**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

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

**Forthe quarterly period ended June 30, 2005**

**OR**

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

**CommissionFile Number: 000-50839**

**Phase Forward Incorporated**

(Exact name of registrantas specified in its charter)

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

 

**(888) 703-1122**

(Registrant’s telephonenumber, including area code)

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days.

Yes   x   No   o

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

Yes   o   No   x

As of July 15, 2005, the registrant had33,133,020 shares of Common Stock outstanding.

 

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**PHASE FORWARDINCORPORATEDQUARTERLY REPORT ON FORM 10-QFor the quarterly period ended June 30, 2005Table of Contents**
|                                             | ** ** | ** **                                                                                                       | ** ** | **Page  Number** |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------------|
| **Part I—Financial  Information** |       |                                                                                                             |       |             |
| Item 1.                                     |       | Condensed  Consolidated Financial Statements (unaudited)                                                         |       |             | 3 |   |
|                                        |       | Condensed  Consolidated Balance Sheets as of December 31, 2004 and June 30,  2005                      |       |             | 3 |   |
|                                        |       | Condensed  Consolidated Statements of Operations for the three and six months ended  June 30, 2004 and 2005 |       |             | 4 |   |
|                                        |       | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2004 and 2005           |       |             | 5 |   |
|                                        |       | Notes to  Condensed Consolidated Financial Statements                                                            |       |             | 6 |   |
| Item 2.                                     |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      |       |             | 18 |   |
| Item 3.                                     |       | Quantitative  and Qualitative Disclosures about Market Risk                                                      |       |             | 47 |   |
| Item 4.                                     |       | Controls and  Procedures                                                                                         |       |             | 47 |   |
| **Part II—Other  Information**    |       |                                                                                                             |       |             |
| Item 5.                                     |       | Other Information                                                                                                |       |             | 49 |   |
| Item 6.                                     |       | Exhibits                                                                                                         |       |             | 49 |   |
| Signatures                                  |       |                                                                                                             | 50         |             |
| Exhibit Index                          |       |                                                                                                             |       |             |

 

2

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**Part I—FinancialInformation**

**Item 1.**                        CondensedConsolidated Financial Statements (unaudited)

**Phase Forward Incorporated and Subsidiaries**

**CondensedConsolidated Balance Sheets**

**(unaudited)**

**(inthousands, except per share amounts)**
| ** **                                                                             | ** ** | **As of   December 31,  2004** | ** ** | **As of  June 30,  2005** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------|------------|
| **Assets**                                                                             |       |                                          |       |                                |       |   |   |
| Current assets:                                                                        |       |                                          |       |                                |       |   |   |
| Cash and cash equivalents                                                              |       |                                          | $          | 53,485                              |       |   | $ | 56,455 |   |
| Short-term investments                                                                 |       |                                          | 4,735      |                                |       | 8,816 |   |
| Accounts receivable, net  of allowance of $391 and $289 in 2004 and 2005, respectively |       |                                          | 19,682     |                                |       | 15,956 |   |
| Deferred set up costs,  current portion                                                |       |                                          | 783        |                                |       | 1,089 |   |
| Prepaid commissions and  royalties, current portion                                    |       |                                          | 3,035      |                                |       | 3,718 |   |
| Prepaid expenses and  other current assets                                             |       |                                          | 2,335      |                                |       | 2,434 |   |
| Total current  assets                                                                  |       |                                          | 84,055     |                                |       | 88,468 |   |
| Property and  equipment, net                                                           |       |                                          | 5,717      |                                |       | 5,603 |   |
| Deferred set up  costs, net of current portion                                         |       |                                          | 665        |                                |       | 687 |   |
| Prepaid  commissions and royalties, net of current portion                             |       |                                          | 2,756      |                                |       | 2,596 |   |
| Goodwill                                                                               |       |                                          | 21,817     |                                |       | 21,047 |   |
| Other assets                                                                           |       |                                          | 240        |                                |       | 186 |   |
| Total assets                                                                           |       |                                          | $          | 115,250                             |       |   | $ | 118,587 |   |
| **Liabilities and Stockholders’ Equity**                                          |       |                                          |       |                                |       |   |   |
| Current Liabilities:                                                                   |       |                                          |       |                                |       |   |   |
| Current portion of notes  payable                                                      |       |                                          | $          | 2,558                               |       |   | $ | — |   |
| Accounts payable                                                                       |       |                                          | 1,619      |                                |       | 1,258 |   |
| Accrued expenses                                                                       |       |                                          | 11,658     |                                |       | 10,717 |   |
| Restructuring accrual                                                                  |       |                                          | 344        |                                |       | — |   |
| Deferred revenue, current  portion                                                     |       |                                          | 35,350     |                                |       | 38,716 |   |
| Deferred rent, current  portion                                                        |       |                                          | 142        |                                |       | 332 |   |
| Total current  liabilities                                                             |       |                                          | 51,671     |                                |       | 51,023 |   |
| Notes payable, net  of current portion                                                 |       |                                          | 1,849      |                                |       | — |   |
| Deferred revenue,  net of current portion                                              |       |                                          | 1,002      |                                |       | 1,456 |   |
| Deferred rent, net  of current portion                                                 |       |                                          | 1,481      |                                |       | 1,387 |   |
| Total liabilities                                                                      |       |                                          | 56,003     |                                |       | 53,866 |   |
| Contingencies (Note 13)                                                                |       |                                          |       |                                |       |   |   |
| Stockholders’ equity:                                                             |       |                                          |       |                                |       |   |   |
| Preferred stock, $0.01 par value:                                                      |       |                                          |       |                                |       |   |   |
| Authorized—5,000 shares                                                           |       |                                          |       |                                |       |   |   |
| Issued—0 shares                                                                   |       |                                          | —     |                                |       | — |   |
| Common stock, $0.01 par value:                                                         |       |                                          |       |                                |       |   |   |
| Authorized—100,000 shares                                                         |       |                                          |       |                                |       |   |   |
| Issued—32,399 and 33,109  shares in 2004 and 2005, respectively                   |       |                                          | 324        |                                |       | 331 |   |
| Additional paid-in  capital                                                            |       |                                          | 165,462    |                                |       | 167,394 |   |
| Subscription receivable                                                                |       |                                          | (127       | )                                   |       | — |   |
| Deferred stock-based compensation                                                      |       |                                          | (1,755     | )                                   |       | (1,119 | ) |
| Treasury stock, 37 shares  at cost                                                     |       |                                          | (111       | )                                   |       | (111 | ) |
| Accumulated other  comprehensive loss                                                  |       |                                          | (160       | )                                   |       | (694 | ) |
| Accumulated deficit                                                                    |       |                                          | (104,386   | )                                   |       | (101,080 | ) |
| Total  stockholders’ equity                                                       |       |                                          | 59,247     |                                |       | 64,721 |   |
| Total liabilities and stockholders’ equity                                        |       |                                          | $          | 115,250                             |       |   | $ | 118,587 |   |

 

See accompanying notes.

3

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**PhaseForward Incorporated and SubsidiariesCondensed Consolidated Statements of Operations(unaudited)(in thousands, except per share amounts)**
| ** **                                                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2004**                                        | ** ** | **2005**                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenues:                                                                                   |       |                                            |       |                                          |       |   |   |   |   |
| License                                                                                     |       | $                                               | 6,357      |                                          | $          | 8,632 |   | $ | 12,523 |   | $ | 17,451 |   |
| Service                                                                                     |       | 11,336                                          |       | 12,066                                        |       | 22,132 |   | 23,809 |   |
| Total revenues                                                                              |       | 17,693                                          |       | 20,698                                        |       | 34,655 |   | 41,260 |   |
| Costs of revenues:                                                                          |       |                                            |       |                                          |       |   |   |   |   |
| License                                                                                     |       | 448                                             |       | 589                                           |       | 870 |   | 1,037 |   |
| Service(1)                                                                                  |       | 6,842                                           |       | 7,464                                         |       | 13,623 |   | 14,676 |   |
| Total costs of revenues                                                                     |       | 7,290                                           |       | 8,053                                         |       | 14,493 |   | 15,713 |   |
| Gross margin:                                                                               |       |                                            |       |                                          |       |   |   |   |   |
| License                                                                                     |       | 5,909                                           |       | 8,043                                         |       | 11,653 |   | 16,414 |   |
| Service                                                                                     |       | 4,494                                           |       | 4,602                                         |       | 8,509 |   | 9,133 |   |
| Total gross margin                                                                          |       | 10,403                                          |       | 12,645                                        |       | 20,162 |   | 25,547 |   |
| Operating expenses:                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Sales and marketing(1)                                                                      |       | 3,536                                           |       | 3,960                                         |       | 6,841 |   | 7,911 |   |
| Research and development(1)                                                                 |       | 3,018                                           |       | 3,489                                         |       | 5,954 |   | 6,770 |   |
| General and administrative(1)                                                               |       | 2,903                                           |       | 3,218                                         |       | 5,546 |   | 7,022 |   |
| Restructuring                                                                               |       | —                                          |       | —                                        |       | — |   | (92 | ) |
| Total operating expenses                                                                    |       | 9,457                                           |       | 10,667                                        |       | 18,341 |   | 21,611 |   |
| Income from operations                                                                      |       | 946                                             |       | 1,978                                         |       | 1,821 |   | 3,936 |   |
| Other income (expense):                                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Interest income                                                                             |       | 67                                              |       | 439                                           |       | 172 |   | 787 |   |
| Interest expense                                                                            |       | (128                                            | )          | —                                        |       | (210 | ) | (144 | ) |
| Other, net                                                                                  |       | 87                                              |       | (11                                           | )          | 71 |   | (141 | ) |
| Total other income                                                                          |       | 26                                              |       | 428                                           |       | 33 |   | 502 |   |
| Income before provision for income taxes                                                    |       | 972                                             |       | 2,406                                         |       | 1,854 |   | 4,438 |   |
| Provision for income taxes                                                                  |       | 542                                             |       | 568                                           |       | 1,041 |   | 1,132 |   |
| Net income                                                                                  |       | 430                                             |       | 1,838                                         |       | 813 |   | 3,306 |   |
| Accretion of preferred stock and dividend declared                                          |       | 6,618                                           |       | —                                        |       | 8,536 |   | — |   |
| Net income (loss) applicable to common stockholders                                         |       | $                                               | (6,188     | )                                             | $          | 1,838 |   | $ | (7,723 | ) | $ | 3,306 |   |
| Net income (loss) per  share applicable to common stockholders:                             |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                                       |       | $                                               | (1.70      | )                                             | $          | 0.05 |   | $ | (2.15 | ) | $ | 0.10 |   |
| Diluted                                                                                     |       | $                                               | (1.70      | )                                             | $          | 0.05 |   | $ | (2.15 | ) | $ | 0.09 |   |
| Weighted average number  of common shares used in net income (loss) per share calculations: |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                                       |       | 3,646                                           |       | 32,869                                        |       | 3,598 |   | 32,663 |   |
| Diluted                                                                                     |       | 3,646                                           |       | 34,639                                        |       | 3,598 |   | 34,588 |   |

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(1)             Amounts include stock-based expenses, as follows:
| Costs of service revenues   |   | $   | 24     |   | $      | 12  |   | $   | 50     |   | $ | 37  |   |
|-----------------------------|--------|-----|--------|--------|--------|-----|--------|-----|--------|--------|---|-----|--------|
| Sales and marketing         |   | 40  |   | 12     |   | 79  |   | (4  | )      |
| Research and development    |   | 83  |   | 40     |   | 179 |   | 95  |   |
| General and administrative  |   | 326 |   | 69     |   | 611 |   | 229 |   |
| Total stock-based  expenses |   | $   | 473    |   | $      | 133 |   | $   | 919    |   | $ | 357 |   |

 

See accompanying notes.

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**PhaseForward Incorporated and SubsidiariesCondensed Consolidated Statements of Cash Flows(unaudited)(in thousands)**
| ** **                                                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2004**                                      | ** ** | **2005** | ** ** |
| **Operating activities**                                                                         |       |                                          |       |   |   |
| Net income                                                                                       |       | $                                             | 813        |   | $ | 3,306 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:               |       |                                          |       |   |   |
| Depreciation and amortization                                                                    |       | 1,492                                         |       | 1,571 |   |
| Stock-based expenses                                                                             |       | 919                                           |       | 357 |   |
| Loss on disposal of fixed assets                                                                 |       | —                                        |       | 12 |   |
| Foreign currency exchange loss                                                                   |       | (38                                           | )          | 147 |   |
| Provision for allowance for doubtful accounts                                                    |       | 65                                            |       | (35 | ) |
| Non-cash income tax expense                                                                      |       | 1,022                                         |       | 769 |   |
| Amortization of premiums or discounts on short-term  investments                                 |       | —                                        |       | (26 | ) |
| Changes in assets and liabilities:                                                               |       |                                          |       |   |   |
| Accounts receivable                                                                              |       | 7,495                                         |       | 3,370 |   |
| Deferred costs                                                                                   |       | (1,310                                        | )          | (945 | ) |
| Prepaid expenses and other current assets                                                        |       | (474                                          | )          | (226 | ) |
| Accounts payable                                                                                 |       | 229                                           |       | (352 | ) |
| Accrued expenses                                                                                 |       | (1,465                                        | )          | (1,052 | ) |
| Deferred revenue                                                                                 |       | (2,647                                        | )          | 4,030 |   |
| Deferred rent                                                                                    |       | 664                                           |       | 105 |   |
| Net cash provided by operating activities                                                        |       | 6,765                                         |       | 11,031 |   |
| **Investing  activities**                                                                        |       |                                          |       |   |   |
| Purchase of short-term investments                                                               |       | —                                        |       | (6,549 | ) |
| Proceeds from maturities of short-term investments                                               |       | —                                        |       | 2,525 |   |
| Purchase of property and equipment                                                               |       | (1,240                                        | )          | (1,532 | ) |
| Decrease in restricted cash, net                                                                 |       | 1,611                                         |       | — |   |
| Decrease (increase) in other assets                                                              |       | (13                                           | )          | 9 |   |
| Net cash provided by (used in) investing activities                                              |       | 358                                           |       | (5,547 | ) |
| **Financing  activities**                                                                        |       |                                          |       |   |   |
| Proceeds from issuance of notes payable and  borrowings under lines of credit                    |       | 1,932                                         |       | — |   |
| Payments on lines of credit and notes payable                                                    |       | (1,266                                        | )          | (4,407 | ) |
| Stock issuance costs                                                                             |       | (1,075                                        | )          | — |   |
| Proceeds from issuance of common stock                                                           |       | 90                                            |       | 2,218 |   |
| Proceeds from repayment of subscriptions receivable                                              |       | 514                                           |       | 127 |   |
| Net cash provided by (used in) financing activities                                              |       | 195                                           |       | (2,062 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                                    |       | 6                                             |       | (452 | ) |
| Net change in cash and cash equivalents                                                          |       | 7,324                                         |       | 2,970 |   |
| Cash and cash equivalents at beginning of year                                                   |       | 19,046                                        |       | 53,485 |   |
| Cash and cash equivalents at end of period                                                       |       | $                                             | 26,370     |   | $ | 56,455 |   |
| **Non-cash  financing activities**                                                               |       |                                          |       |   |   |
| Accretion of Series B, C, and D redeemable  convertible preferred stock to redemption value |       | $                                             | 3,836      |   | $ | — |   |
| Declaration of  special dividend                                                                 |       | $                                             | 4,700      |   | $ | — |   |

 

See accompanying notes.

5

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**PhaseForward Incorporated and SubsidiariesNotes to Condensed Consolidated Financial Statements(unaudited)(in thousands, except share and per share amounts)**

**1.**   Basis ofPresentation

The accompanying unauditedcondensed consolidated financial statements included herein have been preparedby 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, 2005, the results of itsoperations for the three and six months ended June 30, 2004 and 2005 andits cash flows for the six months ended June 30, 2004 and 2005. 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 2004 Annual Report on Form 10-Kfiled with the SEC on March 9, 2005. The results of operations for theinterim periods are not necessarily indicative of the results of operations tobe expected for the year ending December 31, 2005.

**2.**   Revenue Recognitionand Deferred Set up Costs

The Company derives revenues from software licensesand services. License revenue is derived principally from the sale ofmulti-year software term licenses of the Company’s *InFormTM, ClintrialTM* and *ClintraceTM*software products. Service revenue is derived from the Company’s delivery ofthe hosted solution of its *InForm *software product,consulting services and customer support, including training.

Thecomponents of revenue are as follows:
| ** **                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                    | ** ** | **2004**                                        | ** ** | **2005**                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| License                       |       | $                                               | 6,357      |                                          | $          | 8,632 |   | $ | 12,523 |   | $ | 17,451 |   |
| Application  hosting services |       | 6,689                                           |       | 7,275                                         |       | 12,601 |   | 14,106 |   |
| Consulting  services          |       | 1,215                                           |       | 1,622                                         |       | 2,779 |   | 3,017 |   |
| Customer support              |       | 3,432                                           |       | 3,169                                         |       | 6,752 |   | 6,686 |   |
| Total                         |       | $                                               | 17,693     |                                          | $          | 20,698 |   | $ | 34,655 |   | $ | 41,260 |   |

 

The Company recognizes software license revenue inaccordance with Statement of Position (“SOP”) No. 97-2, *Software Revenue Recognition,* as amended,issued by the American Institute of Certified Public Accountants, while revenueresulting from application hosting services are recognized in accordance withEmerging Issues Task Force (“EITF”) Issue No. 00-03, *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”) Nos. 101 and 104, *Revenue Recognition*, and EITF Issue No. 00-21,*RevenueArrangements with Multiple Deliverables.*

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Customers generally have the ability to terminate applicationhosting, consulting and training service agreements upon 30 days notice tothe Company. License agreements, multiple element arrangements, includinglicense and services agreements, and certain application hosting services cangenerally be terminated by either party for material breach of obligations notcorrected within 30 days after notice of the breach.

The Company recognizes revenue when all of thefollowing conditions are satisfied: (1) there is persuasive evidence of anarrangement; (2) the product or service has been provided to the customer;(3) the collection of fees is probable; and (4) the amount of fees tobe paid by the customer is fixed or determinable.

The Company generally enters into software termlicenses with its customers for three to five year periods. These arrangementstypically include multiple elements: a software license, consulting servicesand customer support. The Company bills its customers in accordance with theterms of the underlying contract. Generally, the Company bills the annuallicense fee for the first year of a multi-year contract in advance and billsthe license fees for the subsequent years in advance on the anniversary date.The Company’s payment terms are generally net 30 days.

The Company’s software license revenue is earned fromthe sale of off-the-shelf software requiring no significant modification orcustomization subsequent to delivery to the customer. Consulting services,which can also be performed by third-party consultants, are deemed to be non-essentialto the functionality of the software and typically are for trial configuration,implementation planning, loading of software, building simple interfaces andrunning test data and documentation of procedures.

The Company generally bundles customer support withthe software license for the entire term of the license. As a result, theCompany generally recognizes revenue for all elements, including consultingservices, ratably over the term of the software license and supportarrangement. The Company allocates the revenue 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. Theremaining value is allocated to license and support services, with 10% of thisamount allocated to support services. The Company has allocated the estimatedfair value to its multiple element arrangements to provide meaningfuldisclosures about each of its revenue streams. The costs associated with theconsulting and customer support services are expensed as incurred. There areinstances in which the Company sells software licenses based on usage levels.These software licenses can be based on estimated usage, in which case thelicense fee charged to the customer is fixed based on this estimate. When thefee is fixed, the revenue is recognized ratably over the contractual term ofthe arrangement. If the fee is based on actual usage, and therefore variable,the revenue is recognized in the period of use. Revenue 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 continues to sell the *Clintrial* and *Clintrace* software products to certainexisting customers as perpetual software licenses with the option to purchasecustomer support. The Company generally does not sell perpetual licenses to newcustomers. The Company has established vendor specific objective evidence offair value for the customer support in these arrangements. Accordingly, thelicense revenue is recognized upon delivery of the software and when all otherrevenue recognition criteria are met. The customer support is recognizedratably over the term of the underlying support arrangement. The Companycontinues to generate customer support and maintenance revenue from itsperpetual license customer base. Training revenue is recognized as earned.

In addition to making its software products availableto customers through licenses, the Company offers its *InForm *electronic data capturesoftware product through a fully-hosted, turnkey deployment. 

7

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Revenue resulting fromapplication hosting services consist of three stages for each clinical trial.The first stage includes trial and application set up, including design ofelectronic case report forms and edit checks, implementation of the system andserver configuration. The second stage consists of application hosting andrelated support services. The third stage, database lock, consists of 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 based uponthe complexity of the trial and system requirements. Services for the secondstage are charged separately as a fixed monthly fee. The Company generallyrecognizes revenue from application hosting and related services ratably overthe hosting period. Fees charged and costs incurred for the trial systemdesign, set up and implementation are deferred and capitalized as applicable,until the start of the hosting period. These revenues and costs are recognizedand amortized, as applicable, ratably over the estimated hosting period. Thecapitalized costs include incremental direct costs with third parties andcertain internal direct costs of the trial and application set up, as definedunder Statement of Financial Accounting Standards (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.

In the event that an application hosting customercancels a clinical trial and its related statement of work, all deferredrevenue is recognized, all deferred set up costs are expensed and certaintermination related fees may be charged.

The Company capitalized $322 and $509 of deferred setup costs and amortized $384 and $398 in the three months ended June 30,2004 and 2005, respectively, and capitalized $849 and $1,175 of deferred set upcosts and amortized $880 and $847 in the six months ended June 30, 2004and 2005, respectively. The amortization of deferred set up costs is acomponent of cost of services.

Deferred revenue represents amounts billed or cashreceived in advance of revenue recognition.

Provisions for estimated losses on uncompletedcontracts are made on a contract-by-contract basis and are recognized in theperiod in which such losses become probable and can be reasonably estimated. Todate, the Company has not experienced any material losses on uncompletedapplication hosting contracts.

In accordance with EITFIssue No. 01-14, *Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” ExpensesIncurred,* the Company included $127 and $193 of out of pocketexpenses in service revenue and cost of service revenue in the three monthsended June 30, 2004 and 2005, respectively, and included $424 and $390 ofout of pocket expenses in service revenue and cost of service revenue in thesix months ended June 30, 2004 and 2005, respectively.

**3.**   Prepaid SalesCommissions and Royalties

For arrangements where revenue is recognized over therelevant contract period, the Company capitalizes related commissions paid tosales people and royalties paid to third parties, and recognizes these expensesover the period that the related revenue is recognized. 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 capitalized $820 and $646 of commissions and amortized to sales andmarketing expense $681and $905 in the three months ended June 30, 2004 and2005, respectively, and capitalized $1,580 and $1,323 of commissions andamortized to sales and marketing expense $1,249 and $1,735 in  the six months ended June 30, 2004 and2005, respectively.

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The Company’s royaltyobligation is based upon the license and customer support revenue earned forcertain products in an arrangement. The Company has the right to recover theroyalties in the event the arrangement is cancelled. The Company capitalized$1,051and $1,412 of royalties and amortized to costs of revenues $604 and $728in the three months ended June 30, 2004 and 2005, respectively, andcapitalized $2,201 and $2,234 of royalties and amortized to costs of revenues$1,189 and $1,299 in the six months ended June 30, 2004 and 2005,respectively.

**4.**   Warranties andIndemnification

The Company’s software license arrangements andhosting services are typically warranted to perform in a manner consistent withgeneral industry standards that are reasonably applicable and substantially inaccordance with the Company’s online help documentation under normal use andcircumstances. The Company’s arrangements also include certain provisions forindemnifying customers against liabilities if its products or services infringea third party’s intellectual property rights. See the discussion of possibleindemnification obligations in Note 13.

The Company has entered into service level agreementswith some of its hosted application customers warranting certain levels ofuptime reliability and permitting those customers to receive credits againstmonthly hosting fees or terminate their agreements in the event that theCompany fails to meet those levels.

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.**   Net Income (Loss)Per Share

Basic and diluted net income (loss) per share ispresented in conformity with SFAS No. 128, *Earnings Per Share*. Basic net income (loss) per common sharewas determined by dividing net income (loss) applicable to common stockholdersby the weighted average number of common shares outstanding during the period.Weighted average shares outstanding exclude unvested restricted common stock.The Company’s potentially dilutive shares, which include outstanding commonstock options, redeemable convertible preferred stock and warrants also havenot been included in the computation of diluted net income (loss) per share forall periods in which the Company was in a loss position as the result would beanti-dilutive.

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Thefollowing table reconciles the weighted average shares outstanding used tocalculate basic and diluted net income (loss) per share:
| ** **                                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                  | ** ** | **2004**                                        | ** ** | **2005**                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| Numerator:                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Net income (loss)  applicable to common stockholders                        |       | $                                               | (6,188     | )                                             | $          | 1,838 |   | $ | (7,723 | ) | $ | 3,306 |   |
| Denominator:                                                                |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average  common shares outstanding                                 |       | 3,676,748                                       |       | 32,869,181                                    |       | 3,633,898 |   | 32,662,841 |   |
| Less: Weighted  average unvested restricted common shares outstanding  |       | (30,399                                         | )          | —                                        |       | (35,764 | ) | — |   |
| Basic net income  (loss) per share—weighted average common shares      |       | 3,646,349                                       |       | 32,869,181                                    |       | 3,598,134 |   | 32,662,841 |   |
| Dilutive effect  of common stock options                               |       | —                                          |       | 1,769,664                                     |       | — |   | 1,924,820 |   |
| Diluted net  income (loss) per share—weighted average common shares    |       | 3,646,349                                       |       | 34,638,845                                    |       | 3,598,134 |   | 34,587,661 |   |
| Net income (loss) per  share applicable to common stockholders:             |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                       |       | $                                               | (1.70      | )                                             | $          | 0.05 |   | $ | (2.15 | ) | $ | 0.10 |   |
| Diluted                                                                     |       | $                                               | (1.70      | )                                             | $          | 0.05 |   | $ | (2.15 | ) | $ | 0.09 |   |

 

Thefollowing common share equivalents and unvested restricted shares have beenexcluded from the computation of diluted weighted average shares outstanding asof June 30, 2004 and 2005, respectively, as their effect would have beenanti-dilutive.
| ** **                              | ** ** | **As of  June 30,** | *** *** |
|-----------------------------------------|------------|-----------------------------------------|--------------|
| ** **                              | ** ** | **2004**                                | ** **   | **2005** | ** ** |
| Redeemable  convertible preferred stock |       | 22,841,157                              |         | — |   |
| Options  outstanding                    |       | 4,457,525                               |         | 668,000 |   |
| Unvested  restricted shares             |       | 25,035                                  |         | — |   |
| Warrant                                 |       | 34,330                                  |         | — |   |

 

**6.**   Foreign CurrencyTranslation

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, Germany, Japan andAustralia are the local currencies of those countries. Accordingly, the assetsand liabilities of the Company’s foreign subsidiaries are translated into U.S.dollars using the exchange rate in effect at each balance sheet date. Revenueand expense accounts are generally translated using an average rate of exchangeduring the period. Foreign currency translation adjustments are accumulated asa component of other comprehensive loss as a separate component of stockholders’equity. Gains and losses arising from transactions denominated in foreigncurrencies are primarily related to intercompany accounts that have 

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beendetermined to be temporary in nature and cash and accounts receivabledenominated in non-functional currencies. The Company has recorded foreigncurrency gains (losses) of $54 and ($17) for the three months ended June 30,2004 and 2005, respectively, and approximately $38 and ($147) for the sixmonths ended June 30, 2004 and 2005, respectively. Such gains and (losses)are included in other income (expense) in the accompanying unaudited condensedconsolidated statements of operations.

**7.**   Cash, CashEquivalents and Short-Term Investments

The Company accounts for its investments in accordancewith SFAS No. 115, *Accounting forCertain Investments in Debt and Equity Securities*. Under SFAS No. 115,securities that the Company has the intent and ability to hold to maturity arereported at amortized cost, which approximates market value, and are classifiedas held-to-maturity. The Company considers all highly liquid investments withoriginal maturities of 90 days or less at the time of purchase to be cashequivalents and investments with original maturities of between 91 daysand one year to be short term investments. The Company invests in high qualitycorporate debentures rated at least A2 by Moody’s Investors Service or A byStandard & Poors. At June 30, 2005 cash equivalents primarilyconsisted of money market funds that were readily convertible to cash. At June 30,2005, short-term investments primarily consisted of U.S. agency notes andcorporate debentures.

Cash,cash equivalents and short-term investments as of December 31, 2004 and June 30,2005 were as follows:
| ** **                                 | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------|------------|---------------------------------|------------|
| **Description**                            | ** ** | ** **                      | ** ** | **Contracted  Maturity** | ** ** | **Amortized  Cost** | ** ** | **Fair Market  Value** | ** ** |
| Cash and cash  equivalents                 |       | Demand                          |       |   | $ | 13,138 |   |   |   | $ | 13,138 |   |   |
| U.S. agency notes  and U.S. treasury bills |       | Less  than 90 days              |       |   | 3,390 |   |   |   | 3,390 |   |   |
| Money market  funds                        |       | Demand                          |       |   | 35,014 |   |   |   | 35,014 |   |   |
| Certificate of  deposit                    |       | 30  days                        |       |   | 1,943 |   |   |   | 1,943 |   |   |
| Total cash and  cash equivalents           |       |                            |       |   | $ | 53,485 |   |   |   | $ | 53,485 |   |   |
| Short-term investments                     |       | 147-356 days               |       |   | $ | 4,735 |   |   |   | $ | 4,728 |   |   |
|                                            |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                 | ** ** | **June 30, 2005** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|
| **Description**                            | ** ** | ** **                  | ** ** | **Contracted  Maturity** | ** ** | **Amortized  Cost** | ** ** | **Fair Market  Value** | ** ** |
| Cash and cash  equivalents                 |       | Demand                      |       |   | $ | 14,512 |   |   |   | $ | 14,512 |   |   |
| U.S. agency notes  and U.S. treasury bills |       | Less  than 90 days          |       |   | 4,772 |   |   |   | 4,772 |   |   |
| Money market  funds                        |       | Demand                      |       |   | 37,171 |   |   |   | 37,171 |   |   |
| Total cash and  cash equivalents           |       |                        |       |   | $ | 56,455 |   |   |   | $ | 56,455 |   |   |
| Short-term investments                     |       | 105-359 days                |       |   | $ | 8,816 |   |   |   | $ | 8,803 |   |   |
|                                            |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company has had no realized or unrealized gains orlosses to date on the sale of money market funds or short-term investments.

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**8.   Stock-BasedCompensation**

In January 2003, theFASB issued SFAS No. 148, *Accountingfor Stock-Based Compensation-Transition and Disclosure, an amendment of FASBStatement No. 123,* which provides alternative methods oftransition for a voluntary change to a fair-value-based method of accountingfor stock-based employee compensation. In addition, SFAS No. 148 amendsthe disclosure requirements of SFAS No. 123, *Accounting for Stock-Based Compensation,* to requireprominent disclosures in annual financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. The Company accounts for options granted under itsstock-based compensation plans for employees under Accounting Principles Board(APB) Opinion No. 25, *Accounting forStock Issued to Employee*s, and has elected the disclosure-onlyalternative under SFAS No. 123 and the enhanced disclosures as required bySFAS No. 148. Under APB Opinion No. 25, when the exercise price ofoptions granted under these plans equals or exceeds the market price of theunderlying stock on the date of grant, no compensation expense is required.

The following tablesillustrate the assumptions used and the effect on net income (loss) if theCompany had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation. The Company has computed the pro formadisclosures required under SFAS No. 123 for all employee stock optionsgranted using the Black-Scholes option pricing model prescribed by SFAS No. 123.

The assumptions used andweighted average information are as follows:
| ** **                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                        | ** ** | **2005**                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| Average risk-free  interest rate           |       | 4.07                                            | %          | 3.99                                          | %          | 3.61 | % | 4.00 | % |
| Expected dividend  yield                   |       | —                                          |       | —                                        |       | — |   | — |   |
| Expected life                              |       | 7 years                                         |       | 4 years                                       |       | 7 years |   | 4 years |   |
| Expected  volatility                       |       | 90                                              | %          | 90                                            | %          | 0-90 | % | 90 | % |
| Weighted average fair  value at grant date |       | $                                               | 5.49       |                                          | $          | 6.53 |   | $ | 6.00 |   | $ | 6.41 |   |
|                                            |            |                                                 |            |                                               |            |  |  |  |  |  |  |  |  |

 

The Company offers the2004 Employee Stock Purchase Plan. Accordingly, the Company has calculated theSFAS No. 123 pro forma expense for shares purchased under the 2004Employee Stock Purchase Plan using the following assumptions:
| ** **                       | ** ** | **Three Months Ended  June 30, 2005** | ** **      | **Six Months Ended  June, 30 2005** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------|-----------------|---------------------------------------------------------|------------|
| Average risk-free  interest rate |       |                                                      | 3.12            | %                                                       |       |   | 2.77 | % |   |
| Expected dividend  yield         |       |                                                      | —          |                                                    |       |   | — |   |   |
| Expected life                    |       |                                                      | 0.50 years |                                                    |       |   | 0.50 years |   |   |
| Expected volatility              |       |                                                      | 60              | %                                                       |       |   | 60 | % |   |

 

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Had compensationcosts been determined consistent with SFAS No. 123, the Company’s net income(loss) would have been the following pro forma amounts:
| ** **                                                                                                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2004**                                        | ** ** | **2005**                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income (loss)  applicable to common stockholders, as reported                                                    |       | $                                               | (6,188     | )                                             | $          | 1,838 |   | $ | (7,723 | ) | $ | 3,306 |   |
| Add: Stock-based  compensation expense included in reported net income (loss)                                        |       | 473                                             |       | 133                                           |       | 919 |   | 357 |   |
| Less: Total  stock-based employee compensation expense determined  under fair-value-based method for all awards |       | (604                                            | )          | (859                                          | )          | (1,202 | ) | (1,516 | ) |
| Pro forma net income (loss)                                                                                          |       | $                                               | (6,319     | )                                             | $          | 1,112 |   | $ | (8,006 | ) | $ | 2,147 |   |
| Pro forma net  income (loss) per share applicable to common stockholders:                                            |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                                                                |       | $                                               | (1.73      | )                                             | $          | 0.03 |   | $ | (2.23 | ) | $ | 0.07 |   |
| Diluted                                                                                                              |       | $                                               | (1.73      | )                                             | $          | 0.03 |   | $ | (2.23 | ) | $ | 0.06 |   |

 

**9.   Goodwill**

A rollforward of the net carrying amount of goodwillis as follows:
| Balance as of December 31, 2004                                                     |   | $    | 21,817 |   |
|------------------------------------------------------------------------------------------|--------|------|--------|--------|
| Utilization of acquired net operating losses in the six months ended  June 30, 2005 |   | (770 | )      |
| Balance as of June 30, 2005                                                         |   | $    | 21,047 |   |

 

The Company acquiredClinsoft Corporation, which developed and sold the *Clintrial*and *Clintrace*products, on August 14,2001. The goodwill resulting from the acquisition is reviewed for impairment onan annual basis in accordance with SFAS No. 142,*Goodwilland Other Intangible Assets.*The Company performed its annualimpairment test for the year ended December 31, 2004 as of October 1,2004 and determined that no impairment of goodwill existed.

The utilization of acquired net operating lossesreflects a reduction in cash payments to local taxing authorities for incometaxes that are not reflected as a benefit in the income tax provision forfinancial statement purposes but rather as a reduction to goodwill.

**10.   AccruedExpenses**

Accrued expenses consistof the following:
| ** **                            | ** ** | **As of  December 31,  2004** | ** ** | **As of  June 30,  2005** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| Accrued payroll  and related benefits |       |                                    | $          | 4,791                               |       |   | $ | 3,427 |   |
| Accrued royalties                     |       |                                    | 2,378      |                                |       | 2,347 |   |
| Accrued income  taxes                 |       |                                    | 1,289      |                                |       | 922 |   |
| Accrued other  expenses               |       |                                    | 3,200      |                                |       | 4,021 |   |
|                                  |       |                                    | $          | 11,658                              |       |   | $ | 10,717 |   |

 

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**11.   Restructuring**

The Company recorded a$4,503 restructuring charge for the year ended December 31, 2003 thatrelated to the relocation of the Company’s corporate headquarters in December 2003.Of this amount, $2,486 represented the loss on a facilities lease and $2,017related to the abandonment of the related fixed assets and leaseholdimprovements. The facility lease loss represented 15 months of rentremaining under an existing lease and related operating expenses. As of March 31,2005, payment of all charge related expenses had occurred and as a result theCompany recorded a benefit of $92 representing the elimination of accruedexpenses associated with the restructuring charge.

The rollforward of therestructuring charge is as follows:
| ** **                                                                                    | ** ** | **Lease  Loss** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-----------------|------------|
| Balance as of  December 31, 2003                                                         |       | $               | 2,486      |   |
| Payments made in  the twelve months ended December 31, 2004                              |       | (1,974          | )          |
| Reduction to provision for lease loss in the twelve months ended  December 31, 2004 |       | (168            | )          |
| Balance as of  December 31, 2004                                                         |       | $               | 344        |   |
| Payments made in  the six months ended June 30, 2005                                     |       | (252            | )          |
| Reduction to  provision for lease loss in the six months ended June 30, 2005             |       | (92             | )          |
| Balance as of  June 30, 2005                                                             |       | $               | —     |   |

 

**12.   Debt**

Between April 2000and September 2004, the Company had entered into several equipment linesof credit with a bank. All advances under these equipment lines of credit werepayable in 30 to 36 equal monthly installments of principal, plus accrued interest.The interest that accrued under these notes ranged from prime rate (5.25% and5.75% at December 31, 2004 and March 31, 2005, respectively) to primerate plus 1.0%. As of December 31, 2004, there was a total of $4,407outstanding under all of the Company’s equipment lines of credit. In March 2005,the Company paid in full all outstanding debt related to its equipment lines ofcredit. The equipment line of credit expired on March 31, 2005 and was notrenewed.

Effective March 31,2004, the Company renewed its working capital line of credit with a bank andincreased the amount under which it can borrow to $5,000. Interest accrues atprime rate. All advances made under the working capital line are due andpayable on March 31, 2006. As of December 31, 2004 and June 30,2005, $0 was outstanding under the working capital line of credit. At June 30,2005, there was $3,700 available under the line of credit, and $1,300 reservedunder a letter of credit associated with the Company’s leased facilities.

Borrowings under the working capital line of creditare secured by substantially all assets of the Company, excluding intellectualproperty. The Company has entered into a negative pledge agreement that,subject to certain exceptions, generally prohibits the Company from pledgingits intellectual property to others. Under the working capital line of credit,as amended in March 2004, the Company is required to comply with certainfinancial covenants. At June 30, 2005, the Company was in compliance withall financial covenants. In August of 2005, the working capital line ofcredit was amended to eliminate the security interest in the Company’s assetsand the negative pledge on the Company’s intellectual property. The amendmentalso removed or modified the financial covenants.

**13.   Contingencies**

From time to time and inthe ordinary course of business, the Company may be subject to various claims,charges and litigation.

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Since 2004, the Companyhas been involved in a lawsuit filed against it and one of its customers,Quintiles Inc., by Datasci, LLC (“Datasci”) and Dr. Mark L. Kozam, doingbusiness under the name MLK Software. The lawsuit alleges that the Company’s *InForm, Clintrial* and *Clintrial Integration Solution* productsand its services, and the products and services of Quintiles, infringe a UnitedStates patent claimed to be owned by Datasci and Dr. Kozam. The Companyhas asserted numerous defenses and has filed counterclaims against Datasci and Dr. Kozam.This action is ongoing and the Company is prepared to vigorously defend theclaims and pursue its counterclaims and any other remedies available to theCompany. The Company is unable to predict the outcome of this action and istherefore unable to assess whether its outcome will have a material adverseeffect on its results of operations.

The Company accepts standard indemnificationprovisions in the ordinary course of business, whereby it may be required toindemnify its customers for certain costs and damages arising from third partyclaims in connection with alleged or actual infringement of intellectualproperty, including the claim described above. The term of theseindemnification provisions generally coincides with the customer’s use of theCompany’s products. The Company has never incurred significant costs to settleclaims related to these indemnification provisions. As a result, the Companybelieves the estimated fair value of these provisions is minimal.

**14.   Stockholders’Equity**

During the six monthsended June 30, 2005, the Company issued 621,181 shares of common stock inconnection with the exercise of stock options resulting in proceeds of $1,770,and 79,836 shares of common stock under the Company’s 2004 Employee StockPurchase Plan resulting in proceeds of $448. During this period, the Companyalso issued 9,802 shares in connection with the cashless exercise of a warrantto purchase common stock.

During November and December 2001, theCompany executed full recourse notes receivable in consideration for thepayment of the exercise of options. The notes are reflected as subscriptionsreceivable, a component of stockholders’ equity. There was $127 and $0 of thesenotes receivable outstanding at December 31, 2004 and June 30, 2005,respectively. In February 2005, all outstanding notes were paid in full.

**15.   DeferredCompensation**

The Company recordsdeferred stock-based compensation in the amount by which the exercise price ofan option is less than the deemed fair value of its common stock at the date ofgrant. Because there had been no public market for the Company’s stock prior tothe July 2004 initial public offering of its common stock (the “IPO”), theCompany’s Board of Directors had determined the fair value of the common stockon the date of grant based upon several factors, including, but not limited to,the Company’s operating and financial performance, the issuances of convertiblepreferred stock, the rights and preferences of all securities senior to commonstock and the anticipated offering price of the common stock in connection withthe Company’s IPO. During 2003, all stock options were granted with an exerciseprice of $3.00 per share, while the estimated per share fair value of theCompany’s common stock ranged from $3.00 to $4.00 in the first quarter of 2003,$4.00 to $5.00 in the second quarter of 2003, $5.00 to $7.50 in the thirdquarter of 2003 and $7.50 to $9.00 in the fourth quarter of 2003. During thesix months ended June 30, 2004, options were granted at exercise pricesranging from $4.50 to $6.00 per share while the estimated fair value of theCompany’s common stock was $10 per share. During the six months ended December 31,2004 options were granted at a price of $7.55 per share, which was the fairmarket value of the Company’s common stock at the date of grant. During the sixmonths ended June 30, 2005, options to purchase 889,000 shares of commonstock were granted at exercise prices ranging from $6.30 to $6.53 per share,which was the fair market value of the common stock at the dates of the grant.The Company recorded stock-based compensation of $919 and $357 in the sixmonths ended June 30, 2004 and 2005, respectively. 

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As of June 30, 2005,there was an aggregate of $1,119 of deferred stock-based compensation remainingto be amortized, of which approximately $371 will be amortized in the remainingtwo quarters of 2005. The Company amortizes the deferred compensation chargesover the vesting period of the underlying option awards in accordance withFinancial Interpretation No. 28. On January 1, 2006, the Company isrequired to adopt SFAS No. 123(R) which requires fair valueaccounting for stock-based awards. See Note 18.

**16.   ComprehensiveIncome**

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

Comprehensive incomeconsisted of the following:
| ** **                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                        | ** ** | **2005**                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income                         |       | $                                               | 430        |                                          | $          | 1,838 |   | $ | 813 |   | $ | 3,306 |   |
| Cumulative  translation adjustment |       | (28                                             | )          | (368                                          | )          | (109 | ) | (533 | ) |
| Comprehensive income               |       | $                                               | 402        |                                          | $          | 1,470 |   | $ | 704 |   | $ | 2,773 |   |

 

**17.   ForwardForeign 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 at June 30, 2005:
| ** **    | ** ** | **As of June 30, 2005** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **Local  Currency  Amount**                 | ** ** | **Approximate  U.S. Dollar  Equivalent** | ** ** |
| British pound |       |                                        | 1,200      |   |   |   | $ | 2,149 |   |   |
| Japanese yen  |       |                                        | 40,000     |   |   |   | 362 |   |   |
|          |       |                                        |       |   |   |   | $ | 2,511 |   |   |

 

The forward foreign exchange contracts are short-termand mature within 35 days of origination.

Due to the short period of time between entering intothe forward foreign exchange contracts and June 30, 2005, the forward foreignexchange contract rate approximates the exchange rate as of the end of thereporting period.

Realized and unrealizedgains (losses), net of hedging are accounted for in other income (expense).Gains (losses), net of hedging, were $54 and $(17) for the three months ended June 30,2004 and 2005, respectively and $38 and $(147) for the six months ended June 30,2004 and 2005, respectively. The Company settles foreign exchange contracts incash.

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**18.   RecentlyIssued Accounting Pronouncements**

On December 16, 2004,the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment*, which is a revision of SFAS No. 123,*Accounting for Stock-Based Compensation*.SFAS No. 123(R) supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and amends SFAS No. 95, *Statement ofCash Flows*. Generally, the approach in SFAS No. 123(R) issimilar to the approach described in Statement 123. However, SFAS No. 123(R) requires all share-based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair values. Pro forma disclosure is no longeran alternative.

SFAS No. 123(R) mustbe adopted no later than January 1, 2006 for calendar year-end companies.Early adoption will be permitted in periods in which financial statements havenot yet been issued.

SFAS No. 123(R) permitspublic companies to adopt its requirements using one of two methods:

·       A “modified prospective”method in which compensation cost is recognized beginning with the effectivedate (a) based on the requirements of SFAS No. 123(R) for allshare-based payments granted after the effective date and (b) based on therequirements of SFAS No. 123 for all awards granted to employees prior tothe effective date of SFAS No. 123(R) that remain unvested on theeffective date.

·       A “modified retrospective”method which includes the requirements of the modified prospective methoddescribed above, but also permits entities to restate based on the amountspreviously recognized under SFAS No. 123 for purposes of pro formadisclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.

The Company is continuing to review the twoalternative adoption methods and the resulting impact of fair valuing awards inits financial statements. The Company is also reviewing various optionvaluation techniques and may use a valuation method other than theBlack-Scholes model for new awards upon adoption of SFAS No. 123(R).

The adoption of SFAS No. 123(R)’s fair valuemethod will likely have a significant impact on the Company’s results ofoperations, although it will have no impact on its overall financial position.The impact of adoption of SFAS No. 123(R) cannot be predicted at thistime because it will depend in part on levels of share-based payments grantedin the future. However, had the Company adopted SFAS No. 123(R) inprior periods, the impact of that standard would have approximated the impactof SFAS No. 123 as described in the disclosure of pro forma net income andearnings per share in Note 8 to the Company’s unaudited condensedconsolidated financial statements.

In June 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections*, which will requireentities that voluntarily make a change in accounting principle to apply thatchange retrospectively to prior periods’ financial statements, unless thiswould be impracticable. SFAS No. 154 supersedes APB Opinion No. 20, *Accounting Changes*, which previously required that mostvoluntary changes in accounting principles be recognized by including in thecurrent period’s net income the cumulative effect of changing to the newaccounting principle. SFAS No. 154 also makes a distinction between “retrospectiveapplication” of an accounting principle and the “restatement” of financialstatements to reflect the correction of an error. Another significant change inpractice under SFAS No. 154 will be that if an entity changes its methodof depreciation, amortization, or depletion for long-lived, non-financialassets, the change must be accounted for as a change in accounting estimate. UnderAPB No. 20, such a change would have been reported as a change inaccounting principle. SFAS No. 154 applies to accounting changes and errorcorrections that are made in fiscal years beginning after December 15,2005.

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

*The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with ourunaudited condensed consolidated financial statements and related notes thatappear elsewhere in this Quarterly Report on Form 10-Q. In additionto historical consolidated financial information, the following discussioncontains forward-looking statements that reflect our plans, estimates andbeliefs. Our actual results could differ materially from those discussed in theforward-looking statements. Factors that could cause or contribute to thesedifferences include those discussed below and elsewhere in this QuarterlyReport on Form 10-Q.*

**Overview**

Phase Forward Incorporatedis a provider of integrated enterprise-level electronic data capture,management and adverse event reporting software solutions for use in theclinical trial component of its customers’ global research and development initiatives.We offer software products, services and hosted solutions to pharmaceutical,biotechnology and medical device companies, as well as academic institutions,clinical research organizations and other entities engaged in clinical trials.By automating essential elements of the clinical trial process, we believe ourproducts allow our customers to accelerate the market introduction of newmedical therapies and corresponding revenue, reduce overall research anddevelopment expenditures, enhance existing data quality control efforts andreduce clinical and economic risk.

**Sources of Revenues**

We derive our revenuesfrom software licenses and services. License revenue is derived principallyfrom the sale of multi-year software term licenses for our *InForm, Clintrial* and *Clintrace* software products. Servicerevenue is derived from our delivery of the hosted solution of our *InForm *software product, consultingservices and customer support, including training. We generally recognizerevenue ratably over the life of a license or service contract. This allows usto maintain a backlog that provides multi-year visibility in revenue. As ourbacklog grows, we believe that the predictability of our future revenues willincrease. Two customers including Eli Lilly and Company, the holder of recordof approximately 1% of our common stock, accounted for approximately 20% and25% of our total revenues for the six months ended June 30, 2004 and 2005,respectively. Our top 20 customers accounted for approximately 69% and 72% ofour total revenues in the quarters ended June 30, 2004 and 2005,respectively, net of reimbursable out-of-pocket expenses.

*License Revenue*

We derive our license revenue from our three majorsoftware products: *InForm*, ourInternet based electronic data capture solution; *Clintrial*, our clinical data management solution; and *Clintrace*, our adverse event reportingsolution. Although each of our *InForm,Clintrial* and *Clintrace*software solutions are available as stand-alone enterprise applications, wealso offer integrated enterprise solutions incorporating certain of ourelectronic data capture, data management and adverse event reporting products.

License revenue for our *InForm *electronic data capture software solution,either on a stand-alone or integrated basis, is determined primarily by thenumber, complexity and duration of the clinical trials and the number ofparticipants in each clinical trial. License revenue for our *Clintrial* and *Clintrace* software solutions is determined primarily by thenumber of users accessing the software solution. Except as discussed below, weenter into software license agreements with terms generally of three to fiveyears with payment terms generally annually in advance. License revenue isrecognized ratably over the duration of the software term license agreement, tothe extent that amounts are fixed or determinable and collectable.

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Following our acquisitionof Clinsoft in August of 2001, we began converting holders of Clinsoftperpetual software licenses to our software term license agreements. In certainsituations we continue to sell perpetual licenses of our *Clintrial*and*Clintrace*software products to our existing customers. Werecognize revenue on the perpetual licenses upon delivery of the software.Perpetual license revenue represented less than 1% of total revenue for the sixmonths ended June 30, 2004 and 2005. We continue to provide and charge formaintenance and support on our products to those customers who do not convertto our software term license arrangements. We generally charge 18% of theperpetual license fee for customer support. We intend to continue our effortsto convert the remaining former Clinsoft customer base to software term licensearrangements.

*Service Revenue*

*ApplicationHosting Services.  *In addition to making our softwareproducts available to customers through licenses, we offer our *InForm *electronic data capturesoftware as a hosted application solution delivered through a standardweb-browser, with customer support and training services. Revenue resultingfrom this hosting service consists of three stages for each clinical trial:

·       *First stage—*trial and application set up, including designof 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, thedatabase for the clinical trial.

Services provided for the first and third stages areprovided on a fixed fee basis depending upon the complexity of the trial andsystem requirements. Services for the second stage are charged separately as afixed monthly fee. We recognize revenue from all stages of the hosting serviceratably over the hosting period. Fees charged and costs incurred for the trialsystem design, set up and implementation are deferred until the start of thesecond stage and then amortized ratably over the estimated hosting period. Thedeferred costs include direct costs related to the trial and application setup. Fees for the first and third stages of the services are billed based uponmilestones. Fees for application hosting and related services in the secondstage are billed quarterly in advance. Bundled into this revenue element is therevenue attributable to the software license used by the customer. In addition,application hosting services revenue includes reimbursable out-of-pocketexpenses.

In the event that an application hosting customercancels a clinical trial and its related statement of work, all deferred revenueis recognized and all deferred set up costs are expensed and certaintermination-related fees may be charged. In addition, application hostingservices revenue includes hosting services associated with term licensearrangements and reimbursable out-of-pocket expenses.

*Consulting Services.  *Consultingservices include the design and documentation of the processes related to ourcustomers’ use of our products and services in their clinical trials.Consulting services also include project planning and management services,guidance on best practices in using our software products, as well asimplementation services consisting of application architecture design, systemsintegration, installation and validation. Revenue from consulting servicesincluded in a multiple element software license agreement or in a hostedsolution are recognized ratably over the term of the arrangement. Theassociated costs are expensed as incurred. Revenue from consulting servicesthat are not included in a multiple element software license arrangement arerecognized as services are performed. Fixed priced arrangements are billedbased upon contractual milestones, and time-and-materials arrangements arebilled monthly.

*CustomerSupport.  *We have a multinational services organizationto support our software products and hosted solutions worldwide. Customersupport includes telephone support, software maintenance and training. Webundle customer support in our software term licenses and allocate 10% of thevalue of the 

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license to customersupport revenue. Our customer support revenue also consists of customer supportfees paid by the*Clintrial* and *Clintrace* perpetual license customers.Customer support revenue is recognized ratably over the period of the customersupport or term license agreement, with payment terms generally annually inadvance.

**Costsof Revenues and Operating Expenses**

We allocate overhead expenses such as rent andoccupancy charges and employee benefit costs to all departments based onheadcount. As such, general overhead expenses are reflected in cost of servicerevenue and in the sales and marketing, research and development and generaland administrative expense categories.

*Costs of Revenues.  *Costof license revenue consists primarily of the amortization of royalties paid forcertain modules within our *Clintrial*software product and the Japanese version of our *InForm *software product. The cost of license revenuevaries based upon the mix of revenue from software licenses for our products.We operate our service organization on a global basis as one distinct unit, anddo not segment costs for our various service revenue elements. These servicesinclude performing application hosting, consulting and customer supportservices, and costs consist primarily of employee-related costs associated withthese services, amortization of the deferred clinical trial set up costs,allocated overhead, outside contractors, royalties associated with providing customersupport for third-party modules licensed to our customers for use with the *Clintrial* software product andreimbursable out-of-pocket expenses. Cost of services also includes hostingcosts that primarily consist of hosting facility fees and server depreciation.The cost of service revenue varies based upon employee utilization levels inthe service organization and royalties associated with revenue 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 application hosting services through the use ofoutside contractors. This allows us to utilize outside contractors in thoseperiods where trial design and set up activity is highest while reducing theuse of outside contractors in those periods where trial activity lessens,allowing for a more flexible delivery model. The percentage of the servicesworkforce represented by outside contractors varies from period to perioddepending on the volume of specific support required. The cost of services issignificantly higher as a percentage of revenue as compared to our cost oflicense revenue primarily due to the employee-related and outside contractorexpenses associated with providing services.

*Gross Margin.  *Ourgross margin on license revenue varies based on the mix of royalty- andnonroyalty-bearing license revenue. Our gross margin on service revenue variesprimarily due to variations in the utilization levels of the professionalservice team and the timing of expense and revenue recognition under ourservice arrangements. In situations where the service revenue is recognizedratably over the software license term, typically three to five years, ourcosts associated with delivery of the services are recognized as the servicesare performed, which is typically during the first 9 to 12 months of thecontract period. Accordingly, our gross margin on service revenue will varysignificantly over the life of a contract due to the timing, amount and type ofservice required in delivering certain projects. In addition, consolidatedgross margin will vary depending upon the mix of license and service revenue.

*Sales and 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. We expect that sales and marketing expenses will increase inabsolute dollars, as we expand and further penetrate our customer base, expandour domestic and international selling and marketing activities associated withexisting and new product and service offerings, build brand awareness andsponsor additional marketing events.

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*Research and Development.  *Researchand development expenses consist primarily of employee-related expenses,allocated overhead and outside contractors. We have historically focused ourresearch and development efforts on increasing the functionality, performanceand integration of our software products. We expect that in the future,research and development expenses will increase in absolute dollars as weintroduce additional integrated software solutions to our product suite.

*General and Administrative.  *Generaland administrative expenses consist primarily of employee-relatedexpenses, professional fees, primarily consisting of expenses for accounting,compliance and legal services and other corporate expenses and allocatedoverhead. We expect that in the future, general and administrative expenseswill increase in absolute dollars as we add personnel, incur additionalprofessional fees related to the growth of our business and operations, andincur additional costs associated with being a public company.

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

*Stock-BasedExpenses.  *Our cost of service revenue and operatingexpenses, excluding our restructuring charges, include stock-based expensesrelated to the fair value of options issued to non-employees and optiongrants to employees in situations where the exercise price is determined to beless than the deemed fair value of our common stock at the date of grant.

**Foreign Currency 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 sterling, Australian dollar andJapanese yen. In the three months ended June 30, 2004 and 2005,approximately 41% and 48%, respectively, of our revenues were generated inlocations outside the United States. In the six months ended June 30, 2004and 2005, approximately 40% and 48%, respectively, of our revenues weregenerated in locations outside the United States. The majority of theserevenues were in currencies other than the U.S. dollar. In periods when theU.S. dollar declines or increases in value as compared to the foreigncurrencies in which we conduct business, our foreign currency-based revenuesand expenses increase or decrease, as the case may be, when translated intoU.S. dollars.

**CriticalAccounting Policies and Estimates**

Our unaudited condensed consolidated financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States. The preparation of these financial statementsrequires us to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues, costs and expenses and related disclosures.On an ongoing basis, we evaluate our estimates and assumptions with our auditcommittee. There have been no material changes to these estimates for theperiods presented in this Quarterly Report on Form 10-Q. Our actualresults may differ from these estimates.

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

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*Revenue Recognition and Deferred SetUp Costs.  *We recognize software license revenue inaccordance with Statement of Position (“SOP”) No. 97-2, *Software Revenue Recognition,* as amended,issued by the American Institute of Certified Public Accountants, while revenueresulting from application services are recognized in accordance with EmergingIssues Task Force (“EITF”) Issue No. 00-03, *Application of AICPA Statement of Position 97-2to Arrangements that Include the Right to Use Software Stored on Another Entity’sHardware* and SEC Staff Accounting Bulletin (SAB) Nos. 101 and 104, *Revenue Recognition*. On August 1,2003, we adopted EITF Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables.* Theadoption of EITF Issue No. 00-21 did not have a material impact onour financial position or results of operations.

Customers generally have the ability to terminateapplication hosting, consulting and training service agreements upon30 days notice to us. License agreements, multiple element arrangements,including license and services agreements, and certain application hostingservices can generally be terminated by either party for material breach ofobligations not corrected within 30 days after notice of the breach.

We recognize revenue when all of the followingconditions are satisfied: (1) there is persuasive evidence of anarrangement; (2) the product or service has been provided to the customer;(3) the collection of fees is probable; and (4) the amount of fees tobe paid by the customer is fixed or determinable.

We generally enter into software term licenses withour customers for three to five year periods. These arrangements typicallyinclude multiple elements: software license, consulting services and customersupport. We bill our customers in accordance with the terms of the underlyingcontract. Generally, we bill the annual license fee for the first year of themulti-year contract in advance and bill license fees for subsequent years onthe anniversary date. Our payment terms are generally net 30 days.

Our software license revenue is earned from the saleof off-the-shelf software requiring no significant modification orcustomization subsequent to delivery to the customer. Consulting services,which can also be performed by third-party consultants, are deemed to benon-essential to the functionality of the software and typically are for trialconfiguration, implementation planning, loading of software, building simpleinterfaces and running test data and documentation of procedures.

We generally bundle customer support with the softwarelicense for the entire term of the arrangement. As a result, we generallyrecognize revenue for all elements ratably over the term of the multipleelement arrangement. We allocate the revenue for these arrangements to thedifferent elements based on management’s estimate of the relative fair value ofeach element. For our contracts accounted for ratably under SOP No. 97-2,we allocate to consulting services the anticipated service level throughout theterm of the arrangement at an amount equal to what it would have been had thoseservices been sold separately to the customer. The remaining value is allocatedto license and support services, with a 10% value allocated to supportservices. The costs associated with the consulting and customer supportservices are expensed as incurred. There are instances in which we sellsoftware licenses based on usage levels. These software licenses can be basedon estimated usage, in which case the license fee charged to the customer isfixed based on this estimate. When the fee is fixed, the revenue is recognizedover the contractual term of the arrangement. If the fee is based on actualusage, and therefore variable, the revenue is recognized in the period of use.Revenue from certain follow-on consulting services, which are sold separatelyto customers with existing software licenses and are not considered part of amultiple element arrangement, is generally recognized as the services areperformed.

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Revenue from perpetual software licenses representedless than 1% of total revenues for the six months ended June 30, 2004 and2005. We continue to sell perpetual licenses for the *Clintrial* and *Clintrace*software products in certain situations to our existing customers with theoption to purchase customer support. We have established vendor specificobjective evidence of fair value for the customer support. Accordingly theperpetual license revenue is recognized upon delivery of the software and whenall other revenue recognition criteria are met. Customer support revenue isrecognized ratably over the term of the underlying support arrangement.

In addition to making our software products availableto customers through licenses, we offer our *InForm *electronicdata capture software solution through a hosted application solution deliveredthrough a standard web-browser. Revenue resulting from application hostingservices consist of three stages for each clinical trial: the first stageinvolves application set up, including design of electronic case report formsand edit checks, implementation of the system and server configuration; thesecond stage involves application hosting and related support services; and thethird stage involves services required to close out, or lock, the database forthe clinical trial. Services provided for the first and third stages areprovided on a fixed fee basis based upon the complexity of the trial and systemrequirements. Services for the second stage are charged separately as a fixedmonthly fee. We recognize revenue from all stages of the hosting service overthe hosting period. Fees charged and costs incurred for the trial systemdesign, set up and implementation are deferred and capitalized as applicable,until the start of the second stage and then amortized and recognized, asapplicable, ratably over the estimated hosting period. The capitalized costsinclude incremental direct costs with third parties and certain internal directcosts related to the trial and application set up, as defined under Statementof Financial Accounting Standards (“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 recognized overthe remaining term of the hosting period. Fees for the first and third stagesof the services are billed based upon milestones. Fees for application hostingand related services in the second stage are billed quarterly in advance.Bundled into this revenue element is the revenue attributable to the softwarelicense used by the customer.

We capitalized $322,000 and $509,000 of deferred setup costs and amortized $384,000 and $398,000 in the three months ended June 30,2004 and 2005, respectively, and capitalized $849,000 and $1.2 million ofdeferred set up costs and amortized $880,000 and $847,000 in the six monthsended June 30, 2004 and 2005, respectively. The amortization of deferredset up costs is a component of cost of services.

Deferred revenue represents amounts billed or cashreceived in advance of revenue recognition.

*Accounting for Commission Paymentsand Royalties.  *For arrangements where we recognizerevenue over the relevant contract period, we defer related commission paymentsto our direct sales force and software license royalties paid to third partiesand amortize these amounts over the same period that the related revenue arerecognized. This is done to better match commission and royalty expenses withthe related revenue. We capitalized $820,000 and $646,000 of commissions andamortized to sales and marketing expense $681,000 and $905,000 in the threemonths ended June 30, 2004 and 2005, respectively, and capitalized $1.6million and $1.3 million of commissions and amortized to sales and marketingexpense $1.2 million and $1.7 million in the six months ended June 30,2004 and 2005, respectively.

Royalties are paid on a percentage of billings basisfor certain of our products. We capitalized $1.1 million and $1.4 millionof royalties and amortized to costs of revenues $604,000 and $728,000 in thethree months ended June 30, 2004 and 2005, respectively, and capitalized$2.2 million and $2.2 million of royalties and amortized to costs of revenues$1.2 million and $1.3 million in the six months ended June 30, 2004 and2005, respectively.

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*AccountsReceivable Reserves.  *We maintain allowances fordoubtful accounts for estimated losses resulting from the inability of ourcustomers to make required payments. We regularly evaluate the collectibilityof our trade receivables based on a combination of factors, which may includedialogue with the customer to determine the cause of non-payment, the use ofcollection agencies, and/or the use of litigation. In the event it isdetermined that the customer may not be able to meet its full obligation to us,we record a specific allowance to reduce the related receivable to the amountthat we expect to recover given all information available to us. We monitorcollections from our customers and maintain a provision for estimated creditlosses based upon our historical experience and any specific customercollection issues that we have identified. While such credit losses havehistorically been within our expectations and the provisions established, wecannot guarantee that credit loss rates will not increase in the future. If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired. Our accounts receivable reserves were $391,000 and $289,000 as of December 31,2004 and June 30, 2005, respectively.

*Accountingfor Income Taxes.  *In connection with the preparation ofour financial statements, we are required to estimate our income taxes in eachof the jurisdictions in which we operate. This process involves the assessmentof our net operating loss carryforwards and credits, as well as estimating theactual current tax liability together with assessing temporary differencesresulting from differing treatment of items, such as reserves and accruedliabilities, for tax and accounting purposes. We then assess the likelihoodthat deferred tax assets will be recovered from future taxable income, and tothe extent we believe that recovery is not likely, we must establish avaluation allowance. As of June 30, 2005, we have incurred a three yearcumulative loss from operations. Once we are no longer in a three yearcumulative loss position, we would expect to recognize some or all of ourdeferred tax assets based principally on our ability to forecast futureoperating income. Currently, we believe that it is more likely than not that wewill not realize the value of our deferred tax assets and therefore haveprovided a full valuation allowance against our net deferred tax assets. Wewill continue to evaluate the realizability of our deferred tax assetsquarterly. If in future periods our assessment deems it more likely than notthe deferred tax assets will be recognized, we would record an adjustment toour valuation allowance at that time, which would result in a reduction toincome tax expense, which could be significant in the period in which such determinationis made.

The American Jobs CreationAct of 2004 (the “Act”), which was enacted on October 22, 2004, introduceda special one-time dividends received deduction on the repatriation of certainforeign earnings to a U.S. taxpayer (repatriation provision), provided certaincriteria are met. Even in light of the Act, our current intention is toreinvest the total amount of our unremitted earnings in the local jurisdictionor to repatriate the earnings only when doing so would be tax-effective. Assuch, we have not provided U.S. tax expense on the unremitted earnings of ourforeign subsidiaries.

*Accountingfor Stock-Based Awards.  *We record deferred stock-basedcompensation charges in the amount by which the exercise price of an option isless than the deemed fair value of our common stock at the date of grant.Because there had been no public market for our stock prior to the July 2004initial public offering of our common stock (the “IPO”), our board of directorshad determined the fair value of our common stock based upon several factors,including, but not limited to, our operating and financial performance, salesof convertible preferred stock to third parties, the rights and preferences ofsecurities senior to common stock and the anticipated offering price of ourcommon stock in connection with the IPO.

We have not historicallyengaged unrelated third parties to prepare valuations of our common stock. Inconnection with the IPO, management and the board of directors retroactivelyassessed the fair value of our common stock during 2003 and through the date ofthe IPO.

During 2003, all stockoptions were granted with an exercise price of $3.00 per share, while theestimated per share fair value of our common stock was subsequently determinedto range from $3.00 to 

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$4.00 inthe first quarter of 2003, $4.00 to $5.00 in the second quarter of 2003, $5.00to $7.50 in the third quarter of 2003 and $7.50 to $9.00 in the fourth quarterof 2003.

At the beginning of 2003,we determined the value of our common stock based principally on the per shareamounts that would have been distributed to the common stockholders, after allrequired distributions to the preferred stockholders, in the event of a sale ofthe Company at the value established in our January 2002 preferred stockfinancing. We chose this valuation methodology based on our operatingperformance during 2002 and the limited, if any, access we had to the publicequity markets at the time.

The increase in ourestimated per share fair value of common stock since the beginning of 2003reflects a number of significant factors, including an improvement in ouroperating results, especially in the second half of the year, changes to ourmanagement team throughout 2003, additions to our board of directors in thesecond half of 2003 and an overall improvement in stock market indices andincreasing volume of initial public offerings of common stock throughout 2003.

In the first, second andthird quarters of 2003, we incurred operating losses of $1.4 million,$1.1 million and $31,000, respectively. In the fourth quarter, we had anoperating profit of $432,000, excluding a restructuring charge in the fourthquarter. Our increasing per share fair value of common stock throughout 2003reflects this positive trend in operating results. In addition, in the secondhalf of 2003, because of our improved operating performance and the improvingequity markets, we began to contemplate an initial public offering of ourcommon stock.

During the six monthsended June 30, 2004, options were granted at exercise prices ranging from$4.50 to $6.00 per share while the estimated fair value of our common stock was$10.00 per share. The fair value of our common stock in the six months ended June 30,2004 was based on the high end of the range of estimated offering prices ofcommon stock as contemplated in the preliminary prospectus for our initialpublic offering that was filed with the Securities and Exchange Commission. Alloptions granted since the IPO were priced at the fair market value of thecommon stock at the date of grant.

As of June 30, 2005,there was an aggregate of $1.1 million of deferred stock-based compensationremaining to be amortized. Historically, we have elected not to record employeestock-based awards at fair value. The impact of recording employee stock-basedawards at fair value, using the Black-Scholes option-pricing model, isfurther described in Note 8 of the notes to our unaudited condensedconsolidated financial statements contained in this Quarterly Report on Form 10-Q.Effective January 1, 2006, we will be required to adopt a fair valueapproach to valuing stock-based awards. See Note 18 in the notes to ourunaudited condensed consolidated financial statements.

In the past, we haveawarded a limited number of stock options to non-employees. For these options,we recognize the stock-based compensation over the vesting periods of theunderlying awards, based on an estimate of their fair value on the vestingdates using the Black-Scholes option-pricing model.

*Goodwill Impairment*.   Wereview the carrying value of goodwill periodically based upon the expectedfuture discounted operating cash flows of our business. Our cash flow estimatesare based on historical results adjusted to reflect our best estimate of futuremarkets and operating conditions. 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 for the Three Months Ended June 30, 2004 and 2005**

License revenue increased36% in the three months ended June 30, 2005 as compared to the threemonths ended June 30, 2004. Service revenue increased 6% in the threemonths ended June 30, 2005 as compared to the three months ended June 30,2004.

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Our gross margin increased22%, or $2.2 million, in the three months ended June 30, 2005 to$12.6 million, compared to $10.4 million for the same period in 2004,primarily due to the increase in license revenue which generates a higher grossmargin.

Operating income increased$1.0 million from $946,000 in the three months ended June 30, 2004 toan operating income of $2.0 million for the three months ended June 30,2005. The operating income in the three months ended June 30, 2004 and2005 included $473,000 and $133,000 of stock-based compensation, respectively.As of June 30, 2005, we had $65.3 million of cash, cash equivalentsand short-term investments, an increase of $7.1 million from$58.2 million at December 31, 2004.

The results for the threemonths ended June 30, 2005, were impacted by foreign exchange. Revenues and expensesincreased approximately 2% and 2%, respectively, as a result of fluctuations inforeign exchange rates.

*Revenues*
| ** **                    | ** ** | **For the Three Months Ended June 30,** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                    | ** ** | **2004**                                                              | ** ** | **2005** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | ** **                                                            | ** ** | **Percentage** | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | ** **                                                            | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                                               | ** ** |
| License                       |       |                                                                  | $          | 6,357 |   |   |   | 36 | % |   | $ | 8,632 |   |   | 42 | % |   |   | $ | 2,275 |   |   | 36 | % |
| Application hosting  services |       |                                                                  | 6,689      |   |   |   | 38 |   |   | 7,275 |   |   | 35 |   |   |   | 586 |   |   | 9 | % |
| Professional services         |       |                                                                  | 1,215      |   |   |   | 7 |   |   | 1,622 |   |   | 8 |   |   |   | 407 |   |   | 33 | % |
| Customer support              |       |                                                                  | 3,432      |   |   |   | 19 |   |   | 3,169 |   |   | 15 |   |   |   | (263 | ) |   | (8 | )% |
| Total                         |       |                                                                  | $          | 17,693 |   |   |   | 100 | % |   | $ | 20,698 |   |   | 100 | % |   |   | $ | 3,005 |   |   | 17 | % |
|                               |            |                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Totalrevenues increased in the three months ended June 30, 2005 as compared tothe same period in 2004 due to an increase in license revenue across allproducts, as well as an increases in both**applicationhosting and professional services. The increase in license revenue in the threemonths ended June 30, 2005 was primarily due to an increase in sales of *InForm *into our existing *Clintrial* customer base and, to a lesserextent, an increase in sales of both *Clintrial*and *Clintrace* products. Thisincrease was a result of our continued strategy to expand the usage of oursoftware products by cross selling the *InForm*,*Clintrial* and *Clintrace* products to our existingcustomer base, additional utilization of our products within our customer baseand sales to new customers. The increase in revenue associated with thehosted-application version of our *InForm *productin the three months ended June 30, 2005 was due to an increase in clinicaltrials under management. Professional services revenue for the three monthsended June 30, 2005 increased compared to the same period in 2004 due tothe increase in consulting services associated with our existing enterprisecustomers. Customer support revenue for the three months ended June 30,2005 decreased compared to the same period in 2004 primarily due to thereduction in the *Clintrial*renewal base as a**result of the conversion of the former Clinsoft customersto term-based licenses that have a lower customer support fee, offset partiallyby the increase in both *InForm *supportrevenue associated with an increase in* *licenserevenue as well as**training revenue*.*
| ** **                          | ** ** | **For the Three Months Ended June 30,** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                          | ** ** | **2004**                                                              | ** ** | **2005** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | ** **                                                            | ** ** | **Percentage** | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | ** **                                                            | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                               | ** ** |
| United States                       |       |                                                                  | $          | 10,433 |   |   |   | 59 | % |   | $ | 10,779 |   |   | 52 | % |   |   | $ | 346 |   |   | 3 | % |
| United Kingdom                      |       |                                                                  | 3,807      |   |   |   | 22 |   |   | 6,330 |   |   | 31 |   |   |   | 2,523 |   |   | 66 | % |
| France                              |       |                                                                  | 2,119      |   |   |   | 12 |   |   | 1,936 |   |   | 9 |   |   |   | (183 | ) |   | (9 | )% |
| Asia-Pacific                        |       |                                                                  | 1,334      |   |   |   | 7 |   |   | 1,653 |   |   | 8 |   |   |   | 319 |   |   | 24 | % |
| International subtotal              |       |                                                                  | 7,260      |   |   |   | 41 |   |   | 9,919 |   |   | 48 |   |   |   | 2,659 |   |   | 37 | % |
| Total                               |       |                                                                  | $          | 17,693 |   |   |   | 100 | % |   | $ | 20,698 |   |   | 100 | % |   |   | $ | 3,005 |   |   | 17 | % |
|                                     |            |                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

26

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The increase in revenuesworldwide was due primarily to the increase in *InForm *revenuein the United Kingdom, resulting from additional enterprise-wide license andservice agreements associated with one customer. In addition, Asia-Pacific *InForm *licenseand application hosting services revenue increased.

*Costs of Revenues*
| ** **                      | ** ** | **For the Three Months Ended June 30,** | ** ** | ** **          |       |
|---------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------|------------|
| ** **                      | ** ** | **2004**                                                              | ** ** | **2005**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                                            | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                                            | ** ** | **of Related** | ** ** | ** ** | ** ** | **of Related** | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | ** **                                                            | ** ** | **Amount**          | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                                               | ** ** |                |
| License                         |       |                                                                  | $          | 448                 |       |   |   | 7 | % |   |   | $ | 589 |   |   |   | 7 | % |   |   | $ | 141 |   |   | 31 | % |
| Services                        |       |                                                                  | 6,842      |                |       |   | 60 |   |   |   | 7,464 |   |   |   | 62 |   |   |   | 622 |   |   | 9 | % |
| Total                           |       |                                                                  | $          | 7,290               |       |   |   | 41 | % |   |   | $ | 8,053 |   |   |   | 39 | % |   |   | $ | 763 |   |   | 10 | % |
|                                 |            |                                                                       |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The cost of license revenue increased in the three monthsended June 30, 2005 due to an increase in royalty expense associated withcertain modules of our *Clintrial*software product as well as our *InForm *softwareproducts. Cost of services for the three months ended June 30, 2005increased by $622,000 as we incurred $170,000 of additional employee relatedexpenses and $359,000 incremental outside contractor expense to deliverincreased services. In addition there were also expense increases in computerand related and depreciation of $135,000 and $78,000, respectively. Theseexpense increases were partially offset by a decrease in the amortization ofcapitalized labor of $174,000.

*Gross Margin*
| ** **            | ** ** | **For the Three Months Ended June 30,** | ** ** | ** **             | ** ** | ** **  | ** ** |
|-----------------------|------------|-----------------------------------------------------------------------|------------|------------------------|------------|-------------|------------|
| ** **            | ** ** | **2004**                                                              | ** ** | **2005**               | ** ** | ** **  | ** ** |
| ** **            | ** ** | ** **                                                            | ** ** | **Percentage of** | ** ** | ** **  | ** ** | **Percentage of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **            | ** ** | ** **                                                            | ** ** | **Related**            | ** ** | ** **  | ** ** | **Related** | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | ** **                                                            | ** ** | **Amount**             | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                                               | ** ** |
| License               |       | $                                                                     | 5,909      |                   |       | 93          | %          |   | $ | 8,043 |   |   | 93 | % |   |   | $ | 2,134 |   |   | 36 | % |
| Services              |       | 4,494                                                                 |       |                   | 40         |        |       | 4,602 |   |   | 38 |   |   |   | 108 |   |   | 2 | % |
| Total                 |       | $                                                                     | 10,403     |                   |       | 59          | %          |   | $ | 12,645 |   |   | 61 | % |   |   | $ | 2,242 |   |   | 22 | % |
|                       |            |                                                                       |            |                        |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The license gross margin percentage was unchanged inthe three months ended June 30, 2005. The services gross margin percentagedecreased for the three months ended June 30, 2005 due to increases inlabor and outside contractor expenses. It is likely that gross margin, as apercentage of revenues, will fluctuate, quarter by quarter, due to the timingand mix of license and service revenues, and the amount and type of servicerequired in delivering certain projects.

*Operating Expenses*
| ** **                  | ** ** | **For the Three Months Ended June 30,** | ** ** | ** **     | ** ** | ** **          | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------------|------------|----------------|------------|---------------------|------------|
| ** **                  | ** ** | **2004**                                                              | ** ** | **2005**       | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                                            | ** ** | **Percentage** | ** ** | ** **          | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | ** **                                                            | ** ** | **Amount**     | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                               | ** ** | ** **     | ** ** |                |
| Sales and  marketing        |       |                                                                  | $          | 3,536          |       |                |       | 20 | % |   | $ | 3,960 |   |   | 19 | % |   |   | $ | 424 |   |   | 12 | % |   |
| Research and  development   |       |                                                                  | 3,018      |           |       |                | 17         |   |   | 3,489 |   |   | 17 |   |   |   | 471 |   |   | 16 | % |   |
| General and  administrative |       |                                                                  | 2,903      |           |       |                | 16         |   |   | 3,218 |   |   | 16 |   |   |   | 315 |   |   | 11 | % |   |
| Total                       |       |                                                                  | $          | 9,457          |       |                |       | 53 | % |   | $ | 10,667 |   |   | 52 | % |   |   | $ | 1,210 |   |   | 13 | % |   |
|                             |            |                                                                       |            |                |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

27

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*Salesand Marketing.  *Sales and marketing expenses increasedfor the three months ended June 30, 2005 primarily due to a $223,000increase in commission expense resulting from an increase in revenues and anincrease in the effective commission rate, and an increase in employee-relatedexpenses of $126,000. We expect that our sales and marketing expenses willcontinue to increase in absolute dollars as commission expense increases withour revenues and we continue to build our brand awareness through what webelieve are the most cost-effective channels available. However, sales andmarketing expenses may fluctuate, quarter by quarter, due to the timing ofmarketing programs.

*Researchand Development.  *Research and development expensesincreased in the three months ended June 30, 2005 primarily due to anincrease in employee related expenses of $516,000 as we hired 8 additionalpeople to improve our quality assurance and product development team. We expectthat our research and development costs will continue to increase in absolutedollars as we continue to introduce additional integrated software solutionsand add features and functionality to our products.

*Generaland Administrative.  *General and administrative expensesincreased in the three months ended June 30, 2005 primarily due to a$241,000 increase in professional fees which relate to actions associated withdefending our intellectual properties and increased accounting expenses due tothe requirements of being a public company, as well as $164,000 of increasedemployee-related expenses. In addition, insurance expense of $93,000 due torequirements related to being a public company, and outside contractor expensesincreased $65,000 primarily related to the implementation of Section 404of the Sarbanes-Oxley Act. These expense increases were partially offset by a$257,000 decrease in stock based compensation. We expect that in the future,general and administrative expenses will increase in absolute dollars as we addpersonnel, incur additional professional fees related to the growth of ourbusiness and operations, and incur additional costs associated with being apublic company. However, general and administrative expenses may vary quarterby quarter due to the timing of professional fees.

*Operating Income,Other Income (Expense)*
| ** **                  | ** ** | **For the Three Months Ended June 30,** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                  | ** ** | **2004**                                                              | ** ** | **2005**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                                            | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                                            | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                               | ** ** | ** **          | ** ** |
| **Operating  income**       |       |                                                                  | $          | 946                 |       |       |       | 5 | % |   |   | $ | 1,978 |   |   |   | 10 | % |   |   | $ | 1,032 |   |   | 109 | % |
| **Other  income (expense)** | ** ** |                                                                  |       |                |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Interest income             |       |                                                                  | $          | 67                  |       |       |       | — | % |   |   | $ | 439 |   |   |   | 2 | % |   |   | $ | 372 |   |   | 555 | % |
| Interest expense            |       |                                                                  | (128       | )                   |       |       | —     |   |   |   | — |   |   |   | — |   |   |   | 128 |   |   | 100 | % |
| Other, net                  |       |                                                                  | 87         |                |       |       | —     |   |   |   | (11 | ) |   |   | — |   |   |   | (98 | ) |   | (113 | )% |
| Total                       |       |                                                                  | $          | 26                  |       |       |       | — | % |   |   | $ | 428 |   |   |   | 2 | % |   |   | $ | 402 |   |   | 1546 | % |

 

*OperatingIncome.  *The increase in operating income in the threemonths ended June 30, 2005 was primarily due to an increase in licensegross margin, partially offset by increased operating expenses resulting fromincreases in employee related expenses, commission expense and professionalfees. It is likely that operating income, as a percentage of revenues, willfluctuate, quarter by quarter, due to the timing and mix of license andservices revenues, and the amount and type of service required in deliveringcertain projects, as well as the timing of operating expense activities.

*Other Income (Expense).  *Theincrease in interest income in the three months ended June 30, 2005 wasprimarily due to an increase in cash and cash equivalents available forinvestment and short-term investments. The decrease in interest expense in thethree months ended June 30, 2005 was due to the payoff of all outstandingdebt during the quarter ended March 31, 2005. Other, net expense primarilyincreased due to foreign exchange losses in the three months ended June 30,2005 compared to foreign 

28

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exchange gains inthe three months ended June 30, 2004, related to unfavorable exchange ratemovements on non-U.S. dollar denominated accounts receivable and intercompanybalances.

*Provision forIncome Taxes*
| ** **                  | ** ** | **For the Three Months Ended June 30,** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                  | ** ** | **2004**                                                              | ** ** | **2005**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                                            | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                                            | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                               | ** ** | ** **          | ** ** |
| Provision for  income taxes |       |                                                                  | $          | 542                 |       |       |       | 3 | % |   |   | $ | 568 |   |   |   | 3 | % |   |   | $ | 26 |   |   |   | 5 | % |   |
|                             |            |                                                                       |            |                     |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for income taxes for 2004 representsforeign withholding taxes and income taxes payable that cannot be offsetthrough loss carryforwards. The provision for income taxes for 2005 representsincome taxes payable that cannot be offset through loss carryforwards. Theeffective tax rate for 2005 decreased to 24% compared to an effective tax rateof 56% for 2004. The decrease in our effective tax rate is primarily due to areduction in foreign withholding taxes and U.S. income taxes payable. The decrease in the foreign withholding taxesrelated to the elimination of withholding tax due to changes in legislationbetween the U.S. and Japan effective in the second quarter of 2004. Thedecrease in U.S. income taxes payable related to the change in the mix andtiming of the use of net operating loss carryforwards to offset taxable income.In utilizing our net operating loss carryforwards, we are required to use ouroldest net operating losses first. As a result, we have first used the netoperating losses acquired in the Clinsoft acquisition. The utilization of theacquired net operating losses reduces the amount of income taxes payable tolocal tax authorities. This benefit has been reflected as a reduction ofgoodwill. The benefit of utilization of the net operating loss carryforwardsthat were not acquired has been reflected as a reduction to the income taxprovision.

**Overviewof Results of Operations for the Six Months Ended June 30, 2004 and 2005**

License revenue increased39% in the six months ended June 30, 2005 as compared to the six monthsended June 30, 2004. Service revenue increased 8% in the six months ended June 30,2005 as compared to the six months ended June 30, 2004.

Our gross margin increased27%, or $5.4 million, in the six months ended June 30, 2005 to$25.5 million, compared to $20.2 million for the same period in 2004,primarily due to the increase in license and application hosting servicesrevenue.

Operating income increased by $2.1 million from$1.8 million in the six months ended June 30, 2004 to an operating incomeof $3.9 million for the six months ended June 30, 2005. The operatingincome in the six months ended June 30, 2004 and 2005 included $919,000and $357,000 of stock-based compensation, respectively. As of June 30,2005, we had $65.3 million of cash, cash equivalents and short-terminvestments securities, an increase of $7.1 million from$58.2 million at December 31, 2004.

The results for the sixmonths ended June 30, 2005, were impacted by foreign exchange. Revenues and expensesincreased approximately 2% and 2%, respectively, as a result of fluctuations inforeign exchange rates.

29

----

*Revenues*
| ** **                    | ** ** | **For the Six Months Ended June 30,** | ** ** | ** **     | ** ** | ** **          | ** ** |
|-------------------------------|------------|---------------------------------------------------------------------|------------|----------------|------------|---------------------|------------|
| ** **                    | ** ** | **2004**                                                            | ** ** | **2005**       | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **                    | ** ** | ** **                                                          | ** ** | **Percentage** | ** ** | ** **          | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | ** **                                                          | ** ** | **Amount**     | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                                             | ** ** | ** **     | ** ** |
| License                       |       | $                                                                   | 12,523     |           |       | 36                  | %          |   | $ | 17,451 |   |   | 42 | % |   |   | $ | 4,928 |   |   | 39 | % |
| Application  hosting services |       | 12,601                                                              |       |           | 36         |                |       | 14,106 |   |   | 35 |   |   |   | 1,505 |   |   | 12 | % |
| Professional  services        |       | 2,779                                                               |       |           | 8          |                |       | 3,017 |   |   | 7 |   |   |   | 238 |   |   | 9 | % |
| Customer support              |       | 6,752                                                               |       |           | 20         |                |       | 6,686 |   |   | 16 |   |   |   | (66 | ) |   | (1 | )% |
| Total                         |       | $                                                                   | 34,655     |           |       | 100                 | %          |   | $ | 41,260 |   |   | 100 | % |   |   | $ | 6,605 |   |   | 19 | % |
|                               |            |                                                                     |            |                |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Total revenues increasedin the six months ended June 30, 2005 as compared to the same period in2004 due to an increase in license revenue across all products, as well as anincrease in *InForm *applicationhosting services. The increase in license revenue in the six months ended June 30,2005 was primarily due to an increase in sales of *InForm *into our existing *Clintrial* customer base and, to a lesser extent, an increasein sales of both *Clintrial* and *Clintrace* products. This increase was aresult of our continued strategy to expand the usage of our software productsby cross selling the *InForm*, *Clintrial* and *Clintrace* products to our existing customer base, additionalutilization of our products within our customer base and sales to newcustomers. The increase in revenue associated with the hosted-applicationversion of our *InForm *productin the six months ended June 30, 2005 was due to an increase in clinicaltrials under management. Professional services revenue for the six months endedJune 30, 2005 increased compared to the same period in 2004 due to theincrease in consulting services associated with our existing enterprisecustomers. The small decrease in the customer support revenue for the sixmonths ended June 30, 2005 was primarily due to a decrease in the *Clintrial* and *Clintrace*renewal base as a result of the conversion of the former Clinsoft customers toterm based licenses that have a lower customer support fee, offset partially byan increase in *InForm *support revenueassociated with an increase in license and training revenue associated with our*InForm *product.
| ** **                          | ** ** | **For the Six Months Ended June 30,** | ** ** | ** **     | ** ** | ** **          | ** ** |
|-------------------------------------|------------|---------------------------------------------------------------------|------------|----------------|------------|---------------------|------------|
| ** **                          | ** ** | **2004**                                                            | ** ** | **2005**       | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **                          | ** ** | ** **                                                          | ** ** | **Percentage** | ** ** | ** **          | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | ** **                                                          | ** ** | **Amount**     | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                             | ** ** | ** **     | ** ** |
| United States                       |       | $                                                                   | 20,958     |           |       | 60                  | %          |   | $ | 21,524 |   |   | 52 | % |   |   | $ | 566 |   |   | 3 | % |
| United Kingdom                      |       | 7,212                                                               |       |           | 21         |                |       | 12,476 |   |   | 30 |   |   |   | 5,264 |   |   | 73 | % |
| France                              |       | 4,265                                                               |       |           | 12         |                |       | 4,218 |   |   | 10 |   |   |   | (47 | ) |   | (1 | )% |
| Asia-Pacific                        |       | 2,220                                                               |       |           | 7          |                |       | 3,042 |   |   | 8 |   |   |   | 822 |   |   | 37 | % |
| International subtotal              |       | 13,697                                                              |       |           | 40         |                |       | 19,736 |   |   | 48 |   |   |   | 6,039 |   |   | 44 | % |
| Total                               |       | $                                                                   | 34,655     |           |       | 100                 | %          |   | $ | 41,260 |   |   | 100 | % |   |   | $ | 6,605 |   |   | 19 | % |
|                                     |            |                                                                     |            |                |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in revenues worldwide was due primarilyto the increase in *InForm *revenuein the United Kingdom, resulting from additional enterprise-wide license andservice agreements, with one customer accounting approximately three-fourths ofthe increase. In addition, theAsia-Pacific license and services revenue increased across all products.

30

----

*Costs of Revenues*
| ** **                      | ** ** | **For the Six Months Ended June 30,** | ** ** | ** **             | ** ** | ** **  | ** ** |
|---------------------------------|------------|---------------------------------------------------------------------|------------|------------------------|------------|-------------|------------|
| ** **                      | ** ** | **2004**                                                            | ** ** | **2005**               | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                                          | ** ** | **Percentage of** | ** ** | ** **  | ** ** | **Percentage of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **                                                          | ** ** | **Related**            | ** ** | ** **  | ** ** | **Related** | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | ** **                                                          | ** ** | **Amount**             | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                                             | ** ** | ** **             | ** ** |
| License                         |       | $                                                                   | 870        |                   |       | 7           | %          |   | $ | 1,037 |   |   | 6 | % |   |   | $ | 167 |   |   | 19 | % |
| Services                        |       | 13,623                                                              |       |                   | 62         |        |       | 14,676 |   |   | 62 |   |   |   | 1,053 |   |   | 8 | % |
| Total                           |       | $                                                                   | 14,493     |                   |       | 42          | %          |   | $ | 15,713 |   |   | 38 | % |   |   | $ | 1,220 |   |   | 8 | % |
|                                 |            |                                                                     |            |                        |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The cost of license revenue increased in the sixmonths ended June 30, 2005 due to a $198,000 increase in royalty expenseassociated with our *InForm *softwareproduct as well as certain modules of our *Clintrial*software product. Cost of services for the six months ended June 30, 2005increased by $1.1 million as we incurred $431,000 of additional employee relatedexpenses and $505,000 incremental outside contractor expense to deliverincreased services. In addition there were also expense increases in computerrelated, occupancy and depreciation of $230,000, $120,000 and $116,000,respectively. These expense increases were partially offset by a decrease inthe amortization of capitalized labor of $359,000.

*Gross Margin*
| ** **            | ** ** | **For the Six Months Ended June 30,** | ** ** | ** **             | ** ** | ** **  | ** ** |
|-----------------------|------------|---------------------------------------------------------------------|------------|------------------------|------------|-------------|------------|
| ** **            | ** ** | **2004**                                                            | ** ** | **2005**               | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **            | ** ** | ** **                                                          | ** ** | **Percentage of** | ** ** | ** **  | ** ** | **Percentage of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **            | ** ** | ** **                                                          | ** ** | **Related**            | ** ** | ** **  | ** ** | **Related** | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | ** **                                                          | ** ** | **Amount**             | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                                             | ** ** | ** **             | ** ** |
| License               |       | $                                                                   | 11,653     |                   |       | 93          | %          |   | $ | 16,414 |   |   | 94 | % |   |   | $ | 4,761 |   |   | 41 | % |
| Services              |       | 8,509                                                               |       |                   | 38         |        |       | 9,133 |   |   | 38 |   |   |   | 624 |   |   | 7 | % |
| Total                 |       | $                                                                   | 20,162     |                   |       | 58          | %          |   | $ | 25,547 |   |   | 62 | % |   |   | $ | 5,385 |   |   | 27 | % |
|                       |            |                                                                     |            |                        |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The license gross margin percentage increased in thesix months ended June 30, 2005 primarily due to an increase in sales of *InForm*, which incurs a lower royalty than *Clintrial*. The services gross margin percentage wasunchanged for the six months ended June 30, 2005.

*Operating Expenses*
| ** **                  | ** ** | **For the Six Months Ended June 30,** | ** ** | ** **     | ** ** | ** **          | ** ** |
|-----------------------------|------------|---------------------------------------------------------------------|------------|----------------|------------|---------------------|------------|
| ** **                  | ** ** | **2004**                                                            | ** ** | **2005**       | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                                          | ** ** | **Percentage** | ** ** | ** **          | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | ** **                                                          | ** ** | **Amount**     | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                             | ** ** | ** **     | ** ** |
| Sales and  marketing        |       | $                                                                   | 6,841      |           |       | 20                  | %          |   | $ | 7,911 |   |   | 19 | % |   |   | $ | 1,070 |   |   | 16 | % |
| Research and  development   |       | 5,954                                                               |       |           | 17         |                |       | 6,770 |   |   | 16 |   |   |   | 816 |   |   | 14 | % |
| General and  administrative |       | 5,546                                                               |       |           | 16         |                |       | 7,022 |   |   | 17 |   |   |   | 1,476 |   |   | 27 | % |
| Restructuring               |       | —                                                              |       |           | —     |                |       | (92 | ) |   | — |   |   |   | (92 | ) |   | nm |   |
| Total                       |       | $                                                                   | 18,341     |           |       | 53                  | %          |   | $ | 21,611 |   |   | 52 | % |   |   | $ | 3,270 |   |   | 18 | % |
|                             |            |                                                                     |            |                |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Salesand Marketing.  *Sales and marketing expenses increasedfor the six months ended June 30, 2005 primarily due to a $421,000increase in employee-related expenses, which included one-time chargesassociated with changes in management, and a $491,000 increase in commission expenseresulting from an increase in revenues and an increase in the effectivecommission rate. In addition, travel expense increased by $129,000.

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*Researchand Development.  *Research and development expensesincreased in the six months ended June 30, 2005 primarily due to anincrease in employee related expenses of $1.1 million as we hired additionalpeople to improve our quality assurance and product development team. This waspartially offset by a $244,000 decrease in outside consultant expense as we broughtcertain research and development activities in-house

*General and Administrative.  *Generaland administrative expenses increased in the six months ended June 30,2005 primarily due to a $957,000 increase in professional fees primarilyassociated with actions defending our intellectual properties and increasedaccounting fees due to the requirements of being a public company, as well as, $358,000 of increasedemployee-related expenses. In addition, outside contractor expenses increased$215,000 primarily related to the implementation of Section 404 of theSarbanes-Oxley Act and additional insurance expense of $204,000 due torequirements related to being a public company. These expense increases werepartially offset by a $381,000 decrease in stock-based compensation.

*Operating Income,Other Income (Expense)*
| ** **                  | ** ** | **For the  Six Months Ended June 30,** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                  | ** ** | **2004**                                                                  | ** ** | **2005**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                                                | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                                                | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                                   | ** ** | ** **          | ** ** |
| **Operating  income**       |       |                                                                      | $          | 1,821               |       |       |       | 5 | % |   |   | $ | 3,936 |   |   |   | 10 | % |   |   | $ | 2,115 |   |   | 116 | % |
| **Other  income (expense)** | ** ** |                                                                      |       |                |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Interest income             |       |                                                                      | $          | 172                 |       |       |       | — | % |   |   | $ | 787 |   |   |   | 2 | % |   |   | $ | 615 |   |   | 358 | % |
| Interest expense            |       |                                                                      | (210       | )                   |       |       | —     |   |   |   | (144 | ) |   |   | — |   |   |   | 66 |   |   | 31 | % |
| Other, net                  |       |                                                                      | 71         |                |       |       | —     |   |   |   | (141 | ) |   |   | — |   |   |   | (212 | ) |   | (299 | )% |
| Total                       |       |                                                                      | $          | 33                  |       |       |       | — | % |   |   | $ | 502 |   |   |   | 1 | % |   |   | $ | 469 |   |   | 1421 | % |

 

*OperatingIncome.  *The increase in operating income in the sixmonths ended June 30, 2005 was primarily due to an increase in grossmargins from both license and services, partially offset by increased operatingexpenses resulting from increases in employee related expenses, commissionexpense and professional fees. It is likely that operating income, as apercentage of revenues, will fluctuate, quarter by quarter, due to the timingand mix of license and services revenues, and the amount and type of servicerequired in delivering certain projects, as well as the timing of operatingexpense activities.

*Other Income (Expense).  *Theincrease in interest income in the six months ended June 30, 2005 wasprimarily due to an increase in cash and cash equivalents available forinvestment and short-term investments. The decrease in interest expense in thesix months ended June 30, 2005 was primarily due to the pay off of ourdebt in the quarter ended March 31, 2005. Other, net expense increasedprimarily due to foreign exchange losses in the six months ended June 30,2005 compared to foreign exchange gains in the six months ended June 30,2004, related to unfavorable exchange rate movements on non-U.S. dollardenominated accounts receivable and intercompany balances.

*Provision for Income Taxes.*
| ** **                  | ** ** | **For the Six Months Ended June 30,** | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                  | ** ** | **2004**                                                            | ** ** | **2005**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** **                                                          | ** ** | **Percentage**      | ** ** | ** ** | ** ** | **Percentage** | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                                          | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                             | ** ** | ** **          | ** ** |
| Provision for  income taxes |       |                                                                | $          | 1,041               |       |       |       | 3 | % |   |   | $ | 1,132 |   |   |   | 3 | % |   |   | $ | 91 |   |   |   | 9 | % |   |
|                             |            |                                                                     |            |                     |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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The provision for income taxes for 2004 representsforeign withholding taxes and income taxes payable that cannot be offsetthrough loss carryforwards. The provision for income taxes for 2005 representsincome taxes payable that cannot be offset through loss carryforwards. Theeffective tax rate for 2005 decreased to 26% compared to an effective tax rateof 56% for 2004. The decrease in our effective tax rate is primarily due to areduction in foreign withholding taxes and U.S. income taxes payable. Thedecrease in the foreign withholding taxes related to the elimination ofwithholding tax due to changes in legislation between the U.S. and Japaneffective in the second quarter of 2004. The decrease in U.S. income taxespayable related to the change in the mix and timing of the use of net operatingloss carryforwards to offset taxable income. In utilizing our net operatingloss carryforwards, we are required to use our oldest net operating lossesfirst. As a result we have first used the net operating losses acquired in theClinsoft acquisition. The utilization of the acquired net operating losses reducesthe amount of income taxes payable to local tax authorities. This benefit hasbeen reflected as a reduction of goodwill. The benefit of utilization of thenet operating loss carryforwards that were not acquired has been reflected as areduction to the income tax provision.

**Liquidityand Capital Resources**

At December 31, 2004and June 30, 2005, our principal sources of liquidity were cash, cashequivalents and short-term investments totaling $58.2 million and$65.3 million, respectively, and accounts receivable of $19.7 millionand $16.0 million, respectively.

From our inception, wefunded our operations primarily through issuances of convertible preferredstock for aggregate net cash proceeds of $79.7 million, including net cashacquired in the Clinsoft acquisition, the proceeds from the initial publicoffering and exercise of the over-allotment option resulting in net proceeds of$36.6 million, and the issuance of notes payable for an aggregate of$17.3 million.

Cash provided by (used in)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 depreciation andamortization, non-cash income tax expense and stock-based compensation.Fluctuations within accounts receivable and deferred revenue are primarilyrelated to the timing of billings of our term license customers and theassociated revenue recognition. Movements in deferred costs are related to thevolume and stages of hosted clinical trials and movements in accrued expensesand accounts payable are due to the timing of certain transactions.

Net cash provided byoperating activities was $11.0 million for the six months ended June 30,2005, which was greater than net income of $3.3 million. The difference isprimarily due to $1.6 million of non-cash depreciation, $769,000 of non-cashincome tax expense and changes in working capital, which consisted primarily ofa $3.4 million decrease in accounts receivable and an increase in deferredrevenue of $4.0 million, partially offset by a decrease in accrued expenses of$1.1 million and an increase in deferred costs of $945,000.

Net cash used in investingactivities was $5.5 million for the six months ended June 30, 2005,consisting primarily of the purchase of short-term investments of $6.5 millionand capital expenditures of $1.5 million, partially offset by $2.5 millionof proceeds from maturities of short-term investments.

Net cash used in financing activities was$2.1 million for the six months ended June 30, 2005, consistingprimarily of $4.4 million of debt repayments as we paid all of our outstandingbank debt, partially offset by $2.2 million of proceeds from the exercise ofcommon stock options and sales of common stock under the  employee stock purchase plan.

At December 31, 2004 and June 30, 2005,respectively, we had $1.6 million and $1.3 million of outstanding lettersof credit related to our facilities. The letters of credit are reflected as areduction in the amount available under the line of credit.

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Substantially all of our long-lived assets as of December 31,2004 and June 30, 2005 are located in the United States.

We do not have any special purpose entities or anyoff-balance sheet financing arrangements.

We generally do not enterinto binding purchase commitments. Our principal commitments consist of leasesfor office space. At June 30, 2005, the future minimum payments underthese leases were as follows:
| **Year ended December 31,** | ** ** | ** **              | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                                 | ** ** | **(in thousands)** | ** ** |
| 2005                                       |       |                    | $          | 1,353     |       |   |
| 2006                                       |       |                    | 2,622      |      |       |
| 2007                                       |       |                    | 2,252      |      |       |
| 2008                                       |       |                    | 2,047      |      |       |
| 2009                                       |       |                    | 346        |      |       |
| Total minimum payments                     |       |                    | $          | 8,620     |       |   |

 

Between April 2000 and September 2004, wehad entered into several equipment lines of credit with a bank. All advancesunder these equipment lines of credit were payable in 30 to 36 equal monthlyinstallments of principal, plus accrued interest. The interest that accruedunder these notes ranged from prime rate (5.25% and 5.75% at December 31,2004 and March 31, 2005, respectively) to prime rate plus 1.0%. As of December 31,2004 there was a total of $4.4 million outstanding and $3.2 million availableunder all of our equipment lines of credit. In March 2005, we paid in fullall outstanding debt related to our equipment lines of credit. The equipmentline of credit expired on March 31, 2005 and was not renewed.

Effective March 31, 2004, we renewed our workingcapital line of credit with a bank and increased the amount under which we canborrow to $5.0 million. Interest accrues at prime rate. All advances made underthe working capital line are due and payable on March 31, 2006. As of December 31,2004 and June 30, 2005, $0 was outstanding under the working capital lineof credit. At June 30, 2005, there was $3.7 million available under theline of credit, and $1.3 million reserved under a letter of credit associatedwith our leased facilities.

Borrowings underour working capital line of credit are secured by substantially all of ourassets other than our intellectual property. We have also entered into anegative pledge agreement that, subject to certain exceptions, generallyprohibits us from pledging our intellectual property to others. Under the termsof this credit line, we are required to comply with certain financial covenants.At June 30, 2005, we were in compliance with all financial covenants. In August of2005, the working capital line of credit was amended to eliminate the securityinterest in our assets and the negative pledge on our intellectual property. Theamendment also removed or modified the financial covenants.

At December 31,2004, we had net operating loss carryforwards of approximately$88.4 million, which may be used to offset future U.S. federal taxableincome, if any, and $4.8 million of federal research and development taxcredit carryforwards. In addition, we have $5.6 million of net operatinglosses relating to our non-U.S. jurisdictions. Of these amounts, approximately$26.9 million and $3.0 million of net operating loss carryforwards andtax credit carryforwards, respectively, relate to amounts acquired as part ofthe Clinsoft acquisition. These tax carryforwards may reduce our future cashpayments to the taxing authorities. The realized benefits of the acquiredcarryforwards will be reflected as an adjustment through goodwill and not areduction in the effective tax rate. The carryforwards expire beginning in 2008through 2023 and are subject to review and possible adjustment by the taxingauthorities. The Internal Revenue Code contains provisions that may limit thenet operating loss and tax credit carryforwards available to be used in anygiven year in the event of certain changes in the ownership interests ofsignificant stockholders.

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We believe ourexisting cash, cash equivalents, short-term investments and cash provided byoperating activities and our working capital line of credit will be sufficientto meet our working capital and capital expenditure needs over the next twelvemonths. Our future capital requirements will depend on many factors, includingour rate of revenue growth, the expansion of our marketing and salesactivities, the timing and extent of spending to support product developmentefforts, the timing of introductions of new services and enhancements toexisting services, and the continuing market acceptance of our services. To theextent 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. From time to time, wemay also enter into agreements with respect to potential investments in, oracquisitions of, businesses, services or technologies, which could also requireus to seek additional equity or debt financing. Additional funds for those purposesmay not be available on terms favorable to us or at all.

**CertainFactors Which May Affect Future Results**

*Our operatingresults and financial condition have varied in the past and may in the futurevary significantly depending on a number of factors. Except for the historicalinformation in this report, the matters contained in this report includeforward-looking statements that involve risks and uncertainties. The followingfactors, among others, could cause actual results to differ materially from thosecontained in forward-looking statements made in this report and presentedelsewhere by management from time to time. Such factors, among others, may havea material adverse effect upon our business, results of operations andfinancial condition.*

**RisksRelated to Our Industry**

***We depend primarilyon the pharmaceutical, biotechnology and medical device industries and aretherefore subject to risks relating to changes in these industries.***

Ourbusiness depends on the clinical trials conducted or sponsored bypharmaceutical, biotechnology and medical device companies and other entitiesconducting clinical research. General economic downturns, increasedconsolidation or decreased competition in the industries in which thesecompanies operate could result in fewer products under development or decreasedpressure to accelerate product approval which, in turn, could materiallyadversely impact our revenues. Our operating results may also be adverselyimpacted by other developments that affect these industries generally,including:

·       the introduction oradoption of new technologies or products;

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

·       theassertion of product liability claims;

·       changes in third-partyreimbursement practices;

·       changes in governmentregulation or governmental price controls;

·       changes in medicalpractices;

·       changes in the purchasingpatterns of entities conducting clinical research; and

·       changes in general businessconditions.

Any decrease in research and development expendituresor in the size, scope or frequency of clinical trials conducted or sponsored bypharmaceutical, biotechnology or medical device companies or other entities asa result of the foregoing or other factors could materially adversely affectour operations or financial condition.

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***If entities engaged in clinical trials do not shiftfrom traditional paper-based methods of collecting clinical trial data toelectronic systems, we may not achieve the market penetration necessary tomaintain profitability.***

If entities engaged inclinical trials are unwilling to use our electronic data capture solutions orto change the way of collecting clinical trial data, our future growth andmarket share may be limited. Most clinical trials today rely on pre-printed,three-part paper case report forms for data collection. Our efforts toestablish an electronic process to capture clinical trial data are asignificant departure from the traditional paper-based methods of collectingclinical trial data. As is typical for new and rapidly evolving industries,customer demand for recently introduced technology is highly uncertain. We maynot be successful in persuading entities engaged in clinical trials to changethe manner in which they have traditionally collected clinical trial data andto accept our software products, services and hosted solutions. If we fail toconvince entities engaged in clinical trials to use our methods of capturingclinical trial data, our revenues may be limited and we may fail to maintainprofitability.

***We operate in a highly competitive industry and if weare not able to compete effectively, our business and operating results will beharmed.***

The market for our software products, services andhosted solutions is characterized by rapidly changing technologies, evolvingindustry standards and frequent new product and service introductions andenhancements that may render existing products and services obsolete.Accordingly, we are susceptible to rapid and significant declines in marketshare due to unforeseen changes in the features, functions or pricing ofcompeting products. Barriers to entry are relatively low and, with theintroduction of new technologies and new market entrants, we expect thatcompetition will increase. Increased competition is likely to result in pricingpressures, which could negatively impact our sales, gross margins or marketshare. Our failure to compete effectively could materially adversely affect ourbusiness, financial condition or results of operations.

Some of our currentcompetitors, as well as many of our potential competitors, have greater namerecognition, longer operating histories and significantly greater resources. Asa result, our competitors may be able to respond more quickly and effectivelythan we can to new or changing opportunities, technologies, standards orcustomer requirements. In addition, current and potential competitors haveestablished, and may in the future establish, cooperative relationships withvendors of complementary products, technologies or services to increase theavailability of their products to the marketplace. Accordingly, new competitorsor alliances may emerge that have greater market share, larger customer bases,more widely adopted proprietary technologies, greater marketing expertise andlarger sales forces than we have, which could put us at a competitivedisadvantage. Further, in light of these advantages, even if our products andservices are more effective than the product or service offerings of ourcompetitors, current or potential customers might accept competitive productsand services in lieu of purchasing our software products, services and hostedsolutions. We cannot assure you that we can maintain or enhance our competitiveposition against current and future competitors.

***Changing customer or prospective customer requirementscould decrease the demand for our products and services, which would adverselyaffect our revenues and operating results.***

Our future success willdepend in large part on our ability to enhance and broaden our softwareproducts, services and hosted solutions to meet the evolving needs of ourcustomers and prospective customers. To achieve our goals, we need toeffectively respond to our customers’ and prospective customers’ needs,technological changes and new industry standards and developments in a timelymanner. If we are unable to enhance our existing product and service offeringsor develop new products and services to meet changing requirements, demand forour software products, services and hosted solutions could suffer and our revenuesand operating results could be materially adversely affected. We could also 

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incursubstantial costs if we need to modify our products or services, or informationtechnology infrastructure, to adapt to technological changes or new industrystandards or developments.

***Changes in regulations and regulatory guidanceapplicable to our customers or potential customers and the approval process fortheir products may result in our inability to continue to do business.***

Demand for our software products, services and hostedsolutions is largely a function of regulation and regulatory guidanceassociated with the approval of new drugs, biological products and medicaldevices imposed upon the clinical trial process by the U.S. federal governmentand related regulatory authorities such as the U.S. Food and DrugAdministration, or FDA, and by foreign governments. In recent years, effortshave been made to streamline the FDA approval process and coordinate U.S.standards with those of other developed countries. Any change in the scope ofapplicable regulations and regulatory guidance could alter the type or amountof clinical trial spending or negatively impact interest in our softwareproducts, services and hosted solutions. Any regulatory reform that limits orreduces the research and development spending of entities conducting clinicalresearch upon which our business depends could have a material adverse effecton our revenues or gross margins.

In addition, any failureto conform our software products, services and hosted solutions to domestic orinternational changes in regulations and regulatory guidance applicable to ourcustomers or potential customers and the approval process for their productsmay result in our inability to continue to do business. Changing our softwareproducts, services and hosted solutions to allow our customers to comply withfuture changes in regulation or regulatory guidance, either domestically orinternationally, could cause us to incur substantial costs. We cannot assureyou that our product and service offerings will allow our customers andpotential customers to stay in compliance with regulations and regulatoryguidance as they develop. If our product and service offerings fail to allowour customers and potential customers to operate in a manner that is compliantwith applicable regulations and regulatory guidance, clinical trial sponsorsand other entities conducting clinical research may be unwilling to use oursoftware products, services and hosted solutions.

**Risks Related to Our Company**

***We operate in an emerging market, which makes itdifficult to evaluate our business and future prospects.***

We wereincorporated in June 1997 and operate in an emerging market. Accordingly,our business and future prospects are difficult to evaluate. You shouldconsider the challenges, risks and uncertainties frequently encountered bycompanies using new and unproven business models in rapidly evolving markets.These challenges include our ability to:

·       generate sufficientrevenues to maintain profitability;

·       manage growth in ouroperations;

·       attract and retaincustomers;

·       attract and retain keypersonnel;

·       develop and renew strategicrelationships; and

·       access additional capitalwhen required and on reasonable terms.

We cannot be certain thatwe will successfully address these and other challenges, risks anduncertainties or that our business model will be successful. Failure to do socould adversely affect our business, results of operations or financialcondition.

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***Our software products and hosted solutions are atvarying stages of market acceptance and the failure of any of our products toachieve wide acceptance would harm our operating results.***

We began offeringour *InForm *electronic datacapture software solution for clinical trials in December 1998. Althoughthe *Clintrial* and *Clintrace* products were introduced over10 years ago, we did not begin offering these products until after ouracquisition of Clinsoft Corporation in 2001. Continued use of our *Clintrial* and *Clintrace* software products, and broad and timely acceptanceof our *InForm *product, aswell as integrated solutions combining one or more of our software products, iscritical to our future success and is subject to a number of significant risks,some of which are outside our control. These risks include:

·       our customers’ andprospective customers’ desire for and acceptance of our electronic datacapture, management and adverse event reporting software solutions;

·       our software products andhosted solutions’ ability to support large numbers of users and manage vastamounts of data;

·       our customers’ ability touse our software products and hosted solutions, train their employees andsuccessfully deploy our technology in their clinical trials;

·       our ability to meet productdevelopment and release schedules; and

·       our ability tosignificantly expand our internal resources and increase our capital andoperating expenses to support the anticipated growth and continued integrationof our software products, services and hosted solutions.

Our failure to address,mitigate or manage these risks would seriously harm our business, particularlyif the failure of any or all of our software products or hosted solutions toachieve market acceptance negatively affects our sales of our other productsand services.

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

We are, and may in thefuture be, subject to claims that our technologies infringe upon theintellectual property or other proprietary rights of a third party. Forinstance, Dr. Mark L. Kozam, doing business under the name MLK Softwareand Datasci, LLC have filed a complaint against us and one of our customersalleging that we infringe a patent claimed to be owned by them. We haveincurred substantial professional fees in connection with this claim. Inaddition, the vendors who provide us with technology that we use in ourtechnology could become subject to similar infringement claims. Although webelieve that our software solutions do not infringe the patents of any thirdparty, we cannot assure you that our technology does not infringe patents held byothers or that they will not in the future. The claim referenced above and anyfuture claims of infringement could cause us to incur substantial costsdefending against the claim, even if the claim is without merit, and coulddistract our management from our business. Moreover, any settlement or adversejudgment resulting from the claim could require us to pay substantial amountsor obtain a license to continue to use the technology that is the subject ofthe claim, or otherwise restrict or prohibit our use of the technology. Therecan be no assurance that we would be able to obtain a license from the thirdparty asserting the claim on commercially reasonable terms, if at all, that wewould be able to successfully develop alternative technology on a timely basis,if at all, or that we would be able to obtain a license from another providerof suitable alternative technology to permit us to continue offering, and ourcustomers to continue using, the applicable technology. In addition, wegenerally provide in our customer agreements, including our agreement with thecustomer that is the subject of the claim referenced above, that we willindemnify our customers, against third-party infringement claims relating toour technology provided to the customer, which could obligate us to fundsignificant amounts. 

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Infringementclaims asserted against us or our vendors may have a material adverse effect onour business, results of operations or financial condition.

***As a result of long sales cycles and our businessmodel, we may be required to spend substantial time and expense before werecognize a significant portion of the revenues, if any, attributable to ourcustomer contracts.***

The sales cycle for someof our software solutions frequently takes in excess of nine months frominitial customer contact to contract execution. During this time, we may expendsubstantial time, effort and financial resources without realizing any revenuewith respect to the potential sale. In addition, while we begin recognizingrevenue upon the execution of our agreements for software term licenses andrelated services, it may be difficult for us to rapidly increase our revenuethrough additional sales in any period, as license revenue and, whenapplicable, related services revenue, from new customers is recognized over theapplicable license term, typically three to five years. As a result, we may notrecognize significant revenues, if any, from some customers despite incurringconsiderable expense related to our sales, implementation, and service deliveryprocesses. Even if we do realize revenues from a contract, our term licensepricing model may keep us from recognizing a significant portion of theserevenues (including revenues for related services) during the same period inwhich sales, implementation, and service delivery expenses were incurred. Forexample, pursuant to our contract with GlaxoSmithKline, we have incurredsignificant up-front implementation and other service expenses associated withdelivery of services under the contract, whereas the revenue under the contractwill be recognized ratably over an approximately 5-year period from July 2004.Timing differences of this nature could cause our service gross margins andprofitability to fluctuate significantly from quarter to quarter. Similarly, adecline in new or renewed software term licenses in any one quarter will notnecessarily be fully reflected in the revenue in that quarter and maynegatively affect our revenue in future quarters. This could also cause ouroperating results to fluctuate from quarter to quarter.

***We may be unable to adequately protect, and we mayincur significant costs in defending, our intellectual property and otherproprietary rights.***

Our success depends on ourability to protect our intellectual property and other proprietary rights. Werely upon a combination of trademark, trade secret, copyright, patent andunfair competition laws, as well as license agreements and other contractualprovisions, to protect our intellectual property and other proprietary rights.In addition, we attempt to protect our intellectual property and proprietaryinformation by requiring our employees and consultants to enter intoconfidentiality, noncompetition and assignment of inventions agreements. To theextent that our intellectual property and other proprietary rights are notadequately protected, third parties might gain access to our proprietaryinformation, develop and market products or services similar to ours, or usetrademarks similar to ours, each of which could materially harm our business.Existing U.S. federal and state intellectual property laws offer only limitedprotection. Moreover, the laws of other countries in which we market oursoftware products, services and hosted solutions may afford little or no effectiveprotection of our intellectual property. If we resort to legal proceedings toenforce our intellectual property rights or to determine the validity and scopeof the intellectual property or other proprietary rights of others, theproceedings could be burdensome and expensive, even if we were to prevail. Thefailure to adequately protect our intellectual property and other proprietaryrights may have a material adverse effect on our business, results ofoperations or financial condition.

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

From time to time,we evaluate potential investments in, and acquisitions of, complimentarytechnologies, services and businesses. We have made in the past, and may makein the future, acquisitions 

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orsignificant investments in other businesses. Entering into an acquisitionentails many risks, any of which could harm our business, including:

·       difficulties in integratingthe operations, technologies, products, existing contracts and personnel of thetarget company and realizing the anticipated synergies of the combinedbusinesses;

·       the price we pay or otherresources that we devote may exceed the value we eventually realize or thevalue we could have realized if we had allocated the purchase price or otherresources to another opportunity;

·       potential loss of keyemployees, customers and strategic alliances from either our current businessor the target company’s business;

·       managing the risks ofentering markets or types of businesses in which we have limited or no directexperience;

·       the diversion of management’sattention from other business concerns; and

·       assumption of unanticipatedproblems or latent liabilities, such as problems with the quality of the targetcompany’s products.

In addition, if we financeany future acquisitions by issuing equity securities or convertible debt, ourexisting stockholders may be diluted or the market price of our stock may beadversely affected. The failure to successfully evaluate and executeacquisitions or investments or otherwise adequately address these risks couldmaterially harm our business and financial results.

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

The technology underlyingour software products and hosted solutions processes vast amounts of clinicaltrial data. Customers relying on our products to collect, manage and reportclinical trial information may have a greater sensitivity to product errors andsecurity vulnerabilities than customers of software products in general. In thepast, failures of our technology and human error have negatively impacted thedata capture, management or reporting capabilities of our products, and newerrors may be detected in the future. Any delay or failure of our technologymay result in the disruption of the clinical trial process and could harm ourbusiness and operating results. Product or service errors could materially andadversely affect our reputation, result in significant costs to us and impairour ability to sell our products and services in the future. The costs incurredin correcting any defects or errors may be substantial and could adverselyaffect our operating margins. In addition, security breaches, whetherintentional or accidental, could expose us to a risk of loss of data,litigation and possible liability.

***Interruptions or delays in service from ourthird-party providers could impair the delivery of our hosted InForm electronicdata capture solution and harm our business.***

We host our *InForm *electronic data capturesoftware solution at third-party facilities. Consequently, the occurrence of anatural disaster or other unanticipated problems at the facilities of ourthird-party provider could result in unanticipated interruptions in ourcustomers’ access to our *InForm *electronicdata capture software solution. Our hosted services may also be subject tosabotage, intentional acts of malfeasance and similar misconduct due to the natureof the Internet. In the past, Internet users have occasionally experienceddifficulties with Internet and online services due to system or securityfailures. We cannot assure you that our business interruption insurance willadequately compensate our customers or us for losses that may occur. Even ifcovered by insurance, any failure or breach of security of our systems coulddamage our reputation and cause us to lose customers. Further, certain of ourhosted *InForm *electronicdata capture solutions, are subject to service level agreements that guarantee95% to 99% server availability. In the event that we fail to meet those levels,whether resulting from an 

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interruptionin service caused by our technology or that of a third-party provider, we couldbe subject to customer credits or termination of these customer contracts.

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

Our revenues andoperating results are difficult to predict and may fluctuate from quarter toquarter, particularly because of the rapidly evolving market in which weoperate and our term license model. Our results of operations in any givenquarter will be based on a number of factors, including:

·       the extent to which oursoftware products, services and hosted solutions achieve or maintain marketacceptance;

·       our ability to introducenew products and services and enhancements to our existing products andservices on a timely basis;

·       the competitive environmentin which we operate;

·       the timing of our productsales and the length of our sales and implementation cycles;

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

·       changes in our operatingexpenses;

·       our ability to hire andretain qualified personnel;

·       changes in the regulatoryenvironment related to the clinical trial market;

·       changes in our customers’purchasing patterns;

·       the financial condition ofour current and potential customers; and

·       the timing, size andintegration success of potential future acquisitions.

A significant portion ofour operating expense is relatively fixed in nature and planned expendituresare based in part on expectations regarding future revenues. Accordingly,unexpected revenue shortfalls or operating expenses may decrease our grossmargins and could cause significant changes in our operating results fromquarter to quarter. Results of operations in any quarterly period should not beconsidered indicative of the results to be expected for any future period. Inaddition, our future quarterly operating results may fluctuate and may not meetthe expectations of securities analysts or investors. If this occurs, thetrading price of our common stock could fall substantially either suddenly orover time.

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

Our future success dependsupon our ability to attract, train and retain highly skilled employees andcontract workers, particularly our management team, sales and marketingpersonnel, professional services personnel and software engineers. Each of ourexecutive officers and other employees could terminate his or her relationshipwith us at any time. The loss of any member of our management team mightsignificantly delay or prevent the achievement of our business or developmentobjectives and could materially harm our business. In addition, because of thetechnical nature of our software products, services and hosted solutions andthe dynamic market in which we compete, any failure to attract and retainqualified direct sales, professional services and product developmentpersonnel, as well as our contract workers, could have a material adverseaffect on our ability to generate sales, successfully develop new softwareproducts, services and hosted solutions or software enhancements or deliverservices and solutions as requested by our customers.

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***We have incurred substantial losses in the past andmay not continue to be profitable in the future.***

We incurred significantlosses in each fiscal year from our inception in June 1997 through 2003,and we may incur significant operating losses in the future. As a result of ouroperating losses and accretion of preferred dividends, we had an accumulateddeficit of $101.1 million at June 30, 2005. You should not considerrecent revenue growth as indicative of our future performance as our operatingresults may fluctuate significantly from quarter to quarter. In addition, weexpect our development, sales and other operating expenses to increase in thefuture. If our revenue does not grow to offset these expected increasedexpenses, we may not continue to be profitable. In fact, in future quarters wemay not have any revenue growth and our revenue could decline. Furthermore, ifour operating expenses exceed our expectations, our financial performance willbe adversely affected.

***The global nature of our business exposes us tomultiple risks.***

For the quarterended June 30, 2005, approximately 48% of our revenues were derived frominternational operations. We expect that our international operations willcontinue to account for a significant portion of our revenues. As a result ofour international operations, we are exposed to many risks and uncertainties,including:

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

·                    tariff andinternational trade barriers;

·                    fewer legalprotections for intellectual property and contract rights abroad;

·                    different andchanging legal and regulatory requirements in the jurisdictions in which wecurrently operate or may operate in the future;

·                    governmentcurrency control and restrictions on repatriation of earnings;

·                    fluctuationsin foreign currency exchange and interest rates; and

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

Negative developments inany of these areas in one or more countries could result in a reduction indemand for our software products, services and hosted solutions, thecancellation or delay of orders already placed, threats to our intellectualproperty, difficulty in collecting receivables, and a higher cost of doingbusiness, any of which could adversely affect our business, results ofoperations or financial condition. Moreover, with regard to our internationaloperations, we frequently enter into transactions in currencies other than theU.S. dollar and we incur operating expenses in currencies other than the U.S.dollar. This creates a foreign currency exchange risk for us that could have amaterial adverse effect on our results of operations and financial condition.

***We may lose or delay revenues related to our hostedsolutions if our customers terminate or delay their contracts with us.***

Certain of our hostedelectronic data capture and other service and consulting contracts are subjectto cancellation by our customers at any time with limited notice. Entitiesengaged in clinical trials may terminate or delay a clinical trial for variousreasons including the failure of the tested product to satisfy safety orefficacy requirements, unexpected or undesired clinical results, decisions to de-emphasizea particular product or forego a particular clinical trial, decisions todownsize clinical development programs, insufficient patient enrollment orinvestigator recruitment and production problems resulting in shortages ofrequired clinical supplies. In the case of our hosted solutions, anytermination or delay in the clinical trials would likely result in aconsequential delay or termination in those customers’ service 

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contracts.We have experienced terminations and delays of our customer service contractsin the past and expect to experience additional terminations and delays in thefuture. Because we do not recognize any portion of a hosted service contract’srevenue until the implementation cycle is complete, the termination or delay ofour customers’ clinical trials could result in decreased or delayed revenuesunder these contracts which could materially harm our business.

***Failure to manage our rapid growth effectively couldharm our business.***

We recently experienced aperiod of rapid growth that placed a significant strain on our operational andfinancial resources and our personnel. From January 1, 1999 to March 31,2005, the number of our employees increased from 35 to approximately 361. Tomanage our anticipated future growth effectively, we must continue to maintainand may need to enhance our information technology infrastructure, financialand accounting systems and controls and manage expanded operations ingeographically distributed locations. We will also be required to attract, integrate,train and retain a significant number of qualified sales and marketingpersonnel, professional services personnel, software engineers and othermanagement personnel. Our failure to manage our rapid growth effectively couldhave a material adverse effect on our business, operating results or financialcondition.

***The loss of one or more major customers couldmaterially and adversely affect our results of operations and financialcondition.***

Our top five customersaccounted for approximately 34% and 38% of our revenues during the six months endedJune 30, 2004 and 2005, respectively. Two customers, Eli Lilly and Companyand GlaxoSmithKline, accounted for approximately 25% of our total revenues forthe six months ended June 30, 2005. The loss of any of our major customerscould have a material adverse effect on our results of operations or financialcondition. We may not be able to maintain our customer relationships, and ourcustomers may not renew their agreements with us, which could adversely affectour results of operations or financial condition. A significant change in theliquidity or financial position of any of these customers could also have amaterial adverse effect on the collectibility of our accounts receivables, ourliquidity and our future operating results.

***We could incur substantial costs resulting fromproduct liability claims relating to our products or services or our customers’use of our products or services.***

Any failure or errors in acustomer’s clinical trial or adverse event reporting obligations caused orallegedly caused by our products or services could result in a claim forsubstantial damages against us by our customers or the clinical trialparticipants, regardless of our responsibility for the failure. Although we areentitled to indemnification under our customer contracts against claims broughtagainst us by third parties arising out of our customers’ use of our products,we might find ourselves entangled in lawsuits against us that, even ifunsuccessful, divert our resources and energy and adversely affect ourbusiness. Further, in the event we seek indemnification from a customer, wecannot assure you that a court will enforce our indemnification right ifchallenged by the customer obligated to indemnify us or that the customer willbe able to fund any amounts for indemnification owed to us. We also cannotassure you that our existing general liability insurance coverage will continueto be available on reasonable terms or will be available in amounts sufficientto cover one or more large claims, or that the insurer will not disclaimcoverage as to any future claim.

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

The clinical trial processis subject to extensive and strict regulation by the FDA, as well as otherregulatory authorities worldwide. Our electronic data capture, management andadverse event reporting 

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productsand services could be subjected to state, federal and foreign regulations. Wecannot assure you that our products and service offerings will comply withapplicable regulations and regulatory guidelines as they develop. If ourproducts or services fail to comply with any applicable government regulationsor guidelines, we could incur significant liability or be forced to ceaseoffering our applicable products or services. Also, conforming our products andservices to any applicable regulations and guidelines could substantially increaseour operating expenses.

***Our business could be seriously harmed by ourdependence on a limited number of suppliers.***

We depend upon a limitednumber of suppliers for specific components of our software products and hostedsolutions. We may increase our dependence on certain suppliers as we continueto develop and enhance our software and service solutions. Our dependence on alimited number of suppliers leaves us vulnerable to having an inadequate supplyof required components, price increases, delayed supplier performance and poorcomponent quality. For instance, we rely on Oracle Corporation to supply thedatabase component of our software solutions and on Equinix, Inc. toprovide the server facilities for our hosting services. Oracle Corporation alsooffers a software package that is competitive with our products and services.If we are unable to obtain components for our software solutions fromthird-party suppliers in the quantities and of the quality that we need, on atimely basis or at acceptable prices, we may not be able to deliver oursoftware products, services and hosted solutions on a timely or cost-effectivebasis to our customers, and our business, results of operations and financialcondition could be seriously harmed. Moreover, delays or interruptions in ourservice may reduce our revenue, cause customers to terminate their contractsand adversely affect our customer renewals.

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

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

·                    hireadditional personnel;

·                    develop new orenhance existing software products, services and hosted solutions;

·                    enhance ouroperating infrastructure;

·                    acquirebusinesses or technologies; or

·                    otherwiserespond to competitive pressures.

If we raise additionalfunds through the issuance of equity or convertible debt securities, thepercentage ownership of our stockholders could be significantly diluted, andthese newly issued securities may have rights, preferences or privileges seniorto those of existing stockholders. We cannot assure you that additionalfinancing will be available on terms favorable to us, or at all. If adequatefunds are not available or are not available on acceptable terms, when wedesire them, our ability to fund our operations, take advantage ofunanticipated opportunities, develop or enhance our software products, servicesand hosted solutions, or otherwise respond to competitive pressures would besignificantly limited.

***In the course of conducting our business, we possessor could be deemed to possess personal medical information in connection withthe conduct of clinical trials, which if we fail to keep properly protected,could subject us to significant liability.***

Our software solutions areused to collect, manage and report information in connection with the conductof clinical trails. This information is or could be considered to be personalmedical information of 

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theclinical trial participants. Regulation of the use and disclosure of personalmedical information is complex and growing. Increased focus on individuals’rights to confidentiality of their personal information, including personalmedical information, could lead to an increase of existing and futurelegislative or regulatory initiatives giving direct legal remedies to individuals,including rights to damages, against entities deemed responsible for notadequately securing such personal information. In addition, courts may look toregulatory standards in identifying or applying a common law theory ofliability, whether or not that law affords a private right of action. Since wereceive and process personal information of clinical trial participants fromour customers, there is a risk that we could be liable if there were a breachof any obligation to a protected person under contract, standard of practice orregulatory requirement. If we fail to properly protect this personalinformation that is in our possession or deemed to be in our possession, wecould be subjected to significant liability.

**Risks Related to our Common Stock**

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

We only recentlycompleted our initial public offering. An active public market for our commonstock may not continue to develop or be sustained. Market prices for securitiesof software, technology and health care companies have been particularlyvolatile. The trading price of our common stock may fluctuate significantlyand, accordingly, may not be indicative of future trading prices and we may beunable to sustain or increase the value of an investment in our common stock.Some of the factors that may cause the market price of our common stock tofluctuate include:

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

·                    changes inmarket valuations of similar companies;

·                    changes inestimates of our financial results or recommendations by securities analysts;

·                    financialresults that are below estimate of such results;

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

·                    sales ortransfers of large blocks of stock by existing investors;

·                    the failure ofany of our software products, services and hosted solutions to achieve ormaintain commercial success;

·                    success ofcompetitive products and technologies;

·                    litigationinvolving our company or our general industry or both;

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

·                    regulatorydevelopments in the United States and foreign countries;

·                    additions ordepartures of key personnel;

·                    investors’general perception of us; and

·                    changes ingeneral economic, industry and market conditions.

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In addition, if the marketfor software, technology or health care stocks or the stock market in generalexperiences a loss of investor confidence, the trading price of our commonstock could decline for reasons unrelated to our business, operating results orfinancial condition. If any of the foregoing occurs, it could cause our stockprice to fall and may expose us to class action lawsuits that, even ifunsuccessful, could be costly to defend and a distraction to management.

***Ownership of our common stock is concentrated among asmall number of stockholders and sales of a large block of which could causethe market price of our common stock to drop significantly, even if ourbusiness is doing well.***

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

***Our directors and management exercise significantcontrol over our company.***

At June 30, 2005, ourdirectors and executive officers and their affiliates beneficially controlapproximately 32% of our outstanding common stock. As a result, thesestockholders, if they act together, are able to influence our management andaffairs and all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions. Thisconcentration of ownership may have the effect of delaying or preventing achange in control of our company and might affect the market price of ourcommon stock.

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

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

·                    limitations onthe removal of directors;

·                    advance noticerequirements for stockholder proposals and nominations;

·                    the inabilityof stockholders to act by written consent or to call special meetings; and

·                    the ability ofour board of directors to designate the terms of and issue new series ofpreferred stock without stockholder approval, which could be used to institutea rights plan, or a poison pill, that would work to dilute the stock ownershipof a potential hostile acquirer, likely preventing acquisitions that have notbeen approved by our board of directors.

The affirmative vote of the holders of at least 75% ofour shares of capital stock entitled to vote is necessary to amend or repealthe above provisions of our certificate of incorporation. In addition, absentapproval of our board of directors, our bylaws may only be amended or repealedby the affirmative vote of the holders of at least 75% of our shares of capitalstock entitled to vote.

In addition, Section 203 of the Delaware GeneralCorporation Law prohibits a publicly held Delaware corporation from engaging ina business combination with an interested stockholder, generally a person whichtogether with its affiliates owns, or within the last three years has owned,15% of our voting stock, 

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for a period of threeyears after the date of the transaction in which the person became aninterested stockholder, unless the business combination is approved in aprescribed manner.

The existence of theforegoing provisions could limit the price that investors might be willing topay in the future for shares of our common stock.

**Item 3.**                        Quantitativeand Qualitative Disclosures about Market Risk

*Foreign CurrencyExchange Risk*

Our results of operations and cash flows are subjectto fluctuations due to changes in foreign currency exchange rates, particularlychanges in the Euro, British pound sterling, Australian dollar and Japaneseyen. In the the six months ended June 30, 2004 and 2005, 40% and 48%,respectively, of our revenues were generated in locations outside the UnitedStates. The majority of these revenues are denominated in currencies other thanthe U.S. dollar, as are many of the associated expenses. Except for revenuetransactions in Japan, we enter into transactions directly with substantiallyall of our foreign customers. This creates a foreign currency exchange risk forus.

As of June 30, 2005,we had $4.9 million of receivables denominated in currencies other than theU.S. dollar. If the foreign exchange rates fluctuated by 10% as of June 30,2005, our foreign exchange exposure would have fluctuated by approximately$490,000. In addition, although our foreign subsidiaries have intercompanyaccounts that eliminate upon consolidation such accounts expose us to foreigncurrency rate movements. Exchange rate fluctuations on short-term intercompanyaccounts are recorded in our consolidated statements of operations under “otherincome (expense)”, while exchange rate fluctuations on long-term intercompanyaccounts are recorded in our consolidated balance sheets under “accumulatedother comprehensive loss” in stockholders’ equity. We also maintain cashaccounts denominated in currencies other than the local currency which exposeus to foreign exchange rate movements. We have implemented a risk managementprogram under which we measure foreign currency exchange risk monthly andmanage those exposures through the use of various internal controls and the useof forward foreign exchange contracts. This process is designed to minimizeforeign currency translation exposures that could otherwise affect consolidatedresults of operations. As of June 30, 2005 we hedged approximately$2.5 million of receivables, intercompany accounts and cash balancesdenominated in currencies other than the U.S. dollar.

*Interest RateSensitivity*

We had unrestricted cash, cash equivalents and shortterm investments totaling $65.3 million at June 30, 2005. 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 theshort-term nature of these investments, we believe that we do not have anymaterial exposure to changes in the fair value of our investment portfolio as aresult of changes in interest rates. Declines in interest rates, however, wouldreduce future investment income.

We have a working capitalline of credit which bears interest based upon the prime rate. At December 31,2004 and June 30, 2005 there were no amounts outstanding under our workingcapital line of credit.

**Item 4.**                        Controlsand Procedures

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourSecurities Exchange Act reports is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms, and thatsuch information is accumulated 

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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, 2005, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in enabling us to record, process,summarize and report information required to be included in our periodic SECfilings within the required time period.

There have been no changes in our internal controlover financial reporting that occurred during the period covered by this reportthat have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

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**Part II—Other Information**

**Item 5.**                        OtherInformation

Our policy governing transactions in our securities bydirectors, officers and employees permits our officers, directors and certainother persons to enter into trading plans complying with Rule 10b5-1 underthe Securities Exchange Act of 1934, as amended. We have been advised that ourVice President, General Counsel and Secretary, D. Ari Buchler, Vice Presidentof Worldwide Sales, Stephen J. Powell, Vice President of Development, Steven J.Rosenberg, and our Chairman and Chief Strategy Officer, Paul A. Bleicher haveeach entered into a trading plan in accordance with Rule 10b5-1 and ourpolicy governing transactions in our securities. We anticipate that, aspermitted by Rule 10b5-1 and our policy governing transactions in oursecurities, some or all of our officers, directors and employees may establishtrading plans in the future. We intend to disclose the names of executiveofficers and directors who establish a trading plan in compliance with Rule 10b5-1and the requirements of our policy governing transactions in our securities inour future quarterly and annual reports on Form 10-Q and 10-K filed withthe Securities and Exchange Commission. However, we undertake no obligation toupdate or revise the information provided herein, including for revision ortermination of an established trading plan, other than in such quarterly andannual reports.

In August of 2005, wemodified our loan agreement for our working capital line of credit with SiliconValley Bank. The working capital line of credit was amended to eliminate thesecurity interest in our assets and the negative pledge on our intellectualproperty. The amendment also removed or modified the financial covenants. Theloan modification agreement is being filed as Exhibit 10.2 with this QuarterlyReport on Form 10-Q.

**Item 6.**                        Exhibits.

**EXHIBIT INDEX**
| Exhibit  No. | ** ** | **Description**                                                                                                                                  |
|--------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1*        |       | Amended and Restated 2003 Non-Employee Director  Stock Option Plan, as amended.                                                                  |
| 10.2         |       | Termination Agreement and Sixth Loan Modification  Agreement to the Loan Agreement between the Registrant and Silicon Valley  Bank, as modified. |
| 10.3*        |       | Form of Non-Statutory Stock Option Agreement.                                                                                               |
| 31.1         |       | Certification of CEO pursuant to  Rule 13a-14(a) and 15d-14(s) under the Securities Exchange Act  of 1934.                        |
| 31.2         |       | Certification of CFO pursuant to  rules 13a-14(a) and 15d-14(s) 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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*                    Indicates amanagement contract or a compensatory plan, contract or arrangement.

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**Signatures**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly 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 10,  2005 |                            |

 

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**EXHIBIT INDEX**
| Exhibit  No. | ** ** | **Description**                                                                                                                                  |
|--------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1*        |       | Amended and Restated  2003 Non-Employee Director Stock Option Plan, as amended.                                                                  |
| 10.2         |       | Termination Agreement  and Sixth Loan Modification Agreement to the Loan Agreement between the Registrant  and Silicon Valley Bank, as modified. |
| 10.3*        |       | Form of  Non-Statutory Stock Option Agreement.                                                                                              |
| 31.1         |       | Certification of CEO  pursuant to Rule 13a-14(a) and 15d-14(s) under the Securities  Exchange Act of 1934.                        |
| 31.2         |       | Certification of CFO  pursuant to rules 13a-14(a) and 15d-14(s) 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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*Indicates a management contract or a compensatory plan, contract orarrangement.

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