typically include multiple elements: softwarelicense, consulting services and customer support. The Company bills itscustomers in accordance with the terms of the underlying contract. Generally,the Company bills license fees annually in advance for each year of the licenseterm. Payment terms are generally net 30 days.

 

The Company’s softwarelicense revenues are earned from the sale of off-the-shelf software requiringno significant modification or customization subsequent to delivery to thecustomer. Consulting services, which can also be performed by third-party consultants,are deemed to be non-essential to the functionality of the software andtypically are for trial configuration, implementation planning, loading ofsoftware, building simple interfaces and running test data and documentation ofprocedures.

 

Customer support includestraining services, telephone support and software maintenance.  The Company generally bundles customersupport with the software license for the entire term of the arrangement. As aresult, the Company generally recognizes revenues for all elements, includingconsulting services, ratably over the term of the software license and supportarrangement. The Company allocates the revenues recognized for thesearrangements to the different elements based on management’s estimate of therelative fair value of each element. For its term-based licenses, the Companyallocates to consulting services the anticipated service effort and valuethroughout the term of the arrangement at an amount that would have beenallocated had those services been sold separately to the customer. The value ofthe Company’s consulting services sold within a bundled arrangement is equal tothe value of consulting services sold on a stand-alone basis, as the activitiesperformed under both types of arrangements are similar in nature.  The remaining value is allocated to licenseand support services, with 10% of this amount allocated to support services.The customer support services rate of 10% for multi-year term-based licensesreflects a significant discount from the rate for customer support servicesassociated with perpetual licenses due to the reduction in the time periodduring which the customer can utilize the upgrades and enhancements.  The Company believes this rate is substantiveand represents an amount it believes reasonable to be allocated.  The Company has allocated the estimated fairvalue to its multiple element arrangements to provide meaningful disclosuresabout each of its revenue streams. The costs associated with the consulting andcustomer support services are expensed as incurred. There are instances inwhich the Company sells software licenses based on usage levels. These softwarelicenses can be based on estimated usage, in which case the license fee chargedto the customer is fixed based on this estimate. When the fee is fixed, therevenues are generally recognized ratably over the contractual term of thearrangement. If the fee is based on actual usage, and therefore variable, therevenues are recognized in the period of use. Revenues from certain follow-onconsulting services, which are sold separately to customers with existingsoftware licenses and are not considered part of a multiple elementarrangement, are recognized as the services are performed.

 

The Company may sellincremental perpetual licenses for the *Clintrial* and *Empirica Trace* software products incertain situations to its existing customers with the option to purchasecustomer support. The Company has established vendor specific objectiveevidence of fair value for the customer support. Accordingly, license revenuesare recognized upon delivery of the software and when all other revenuerecognition criteria are met. Customer support revenues are recognized ratablyover the term of the underlying support arrangement. The Company generatescustomer support and maintenance revenues from its perpetual license customerbase. Training revenues are recognized as earned.

 

In addition to making itssoftware products available to customers through licenses, the Company offersits *InForm*, *Empirica Signal*, *CTSD* and *WebSDM*software solutions through a hosted application solution delivered through astandard web-browser.

 

Revenues resulting from *InForm *application hosting services consist of threestages for each clinical trial: the first stage involves application set up,including design of electronic case report forms and edit checks,implementation of the system and server configuration; the second stageinvolves application hosting and related support services; and the third stage 

 

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involves servicesrequired to close out, or lock, the database for the clinical trial. Servicesprovided for the first and third stages are provided on a fixed fee basis basedupon the complexity of the trial and system requirements. Services for thesecond stage are charged separately as a fixed monthly fee. The Companyrecognizes revenues from all stages of the *InForm *hostingservice ratably over the hosting period. Fees charged and costs incurred forthe trial system design, set up and implementation are deferred until the startof the hosting period and are amortized and recognized ratably over theestimated hosting period. The deferred costs include incremental direct costswith third parties and certain internal direct costs related to the trial andapplication 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 service are billed based upon 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.

 

Revenues resulting fromhosting services for the *Empirica Signal*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related supportservices.  Services for this offering aregenerally charged a monthly fixed fee. Revenues are recognized ratably over the period of the service.

 

In the event that anapplication hosting customer cancels a clinical trial and its related statementof work, all deferred revenues are recognized and all deferred set up costs areexpensed.  In addition, certain terminationrelated fees may be charged and if so, such fees are recognized in the periodof termination.

 

The Company may alsoenter into arrangements to provide consulting services separate from a licensearrangement. In these situations, revenue is recognized in accordance with SOP81-1, *Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts,*on either atime and materials basis or using the proportional performance method. If theCompany is not able to produce reasonably dependable estimates, revenue is recognizedupon completion of the project and final acceptance from the customer. Ifsignificant uncertainties exist about project completion or receipt of payment,the revenue is deferred until the uncertainty is resolved. Provisions forestimated losses on contracts are recorded during the period in which they areidentified.

 

One customer,GlaxoSmithKline, accounted for approximately 16% and 12% of the Company’s totalrevenues in the three months ended June 30, 2007 and 2008, respectively,and 16% and 13% of the Company’s total revenues in the six months ended June 30,2007 and 2008, respectively. The same customer accounted for $1,803 and $1,069,or 5% and 4%, of accounts receivable outstanding as of December 31, 2007and June 30, 2008, respectively.

 

The Company deferred $731and $1,074 of set up costs and amortized $604 and $878 of set up costs in thethree months ended June 30, 2007 and 2008, respectively, and deferred$1,673 and $2,279 of set up costs and amortized $1,164 and $1,683 of set upcosts in the six months ended June 30, 2007 and 2008, respectively.  The amortization of deferred set up costs isa component of cost of service revenues.

 

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

 

Provisions for estimatedlosses on uncompleted contracts are made on a contract-by-contract basis andare recognized in the period in which such losses become probable and can bereasonably estimated. To date, the Company has not experienced any materiallosses on uncompleted application hosting or consulting contracts.

 

In accordance with EITFIssue No. 01-14, *Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” ExpensesIncurred,* the Company included $178 and $188 of out-of-pocketexpenses in service revenues and cost of service revenues in the three monthsended June 30, 2007 and 2008, respectively, and included $297 and $343 ofout-of-pocket expenses in service revenues and cost of service revenues in thesix months ended June 30, 2007 and 2008, respectively.

 

**3.****              Prepaid SalesCommissions and Royalties**

 

For arrangements whererevenues are recognized over the relevant contract period, the Company defersrelated commissions paid to its direct sales force and software licenseroyalties paid to third parties, and amortizes these expenses over the periodin which the related revenues are recognized.

 

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Commission payments arenonrefundable unless amounts due from a customer are determined to beuncollectible or if the customer subsequently changes or terminates the levelof service, in which case commissions paid are recoverable by the Company. TheCompany deferred $1,963 and $2,361 of commissions and amortized to sales andmarketing expense $1,390 and $2,035 in the three months ended June 30,2007 and 2008, respectively, and deferred $3,626 and $4,380 of commissions andamortized to sales and marketing expense $2,905 and $3,818 in the six monthsended June 30, 2007 and 2008, respectively.

 

The Company’s royaltyobligation is based upon the license and customer support revenues earned forcertain products in an arrangement. The Company has the right to recover theroyalties in the event the arrangement is cancelled. The Company deferred $796and $521 of royalties and amortized to cost of revenues $579 and $648 in thethree months ended June 30, 2007 and 2008, respectively, and deferred$1,540 and $1,569 of royalties and amortized to cost of revenues $1,267 and$1,340 in the six months ended June 30, 2007 and 2008, respectively.

 

**4.****              Warranties andIndemnification**

 

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 productdocumentation under normal use and circumstances. The Company’s arrangementsalso include certain provisions for indemnifying customers against liabilitiesif its products or services infringe a third party’s intellectual propertyrights.

 

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.****              Acquisitions**

 

On October 30, 2007, the Company acquired all of theoutstanding capital stock of Green Mountain Logic, Inc. (“Green Mountain”),a process automation software company that provides targeted solutions for thelife sciences industry, including *LabPas* Phase Iclinic automation software.  The Companypaid a premium to acquire the technology and products of Green Mountain whichprovide the Company with a solution targeted for Phase I clinical trials.  The aggregate purchase price was $5,397.  The acquisition of Green Mountain wasaccounted for as a purchase under SFAS No. 141, *BusinessCombinations*.  Accordingly,the results of Green Mountain have been included in the consolidated financialstatements since the date of acquisition.

 

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

 

Basic and diluted net income per share is presented inconformity with SFAS No. 128, *Earnings PerShare*. Basic net income per common share for all periods presentedwas determined by dividing net income applicable to common stockholders by theweighted average number of common shares outstanding during the period.Weighted average shares outstanding exclude unvested restricted common stock.Diluted net income per share includes the effects of all dilutive, potentiallyissuable common shares using the treasury stock method.

 

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The calculation of basicand diluted net income per share is as follows:

 
| ** **                                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                            | ** ** | **2007**                                        | ** ** | **2008**                                      | ** ** | **2007** | ** ** | **2008** | ** ** |
| Numerator:                                                            |       |                                            |       |                                          |       |   |   |   |   |
| Net income                                                            |       | $                                               | 4,328      |                                          | $          | 3,694 |   | $ | 7,809 |   | 7,696 |   |
|                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Denominator:                                                          |       |                                            |       |                                          |       |   |   |   |   |
| Weighted-average  common shares outstanding                           |       | 37,922,355                                      |       | 42,800,795                                    |       | 36,748,370 |   | 42,759,162 |   |
| Less  weighted-average unvested restricted common shares outstanding  |       | (931,467                                        | )          | (793,761                                      | )          | (933,089 | ) | (826,301 | ) |
| Basic  weighted-average common shares outstanding                     |       | 36,990,888                                      |       | 42,007,034                                    |       | 35,815,281 |   | 41,932,861 |   |
| Dilutive effect  of common stock options                              |       | 1,665,781                                       |       | 1,307,323                                     |       | 1,631,787 |   | 1,335,742 |   |
| Dilutive effect  of unvested restricted common stock awards and units |       | 340,152                                         |       | 544,204                                       |       | 279,464 |   | 529,650 |   |
| Diluted  weighted-average common shares outstanding                   |       | 38,996,821                                      |       | 43,858,561                                    |       | 37,726,532 |   | 43,798,253 |   |
|                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Net income per  share applicable to common                            |       |                                            |       |                                          |       |   |   |   |   |
| stockholders:                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                 |       | $                                               | 0.12       |                                          | $          | 0.09 |   | $ | 0.22 |   | $ | 0.18 |   |
|                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Diluted                                                               |       | $                                               | 0.11       |                                          | $          | 0.08 |   | $ | 0.21 |   | $ | 0.18 |   |

 

In the six months ended June 30,2007 and 2008, diluted weighted-average common shares outstanding do notinclude options outstanding and restricted stock units to purchase 2,652 and399,176 common equivalent shares, respectively, as their effect would have beenanti-dilutive.

 

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

 

The financial statementsof the Company’s foreign subsidiaries are translated in accordance with SFAS No. 52,*Foreign Currency Translation.* Thereporting currency for the Company is the U.S. dollar. The functional currencyof the Company’s subsidiaries in the United Kingdom, France, Belgium, Germany,Japan, India and Australia are the local currencies of those countries.Accordingly, the assets and liabilities of the Company’s foreign subsidiariesare translated into U.S. dollars using the exchange rate in effect at eachbalance sheet date. Revenues and expense accounts are translated generallyusing an average rate of exchange during the period. Gains and losses arisingfrom transactions denominated in foreign currencies are primarily related tointercompany accounts that have been determined to be temporary in nature andcash and accounts receivable denominated in non-functional currencies.  The Company recorded foreign currency gainsof $3 and $15 in the three months ended June 30, 2007 and 2008,respectively.  The Company recorded aforeign currency loss of $62 and a foreign currency gain of $14 in the sixmonths ended June 30, 2007 and 2008, respectively.  Such gains (losses) are included in otherincome (expense) in the accompanying unaudited condensed consolidatedstatements of income.

 

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

 

**8.****              Cash, Cash Equivalents, Short-term andLong-term Investments**

 

The Company accounts forits investments in accordance with SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*. Under SFAS No. 115, securities that the Company hasthe intent and ability to hold to maturity are reported at amortized cost,which approximates market value, and are classified as held-to-maturity, whilethose securities for which it is not the Company’s intent to hold to maturityare classified as available-for-sale securities and are reported at fair value,with unrealized gains and losses excluded from earnings and reported as aseparate component of stockholders’ equity. The Company considers all highlyliquid investments with original maturities of 90 days or less at the timeof purchase to be cash equivalents and investments with original maturities ofbetween 91 days and one year to be short-term 

 

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investments.  Allsecurities, with the exception of auction rate securities (“ARS”), areclassified as held-to-maturity securities.  The ARS are debt instrumentsissued by various states throughout the United States and are classified asavailable-for-sale because it is the Company’s intent not to hold them tomaturity.

 

Cash, cash equivalents,short-term and long-term investments as of December 31, 2007 and June 30,2008 consist of the following:

 
| ** **                                   | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------|------------|---------------------------------|------------|
| **Description**                              | ** ** | **Contracted  Maturity**        | ** ** | **Amortized  Cost** | ** ** | **Fair Market  Value** | ** ** | **Balance Per  Balance Sheet** | ** ** |
| Cash                                         |       | Demand                          |       | $ | 8,718 |   | $ | 8,718 |   | $ | 8,718 |   |
| Certificate of  deposit                      |       | 50 Days                         |       | 3,100 |   | 3,100 |   | 3,100 |   |
| Money market  funds                          |       | Demand                          |       | 121,583 |   | 121,583 |   | 121,583 |   |
|   Total  cash and cash equivalents |       |                            |       | $ | 133,401 |   | $ | 133,401 |   | $ | 133,401 |   |
|                                         |       |                            |       |   |   |   |   |   |   |
| Auction rate  securities (1)                 |       | 26 years                        |       | $ | 10,450 |   | $ | 10,450 |   | $ | 10,450 |   |
| U.S. agency  notes                           |       | 173 days                        |       | 1,502 |   | 1,501 |   | 1,502 |   |
| Corporate bonds                              |       | 210 days                        |       | 13,219 |   | 13,222 |   | 13,219 |   |
| Total short-term  investments                |       |                            |       | $ | 25,171 |   | $ | 25,173 |   | $ | 25,171 |   |
|                                         |       |                            |       |   |   |   |   |   |   |
| Auction rate  securities                     |       | 34 years                        |       | $ | 24,050 |   | $ | 24,050 |   | $ | 24,050 |   |
| Total long-term  investments                 |       |                            |       | $ | 24,050 |   | $ | 24,050 |   | $ | 24,050 |   |

 

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(1)             TheseARS were successfully liquidated subsequent to December 31, 2007, with noloss.

 
| ** **                                   | ** ** | **June 30, 2008** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|
| **Description**                              | ** ** | **Contracted  Maturity**    | ** ** | **Amortized  Cost** | ** ** | **Fair Market  Value** | ** ** | **Balance Per  Balance Sheet** | ** ** |
| Cash                                         |       | Demand                      |       | $ | 16,750 |   | $ | 16,750 |   | $ | 16,750 |   |
| Money market  funds                          |       | Demand                      |       | 154,851 |   | 154,851 |   | 154,851 |   |
|   Total  cash and cash equivalents |       |                        |       | $ | 171,601 |   | $ | 171,601 |   | $ | 171,601 |   |
|                                         |       |                        |       |   |   |   |   |   |   |
| U.S. agency  notes                           |       | 301 days                    |       | $ | 4,000 |   | $ | 4,000 |   | $ | 4,000 |   |
| Municipal bonds                              |       | 360 days                    |       | 1,004 |   | 1,006 |   | 1,004 |   |
| Corporate bonds                              |       | 227 days                    |       | 16,039 |   | 16,097 |   | 16,039 |   |
| Total short-term  investments                |       |                        |       | $ | 21,043 |   | $ | 21,103 |   | $ | 21,043 |   |
|                                         |       |                        |       |   |   |   |   |   |   |
| Auction rate  securities                     |       | 34 years                    |       | $ | 24,050 |   | $ | 22,773 |   | $ | 22,773 |   |
| Corporate bonds                              |       | 411 days                    |       | 519 |   | 532 |   | 519 |   |
| Total long-term  investments                 |       |                        |       | $ | 24,569 |   | $ | 23,305 |   | $ | 23,292 |   |

 

The Company has had norealized gains or losses from the sale of cash equivalents or short-terminvestments.  The Company recorded anunrealized loss of $1,277 in connection with its ARS as further discussedbelow.

 

As of June 30, 2008,the Company held ARS totaling $24,050 at par value, which were considered asavailable-for-sale securities and classified as long-term investments in theaccompanying condensed consolidated balance sheet, and recorded at fair value.These ARS are debt instruments issued by various states throughout the UnitedStates to finance student loans.  Thetypes of ARS that the Company owns are backed by student loans, 95% of whichare guaranteed under the Federal Family Education Loan Program, and all havecredit ratings of AAA (or equivalent) from a recognized rating agency.  Historically, the carrying value of ARSapproximated fair value due to the frequent resetting of the interest rates.With the liquidity issues experienced in the global credit and capital markets,the Company’s ARS have experienced multiple failed auctions. While the Companycontinues to earn and receive interest on these investments at the maximumcontractual rate, the estimated fair value of these ARS no longer approximatespar value.

 

The Company concludedthat the fair value of these ARS at June 30, 2008 was $22,773, a declineof $1,277 from par value. Fair value was determined using a trinomial discountmodel as recent auctions of these securities were not successful, resulting inthe Company continuing to hold these securities and issuers paying interest atthe estimated maximum contractual rate. This valuation technique considers the complexity and transparency ofthe structure of each ARS and cash 

 

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flows within each structure; the quality of the collateral; andliquidity determinants affecting each ARS. The decline in fair value was deemed temporary as the Company believesthe decline in fair value of these investments is due to general marketconditions as well as the fact that the Company has the ability and intent tohold these securities until market conditions improve. Accordingly, the Companyhas recorded a temporary impairment on these securities of $1,277 in othercomprehensive income.  Depending onfuture market conditions, future fair value adjustments to the ARS may berequired.   If in the future the Companydetermines that any decline in fair value of the ARS is other-than-temporary,the Company would be required to recognize the loss in its statement of income,which could have a material impact on the Company’s operating results in theperiod it is recognized.

 

Refer to Note 17 forfurther discussion on the accounting treatment for the ARS as well as adiscussion of the adoption of SFAS No. 157 and SFAS No. 159.

 

**9.****              Restricted Cash andDebt**

 

As of December 31, 2007, the Company had aworking capital line of credit with a bank under which the Company could borrowup to $2,000, of which $1,500 was available and $500 reserved under a letter ofcredit associated with the Company’s leased facility. The line of creditexpired on March 31, 2008, and was not renewed.  As of June 30, 2008, the $500 collateralobligation for the Company’s leased facility was secured by a certificate ofdeposit.  The certificate of deposit hasbeen classified as “Restricted cash, current portion” in the accompanyingcondensed consolidated balance sheet.

 

Inconnection with the signing of a lease on February 13, 2008 to secureoffice space for the Company’s future corporate headquarters at 77 FourthAvenue, Waltham, Massachusetts, the Company deposited with the landlord anunconditional, irrevocable letter of credit in the landlord’s favor in theamount of $962, secured by a certificate of deposit.  The certificate of deposit has beenclassified as “Restricted cash, non-current portion” in the accompanyingcondensed consolidated balance sheet.

 

**10.****       Goodwill and IntangibleAssets**

 

Goodwill and intangibleassets that have indefinite lives are not amortized but are evaluated forimpairment annually or whenever events or changes in circumstances indicate thecarrying value may not be recoverable. Intangible assets that have finite livesare amortized over their useful lives.

 

The goodwill resultingfrom acquisitions is reviewed for impairment on an annual basis in accordancewith SFAS No. 142,*Goodwill andOther Intangible Assets.* Consistent with prior years, the Company conducted its annual impairmenttest of goodwill in the fourth quarter of 2007. Based on the results of the first step of the goodwill impairment test,the Company has determined that no impairment of goodwill existed at December 31,2007, as the carrying amount of goodwill of the reporting unit was less thanits fair value and therefore, the second step of the goodwill impairment testwas not necessary.  The net carryingamount of goodwill was $25,511 and $25,486 at December 31, 2007 and June 30,2008, respectively.  In the six monthsended June 30, 2008, the Company recorded an adjustment to goodwill of $25for the reduction of accrued vacation associated with the acquisition of GreenMountain.

 

Intangible assets consistof the following:

 
| ** **                         | ** ** | ** **                      | ** ** | **As of December 31, 2007** | ** ** | **As of June 30, 2008** | ** ** |
|------------------------------------|------------|---------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------|------------|
| **Description**                    | ** ** | **Estimated  Useful Life** | ** ** | **Gross  Carrying  Value**                      | ** ** | **Accumulated  Amortization**               | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed  technology and know-how |       | 5 years                         |       | $                                               | 3,100      |                                        | $          | 890 |   | $ | 3,100 |   | $ | 1,200 |   |
| Customer  relationships            |       | 5 years                         |       | 1,700                                           |       | 756                                         |       | 1,700 |   | 926 |   |
| Non-compete  agreements            |       | 2 years                         |       | 300                                             |       | 300                                         |       | 300 |   | 300 |   |
| Tradename                          |       | 5 years                         |       | 300                                             |       | 98                                          |       | 300 |   | 128 |   |
| Total                              |       |                            |       | $                                               | 5,400      |                                        | $          | 2,044 |   | $ | 5,400 |   | $ | 2,554 |   |

 

 

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Amortization expenserelated to intangible assets for the three months ended June 30, 2007 and2008 was $217 and $255, respectively, and $435 and $510 for the six monthsended June 30, 2007 and 2008, respectively.

 

The estimated remainingamortization expense for each of the five succeeding years is as follows:

 
| **Year ended December 31,** | ** ** | **Amount** | ** ** |
|--------------------------------------------|------------|------------|------------|
| 2008  (1)                                  |       | $          | 510        |   |
| 2009                                       |       | 1,020      |       |
| 2010                                       |       | 766        |       |
| 2011                                       |       | 300        |       |
| 2012                                       |       | 250        |       |
| Total                                      |       | $          | 2,846      |   |

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(1) Thisamount reflects amortization expense that the Company anticipates recognizingfrom July 1, 2008 through December 31, 2008.

 

**11.  Accrued Expenses**

 

Accrued expenses consistof the following:

 
| ** **                            | ** ** | **As of   December 31,** | ** ** | **As of   June 30,** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| ** **                            | ** ** | **2007**                                | ** ** | **2008**                            | ** ** |
| Accrued payroll  and related benefits |       | $                                       | 12,084     |                                | $          | 11,009 |   |
| Accrued other  expenses               |       | 4,922                                   |       | 4,829                               |       |
| Accrued  royalties                    |       | 2,010                                   |       | 1,342                               |       |
| Accrued income  taxes                 |       | 431                                     |       | 30                                  |       |
|                                  |       |                                    |       |                                |       |
| Total                                 |       | $                                       | 19,447     |                                | $          | 17,210 |   |

 

**12.  Commitments and Contingencies**

 

From time to time and inthe ordinary course of business, the Company is subject to various claims,charges and litigation. Intellectual property disputes often have a risk ofinjunctive relief which, if imposed against the Company, could materially andadversely affect its financial condition or results of operations. From time totime, third parties have asserted and may in the future assert intellectualproperty rights to technologies that are important to the Company’s businessand have demanded and may in the future demand that the Company license theirtechnology. Although the outcome of litigation cannot be predicted withcertainty and some lawsuits, claims or proceedings may be disposed ofunfavorably to the Company, which could materially and adversely affect itsfinancial condition or results of operations, the Company does not believe thatit is currently a party to any material legal proceedings.

 

On February 13, 2008, the Company entered into alease (“Lease”) with BP Fourth Avenue, L.L.C. (the “Landlord”) to secure officespace for the Company’s future corporate headquarters at 77 Fourth Avenue,Waltham, Massachusetts. The estimated commencement date for occupancy under theLease is December 2008. The lease for the Company’s current corporateheadquarters at 880 Winter Street in Waltham is due to expire in February 2009.  The Lease provides for the rental of 165,129rentable square feet of space and has an initial term of 10 years and threemonths. The Company can, subject to certain conditions, extend this term byexercising up to two consecutive five year options. The Company is not requiredto pay any rent for the first three months of the initial Lease term.  Thereafter, the annual rent under the Leasefor years one through five will be $6.6 million, or approximately $548 permonth.  For years six through ten, theannual rent will be $7.2 million, or approximately $603 per month.  The total base rent payable in the initialterm is $69.1 million.  In connectionwith the signing of the Lease, the Company has deposited with the Landlord anunconditional, irrevocable letter of credit in the Landlord’s favor in theamount of $962.

 

**13.**       Stockholders’ Equity and Stock-BasedCompensation

** **

 

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*Common Stock*

 

In the three and six months ended June 30,2008, the Company issued 93,443 and 168,098 shares of common stock,respectively, in connection with the exercise of stock options resulting inproceeds of $601 and $1,047, respectively. In the three and six months ended June 30, 2008, the Company issued19,839 shares of common stock under the 2004 Employee Stock Purchase Planresulting in proceeds of $327.  In thethree and six months ended June 30, 2008, the Company released 225,350shares of common stock in connection with the vesting of restricted stockawards.  The Company retired 74,961 ofthese shares to cover withholding taxes in the amount of $1,247.

 

*Stock Option Activity*

 

Foroptions accounted for under SFAS No. 123(R), *Share-BasedPayments*, the fair value of each option grant is estimated on thedate of grant using the Black-Scholes pricing model. No options were grantedduring the three months ended June 30, 2007 and 2008. For purposes ofutilizing the Black-Scholes option pricing model and because there was alimited trading history for its common stock, the Company determined theexpected life and the volatility for options based on an analysis of reporteddata for a peer group of companies that have issued stock options withsubstantially similar terms. The expected life of options granted by theCompany has been determined based on the average expected life of the optionsas reported by this peer group of companies during a similar reporting period.The expected volatility of options granted has been determined using an averageof the historical volatility measures of this peer group of companies as wellas the historical volatility of the Company’s common stock beginning in January 2005.The risk-free interest rate is based on a treasury instrument whose term isconsistent with the expected life of the stock options. The Company has notpaid and does not anticipate paying cash dividends on its shares of commonstock; therefore, the expected dividend yield is assumed to be zero. Inaddition, while SFAS No. 123, *Accounting for Stock-BasedCompensation,* permitted companies to record forfeitures based onactual forfeitures, which was the Company’s historical policy under SFAS No. 123,SFAS No. 123(R) requires companies to utilize an estimated forfeiturerate when calculating stock-based compensation expense for the period.  As a result, the Company has applied aforfeiture rate of 8%, derived from an analysis of its historical data, indetermining the expense recorded in the Company’s consolidated statements ofincome.

 

In thethree months ended June 30, 2007 and 2008, the Company recorded $1,165 and$1,992 of aggregate stock-based compensation expense, respectively, of which$1,132 and $1,992, respectively, was a result of the adoption of SFAS No. 123(R).  In the six months ended June 30, 2007and 2008, the Company recorded $2,197 and $3,738 of aggregate stock-basedcompensation expense, respectively, of which $2,119 and $3,738, respectively,was a result of the adoption of SFAS No. 123(R).  As of June 30, 2008, there was $21,694of unrecognized stock-based compensation expense related to stock-based awardsthat is expected to be recognized over a weighted average period of 2.94****years.

 

A summary of stock optionactivity under the Phase Forward Incorporated 1997 Stock Option Plan, the PhaseForward Incorporated 2004 Stock Option and Incentive Plan and the 2003Non-Employee Director Stock Option Plan as of June 30, 2008, and changesduring the six months ended June 30, 2008, 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, 2007               |       | 2,473,717                        |       | $                                                                            | 4.99       |                                                                                     | 5.76       |                                                 | $          | 41,468 |   |
| Granted                                                 |       | —                           |       | —                                                                       |       |                                                                                     |       |                                                 |       |
| Exercised                                               |       | (168,098                         | )          | 6.23                                                                         |       |                                                                                     |       | $                                                    | 1,910      |   |
| Canceled                                                |       | (7,919                           | )          | 7.54                                                                         |       |                                                                                     |       |                                                 |       |
|                                                    |       |                             |       |                                                                         |       |                                                                                     |       |                                                 |       |
| Outstanding as  of June 30, 2008                   |       | 2,297,700                        |       | $                                                                            | 4.89       |                                                                                     | 5.29       |                                                 | $          | 30,061 |   |
|                                                    |       |                             |       |                                                                         |       |                                                                                     |       |                                                 |       |
| Exercisable as  of June 30, 2008                   |       | 1,929,568                        |       | $                                                                            | 4.48       |                                                                                     | 5.01       |                                                 | $          | 26,032 |   |
|                                                    |       |                             |       |                                                                         |       |                                                                                     |       |                                                 |       |
| Vested or  expected to vest as of June 30, 2008(1) |       | 2,244,815                        |       | $                                                                            | 4.85       |                                                                                     | 5.26       |                                                 | $          | 29,457 |   |

 

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(1) Thevested or expected to vest options at June 30, 2008 include both thevested options and the number of options expected to vest calculated afterapplying an estimated forfeiture rate to the unvested options.

 

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(2) The aggregate intrinsic value is calculated based on the positive differencebetween the fair value per share of the Company’s common stock on June 30,2008 of $17.97 or as of the date of exercise, as applicable and the exerciseprice of the underlying options.

 

*Restricted Stock Awards and Unit Activity*

 

A summary of activityrelated to restricted common stock awards and unit awards during the six monthsended June 30, 2008, is as follows:

 
| ** **                              | ** ** | **Number of   Shares** | ** ** | **Market Price   Per Share** | ** **         | **Weighted   Average   Grant Date   Fair Value   Per Share** | ** ** | **Weighted   Average   Remaining   contractual   Term   (years)** | ** ** | **Aggregate   Intrinsic   Value (2)** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|---------------------------------------------|--------------------|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| Unvested at  December 31, 2007     |       | 1,569,469                        |       | $                                           | 12.12 – 23.20 |                                                                                            | $          | 16.52                                                                                      |       | 2.90                                                 |       |   |   |
| Granted                                 |       | 458,606                          |       | 17.45 – 18.64                          |               | 17.81                                                                                           |       |                                                                                       |       |                                                 |       |
| Vested                                  |       | (225,350                         | )          | 12.12 – 12.12                          |               | 12.12                                                                                           |       |                                                                                       |       |                                                 |       |
| Forfeited                               |       | (23,450                          | )          | 12.12 – 23.20                          |               | 17.64                                                                                           |       |                                                                                       |       |                                                 |       |
| Unvested at  June 30, 2008         |       | 1,779,275                        |       | $                                           | 12.12 – 23.20 |                                                                                            | $          | 16.04                                                                                      |       | 2.80                                                 |       | $ | 31,974 |   |
|                                    |       |                             |       |                                        |               |                                                                                            |       |                                                                                       |       |                                                 |       |
| Expected to be  free of restrictions(1) |       | 1,437,968                        |       | $                                           | 12.12 – 23.20 |                                                                                            | $          | 16.09                                                                                      |       | 2.99                                                 |       | $ | 25,840 |   |
|                                    |       |                             |       |                                        |               |                                                                                            |       |                                                                                       |       |                                                 |       |

 

----

(1) The expected to be free of restrictions at June 30,2008 was calculated by applying an estimated forfeiture rate to the unvested shares.

 

(2) The aggregate intrinsic value is calculatedbased on the fair value per share of the Company’s common stock on June 30,2008 of $17.97.

 

**14.  Comprehensive Income**

** **

The Company’s othercomprehensive income relates to foreign currency translation adjustments andunrealized losses on our ARS that are classified as available-for-sale.  Comprehensive income is presented separatelyon the balance sheet as required.

 

Comprehensive income consisted of the following:

 
| ** **                                         | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                              | ** ** | **2008**                                            | ** ** | **2007** | ** ** | **2008** | ** ** |
| Net income                                         |       | $                                                     | 4,328      |                                                | $          | 3,694 |   | $ | 7,809 |   | $ | 7,696 |   |
| Translation  adjustment                            |       | 114                                                   |       | (15                                                 | )          | 246 |   | 517 |   |
| Impairment of  auction rate securities, net of tax |       | —                                                |       | (87                                                 | )          | — |   | (796 | ) |
| Comprehensive  income                              |       | $                                                     | 4,442      |                                                | $          | 3,592 |   | $ | 8,055 |   | $ | 7,417 |   |

 

**15.   Forward Foreign Exchange Contracts**

 

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

 

The following tablesummarizes the outstanding forward foreign exchange contracts held by theCompany as of December 31, 2007 and June 30, 2008:

 

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| ** **    | ** ** | ** **          | ** ** | **As of December 31, 2007** | ** ** | **As of June 30, 2008**               | ** ** |
|---------------|------------|---------------------|------------|-------------------------------------------------|------------|-----------------------------------------------------------|------------|
| **Currency**  | ** ** | **Hedge Type** | ** ** | **Local   Currency   Amount**         | ** ** | **Approximate   U.S. Dollar   Equivalent** | ** ** | **Local   Currency   Amount** | ** ** | **Approximate   U.S. Dollar   Equivalent** | ** ** |
| British pound |       | Sale                |       | 7,500                                           |       | $                                                         | 14,861     |   | — |   | $ | — |   |
| Euro          |       | Sale                |       | 3,400                                           |       | 4,965                                                     |       | — |   | — |   |
|          |       |                |       |                                            |       | $                                                         | 19,826     |   |   |   | $ | — |   |

 

Theforward foreign exchange contracts are short-term and generally mature withinone month of origination.

 

Realized and unrealizedforeign currency gains (losses), net of hedging, are accounted for in non-operatingincome (expense).  The Company recordedforeign currency gains of $3 and $15 in the three months ended June 30,2007 and 2008.  The Company recorded aforeign currency loss of $62 and a foreign currency gain of $14 in the sixmonths ended June 30, 2007 and June 30, 2008, respectively.  The Company settles forward foreign exchangecontracts in cash.

 

**16.**       Income Taxes

** **

**TheCompany’s effective tax rates for the three months ended June 30, 2007 and2008 were 8% and 35%, respectively.  The Company’s effective tax rates forthe six months ended June 30, 2007 and 2008 were 11% and 37%,respectively.  In the three and sixmonths ended June 30, 2007, the Company’s provision for taxes includesforeign and alternative minimum tax as the Company utilized available U.S. netoperating losses to offset its primary federal obligations resulting ineffective tax rates of 8% and 11%, respectively.**

** **

On January 1, 2007,the Company adopted the provisions of Financial Standards Accounting Board(FASB) Interpretation No. 48 *Accountingfor Uncertainty in Income Taxes*, an interpretation of SFAS No. 109,*Accounting for Income Taxes*. As of June 30, 2008, the Company had a liability of $1,193 forunrecognized tax benefits, all of which would favorably impact the Company’s effectivetax rate if recognized.  The Company recognizes interest and penaltiesrelated to uncertain tax positions as a component of income tax expense. As of June 30, 2008, the Company had approximately $124 of accruedinterest and penalties related to unrecognized tax benefits.  The Companyanticipates a reduction of approximately $144 to the amount of unrecognized taxbenefits over the next twelve months associated with lapsing statutes oflimitations.  The unrecognized tax liability of $1,193 and accruedinterest and penalties of $124 are classified as other long-term liabilities onthe consolidated balance sheet as of June 30, 2008.

 

**17.  Fair Value Measurements**

 

InSeptember 2006, the FASB issued SFAS No. 157, which definesfair value, establishes a framework for measuring fair value in accordance withgenerally accepted accounting principles and expands disclosures about fairvalue measurements. SFAS No. 157 does not require any new fair valuemeasurements, but its provisions apply to all other accounting pronouncementsthat require or permit fair value measurement. SFAS No. 157 is effectivefor the Company’s fiscal year beginning January 1, 2008 and for interimperiods within that year. In February 2008, the FASB issued FASB StaffPosition (FSP) No. 157-2, *EffectiveDate of FASB Statement No. 157*, which delayed for one year theeffective date of SFAS No. 157 for nonfinancial assets and nonfinancialliabilities, except for items that are recognized or disclosed at fair value inthe financial statements on a recurring basis (at least annually). As required,the Company adopted SFAS No. 157 for its financial assets on January 1,2008. Adoption did not have a material impact on the Company’s financialposition or results of operations. The Company has not yet determined theimpact on its financial statements of the January 1, 2009 adoption of SFASNo. 157 as it pertains to non-financial assets and liabilities.

 

SFAS No. 157clarifies that fair value is an exit price, representing the price that wouldbe received to sell an asset or paid to transfer a liability in an orderlytransaction between market participants based on the highest and best use ofthe asset or liability. As such, fair value is a market-based measurement thatshould be determined based on assumptions that market participants would use inpricing an asset or liability. SFAS No. 157 requires the Company to usevaluation techniques to measure fair value that maximize the use of observableinputs and minimize the use of unobservable inputs. These inputs areprioritized as follows:

 

·                  *Level 1*: Observable inputs such as quoted prices foridentical assets or liabilities in active markets;

 

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·                  *Level 2*: Inputs, other than the quotedprices in active markets, that are observable either directly or indirectlysuch as quoted prices for similar assets or liabilities or market-corroboratedinputs; and

·                  *Level 3*: Unobservable inputs for whichthere is little or no market data, which require the reporting entity todevelop its own assumptions about how market participants would price theassets or liabilities.

 

Thevaluation techniques that may be used to measure fair value are as follows:

 

A.    *Market approach* - Uses prices and other relevant informationgenerated by market transactions involving identical or comparable assets orliabilities

B.    *Income approach* - Uses valuation techniques to convertfuture amounts to a single present amount based on current market expectationsabout those future amounts, including present value techniques, option-pricingmodels and excess earnings method

C.    *Cost approach* - Based on the amount that currently would berequired to replace the service capacity of an asset (replacement cost)

 

The following table sets forth the Company’s financialinstruments carried at fair value within the SFAS No. 157 hierarchy andusing the lowest level of input as of June 30, 2008:

 

 
| ** **                                  | ** ** | **Quoted Prices**       | ** ** | **Significant Other** | ** ** | **Significant**  | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------|------------|------------------|------------|------------|------------|
| ** **                                  | ** ** | **in Active Markets**   | ** ** | **Observable**        | ** ** | **Unobservable** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **for Identical Items** | ** ** | **Inputs**            | ** ** | **Inputs**       | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **(Level 1)**           | ** ** | **(Level 2)**         | ** ** | **(Level 3)**    | ** ** | **Total**  | ** ** |
| Assets:                                     |       |                    |       |                  |       |             |       |       |       |
|                                        |       |                    |       |                  |       |             |       |       |       |
| Money market  funds                         |       | $                       | 154,851    |                  | $          | —           |       | $          | —     |   | $ | 154,851 |   |
| Restricted cash                             |       | 1,462                   |       | —                |       | —           |       | 1,462      |       |
| Total cash  equivalents and restricted cash |       | 156,313                 |       | —                |       | —           |       | $          | 156,313    |   |
|                                        |       |                    |       |                  |       |             |       |       |       |
| U.S. agency  notes                          |       | —                  |       | 4,000                 |       | —           |       | 4,000      |       |
| Municipal bonds                             |       | —                  |       | 1,006                 |       | —           |       | 1,006      |       |
| Corporate bonds                             |       | —                  |       | 16,097                |       | —           |       | 16,097     |       |
| Total short-term  investments               |       | —                  |       | 21,103                |       | —           |       | 21,103     |       |
|                                        |       |                    |       |                  |       |             |       |       |       |
| Auction rate  securities (1)                |       | —                  |       | —                |       | 22,773           |       | 22,773     |       |
| Corporate bonds                             |       | —                  |       | 532                   |       | —           |       | 532        |       |
| Long-term  investments                      |       | —                  |       | 532                   |       | 22,773           |       | 23,305     |       |
|                                        |       |                    |       |                  |       |             |       |       |       |
| Total Assets                                |       | $                       | 156,313    |                  | $          | 21,635           |       | $          | 22,773     |   | $ | 200,721 |   |

----

(1)      For additional informationregarding auction rate securities, see Note 8.

 

The following table setsforth a summary of changes in the fair value of the Company’s Level 3financial assets for the six months ended June 30, 2008:

 
| ** **                                                  | ** ** | **Level 3 Financial** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                  | ** ** | **Assets**                      | ** ** |
| Balance,  beginning of period                               |       | $                               | —     |   |
| Transfers in  (out) of Level 3                              |       | 24,050                          |       |
| Sales                                                       |       | —                          |       |
| Realized gains  (losses)                                    |       | —                          |       |
| Unrealized gains  (losses) on securities held at period end |       | (1,277                          | )          |
| Balance, end of  period                                     |       | $                               | 22,773     |   |

 

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Realized gains and lossesfrom sales of the Company’s investments are included in “Other income (expense)”and unrealized gains and losses are included as a separate component of equity,net of tax, unless the loss is determined to be other-than-temporary.

 

The Company also adoptedthe provisions of SFAS No. 159 in the first quarter of 2008. SFAS No.159allows companies to choose to measure eligible assets and liabilities at fairvalue with changes in value recognized in earnings. Fair value treatment may beelected either upon initial recognition of an eligible asset or liability or,for an existing asset or liability, if an event triggers a new basis ofaccounting. The Company did not elect to re-measure any of its existingfinancial assets or liabilities under the provisions of this Statement.

 

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

 

In December 2007,the FASB issued SFAS No. 141 (Revised 2007), *Business Combinations*(“SFAS No. 141(R)”). SFAS No. 141(R) retains thefundamental requirements in SFAS No. 141 that the acquisition method ofaccounting (which SFAS No. 141 called the purchase method) be used for allbusiness combinations and for an acquirer to be identified for each businesscombination. SFAS No. 141(R) requires an acquirer to recognizethe assets acquired, the liabilities assumed, and any noncontrolling interestin the acquiree at the acquisition date, measured at their fair values as ofthat date, with limited exceptions specified in SFAS No. 141(R).  That replaces SFAS No. 141’scost-allocation method, which required the cost of an acquisition to beallocated to the individual assets acquired and liabilities assumed based ontheir estimated fair values.  SFAS No. 141(R) retainsthe guidance in SFAS No. 141 for identifying and recognizing intangibleassets separately from goodwill. SFAS No. 141(R) will now require the following:acquisition costs to be expensed as incurred, restructuring costs associatedwith a business combination must be expensed prior to the acquisition date andchanges in deferred tax asset valuation allowances and income tax uncertaintiesafter the acquisition date generally will affect income tax expense.  SFAS No. 141(R) appliesprospectively to business combinations for which the acquisition date is on orafter the beginning of the first annual reporting period beginning on or after December 15,2008, which is the Company’s 2009 fiscal year. Earlier adoption is prohibited.

 

In March 2008, theFASB issued SFAS No. 161,*Disclosuresabout Derivative Instruments and Hedging Activities, an amendment of FASBStatement No. 133* (“SFASNo. 161”)*.*  SFAS No. 161 requires disclosure of howand why an entity uses derivative instruments, how derivative instruments andrelated hedged items are accounted for and how derivative instruments andrelated hedged items affect an entity’s financial position, financialperformance, and cash flows. SFAS No. 161 is effective for fiscal yearsbeginning after November 15, 2008, with early adoption permitted. Theadoption of SFAS No. 161 is not expected to have a material effect on theCompany’s consolidated financial position and results of operations.

 

In May 2008, theFASB issued SFAS No. 162, *The Hierarchy of GenerallyAccepted Accounting Principles* (“SFAS No. 162”). SFAS No. 162identifies the sources of generally accepted accounting principles in theUnited States. SFAS No. 162 is effective sixty days following the SEC’sapproval of the Public Company Accounting Oversight Board amendments to AU Section 411,*The Meaning of Present Fairly in Conformity WithGenerally Accepted Accounting Principles*.  The adoption of SFAS No. 162 is notexpected to have a material effect on the Company’s consolidated financialposition and results of operations.

 

**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*.***

** **

*Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with our unaudited condensedconsolidated financial statements and related notes thereto that appearelsewhere in this Quarterly Report on Form 10-Q and the audited financialstatements and related notes thereto and Management’s Discussion and Analysisof Financial Condition and Results of Operations included in our Annual Reporton Form 10-K for the year ended December 31, 2007, which has beenfiled with the Securities and Exchange Commission (“SEC”).*

 

**SpecialNote Regarding Forward-Looking Statements**

 

Inaddition to historical consolidated financial information, this QuarterlyReport on Form 10-Q contains forward-looking statements **within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities and Exchange Act of 1934, as amended, and are intended to be coveredby the “safe harbor” created by those sections. **All statements, other than statements ofhistorical facts, included in this Quarterly Report on Form 10-Q regarding ourstrategy, future operations, future financial position, future net sales,projected costs, projected expenses, prospects and plans and objectives ofmanagement are forward-looking statements. The words “anticipates,” “believes,”“estimates,” 

 

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“expects,” “intends,” “may,”“plans,” “projects,” “will,” “would” and similar expressions are intended toidentify forward-looking statements, although not all forward-lookingstatements contain these identifying words.

 

We maynot actually achieve the plans, intentions or expectations disclosed in ourforward-looking statements and you should not place undue reliance on ourforward-looking statements. We have based these forward-looking statements onour current expectations and projections about future events. Although webelieve that the expectations underlying any of our forward-looking statementsare reasonable, these expectations may prove to be incorrect, and all of thesestatements are subject to risks and uncertainties. We discuss many of the risksthat we believe could cause actual results or events to differ materially fromthese forward-looking statements in greater detail in the section entitled “RiskFactors” in **ourAnnual**Report on**Form 10-Kfor the year ended December 31, 2007. **We urge you to considerthe risks and uncertainties described in Item 1A of our Annual**Reporton**Form 10-K for the year ended December 31,2007, and as otherwise set forth 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 those anticipated,estimated or expected. Our forward-looking statements do not reflect thepotential impact of any future acquisitions, mergers, dispositions, jointventures 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.**

 

**Overview**

 

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

 

**Acquisitions**

 

From time to time we have expanded our product andservice offerings through the acquisition of other businesses or technologies.The most significant of these transactions are the acquisitions of ClinsoftCorporation (“Clinsoft”) in 2001 and Lincoln Technologies, Inc. (“Lincoln”)in 2005. We also recently completed the acquisition of Green Mountain Logic, Inc.(“Green Mountain”), which is described below.

 

*Green Mountain Logic*

 

On October 30,2007, we acquired all of the outstanding capital stock of Green Mountain, aprocess automation software company that provides targeted solutions for thelife sciences industry, including the *LabPas*Phase Iclinic automation software.  The acquiredtechnology and products of Green Mountain provide us with a solution targetedfor Phase I clinical trials. The aggregate purchase price was $5.4 million.  The acquisition of Green Mountain wasaccounted for as a purchase under Statement of Financial Accounting Standards (“SFAS”)No. 141, *Business Combinations*.Accordingly, the results of Green Mountain have been included in ourconsolidated financial statements since the date of acquisition.

 

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**Sourcesof Revenues**

 

We derive our revenuesfrom software licenses and services.  Our product line iscomprised of three general categories that include the following softwareproducts:

 

·*ElectronicData Capture (EDC)*

 

·       *InForm*, our Internet-basedelectronic data capture solution for collection and transmission of patientinformation in clinical trials; and

 

·       *LabPas*, our system for Phase Iclinic automation.

 

·*ClinicalData Management*

 

·       *Clintrial*, our clinical datamanagement solution; and

 

·      *WebSDM*, our system forvalidating and reviewing clinical trial data represented in formats meetingindustry standards, such as those established by the Clinical Data InterchangeStandards Consortium, or CDISC.

 

·*Safety*

 

·       *EmpiricaTrace*(formerly*Clintrace*), our adverse event managementsolution for monitoring drug safety and reporting adverse events that occurduring and after conclusion of the clinical trial process;

 

·       *EmpiricaSignal*(formerly*WebVDME*), our data mining and signaldetection solution for post-marketing data; and

 

·         *CTSD*, our signal detection solution for data fromclinical trials.

 

License revenues arederived principally from the sale of term licenses for our softwareproducts.  Service revenues are derivedprincipally from our delivery of the hosted solution of our *InForm,**EmpiricaSignal*, *CTSD* and *WebSDM* software products, and consulting services and customer support, includingtraining, for all of our products.  Wegenerally recognize revenues ratably over the life of a license or servicecontract. This allows us to maintain a backlog that provides multi-yearvisibility in revenues.

 

One customer,GlaxoSmithKline, accounted for approximately 16% and 12% of our total revenuesin the three months ended June 30, 2007 and 2008, respectively, and 16%and 13% of our total revenues in the six months ended June 30, 2007 and2008 respectively.  This same customeraccounted for $1.8 million and $1.1 million, or 5% and 4%, of accountsreceivable outstanding as of December 31, 2007 and June 30, 2008,respectively.  Our top 20 customersaccounted for approximately 68% and 63% of our total revenues, net ofreimburseable out-of-pocket expenses, in the three months ended June 30,2007 and 2008, respectively, and 66% and 64% of our total revenues, net ofreimburseable out-of-pocket expenses, in the six months ended June 30,2007 and 2008, respectively.

 

*LicenseRevenues*

 

We derive our licenserevenues principally from the sale of term licenses for the following softwareproducts: *InForm*, ourInternet-based electronic data capture, or EDC, solution; *Clintrial* and *WebSDM*, ourclinical data management solutions; our drug safety solutions, including our *Empirica Trace*, *Empirica Signal*and *CTSD* products; and our *LabPas* Phase I clinic automation solution.  Although each of our softwaresolutions is available as a stand-alone enterprise application, we offerintegrated enterprise solutions incorporating certain of our electronic datacapture, data management and drug safety products.

 

License revenues for our *InForm *electronic data capturesoftware solution, either on a stand-alone or integrated basis, are determinedprimarily by the number, complexity and duration of the clinical trials and thenumber of participants in each clinical trial. License revenues for our *Clintrial,**WebSDM,Empirica Trace,**Empirica Signal*,*CTSD* and *LabPas*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 *Empirica Trace* products**withterms generally of three to five years with payment terms generally annually inadvance. License agreements for our other products are generally annual ormulti-year with payment terms generally annually in advance.  License revenues are recognized ratably overthe duration of the software term license agreement, to the extent that amountsare fixed or determinable and collectable.

 

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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 additional perpetual licenses of these products in certainsituations to our existing customers with the option to purchase customersupport, and may in the future do so for new customers based on customerrequirements or market conditions. We recognize revenues on the perpetuallicenses upon delivery of the software when all other revenue recognitioncriteria are met. We continue to provide and charge for maintenance and supporton our products to those customers who do not convert to our software termlicense arrangements.  We will continueour efforts to convert the remaining former Clinsoft customer base to softwareterm license arrangements. However, we anticipate that some customers will notconvert and instead will continue to make annual customer support payments.

 

*ServiceRevenues*

 

*ApplicationHosting Services.*    Inaddition to making our software products available to customers throughlicenses, we offer our *InForm*,*Empirica Signal, CTSD*and*WebSDM* software as hosted applicationsolutions delivered through a standard web-browser, with customer support andtraining services.  Service revenues fromapplication hosting services are derived principally from our *InForm *hosted solution.

 

Revenues resulting fromthe *InForm *hosting serviceconsist of three stages for each clinical trial:

 

·                 *First stage—*trial and application set up, includingdesign of electronic case report forms and edit checks, installation and serverconfiguration of the system;

 

·                 *Second stage—*application hosting and related supportservices; and

 

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

 

Services provided for thefirst and third stages are provided on a fixed fee basis depending upon thecomplexity of the trial and system requirements. Services for the second stageare charged separately as a fixed monthly fee. We recognize revenues from allstages of the hosting service ratably over the hosting period. Fees charged andcosts incurred for the trial system design, set up and implementation aredeferred until the start of the hosting period and are amortized and recognizedratably over the estimated hosting period. The deferred costs include directcosts related to the trial and application set up. Fees for the first and thirdstages of the services are billed based upon milestones. Fees for applicationhosting and related services in the second stage are generally billed quarterlyin advance. Bundled into this revenue element are the revenues attributable tothe software license used by the customer.

 

In the event that anapplication hosting customer cancels a clinical trial and its related statementof work, all deferred revenues are recognized and all deferred set up costs areexpensed.  In addition, certain termination-relatedfees may be charged and if so, such fees are recognized in the period oftermination.

 

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

 

In addition, applicationhosting service revenues include hosting services associated with term licensecustomers and reimbursable out-of-pocket expenses.

 

*ConsultingServices**. *Consulting services include the design anddocumentation of the processes related to our customers’ use of our productsand services in their clinical trials and safety monitoring activities.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.  Consultingservices can be sold on a stand-alone basis or as part of a bundledarrangement.  In some circumstances, wesell additional follow on consulting services to a customer at a later dateeven if the customer purchased consulting services at the time of the initiallicense purchase under a bundled arrangement. Revenues from consulting services included in either a multiple elementsoftware license agreement or in an application hosting agreement arerecognized ratably over the term of the arrangement. The value of ourconsulting services sold within a bundled arrangement is equal to the value ofconsulting services sold on a stand-alone basis, as the

 

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activities performedunder both types of arrangements are similar in nature.  The associated costs are expensed asincurred.  We may also enter intoarrangements to provide consulting services separate from a licensearrangement. In these situations, revenue is recognized in accordance with theAmerican Institute of Certified Public Accountants’ (“AICPA”) Statement ofPosition No. 81-1 (SOP No. 81-1), *Accountingfor Performance of Construction-Type and Certain Production-Type Contracts,*oneither a time and materials basis or using the proportional performance method.If we are not able to produce reasonably dependable estimates, revenue isrecognized upon completion of the project and final acceptance from thecustomer. If significant uncertainties exist about project completion orreceipt of payment, the revenue is deferred until the uncertainty is resolved.Provisions for estimated losses on contracts are recorded during the period inwhich they are identified.

 

*CustomerSupport.*    We have amultinational services organization to support our software products and hostedsolutions worldwide. Customer support includes training services, telephonesupport and software maintenance. We bundle customer support in our softwareterm licenses and allocate 10% of the value of the license to customer supportrevenues. The customer support services rate of 10% for multi-year term-basedlicenses reflects a significant discount from the rate for customer supportservices associated with perpetual licenses due to the reduction in the timeperiod during which the customer can utilize the upgrades and enhancements. We believe this rate is substantive andrepresents an amount we believe reasonable to be allocated.  Our customer support revenuesalso consist of customer support fees paid by perpetual license customers.Customer support revenues are recognized ratably over theperiod of the customer support or term license agreement, with payment termsgenerally annually in advance.

 

**Cost ofRevenues and Operating Expenses**

 

We allocate overheadexpenses such as rent and occupancy charges and employee benefit costs to alldepartments based on headcount. As such, general overhead expenses arereflected in cost of service revenues and in the sales and marketing, researchand development, and general and administrative expense categories.

 

*Costof Revenues.*    Costof license revenues consists primarily of the amortization of royalties paidfor certain 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 the deferredclinical trial set up costs, allocated overhead, outside contractors, royaltiesassociated 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.

 

The cost of servicerevenues varies based upon the number of employees in the service organization,the type of work performed, and royalties associated with revenues derived fromproviding customer support, as well as costs associated with the flexible useof outside contractors to support internal resources. We supplement the trialdesign and set up activity for our *InForm *applicationhosting services through the use of outside contractors. This allows us toutilize outside contractors in those periods where trial design and set upactivity is highest while reducing the use of outside contractors in thoseperiods where trial activity lessens, allowing for a more flexible deliverymodel. The percentage of the services workforce represented by outsidecontractors varies from period to period depending on the volume of specificsupport required. The cost of services is significantly higher as a percentageof revenues as compared to our cost of license revenues primarily due to theemployee-related and outside contractor expenses associated with providingservices.

 

*GrossMargin.*    Ourgross margin on license revenues varies based on the mix of royalty- andnon-royalty-bearing license revenues and the amount of amortization of acquiredtechnologies. Our gross margin on service revenues varies primarily due tovariations in the utilization levels of the professional service team and thetiming of expense and revenue recognition under our service arrangements. Insituations where the service revenues are recognized ratably over the softwarelicense term, our costs associated with delivery of the services are recognizedas the services are performed, which is typically during the first 6 to12 months of the contract period. Accordingly, our gross margin on servicerevenues will vary significantly over the life of a contract due to the timing,amount and type of service required in delivering certain projects. Inaddition, consolidated gross margin will vary depending upon the mix of licenseand service revenues.

 

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*Salesand Marketing.*    Salesand marketing expenses consist primarily of employee-related expenses,including travel, marketing programs which include product marketing expensessuch as trade shows, workshops and seminars, corporate communications, otherbrand building 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 andmarketing expenses will continue to increase in absolute dollars as commissionexpense increases with our revenues and as we continue to expand sales coverageand to build brand awareness through what we believe are the most costeffective channels available, but may fluctuate quarter over quarter due to thetiming of marketing programs.

 

*Researchand Development.*    Researchand development expenses consist primarily of employee-related expenses,allocated overhead and outside contractors. We focus our research anddevelopment efforts on increasing the functionality, performance andintegration of our software products. We expect that in the future, researchand development expenses will increase in absolute dollars as we continue toadd features and functionality to our products, introduce additional integratedsoftware solutions to our product suite and expand our product and serviceoffering.

 

*Generaland Administrative.*    Generaland administrative expenses consist primarily of employee-related expenses,professional fees, primarily consisting of expenses for accounting, compliancewith the Sarbanes-Oxley Act of 2002, and legal services, including litigation,information technology and other corporate expenses and allocated overhead. Weexpect that in the future 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.

 

*Stock-BasedCompensation Expenses.*    Our cost ofservice revenues, sales and marketing, research and development, and generaland administrative expenses include stock-based compensation expense.  Stock-based compensation expense is the fairvalue of outstanding stock options and restricted stock awards and units, whichare recognized over the respective stock option and award service periods.  It also includes amortization of the excessof the deemed fair market value over the exercise price of stock optionsgranted prior to our July 2004 initial public offering.  During the three months ended June 30,2007 and 2008, we recorded $1.2 million and $2.0 million of stock-basedcompensation expense, respectively. During the six months ended June 30, 2007 and 2008, we recorded$2.2 million and $3.7 million of stock-based compensation expense,respectively.

 

**ForeignCurrency Translation**

 

With regard to ourinternational operations, we frequently enter into transactions in currenciesother than the U.S. dollar. As a result, our revenues, expenses and cash flowsare subject to fluctuations due to changes in foreign currency exchange rates,particularly changes in the euro, British pound, Australian dollar and Japaneseyen.  In the three months ended June 30,2007 and 2008, approximately 53% and 45%, respectively, of our revenues weregenerated in locations outside the United States.  In the six months ended June 30, 2007and 2008, approximately 52% and 46%, respectively, of our revenues weregenerated in locations outside the United States.  The majority of these revenues are incurrencies other than the U.S. dollar, as are many of the associated expenses.In periods when the U.S. dollar declines in value as compared to the foreigncurrencies in which we conduct business, our foreign currency-based revenuesand expenses generally increase 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 during the reporting periods. On an ongoingbasis, we evaluate our estimates and assumptions with our audit committee,including those related to revenue recognition, deferred set up costs,commissions and royalties, accounts receivable reserves, stock-based compensationexpenses, long-lived assets, intangible 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 basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. There have been no material changes tothese estimates for the periods presented in this Quarterly Report on Form 10-Q.Our actual results may differ from these estimates under different assumptionsor 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, 2007, the following 

 

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accounting policies involve a greater degree ofjudgment and complexity. Accordingly, these are the policies we believe are themost critical to aid in fully understanding and evaluating our consolidatedfinancial condition and results of operations.

 

*RevenueRecognition and Deferred Set Up Costs.*    We recognize software licenserevenues in accordance with Statement of Position (SOP) No. 97-2, *Software Revenue Recognition,* as amended,issued by the AICPA, while revenues resulting from application services arerecognized in accordance with Emerging Issues Task Force (EITF) Issue No. 00-3,*Application of AICPA Statement of Position97-2 to Arrangements that Include the Right to Use Software Stored on AnotherEntity’s Hardware*, Securities and Exchange Commission’s (SEC) StaffAccounting Bulletin (SAB) No. 104, *RevenueRecognition* and EITFIssue No. 00-21, *Revenue Arrangementswith Multiple Deliverables.*

 

Customers generally havethe ability to terminate application hosting, consulting and training serviceagreements upon 30 days notice. License agreements, multiple elementarrangements, including license and services agreements and certain applicationhosting services can generally be terminated by either party for materialbreach of obligations not corrected within 30 days after notice of thebreach.

 

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

 

We generally enter intosoftware term licenses for our *InForm*,*Clintrial* and *Empirica Trace* products with our customersfor 3- to 5-year periods. License agreements for our *EmpiricaSignal, CTSD*and*WebSDM*products are generally annual or multi-year terms.  These arrangements typically include multipleelements: software license, consulting services and customer support. We billour customers in accordance with the terms of the underlying contract.Generally, we bill license fees annually in advance for each year of thelicense term. Our payment terms are generally net 30 days.

 

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

 

Customer support includes training services, telephonesupport and software maintenance.  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 value of our consulting services sold withina bundled arrangement is equal to the value of consulting services sold on astand-alone basis, as the activities performed under both types of arrangementsare similar in nature.  Theremaining value is allocated to license and support services, with 10% of thisamount allocated to support services. The customer support services rate of 10% formulti-year term-based licenses reflects a significant discount from the ratefor customer support services associated with perpetual licenses due to thereduction in the time period during which the customer can utilize the upgradesand enhancements. We believe this rateis substantive and represents a reasonable basis of allocation. We haveallocated the estimated fair value to our multiple element arrangements toprovide meaningful disclosures about each of our revenue streams. The costsassociated with the consulting and customer support services are expensed asincurred. There are instances in which we sell software licenses based on usagelevels. These software licenses can be based on estimated usage, in which casethe license fee charged to the customer is fixed based on this estimate. Whenthe fee is fixed, the revenues are generally recognized ratably over thecontractual term of the arrangement. If the fee is based on actual usage, andtherefore variable, the revenues are recognized in the period of use. Revenuesfrom certain follow-on consulting services, which are sold separately tocustomers with existing software licenses and are not considered part of amultiple element arrangement, are recognized as the services are performed.

 

We continue to selladditional perpetual licenses for the *Clintrial*and *Empirica Trace* softwareproducts in certain situations to our existing customers with the option topurchase customer support and may in the future do so for new customers basedon customer requirements or market conditions. We have established vendorspecific objective evidence of fair value for the customer support.Accordingly, license revenues are recognized upon delivery of the software andwhen all other revenue recognition criteria are met.  Customer support revenues are recognizedratably over the term of the underlying 

 

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support arrangement. Wecontinue to generate customer support and maintenance revenues from ourperpetual license customer base. Training revenues are recognized as earned.

 

In addition to making oursoftware products available to customers through licenses, we offer our *InForm*, *EmpiricaSignal*, *CTSD* and *WebSDM* software solutions through a hosted applicationsolution delivered through a standard web-browser.

 

Revenues resulting from *InForm *application hosting services consist of threestages for each clinical trial: the first stage involves application set up,including design of electronic case report forms and edit checks,implementation of the system and server configuration; the second stageinvolves application hosting and related support services; and the third stageinvolves services required to close out, or lock, the database for the clinicaltrial. Services provided for the first and third stages are provided on a fixedfee basis based upon the complexity of the trial and system requirements. Servicesfor the second stage are charged separately as a fixed monthly fee. Werecognize revenues from all stages of the *InForm *hostingservice ratably over the hosting period. Fees charged and costs incurred forthe trial system design, set up and implementation are deferred as applicable,until the start of the hosting period and then amortized and recognized, asapplicable, ratably over the estimated hosting period. The deferred costsinclude incremental direct costs with third parties and certain internal directcosts related to the 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 forapplication hosting and related services in the second stage are billedquarterly in advance. Bundled into this revenue element are the revenuesattributable to the software license used by the customer.

 

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

 

In the event that anapplication hosting customer cancels a clinical trial and its related statementof work, all deferred revenues are recognized and all deferred set up costs areexpensed.   In addition, certaintermination related fees may be charged and if so, such fees are recognized inthe period of termination.

 

We may also enter into arrangementsto provide consulting services separate from a license arrangement. In thesesituations, revenue is recognized in accordance with SOP No. 81-1, *Accounting for Performance of Construction-Type andCertain Production-Type Contracts,*on either a time and materialsbasis or using the proportional performance method. If we are not able toproduce reasonably dependable estimates, revenue is recognized upon completionof the project and final acceptance from the customer. If significantuncertainties exist about project completion or receipt of payment, the revenueis deferred until the uncertainty is resolved. Provisions for estimated losseson contracts are recorded during the period in which they are identified.

 

We deferred $731,000 and$1.1 million of set up costs and amortized $604,000 and $878,000 in the threemonths ended June 30, 2007 and 2008, respectively, and deferred $1.7million and $2.3 million of set up costs and amortized $1.2 million and $1.7million in the six months ended June 30, 2007 and 2008, respectively.  The amortization of deferred set up costs isa component of cost of services.

 

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

 

Provisions for estimatedlosses on uncompleted contracts are made on a contract-by-contract basis andare recognized in the period in which such losses become probable and can bereasonably estimated. To date, we have not experienced any material losses onuncompleted application hosting contracts.

 

*Accountingfor Prepaid Sales Commissions and Royalties.*    For arrangements where werecognize revenue over the relevant contract period, we defer relatedcommission payments to our direct sales force and software license royaltiespaid to third parties and amortize these amounts over the same period that therelated revenues are recognized. This is done to better match commission androyalty expenses with the related revenues. 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 which were paid are recoverable byus.  We deferred $2.0 million and $2.4 million of 

 

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commissions and amortizedto sales and marketing expense $1.4 million and $2.0 million of commissions inthe three months ended June 30, 2007 and 2008, respectively, and deferred$3.6 million and $4.4 million of commissions and amortized to sales andmarketing expense $2.9 million and $3.8 million of commissions in the sixmonths ended June 30, 2007 and 2008, 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 $796,000 and $521,000 of royalties and amortized to cost ofrevenues $579,000 and $648,000 of royalties in the three months ended June 30,2007 and 2008, respectively, and deferred $1.5 million and $1.6 million ofroyalties and amortized to cost of revenues $1.3 million and $1.3 million ofroyalties in the six months ended June 30, 2007 and 2008, respectively.

 

*AccountsReceivable Reserve.*    Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. We regularly evaluatethe collectability 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 its fullobligation 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 accounts receivablereserves were $270,000 and $387,000 as of December 31, 2007 and June 30,2008, respectively.

 

*Accountingfor Income Taxes.*    Weare subject to income taxes in both the United States and foreignjurisdictions, and we use estimates in determining our provision for incometaxes.  We account for income taxes inaccordance with SFAS No. 109, *Accountingfor Income Taxes*, which is the asset and liability method foraccounting and reporting for income taxes. We adopted the provisions of FASB Interpretation No. (FIN) 48, *Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109*, on January 1,2007.  Under SFAS No. 109, deferredtax assets and liabilities are recognized based on temporary differencesbetween the financial reporting and income tax bases of assets and liabilitiesusing statutory rates. This process requires that we project our current taxliability and estimate our deferred tax assets and liabilities, including netoperating loss and tax credit carryforwards. In assessing the need for a valuationallowance, we have considered our recent operating results, future taxableincome projections and all prudent and feasible tax planning strategies. In2007, we determined that it was more likely than not that we would realize thefull value of our deferred tax assets and eliminated the remaining balance ofour valuation allowance.

 

*Accountingfor Stock-Based Awards.*   On January 1, 2006,we adopted the provisions of SFAS No. 123(R), *Share-based Payment*, which requires us torecognize expense related to the fair value of stock-based compensation awards.We elected to use the modified prospective transition method as permitted bySFAS No. 123(R) and therefore have not restated our financialresults for prior periods. Under this transition method, stock-basedcompensation expense includes compensation expense for all stock-basedcompensation awards granted on or after March 15, 2004 (the filing datefor the initial registration statement for our initial public offering), basedon the grant-date fair value estimated in accordance with the provisions ofSFAS No. 123(R).

 

Stock options grantedprior to March 15, 2004 are minimum value options pursuant to SFAS No. 123,*Accounting for Stock-Based Compensation*.Under the provisions of SFAS No. 123(R), the value of these optionswill not be recorded in the statement of income subsequent to the date of ouradoption of SFAS No. 123(R). Instead, we will continue to account forthese options using Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*,and related interpretations.

 

For service-basedoptions, accounted for under SFAS No. 123(R), we recognizecompensation expense on a straight-line basis over the requisite service periodof the award.  For performance-basedoptions, we recognize expense over the estimated performance period. Inaddition, SFAS 123(R) requires the benefits of tax deductions inexcess of recognized stock-based compensation to be reported as a financingactivity rather than an operating activity in the statements of cash flows.This requirement can have the effect of reducing our net operating cash flowsand increasing our net financing cash flows in certain periods.  To date, we have not recorded these benefitsas they have not been realized.

 

Effectivewith the adoption of SFAS No. 123(R), we use the Black-Scholes optionpricing model to determine the weighted average fair value of options granted.

 

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During the three and sixmonths ended June 30, 2008, we recorded $2.0 million and $3.7 million ofaggregate stock-based compensation expense, respectively, which were a resultof the adoption of SFAS No. 123(R). During the three months ended June 30, 2008, stock-basedcompensation expense included $448,000 in cost of revenues, $323,000 inresearch and development, $368,000 in sales and marketing and $853,000 in generaland administrative expense.  In the sixmonths ended June 30, 2008, stock-based compensation expense included$841,000 in cost of revenues, $602,000 in research and development, $682,000 insales and marketing and $1.6 million in general and administrativeexpense.  In the three months ended June 30,2007 and 2008, stock-based compensation expense reduced basic and dilutedearnings per share by $0.03.  In the sixmonths ended June 30, 2007, stock-based compensation expense reduceddiluted earnings per share by $0.06.  Inthe six months ended June 30, 2008, stock-based compensation expensereduced basic and diluted earnings per share by $0.06 and $0.05,respectively.  As of June 30, 2008,we had $21.7 million of unrecognized stock-based compensation expenserelated to market-based share awards that we expect to recognize over aweighted average period of 2.94 years.

 

*Goodwilland Intangible Assets Impairment.*    We review the carrying valueof goodwill and intangible assets periodically based upon the expected futurediscounted operating cash flows of our business. Our cash flow estimates arebased on historical results adjusted to reflect our best estimate of ouroperating results in future periods. Actual results may differ materially fromthese estimates. The timing and size of impairment charges, if any, involvesthe application of management’s judgment regarding the estimates and couldsignificantly affect our operating results.

 

**Overviewof Results of Operations in the Three Months Ended June 30, 2007 and 2008**

 

Total revenues increasedby 30%, or $9.3 million, in the three months ended June 30, 2008 comparedto the same period in 2007, primarily due to an increase in service revenues of$7.7 million, or 38%.  In addition,license revenues increased by $1.6 million, or 14%.

 

Our gross marginincreased by 24%, or $4.4 million, in the three months ended June 30, 2008compared to the same period in 2007, primarily due to the increase in servicerevenues.

 

Operating income for thethree months ended June 30, 2008 of $4.2 million increased 32%, or $1.0million, compared to the same period in 2007. The operating income for the three months ended June 30, 2007 and2008 also included $1.2 million and $2.0 million of stock-based compensationexpense, respectively.

 

The results in the threemonths ended June 30, 2008 were impacted by foreign exchange ratefluctuations, resulting in increases of approximately 3% and 2% in revenues andexpenses, respectively, for the period.

 

As of June 30,2008, we had $192.6 million of unrestricted cash, cash equivalents andshort-term investments, an increase of $34.0 million from$158.6 million at December 31, 2007. As of June 30, 2008, we had no outstanding debt.

 

*Revenues*

 
| ** **                                           | ** ** | **Three Months Ended June 30,** | ** ** | ** **                               | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| ** **                                           | ** ** | **2007**                                            | ** ** | **2008**                                 | ** ** | **Change** | ** ** |
| **Revenues by Product Line (1)** | ** ** | **Amount**                                          | ** ** | **Percentage   of   Revenues** | ** ** | **Amount** | ** ** | **Percentage   of   Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                             | ** ** |
| Electronic data capture                              |       | $                                                   | 22,754     |                                     | 72         | %          | $          | 31,332 |   | 77 | % | $ | 8,578 |   | 38 | % |
| Clinical data management                             |       | 5,122                                               |       | 16                                       |       | 5,642      |       | 14 |   | 520 |   | 10 |   |
| Safety                                               |       | 3,658                                               |       | 12                                       |       | 3,877      |       | 9 |   | 219 |   | 6 |   |
| Total                                                |       | $                                                   | 31,534     |                                     | 100        | %          | $          | 40,851 |   | 100 | % | $ | 9,317 |   | 30 | % |

 

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(1) Revenuesby Product Line include product license revenues and product-related servicerevenues.

 

The increase inelectronic data capture revenues is primarily due to increases in applicationhosting services and license revenues of $7.7 million and $1.1 million,respectively.  The increases are partially offset by decreases inconsulting services and customer support, totaling $275,000.  The increasein clinical data management can be attributed to increases in license revenuesand consulting services revenues of $331,000 and $198,000, respectively.  The increase in safety was due to increasesin license revenues, customer support revenues and application hosting servicesrevenues of $173,000, $77,000 and $76,000, respectively.  These increases are partially offset by adecrease in consulting services revenues of $107,000.

 

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| ** **                    | ** ** | **Three Months Ended June 30,** | ** ** | ** **                             | ** ** |
|-------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | **2007**                                            | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                          | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                             | ** ** |
| License                       |       | $                                                   | 11,469     |                                   | 36         | % | $ | 13,087 |   | 32 | % | $ | 1,618 |   | 14 | % |
| Application  hosting services |       | 13,412                                              |       | 43                                     |       | 21,234 |   | 52 |   | 7,822 |   | 58 |   |
| Consulting  services          |       | 3,098                                               |       | 10                                     |       | 3,604 |   | 9 |   | 506 |   | 16 |   |
| Customer support              |       | 3,555                                               |       | 11                                     |       | 2,926 |   | 7 |   | (629 | ) | (18 | ) |
| Total                         |       | $                                                   | 31,534     |                                   | 100        | % | $ | 40,851 |   | 100 | % | $ | 9,317 |   | 30 | % |

 

Total revenues increasedin the three months ended June 30, 2008 as compared to the same period in2007, primarily due to increases in application hosting and licenserevenues.  The increase in revenuesassociated with our application hosting services in the three months ended June 30,2008 was partially due to an approximately 8% increase in production trialsunder management from approximately 750 as of June 30, 2007 toapproximately 810 as of June 30, 2008, which include both applicationhosting services trials as well as trials hosted for our *InForm*license customers.  The increase inproduction trials is primarily from customers who purchase all trial-relatedservices from us and who do not have a separate license to *InForm*,and to an increase in average fee per trial. The increase in license revenues was primarily the result of additional *InForm *revenue from new and existing customers and, toa lesser extent, growth in sales relating to our clinical data management andsafety products.  The increase inconsulting revenues was primarily attributable to additional *InForm *revenues which were related to both new andexisting customers, as well as an increase in *Clintrial*and *Empirica Trace** *revenues.  The decrease in customer support revenues inthe three months ended June 30, 2008 was due primarily to a decrease insupport revenues related to electronic data capture, primarily *InForm*.  Our revenueswere not significantly impacted by price increases or decreases.  Inflation had only a nominal impact on ourrevenues.

 
| ** **                          | ** ** | **Three Months Ended June 30,** | ** ** | ** **                             | ** ** |
|-------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **2007**                                            | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                          | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                             | ** ** |
| United States                       |       | $                                                   | 14,765     |                                   | 47         | % | $ | 22,238 |   | 55 | % | $ | 7,473 |   | 51 | % |
|                                |       |                                                |       |                                   |       |   |   |   |   |   |   |   |   |
| United Kingdom                      |       | 12,010                                              |       | 38                                     |       | 12,810 |   | 31 |   | 800 |   | 7 |   |
| France                              |       | 2,857                                               |       | 9                                      |       | 3,429 |   | 8 |   | 572 |   | 20 |   |
| Asia Pacific                        |       | 1,902                                               |       | 6                                      |       | 2,374 |   | 6 |   | 472 |   | 25 |   |
| International  subtotal             |       | 16,769                                              |       | 53                                     |       | 18,613 |   | 45 |   | 1,844 |   | 11 |   |
| Total                               |       | $                                                   | 31,534     |                                   | 100        | % | $ | 40,851 |   | 100 | % | $ | 9,317 |   | 30 | % |

 

The increase in revenuesworldwide was primarily due to an increase in electronic data capture revenues,as well as increases in clinical data management and safety revenues. Theincrease in U.S. revenues is primarily due to an increase in electronic datacapture of $7.3 million, as well as increases in safety and clinical datamanagement revenues of $133,000 and $29,000, respectively. The increase ininternational revenues is primarily the result of electronic data capturerevenues of $1.3 million, as well as increases in clinical data management andsafety revenues of $492,000 and $86,000, respectively.

 

*Cost ofRevenues*

 
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** | ** **                                            | ** ** | ** ** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2007**                                            | ** ** | **2008**                                              | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                          | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                             | ** ** |
| License                         |       | $                                                   | 529        |                                                  | 5          | %          | $          | 626 |   | 5 | % | $ | 97 |   | 18 | % |
| Services                        |       | 12,359                                              |       | 62                                                    |       | 17,191     |       | 62 |   | 4,832 |   | 39 |   |
| Total                           |       | $                                                   | 12,888     |                                                  | 41         | %          | $          | 17,817 |   | 44 | % | $ | 4,929 |   | 38 | % |

 

The cost of licenserevenues increased in the three months ended June 30, 2008 primarily dueto a $65,000 increase in amortization of intangible assets as well as a$42,000 increase in cost of royalties associated with our *InForm *software product.  The increase in cost of services in the threemonths ended June 30, 2008 was due primarily to increases in salary andbenefits and outside contractor expense of $2.1 million and $1.5 million,respectively.  Other increases include 

 

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depreciation andstock-based compensation expense of $468,000 and $330,000, respectively.  In addition, we had increases in recruitmentfees of $170,000 and hosting fees of $147,000.

 

*GrossMargin*

 
| ** **            | ** ** | **Three Months Ended June 30,** | ** ** | ** **                                            | ** ** | ** ** | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2007**                                            | ** ** | **2008**                                              | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                          | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                             | ** ** |
| License               |       | $                                                   | 10,940     |                                                  | 95         | %          | $          | 12,461 |   | 95 | % | $ | 1,521 |   | 14 | % |
| Services              |       | 7,706                                               |       | 38                                                    |       | 10,573     |       | 38 |   | 2,867 |   | 37 |   |
| Total                 |       | $                                                   | 18,646     |                                                  | 59         | %          | $          | 23,034 |   | 56 | % | $ | 4,388 |   | 24 | % |

 

The net gross marginpercentage in the three months ended June 30, 2008 declined 3% from thethree months ended June 30, 2007 primarily due to an increase in the lowermargin service revenues as a percentage of total revenues.  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 are performed on a time and materials basis,the timing of expense and revenue recognition is more closely aligned than whenservices are performed under bundled arrangements, where the revenues arerecognized ratably over the license period and the expenses are recognized asincurred.

 

*OperatingExpenses*

 
| ** **                  | ** ** | **Three Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2007**                                            | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                          | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                             | ** ** |
| Sales and  marketing        |       | $                                                   | 5,775      |                                   | 18         | %          | $          | 6,783 |   | 17 | % | $ | 1,008 |   | 17 | % |
| Research and  development   |       | 4,922                                               |       | 16                                     |       | 6,021      |       | 15 |   | 1,099 |   | 22 |   |
| General and  administrative |       | 4,787                                               |       | 15                                     |       | 6,045      |       | 15 |   | 1,258 |   | 26 |   |
| Total                       |       | $                                                   | 15,484     |                                   | 49         | %          | $          | 18,849 |   | 47 | % | $ | 3,365 |   | 22 | % |

 

*Salesand Marketing.*    Salesand marketing expenses increased in the three months ended June 30, 2008primarily due to a $645,000 increase in commission expense due to an increasein revenues.  We also had increases inemployee-related expenses and stock-based compensation expense of $204,000 and$165,000, respectively.  We expect thatour sales and marketing expense will continue to increase in absolute dollarsas commission expense increases with our revenues and as we continue to expandsales coverage and to build brand awareness through what we believe are themost cost effective channels available, but may fluctuate quarter over quarterdue to the timing of marketing programs.

 

*Researchand Development.*    Researchand development expenses increased in the three months ended June 30, 2008primarily due to an increase in employee-related expenses of $511,000 relatedto a headcount increase of 17 people.  Wealso experienced additional expenses related to outside contractors andstock-based compensation expense of $318,000 and $144,000, respectively.  We expect that our research and developmentcosts will continue to increase in absolute dollars as we continue to addfeatures and functionality to our products and expand our product and serviceofferings.

 

*Generaland Administrative.*    Generaland administrative expenses increased in the three months ended June 30,2008 primarily due to an increase in employee-related expenses of $487,000,primarily related to a headcount increase of 12 people.  In addition, stock-based compensationexpense, depreciation expense and travel expense increased $188,000, $109,000and $64,000, respectively.  We expectthat in the future our general and administrative expenses will increase inabsolute dollars as we add personnel and incur additional costs related to thegrowth of our business and operations.

 

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*OperatingIncome*

 
| ** **       | ** ** | **Three Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **       | ** ** | **2007**                                            | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Amount**                                          | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                             | ** ** |
| Operating income |       | $                                                   | 3,162      |                                   | 10         | %          | $          | 4,185 |   | 10 | % | $ | 1,023 |   | 32 | % |
|                  |            |                                                     |            |                                        |            |            |            |  |  |  |  |  |  |  |  |  |

 

*OperatingIncome.*   Theincrease in operating income in the three months ended June 30, 2008 wasprimarily due to an increase in revenues and in gross margin and the reductionin operating expenses as a percentage of revenues.

 

*OtherIncome (Expense)*

 
| ** **              | ** ** | **Three Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **              | ** ** | **2007**                                            | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                          | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                             | ** ** | ** **                             |
| Other income (expense): |       |                                                |       |                                   |       |       |       |   |   |   |   |   |   |
| Interest income         |       | $                                                   | 1,532      |                                   | 5          | %          | $          | 1,386 |   | 3 | % | $ | (146 | ) | (10 | )% |
| Other, net              |       | 4                                                   |       | —                                 |       | 115        |       | — |   | 111 |   | — |   |
| Total other  income     |       | $                                                   | 1,536      |                                   | 5          | %          | $          | 1,501 |   | 3 | % | $ | (35 | ) | (2 | )% |

 

*Other Income (Expense).*    The decrease in interestincome in the three months ended June 30, 2008 was primarily due to thedecrease in interest rates.

 

*Provisionfor Income Taxes*

 
| ** **                  | ** ** | **Three Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2007**                                            | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                          | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                             | ** ** |
| Provision for  income taxes |       | $                                                   | 370        |                                   | 1          | %          | $          | 1,992 |   | 5 | % | $ | 1,622 |   | NM |   |
|                             |            |                                                     |            |                                        |            |            |            |  |  |  |  |  |  |  |  |  |

 

***Provisionfor Income Taxes.****   *Our effective tax rates for the three months ended June 30,2007 and 2008 were 8% and 35%, respectively.  In the three months ended June 30,2007, our provision for taxes includes foreign and alternative minimum tax aswe utilized available U.S. net operating losses to offset our primary federalincome tax obligations resulting in an effective tax rate of 8%.  In thethree months ended June 30, 2008, our effective tax rate was lower thanour statutory rate of 38% primarily due to the utilization of state researchand development tax credits.

** **

**Overviewof Results of Operations in the Six Months Ended June 30, 2007 and 2008**

 

Total revenues increasedby 28%, or $17.3 million, in the six months ended June 30, 2008 comparedto the same period in 2007 due primarily to an increase in service revenues of36%.  Additionally, license revenuesincreased by 14%, or $3.2 million, in the six months ended June 30, 2008compared to the same period in 2007.

 

Our gross marginincreased by 23%, or $8.3 million, in the six months ended June 30,2008 compared to the same period in 2007, primarily due to the increase inservices revenues.

 

Operating income in thesix months ended June 30, 2008 of $8.6 million increased 35%, or $2.2million, compared to the same period in 2007. The operating income in the six months ended June 30, 2007 and 2008also included $2.2 million and $3.7 million of stock-based compensationexpense, respectively.

 

The results in the sixmonths ended June 30, 2008 were affected by foreign exchange ratefluctuations, resulting in increases of approximately 3% and 2% in revenues andexpenses, respectively, in the period.

 

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*Revenues*

 
| ** **                                           | ** ** | **Six Months Ended June 30,** | ** ** | ** **                               | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| ** **                                           | ** ** | **2007**                                          | ** ** | **2008**                                 | ** ** | **Change** | ** ** |
| **Revenues by Product Line (1)** | ** ** | **Amount**                                        | ** ** | **Percentage   of   Revenues** | ** ** | **Amount** | ** ** | **Percentage   of   Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                           | ** ** |
| Electronic data capture                              |       | $                                                 | 44,029     |                                     | 71         | %          | $          | 60,283 |   | 76 | % | $ | 16,254 |   | 37 | % |
| Clinical data management                             |       | 10,158                                            |       | 17                                       |       | 11,172     |       | 14 |   | 1,014 |   | 10 |   |
| Safety                                               |       | 7,431                                             |       | 12                                       |       | 7,416      |       | 10 |   | (15 | ) | — |   |
| Total                                                |       | $                                                 | 61,618     |                                     | 100        | %          | $          | 78,871 |   | 100 | % | $ | 17,253 |   | 28 | % |

 

----

(1) Revenuesby Product Line include product license revenues and product-related servicerevenues.

 

The increase inelectronic data capture revenues is primarily due to an increase in applicationhosting services of $14.8 million.  Inaddition, there were increases in license revenues and consulting servicesrevenues of $2.3 million and $625,000, respectively.  These increases arepartially offset by a decrease in customer support of $1.5 million.  Theincrease in clinical data management can be attributed to increases in licenserevenues and consulting services of $725,000 and $421,000, respectively,partially offset by a decrease in customer support revenues of $132,000.  The decrease in safety was primarily due to adecrease in consulting services of $398,000. This decrease was offset by increases in license revenues, applicationhosting services and customer support revenues of $154,000, $151,000 and $78,000,respectively.

 
| ** **                    | ** ** | **Six Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|-------------------------------|------------|---------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                    | ** ** | **2007**                                          | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                        | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                           | ** ** |
| License                       |       | $                                                 | 22,505     |                                   | 37         | %          | $          | 25,701 |   | 33 | % | $ | 3,196 |   | 14 | % |
| Application  hosting services |       | 25,464                                            |       | 41                                     |       | 40,420     |       | 51 |   | 14,956 |   | 59 |   |
| Consulting  services          |       | 6,524                                             |       | 11                                     |       | 7,170      |       | 9 |   | 646 |   | 10 |   |
| Customer support              |       | 7,125                                             |       | 11                                     |       | 5,580      |       | 7 |   | (1,545 | ) | (22 | ) |
| Total                         |       | $                                                 | 61,618     |                                   | 100        | %          | $          | 78,871 |   | 100 | % | $ | 17,253 |   | 28 | % |

 

Total revenues increasedin the six months ended June 30, 2008 as compared to the same period in2007, primarily due to increases in application hosting and licenserevenues.  The increase in revenuesassociated with our application hosting services in the six months ended June 30,2008 was partially due to an approximately 8% increase in production trialsunder management from approximately 750 as of June 30, 2007 toapproximately 810 as of June 30, 2008, which include both applicationhosting services trials as well as trials hosted for our *InForm *licensecustomers.  The increase in production trialsis primarily from customers who purchase all trial-related services from us andwho do not have a separate license to *InForm*, and toan increase in average fee per trial.  Theincrease in license revenues was primarily the result of additional electronicdata capture**revenues from both new and existingcustomers, and to a lesser extent, growth in sales relating to our clinicaldata management and safety products.  Theincrease in consulting services was primarily attributable to additionalelectronic data capture revenues which were related to both new and existingcustomers.  The decrease in customersupport revenues in the six months ended June 30, 2008 was due primarilyto decreases in electronic data capture revenues.  Our revenues were not significantly impactedby price increases or decreases. Inflation had only a nominal impact on our revenues.

 
| ** **                          | ** ** | **Six Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|-------------------------------------|------------|---------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2007**                                          | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                        | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                           | ** ** |
| United States                       |       | $                                                 | 29,713     |                                   | 48         | %          | $          | 42,432 |   | 54 | % | $ | 12,719 |   | 43 | % |
|                                |       |                                              |       |                                   |       |       |       |   |   |   |   |   |   |
| United Kingdom                      |       | 22,920                                            |       | 37                                     |       | 24,903     |       | 31 |   | 1,983 |   | 9 |   |
| France                              |       | 5,375                                             |       | 9                                      |       | 7,016      |       | 9 |   | 1,641 |   | 31 |   |
| Asia Pacific                        |       | 3,610                                             |       | 6                                      |       | 4,520      |       | 6 |   | 910 |   | 25 |   |
| International  subtotal             |       | 31,905                                            |       | 52                                     |       | 36,439     |       | 46 |   | 4,534 |   | 14 |   |
| Total                               |       | $                                                 | 61,618     |                                   | 100        | %          | $          | 78,871 |   | 100 | % | $ | 17,253 |   | 28 | % |

 

The increase in revenuesworldwide was primarily due to an increase in electronic data capture revenuesof $16.2 million.  In addition there wasan increase in clinical data management revenues of $1.0 million.  The increase in U.S. revenues is primarilyrelated to an increase in electronic data capture revenues of $12.6million.  The increase in international 

 

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revenues is primarily theresult of electronic data capture revenues from both new and existing customersof $3.7 million, as well as an increase in clinical data management revenues of$829,000.

 

*Costsof Revenues*

 
| ** **                      | ** ** | **Six Months Ended June 30,** | ** ** | ** **                                            | ** ** | ** ** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2007**                                          | ** ** | **2008**                                              | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                        | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                           | ** ** |
| License                         |       | $                                                 | 1,134      |                                                  | 5          | %          | $          | 1,281 |   | 5 | % | $ | 147 |   | 13 | % |
| Services                        |       | 23,886                                            |       | 61                                                    |       | 32,719     |       | 62 |   | 8,833 |   | 37 |   |
| Total                           |       | $                                                 | 25,020     |                                                  | 41         | %          | $          | 34,000 |   | 43 | % | $ | 8,980 |   | 36 | % |

 

The costs of license revenues increased in the six monthsended June 30, 2008 primarily due to a $130,000 increase in the amortization ofintangible assets.  The increase in cost of services in the sixmonths ended June 30, 2007 was primarily due to increases inemployee-related and outside contractor expenses of $4.1 million and $2.5million, respectively, associated with delivering increased services.  We also had expense increases fordepreciation, stock-based compensation and hosting of $1.0 million, $613,000and $307,000, respectively.  In addition,there were also increases in recruiting, facilities, and phone and internetexpenses of $187,000, $167,000 and $163,000, respectively.  These expense increases are partially offsetby a decrease in computer-related expense of $235,000.  Computer-related expenses include hardwareand software support agreements as well as computer accessories.

 

*GrossMargin*

 
| ** **            | ** ** | **Six Months Ended June 30,** | ** ** | ** **                                            | ** ** | ** ** | ** ** |
|-----------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2007**                                          | ** ** | **2008**                                              | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                        | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Related   Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                           | ** ** |
| License               |       | $                                                 | 21,371     |                                                  | 95         | %          | $          | 24,420 |   | 95 | % | $ | 3,049 |   | 14 | % |
| Services              |       | 15,227                                            |       | 39                                                    |       | 20,451     |       | 38 |   | 5,224 |   | 34 |   |
| Total                 |       | $                                                 | 36,598     |                                                  | 59         | %          | $          | 44,871 |   | 57 | % | $ | 8,273 |   | 23 | % |

 

The services gross marginpercentage decreased slightly in the six months ended June 30, 2008, asour expense increase outpaced our revenues growth.  The overall net gross margin decreased 2% inthe six months ended June 30, 2008 due to the decline in services grossmargin.

 

*OperatingExpenses*

 
| ** **                  | ** ** | **Six Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2007**                                          | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                        | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                           | ** ** |
| Sales and  marketing        |       | $                                                 | 11,222     |                                   | 18         | %          | $          | 12,934 |   | 16 | % | $ | 1,712 |   | 15 | % |
| Research and  development   |       | 9,554                                             |       | 16                                     |       | 11,579     |       | 15 |   | 2,025 |   | 21 |   |
| General and  administrative |       | 9,425                                             |       | 15                                     |       | 11,745     |       | 15 |   | 2,320 |   | 25 |   |
| Total                       |       | $                                                 | 30,201     |                                   | 49         | %          | $          | 36,258 |   | 46 | % | $ | 6,057 |   | 20 | % |

 

*Salesand Marketing.*    Sales and marketing expenses increased inthe six months ended June 30, 2008 primarily due to a $920,000 increase incommission expense due to an increase in revenues, and a $426,000 increase inemployee-related expenses.  We alsoexperienced increases in stock-based compensation and travel expenses of$313,000 and $75,000, respectively.

 

*Researchand Development.*    Researchand development expenses increased in the six months ended June 30, 2008primarily due to employee-related expenses of $1.0 million related to aheadcount increase of 17 people.  Inaddition, outside contractor, stock-based compensation and recruiting expenseincreased $417,000, $267,000 and $96,000 respectively.  

 

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Further, there wereincreases in depreciation, travel and phone and internet expense of $73,000,$66,000 and $37,000, respectively.

* *

*Generaland Administrative.*    Generaland administrative expenses increased in the six months ended June 30, 2008primarily due to an increase in employee-related expenses of $854,000 relatedto a headcount increase of 12 people.  Further, depreciation, stock-based compensation andprofessional expenses increased $490,000, $348,000 and $174,000,respectively.  Additionally, weexperienced expense increases in computer-related, employee appreciation andretention programs and internal network hosting in the amount of $108,000,$101,000 and $80,000, respectively.  Inaddition, recruiting, travel and insurance expenses increased $62,000, $51,000and $39,000, respectively.

 

*OperatingIncome*

 
| ** **       | ** ** | **Six Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|------------------|------------|---------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **       | ** ** | **2007**                                          | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Amount**                                        | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage   of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                           | ** ** |
| Operating income |       | $                                                 | 6,397      |                                   | 10         | %          | $          | 8,613 |   | 11 | % | $ | 2,216 |   | 35 | % |
|                  |            |                                                   |            |                                        |            |            |            |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome in the six months ended June 30, 2008 was primarily due to thereduction in operating expenses as a percentage of revenues.

 

*OtherIncome (Expense)*

 
| ** **               | ** ** | **Six Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|--------------------------|------------|---------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **               | ** ** | **2007**                                          | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Amount**                                        | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage of   Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **               | ** ** | **(in thousands)**                           | ** ** |
| Other income  (expense): |       |                                              |       |                                   |       |       |       |   |   |   |   |   |   |
| Interest income          |       | $                                                 | 2,396      |                                   | 4          | %          | $          | 3,287 |   | 4 | % | $ | 891 |   | 37 | % |
| Other, net               |       | (62                                               | )          | —                                 |       | 249        |       | — |   | 311 |   | — |   |
| Total other  income      |       | $                                                 | 2,334      |                                   | 4          | %          | $          | 3,536 |   | 4 | % | $ | 1,202 |   | 51 | % |

 

Theincrease in interest income in the six months ended June 30, 2008 wasprimarily due to an increase in cash and cash equivalents available forshort-term investments.

 

*Provisionfor Income Taxes*

 
| ** **                  | ** ** | **Six Months Ended June 30,** | ** ** | ** **                             | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|----------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2007**                                          | ** ** | **2008**                               | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                        | ** ** | **Percentage   of Revenues** | ** ** | **Amount** | ** ** | **Percentage of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                           | ** ** |
| Provision for  income taxes |       | $                                                 | 922        |                                   | 2          | %          | $          | 4,453 |   | 6 | % | $ | 3,531 |   | 383 | % |
|                             |            |                                                   |            |                                        |            |            |            |  |  |  |  |  |  |  |  |  |

 

*** ***Our effective tax rates for the six months ended June 30,2007 and 2008 were 11% and 37%, respectively.  In the six months ended June 30,2007, our provision for taxes includes foreign and alternative minimum tax aswe utilized available U.S. net operating losses to offset our primary federalobligations resulting in an effective tax rate of 11%.

** **

**Liquidityand Capital Resources**

 

Our principal sources ofliquidity were unrestricted cash, cash equivalents, short-term and long-terminvestments totaling $182.6 million and $215.9 million at December 31,2007 and June 30, 2008, respectively, and accounts receivable of $35.5million and $29.0 million, respectively.

 

Cash provided by and usedin operating activities has historically been affected by changes in workingcapital accounts, primarily deferred revenue, accounts receivable and accruedexpenses, and add-backs of non-cash expense items such as 

 

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depreciation andamortization and stock-based compensation expense. Fluctuations within accountsreceivable and deferred revenue are primarily related to the timing of billingsto our term license customers and the associated revenue recognition. Movementsin deferred costs are related to the volume and stages of hosted clinicaltrials and movements in accrued expenses and accounts payable are due to thetiming of certain transactions.

 

Net cash provided byoperating activities was $41.7 million in the six months ended June 30,2008, which was greater than net income of $7.7 million.  This difference was primarily due to anincrease in deferred revenues of $15.4 million and a decrease in accountsreceivable of $7.2 million.  In addition,over the same period there was $4.5 million of non-cash depreciation andamortization expense, $4.3 million of non-cash income tax expense, $3.7 millionof non-cash stock-based compensation expense and an increase in accountspayable of $1.4 million.  These increasesin cash were partially offset by a decrease in accrued expense of $1.6 millionand increases in deferred set up costs of $1.3 million.

 

Net cash used ininvesting activities was $3.6 million in the six months ended June 30,2008, which was primarily due to the purchase of short-term and long-terminvestments of $36.1 million, capital expenditures of $5.9 million and anincrease in restricted cash associated with our leases of $1.5 million.  These decreases in cash were partially offsetby $39.8 million of proceeds from maturities of short-term investments.

 

Net cash providedby financing activities was $126,000 in the six months ended June 30,2008, consisting of proceeds from the exercise of stock options of $1.4million, partially offset by the payment of withholding taxes associated withthe vesting of restricted stock awards of $1.2 million.

 

Substantially all of ourlong-lived assets at December 31, 2007 and June 30, 2008 are locatedin the United States.

 

We generally do not enterinto long-term binding purchase commitments. Our principal commitments consist of obligations under non-cancelableoperating leases for office space.

 

The following table ofour material contractual obligations as of December 31, 2007 summarizesthe aggregate effect that these obligations are expected to have on our cashflows 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 |       | $                                         | 7,872      |   | $ | 3,902 |   | $ | 2,779 |   | $ | 1,153 |   | $ | 38 341 | ** ** |
| Total                                 |       | $                                         | 7,872      |   | $ | 3,902 |   | $ | 2,779 |   | $ | 1,153 |   | $ | 38 341 |   |

 

The above table does not include the new lease we enteredinto subsequent to December 31, 2007. On February 13, 2008, we entered into a lease (“Lease”) with BPFourth Avenue, L.L.C. (the “Landlord”) to secure office space for our futurecorporate headquarters at 77 Fourth Avenue, Waltham, Massachusetts. Theestimated commencement date for occupancy under the Lease is December 2008.The Lease for our current corporate headquarters at 880 Winter Street inWaltham is due to expire in February 2009.

 

The Lease provides for the rental of 165,129 rentablesquare feet of space and has an initial term of 10 years and three months. Wecan, subject to certain conditions, extend this term by exercising up to twoconsecutive five year options. We are not required to pay any rent for thefirst three months of the initial Lease term. Thereafter, the annual rent on the Lease for years one through five willbe $6.6 million, or approximately $548,000 per month.  For years six through ten, the annual rentwill be $7.2 million, or approximately $603,000 per month.  The total base rent payable in the initialterm is $69.1 million.

 

As of December 31, 2007, we had a working capitalline of credit with a bank under which we could borrow up to $2.0 million, ofwhich $1.5 million was available and $500,000 reserved under a letter of creditassociated with our leased facility. The line of credit expired on March 31,2008, and was not renewed.  As of June 30,2008, the $500,000 collateral obligation for our leased facility was secured bya certificate of deposit.

 

Inconnection with the signing of the Lease, we deposited with the Landlord anunconditional, irrevocable letter of credit in the Landlord’s favor in theamount of $962,000 secured by a certificate of deposit.

 

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At December 31,2007, we had $54.8 million of net operating loss carryforwards that may be usedto offset future U.S. federal taxable income.  These attributes may reduceour future cash tax liability.  In addition, we had $15.6 million of netoperating losses resulting from excess tax deductions related to stock-basedcompensation expense.  We will realize the benefit of these excess taxdeductions through increases to stockholders’ equity in the periods in whichthe losses are utilized to reduce tax payments.  In addition, we had $1.7million of federal research and development tax credit carryforwards that maybe utilized to offset future U.S. taxes.  The net operating loss and taxcredit carryforward periods extend through 2026 and 2027, respectively. In addition, we had $3.6 million of foreign net operating loss carryforwardsthat may be used to offset future foreign taxable income. These foreign net operatingloss carryforwards have an unlimited carryforward period. We also had $3.1million of research and development tax credit carryforwards that may beutilized to offset future Massachusetts state taxable income.  TheMassachusetts tax credit carryforward period extends through 2022.  Thefederal and state net operating loss carryforwards and research and developmenttax credits are subject to review and possible adjustment by the taxingauthorities.  Also, the Internal Revenue Code contains provisions that maylimit the net operating loss and tax credit carryforwards available in anygiven year in the event of certain changes in the ownership interests ofsignificant stockholders.  We currently expect to realize the benefit ofrecorded deferred tax assets as of June 30, 2008 of $22.3 million. Our conclusion that such assets will be recovered is based upon ourexpectation that our future earnings combined with tax planning strategiesavailable to us will provide sufficient taxable income to realize recorded taxassets.

 

We may be required tomake cash outlays related to our unrecognized tax benefits.  However, dueto the uncertainty of the timing of future cash flows associated with ourunrecognized tax benefits, we are unable to make reasonably reliable estimatesof the period of cash settlement, if any, with the respective taxingauthorities.  Accordingly, unrecognized tax benefits of $1.2 million as ofDecember 31, 2007 have been excluded from the contractual obligationstable above.  For further information on unrecognized tax benefits, seeNote 7 in the notes to our 2007 consolidated financial statements included inour Annual Report on Form 10-K for the year ended December 31, 2007filed with the SEC.

 

We believe our existingunrestricted cash, cash equivalents, short-term investments and cash providedby operating activities will be sufficient to meet our working capital andcapital expenditure needs over at least the next 12 months. Our futurecapital requirements will depend on many factors, including our rate of revenuegrowth, the expansion of our marketing and sales activities, the timing andextent of spending to support product development efforts, the timing ofintroductions of new products and services and enhancements to existingproducts and services and the continuing market acceptance of our products andservices.  From time to time, we may alsoenter into agreements with respect to potential investments in, or acquisitionsof, businesses, services or technologies, which could also require us to seekadditional equity or debt financing.  Tothe extent that existing cash and securities and cash from operations areinsufficient to fund our future activities, we may need to raise additionalfunds through public or private equity or debt financing.

 

Included within ourinvestment portfolio at June 30, 2008, were $24.1 million of auction ratesecurities (“ARS”) at par value, which are classified as available-for-salesecurities and noncurrent assets on our condensed consolidated balance sheets,and recorded at fair market value. These ARS are debt instruments issued byvarious states throughout the United States to finance student loans.  The types of ARS that we own are backed bystudent loans, 95% of which are guaranteed under the Federal Family EducationLoan Program, and all have credit ratings of AAA (or equivalent) from arecognized rating agency.  Historically,the carrying value of ARS approximated fair value due to the frequent resettingof the interest rates. With the liquidity issues experienced in the globalcredit and capital markets, our ARS have experienced multiple failed auctions.While we continue to earn and receive interest on these investments at themaximum contractual rate, the estimated fair value of these ARS no longerapproximates par value.

 

We concluded that thefair value of these ARS at June 30, 2008 was $22.8 million, a decline of$1.3 million from par value. Fair value was determined using a discounted cashflow model as recent auctions of these securities were not successful,resulting in our continuing to hold these securities and issuers payinginterest at the maximum contractual rate. This valuation technique considers the complexity and transparency ofthe structure of each ARS and cash flows within each structure; the quality ofthe collateral; and liquidity determinants affecting each ARS.  The decline in fair value is deemed temporaryas we believe the decline in fair value of these investments is due to currentmarket conditions as well as the fact that we have the ability and intent tohold these securities until market conditions improve. Accordingly, we recordedan unrealized loss on these securities of $1.3 million in other comprehensiveincome.  Depending on future market conditions,the ARS may result in future fair value adjustments.   If in the future we determine that anydecline in value of the ARS is other-than-temporary, we would be required torecognize the loss in our statement of income, which could have a material impacton our operating results in the period it is recognized.

 

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We believe that, based onour unrestricted cash, cash equivalents and short-term investment balances of$192.6 million at June 30, 2008, excluding fair market value of ARS of$22.8 million, the current lack of liquidity in the credit and capital marketswill not have a material impact on our liquidity, cash flow or the ability tofund our operations.

 

**Recently Issued AccountingPronouncements**

 

In December 2007,the FASB issued SFAS No. 141 (Revised 2007), *Business Combinations.* SFAS No. 141(R) retains thefundamental requirements in SFAS No. 141 that the acquisition methodof accounting (which SFAS No. 141 called the “purchase method”) be usedfor all business combinations and for an acquirer to be identified for eachbusiness combination. SFAS No. 141(R) requires an acquirer torecognize the assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquiree at the acquisition date, measured at their fair valuesas of that date, with limited exceptions specified in SFAS No. 141(R).This approach replaces SFAS No. 141’s cost-allocation process, whichrequired the cost of an acquisition to be allocated to the individual assetsacquired and liabilities assumed based on their estimated fair values. SFAS No. 141(R) retainsthe guidance in SFAS No. 141 for identifying and recognizing intangibleassets separately from goodwill. SFAS No. 141(R) will nowrequire acquisition costs to be expensed as incurred, restructuring costsassociated with a business combination must generally be expensed prior to theacquisition date and changes in deferred tax asset valuation allowances andincome tax uncertainties after the acquisition date generally will affectincome tax expense. SFAS No. 141(R) applies prospectively to businesscombinations for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15, 2008,which is our 2009 fiscal year. Earlier adoption is prohibited.

 

In March 2008, theFASB issued SFAS No. 161,*Disclosuresabout Derivative Instruments and Hedging Activities an amendment of FASBStatement No. 133.*  SFAS No. 161requires disclosures of how and why an entity uses derivative instruments, howderivative instruments and related hedged items are accounted for and howderivative instruments and related hedged items affect an entity’s financialposition, financial performance, and cash flows. SFAS No. 161 is effectivefor fiscal years beginning after November 15, 2008, with early adoptionpermitted. The adoption of SFAS No. 161 is not expected to have a materialeffect on our consolidated financial position and results of operations.

 

In May 2008, theFASB issued SFAS No. 162, *The Hierarchy of GenerallyAccepted Accounting Principles* (“SFAS No. 162”). SFAS No. 162identifies the sources of generally accepted accounting principles in theUnited States and prioritizes the generally accepted accounting principlesthereunder. SFAS No. 162 is effective sixty days following the SEC’sapproval of the Public Company Accounting Oversight Board amendments to AU Section 411,*The Meaning of Present Fairly in Conformity With GenerallyAccepted Accounting Principles*. The adoption of SFAS No. 162 isnot expected to have a material effect on our consolidated financial positionand results of operations.

 

**Off-Balance Sheet Arrangements**

 

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

 

**Item 3. *Quantitative and Qualitative Disclosuresabout Market Risk***

 

*ForeignCurrency Exchange Risk*

* *

Our results of operationsand cash flows are subject to fluctuations due to changes in foreign currencyexchange rates, particularly changes in the euro, British pound, Australiandollar and Japanese yen.  During the sixmonths ended June 30, 2007 and 2008, 52% and 46%, respectively, of ourrevenues were generated in locations 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 June 30, 2008,we had $7.6 million of receivables denominated in currencies other than theU.S. dollar.  We also maintain cashaccounts denominated in currencies other than the local currency which exposeus 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

 

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long-term intercompany accounts are recorded inour consolidated balance sheets under “accumulated other comprehensive loss” instockholders’ equity, as they are considered part of our net investment andhence do not give rise to gains or losses.

 

Wehave implemented a risk management program under which we measure foreigncurrency exchange risk monthly and manage those exposures through the use ofvarious operating strategies.  Weregularly hedge our non-U.S. dollar-based exposures by entering into short-termforward foreign exchange contracts. This process is designed to minimizeforeign currency translation exposures that could otherwise affect consolidatedresults of operations. The terms of these contracts are for periods generallyfor one month. The short-term nature of these contracts has resulted in theseinstruments having insignificant fair values.

 

Currently, our largest foreign currency exposure is theeuro.  Relative to foreign currencyexposures existing at December 31, 2006 and 2007, a 10% unfavorablemovement in foreign currency exchange rates would not expose us to significantlosses in earnings or cash flows or significantly diminish the fair value ofour foreign currency financial instruments. This is primarily due to the shortlives of the affected financial instruments that effectively hedgesubstantially all of our year-end exposures against fluctuations in foreigncurrency exchange rates. The calculation assumes that each exchange rate wouldchange in the same direction relative to the U.S. dollar.

 

As of June 30, 2007,we entered into contracts to hedge approximately $4.3 million of receivables,intercompany accounts and cash balances denominated in currencies other thanthe U.S. dollar.  As of June 30,2008, we were not a party to any hedging contracts.

 

*InterestRate Sensitivity*

 

We had unrestricted cash,cash equivalents, short-term and long-term investments totaling $215.9 millionat June 30, 2008.  Investments insecurities are invested primarily in high quality securities of a shortduration and are not materially affected by fluctuations in interest rates. Thecash and cash equivalents are held for working capital purposes. We do notenter into investments for trading or speculative purposes. Due to the short-termnature of these investments, we believe that we do not have any materialexposure to changes in the fair value of our investment portfolio as a resultof changes in interest rates. Declines in interest rates, however, would reducefuture investment income.

 

As of June 30, 2008,we held auction rate securities (“ARS”) totaling $24.1 million at par value,which are classified as available-for-sale securities and noncurrent assets onour condensed consolidated balance sheets, and recorded at fair value. TheseARS are debt instruments issued by various states throughout the United Statesto finance student loans.  The types ofARS that we own are backed by student loans, 95% of which are guaranteed underthe Federal Family Education Loan Program, and all have credit ratings of AAA(or equivalent) from a recognized rating agency.  Historically, the carrying value of ARSapproximated fair value due to the frequent resetting of the interest rates.With the liquidity issues experienced in the global credit and capital markets,our ARS have experienced multiple failed auctions. While we continue to earnand receive interest on these investments at the maximum contractual rate, theestimated fair value of these ARS no longer approximates par value.

 

We concluded that thefair value of these ARS at June 30, 2008 was $22.8 million, a decline of$1.3 million from par value. Fair value was determined using a trinomialdiscount model as recent auctions of these securities were not successful,resulting in us continuing to hold these securities and issuers paying interestat the estimated maximum contractual rate. This valuation technique considers the complexity and transparency ofthe structure of each ARS and cash flows within each structure; the quality ofthe collateral; and liquidity determinants affecting each ARS.  The decline in fair value is deemed temporaryas we believe the decline in fair value of these investments is due to generalmarket conditions. Accordingly, we have recorded a temporary impairment on thesesecurities of $1.3 million in other comprehensive income.  Depending on future market conditions, theARS may result in future fair market value adjustments.   If in the future we determine that anydecline in value of the ARS is other-than-temporary, we would be required torecognize the loss in our statement of income, which could have a materialimpact on our operating results in the period it is recognized.

 

We believe that, based onour unrestricted cash, cash equivalents and short-term marketable securitiesbalances of $192.6 million at June 30, 2008, excluding fair market valueof ARS of $22.8 million, the current lack of liquidity in the credit andcapital markets will not have a material impact on our liquidity, cash flow orour ability to fund our operations.

 

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

** **

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our Securities Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the SEC’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 desiredcontrol objectives, as ours are designed to do, and management necessarily wasrequired to apply its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.

 

As of June 30, 2008,we carried out an evaluation, under the supervision and with the participationof our management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective at that reasonable assurance level in (i) enablingus to record, process, summarize and report information required to be includedin our periodic SEC filings within the required time period and (ii) ensuringthat information required to be disclosed in the reports that we file or submitunder the Securities Exchange Act is accumulated and communicated to ourmanagement, including our Chief Executive Officers and Chief Financial Officer,to allow timely decisions regarding required disclosure.

 

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

 

**Part II—Other Information**

** **

**Item 1. *Legal Proceedings***

 

From time to time and inthe ordinary course of business, we are subject to various claims, charges andlitigation.  The outcome of litigationcannot be predicted with certainty and some lawsuits, claims or proceedings maybe disposed of unfavorably to us, which could materially affect our financialcondition or results of operations.

 

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

 

**CertainFactors Which May Affect Future Results**

** **

*Weoperate in a rapidly changing environment that involves a number of risks, someof which are beyond our control.  The risks and uncertainties that webelieve are most important for you to consider are described under the title “RiskFactors” in our Annual Report on Form 10-K for the year ended December 31,2007.  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 ended December 31,2007.  Additional risks and uncertaintiesnot presently known to us, which we currently deem immaterial or which aresimilar to those faced by other companies in our industry or business ingeneral, may also impair our business operations.  If any of the foregoingrisks or uncertainties actually occurs, our business, financial condition andoperating results would likely suffer.*

* *

**Item4. *Submission of Matters to a Vote of Security Holders***

 

At the annual meeting ofour stockholders held April 30, 2008, our stockholders took the followingactions:

 

Our stockholders electedAxel Bichara, Paul A. Bleicher, Richard D’Amore, James I. Cash, Jr., GaryE. Haroian, Kenneth I. Kaitin, Dennis R. Shaughnessy, and Robert K. Weiler asdirectors, each to serve for a one-year term and until their successors havebeen duly elected and qualified or until their earlier death, resignation orremoval. The directors were elected by a plurality of the votes cast at the2008 annual meeting, as follows:

 

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| **Nominee**              | ** ** | **Votes  For** | ** ** | **Shares  Withheld** | ** ** |
|--------------------------|------------|----------------|------------|----------------------|------------|
|                     |       |           |       |                 |       |
| Axel Bichara             |       | 40,080,680     |       | 190,323              |       |
| Paul A. Bleicher         |       | 39,875,015     |       | 395,988              |       |
| Richard D’Amore     |       | 39,874,916     |       | 396,087              |       |
| James I.  Cash, Jr. |       | 39,750,854     |       | 520,149              |       |
| Gary E. Haroian          |       | 40,058,769     |       | 212,234              |       |
| Kenneth I.  Kaitin       |       | 40,039,470     |       | 231,553              |       |
| Dennis R.  Shaughnessy   |       | 40,080,580     |       | 190,423              |       |
| Robert K. Weiler         |       | 39,897,028     |       | 373,975              |       |

 

No other persons werenominated, nor received votes, for election as a director at the 2008 annualmeeting.

 

Our stockholders approvedthe selection of Ernst & Young LLP as our independent registeredpublic accounting firm for the fiscal year ending December 31, 2008. Thevotes cast at the 2008 annual meeting were as follows: 39,966,688 shares votedfor, 283,858 shares voted against and 20,457 shares abstained from voting.

 

**Item 5. *Other Information***

 

Our policy governingtransactions in our securities by directors, officers and employees permits ourofficers, directors and certain other persons to enter into trading planscomplying with Rule 10b5-1 under the Securities Exchange Act of 1934, asamended. We have been advised that our Vice President, Corporate Development,Martin Young; our Vice President, Quality and Regulatory Compliance, Michael P.Owings; our Senior Vice President, Development, Steven Rosenberg; our SeniorVice President, Worldwide Sales, Stephen J. Powell; and our Senior VicePresident and Chief Financial Officer, Rodger Weismann have each entered into atrading plan covering periods after the date of this Quarterly Report inaccordance with Rule 10b5-1 and our policy governing transactions in oursecurities.  Generally, under thesetrading plans, the individual relinquishes control over the transactions oncethe trading plan is put into place. Accordingly, sales under these plans may occur at any time, includingpossibly before, simultaneously with, or immediately after significant eventsinvolving our company.

 

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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. |

** **

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*** Filedherewith.**

 

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**Signatures**

** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                           | **PHASE FORWARD INCORPORATED** |
|---------------------------|--------------------------------|
|                      |                           |
|                      | By:                            | /s/ ROBERT K. WEILER |
|                      |                           | Robert K. Weiler*Chief Executive Officer  (Duly authorized officer)* |
|                      |                           |   |
|                      | By:                            | /s/ RODGER WEISMANN |
|                      |                           | Rodger Weismann*Chief Financial Officer  (Duly authorized officer and  principal financial officer)* |
| Date: August 8, 2008 |                           |

 

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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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*Filed herewith.

 

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