**UNITED STATES**

**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

 

**For the quarterly period ended June 30, 2007**

 

**OR**

 

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

 

**For the transition period from                               to                               **

 

**CommissionFile Number: 000-50839**

**Phase Forward Incorporated**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                     |   | **04-3386549**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

| **880 Winter Street**                     |   | ** ** |
|-------------------------------------------|--------|------------|
| **Waltham,  Massachusetts**               |   | **02451**  |
| (Address of  principal executive offices) |   | (Zip Code) |

 

**(888) 703-1122**

(Registrant’s telephonenumber, including area code)

 

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

Yes   x   No   o

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

 

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

Yes   o   No   x

As of July 31, 2007, the registrant had 42,074,918shares of Common Stock outstanding.

 

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**PHASEFORWARD INCORPORATEDQUARTERLY REPORT ON FORM 10-QFor the quarterly period ended June 30, 2007Table of Contents**
|                                             | ** ** |                                                                                                                                          | **Page  Number** |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------------|
| **Part I—Financial  Information** |       |                                                                                                                                     |             |
| ** **                                  |       |                                                                                                                                     |             |
| Item 1.                                     |       | Condensed Consolidated Balance Sheets as of  December 31, 2006 (unaudited) and  June 30, 2007 (unaudited)                           |             | 3 |   |
|                                        |       |                                                                                                                                     |             |   |   |
|                                        |       | Condensed Consolidated Statements of Income for the  three and six months ended  June 30, 2006 (unaudited) and June 30, 2007 (unaudited) |             | 4 |   |
|                                        |       |                                                                                                                                     |             |   |   |
|                                        |       | Condensed Consolidated Statements of Cash Flows for  the six months ended  June 30, 2006 (unaudited) and June 30, 2007 (unaudited)       |             | 5 |   |
|                                        |       |                                                                                                                                     |             |   |   |
|                                        |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                        |             | 6 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Item 2.                                     |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                              |             | 19 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Item 3.                                     |       | Quantitative and Qualitative Disclosures about Market  Risk                                                                              |             | 35 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Item 4.                                     |       | Controls and Procedures                                                                                                                  |             | 35 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| **Part II—Other  Information**    |       |                                                                                                                                     |             |
| ** **                                  |       |                                                                                                                                     |             |
| Item  1.                                    |       | Legal  Proceedings                                                                                                                       |             | 36 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Item 1A.                                    |       | Risk Factors                                                                                                                             |             | 36 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Item 4                                      |       | Submission of Matters to a Vote of Security Holders                                                                                      |             | 37 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Item  5.                                    |       | Other  Information                                                                                                                       |             | 37 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Item 6.                                     |       | Exhibits                                                                                                                                 |             | 38 |   |
|                                        |       |                                                                                                                                     |             |   |   |
| Signatures                                  |       | 39                                                                                                                                       |             |
|                                        |       |                                                                                                                                     |             |
| Exhibit Index                          |       | 40                                                                                                                                       |             |

 

2

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**Part I—Financial Information**

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

**Phase Forward Incorporated****Condensed Consolidated Balance Sheets****(unaudited)****(in thousands, except per share amounts)**
| ** **                                                                                               | ** ** | **As of December 31,** | ** ** | **As of June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                               | ** ** | **2006**                              | ** ** | **2007**                          | ** ** |
| **Assets**                                                                                               | ** ** | ** **                            | ** ** | ** **                        | ** ** |
| Current assets:                                                                                          |       |                                  |       |                              |       |
| Cash and cash  equivalents                                                                               |       | $                                     | 42,169     |                              | $          | 145,468 |   |
| Short-term  investments                                                                                  |       | 27,466                                |       | 33,924                            |       |
| Accounts  receivable, net of allowance of $384 and $477 in 2006 and 2007, respectively                   |       | 29,652                                |       | 26,030                            |       |
| Deferred set up  costs, current portion                                                                  |       | 1,649                                 |       | 1,907                             |       |
| Prepaid  commissions and royalties, current portion                                                      |       | 3,570                                 |       | 4,157                             |       |
| Prepaid expenses  and other current assets                                                               |       | 2,972                                 |       | 3,576                             |       |
| Deferred income  taxes                                                                                   |       | 5,158                                 |       | 5,173                             |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total current assets                                                                                     |       | 112,636                               |       | 220,235                           |       |
|                                                                                                     |       |                                  |       |                              |       |
| Property and equipment,  net                                                                             |       | 8,561                                 |       | 11,945                            |       |
| Deferred set up costs,  net of current portion                                                           |       | 1,000                                 |       | 1,251                             |       |
| Prepaid commissions and  royalties, net of current portion                                               |       | 2,670                                 |       | 3,077                             |       |
| Intangible assets, net  of accumulated amortization of $1,176 and $1,611 in 2006 and 2007,  respectively |       | 2,724                                 |       | 2,289                             |       |
| Goodwill                                                                                                 |       | 27,820                                |       | 27,505                            |       |
| Deferred income taxes                                                                                    |       | 4,988                                 |       | 4,735                             |       |
| Other assets                                                                                             |       | 252                                   |       | 243                               |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total assets                                                                                             |       | $                                     | 160,651    |                              | $          | 271,280 |   |
|                                                                                                     |       |                                  |       |                              |       |
| **Liabilities and Stockholders’  Equity**                                                           | ** ** | ** **                            | ** ** | ** **                        | ** ** |
| Current liabilities:                                                                                     |       |                                  |       |                              |       |
| Accounts payable                                                                                         |       | $                                     | 2,893      |                              | $          | 3,260 |   |
| Accrued expenses                                                                                         |       | 14,183                                |       | 13,493                            |       |
| Accrued earn-out                                                                                         |       | 3,500                                 |       | 3,500                             |       |
| Deferred  revenues, current portion                                                                      |       | 47,128                                |       | 58,296                            |       |
| Deferred rent,  current portion                                                                          |       | 352                                   |       | 387                               |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total current  liabilities                                                                               |       | 68,056                                |       | 78,936                            |       |
|                                                                                                     |       |                                  |       |                              |       |
| Deferred revenues, net  of current portion                                                               |       | 3,527                                 |       | 3,179                             |       |
| Deferred rent, net of  current portion                                                                   |       | 596                                   |       | 262                               |       |
| Other long-term  liabilities                                                                             |       | 451                                   |       | 550                               |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total  liabilities                                                                                       |       | 72,630                                |       | 82,927                            |       |
|                                                                                                     |       |                                  |       |                              |       |
| Contingencies (Note 13)                                                                                  |       |                                  |       |                              |       |
|                                                                                                     |       |                                  |       |                              |       |
| Stockholders’ equity:                                                                               |       |                                  |       |                              |       |
| Preferred stock,  $0.01 par value:                                                                       |       |                                  |       |                              |       |
| Authorized—5,000  shares                                                                            |       |                                  |       |                              |       |
| Issued—0 shares                                                                                     |       | —                                |       | —                            |       |
| Common stock,  $0.01 par value:                                                                          |       |                                  |       |                              |       |
| Authorized—100,000  shares                                                                          |       |                                  |       |                              |       |
| Issued—35,529  and 42,050 shares in 2006 and 2007, respectively                                     |       | 355                                   |       | 421                               |       |
| Additional  paid-in capital                                                                              |       | 176,545                               |       | 268,756                           |       |
| Treasury stock,  37 shares at cost                                                                       |       | (111                                  | )          | (111                              | )          |
| Accumulated  other comprehensive (loss) income                                                           |       | (72                                   | )          | 174                               |       |
| Accumulated  deficit                                                                                     |       | (88,696                               | )          | (80,887                           | )          |
|                                                                                                     |       |                                  |       |                              |       |
| Total stockholders’  equity                                                                         |       | 88,021                                |       | 188,353                           |       |
|                                                                                                     |       |                                  |       |                              |       |
| Total liabilities and  stockholders’ equity                                                         |       | $                                     | 160,651    |                              | $          | 271,280 |   |

 

See accompanying notes.

3

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**PhaseForward Incorporated****CondensedConsolidated Statements of Income****(unaudited)****(in thousands,except per share amounts)**
| ** **                                                                           | ** ** | **Three Months Ended  June 30**, | ** ** | **Six Months Ended  June 30**, | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                                        | ** ** | **2007**                                      | ** ** | **2006** | ** ** | **2007** | ** ** |
| Revenues:                                                                            | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| License                                                                              |       | $                                               | 9,383      |                                          | $          | 11,469 |   | $ | 18,408 |   | $ | 22,505 |   |
| Service                                                                              |       | 15,339                                          |       | 20,065                                        |       | 29,930 |   | 39,113 |   |
| ** **                                                                           | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenues                                                                       |       | 24,722                                          |       | 31,534                                        |       | 48,338 |   | 61,618 |   |
| Costs of revenues:                                                                   |       |                                            |       |                                          |       |   |   |   |   |
| License                                                                              |       | 597                                             |       | 529                                           |       | 1,303 |   | 1,134 |   |
| Service(1)                                                                           |       | 9,007                                           |       | 12,359                                        |       | 17,902 |   | 23,886 |   |
| ** **                                                                           | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total cost of revenues                                                               |       | 9,604                                           |       | 12,888                                        |       | 19,205 |   | 25,020 |   |
| Gross margin:                                                                        |       |                                            |       |                                          |       |   |   |   |   |
| License                                                                              |       | 8,786                                           |       | 10,940                                        |       | 17,105 |   | 21,371 |   |
| Service                                                                              |       | 6,332                                           |       | 7,706                                         |       | 12,028 |   | 15,227 |   |
| ** **                                                                           | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total gross margin                                                                   |       | 15,118                                          |       | 18,646                                        |       | 29,133 |   | 36,598 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Operating expenses:                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Sales and  marketing(1)                                                              |       | 5,184                                           |       | 5,775                                         |       | 9,421 |   | 11,222 |   |
| Research and  development(1)                                                         |       | 3,860                                           |       | 4,922                                         |       | 7,484 |   | 9,554 |   |
| General and  administrative(1)                                                       |       | 4,448                                           |       | 4,787                                         |       | 8,587 |   | 9,425 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Total operating  expenses                                                            |       | 13,492                                          |       | 15,484                                        |       | 25,492 |   | 30,201 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Income from operations                                                               |       | 1,626                                           |       | 3,162                                         |       | 3,641 |   | 6,397 |   |
| Other income (expense):                                                              |       |                                            |       |                                          |       |   |   |   |   |
| Interest income                                                                      |       | 679                                             |       | 1,532                                         |       | 1,275 |   | 2,396 |   |
| Other, net                                                                           |       | —                                          |       | 4                                             |       | (64 | ) | (62 | ) |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Total other income                                                                   |       | 679                                             |       | 1,536                                         |       | 1,211 |   | 2,334 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Income before provision  for income taxes                                            |       | 2,305                                           |       | 4,698                                         |       | 4,852 |   | 8,731 |   |
| Provision for income  taxes                                                          |       | 417                                             |       | 370                                           |       | 878 |   | 922 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Net income                                                                           |       | $                                               | 1,888      |                                          | $          | 4,328 |   | $ | 3,974 |   | $ | 7,809 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Net income per share  applicable to common stockholders:                             | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                |       | $                                               | 0.06       |                                          | $          | 0.12 |   | $ | 0.12 |   | $ | 0.22 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Diluted                                                                              |       | $                                               | 0.05       |                                          | $          | 0.11 |   | $ | 0.11 |   | $ | 0.21 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average number  of common shares used in net income per share calculations: |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                                |       | 34,256                                          |       | 36,991                                        |       | 34,006 |   | 35,815 |   |
|                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Diluted                                                                              |       | 35,933                                          |       | 38,997                                        |       | 35,587 |   | 37,727 |   |

----

(1)             Amountsinclude stock-based compensation expense, as follows:
| Costs of service revenues  |   | $   | 49     |   | $      | 118 |   | $     | 93     |   | $ | 228 |   |
|----------------------------|--------|-----|--------|--------|--------|-----|--------|-------|--------|--------|---|-----|--------|
| Sales and marketing        |   | 98  |   | 203    |   | 208 |   | 369   |   |
| Research and development   |   | 67  |   | 179    |   | 127 |   | 335   |   |
| General and administrative |   | 345 |   | 665    |   | 587 |   | 1,265 |   |

 

See accompanying notes.

4

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**PhaseForward Incorporated****CondensedConsolidated Statements of Cash Flows****(unaudited)****(in thousands)**
| ** **                                                                         | ** ** | **Six Months Ended   June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                            | ** ** | **2007** | ** ** |
| **Operating  activities**                                                          | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                                   | 3,974      |   | $ | 7,809 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                      |       | 2,525                                               |       | 3,172 |   |
| Stock-based compensation                                                           |       | 1,015                                               |       | 2,197 |   |
| Loss on disposal of fixed assets                                                   |       | 12                                                  |       | — |   |
| Foreign currency exchange loss                                                     |       | 61                                                  |       | 62 |   |
| Provision for allowance for doubtful accounts                                      |       | 79                                                  |       | 100 |   |
| Deferred income taxes                                                              |       | (267                                                | )          | (2,592 | ) |
| Tax benefit related to exercise of stock options                                   |       | (724                                                | )          | — |   |
| Non-cash income tax expense                                                        |       | 912                                                 |       | 3,023 |   |
| Amortization of premiums or discounts on short-term  investments                   |       | (9                                                  | )          | 40 |   |
| Changes in assets and liabilities:                                                 |       |                                                |       |   |   |
| Accounts receivable                                                                |       | 6,978                                               |       | 3,641 |   |
| Deferred costs                                                                     |       | (872                                                | )          | (1,448 | ) |
| Prepaid expenses and other current assets                                          |       | 432                                                 |       | (561 | ) |
| Accounts payable                                                                   |       | 407                                                 |       | 349 |   |
| Accrued expenses                                                                   |       | (2,126                                              | )          | (629 | ) |
| Accrued litigation settlement                                                      |       | (8,500                                              | )          | — |   |
| Deferred revenues                                                                  |       | 1,776                                               |       | 11,043 |   |
| Deferred rent                                                                      |       | (375                                                | )          | (293 | ) |
|                                                                               |       |                                                |       |   |   |
| Net cash  provided by operating activities                                         |       | 5,298                                               |       | 25,913 |   |
|                                                                               |       |                                                |       |   |   |
| **Investing  activities**                                                          | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Proceeds from  maturities of short-term investments                                |       | 15,718                                              |       | 45,422 |   |
| Purchase of  short-term investments                                                |       | (29,249                                             | )          | (51,919 | ) |
| Purchase of  property and equipment                                                |       | (2,530                                              | )          | (6,105 | ) |
| Payment on  earn-out under acquisition                                             |       | (2,000                                              | )          | — |   |
| Increase in  other assets                                                          |       | (79                                                 | )          | — |   |
|                                                                               |       |                                                |       |   |   |
| Net cash used in  investing activities                                             |       | (18,140                                             | )          | (12,602 | ) |
|                                                                               |       |                                                |       |   |   |
| **Financing  activities**                                                          | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Proceeds from  issuance of common stock                                            |       | 1,675                                               |       | 90,078 |   |
| Tax benefit  related to exercise of options                                        |       | 724                                                 |       | — |   |
|                                                                               |       |                                                |       |   |   |
| Net cash  provided by financing activities                                         |       | 2,399                                               |       | 90,078 |   |
|                                                                               |       |                                                |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                      |       | 50                                                  |       | (90 | ) |
|                                                                               |       |                                                |       |   |   |
| Net change in  cash and cash equivalents                                           |       | (10,393                                             | )          | 103,299 |   |
| Cash and cash  equivalents at beginning of period                                  |       | 51,779                                              |       | 42,169 |   |
|                                                                               |       |                                                |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | 41,386                                              |       | 145,468 |   |
| Short-term  investments at end of period                                           |       | 22,347                                              |       | 33,924 |   |
| Total cash, cash  equivalents and short-term investments at end of period          |       | $                                                   | 63,733     |   | $ | 179,392 |   |

 

See accompanying notes.

5

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

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

Theaccompanying unaudited condensed consolidated financial statements includedherein have been prepared by Phase Forward Incorporated (the “Company”)pursuant to the rules and regulations of the Securities and ExchangeCommission (“SEC”). Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles in the United States have been condensed or omittedpursuant to such SEC rules and regulations. Management of the Companybelieves that the disclosures herein are adequate to make the information presentednot misleading. In the opinion of management, the unaudited condensedconsolidated financial statements have been prepared on the same basis as theaudited consolidated financial statements and reflect all material adjustments(consisting only of those of a normal and recurring nature) which are necessaryto present fairly the consolidated financial position of the Company as of June30, 2007, the results of its operations for the three and six months ended June30, 2006 and 2007 and its cash flows for the six months ended June 30, 2006 and2007. These unaudited condensed consolidated financial statements and notesthereto should be read in conjunction with the audited consolidated financialstatements and notes thereto included in the Company’s Annual Report onForm 10-K for the year ended December 31, 2006. The results of operationsfor the interim periods are not necessarily indicative of the results ofoperations to be expected for the year ending December 31, 2007.

Asof June 30, 2007, the Company’s significant accounting policies and estimates,which are detailed in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2006, have not changed except for the adoption ofFinancial Accounting Standards Board Interpretation (FASB) No. (FIN) 48, *Accounting for Uncertainty in Income Taxes*.  See Note 17 for additional informationregarding the Company’s adoption of FIN 48.

On May 29, 2007,the Company sold 5,500,000 shares of common stock at $15.00 per share in apublic offering, resulting in proceeds of $77,455 after deducting underwriters’discounts and offering related expenses. The Company also granted the underwriters an option for 30 days topurchase up to an additional 825,000 shares to cover over-allotments, if any,which was exercised in full on June 1, 2007, resulting in net proceeds of$11,694 after deducting underwriters’ discounts.

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

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

        Thecomponents of revenues are as follows:

|                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                        | ** ** | **2007**                                      | ** ** | **2006** | ** ** | **2007** | ** ** |
| License                       |       | $                                               | 9,383      |                                          | $          | 11,469 |   | $ | 18,408 |   | $ | 22,505 |   |
| Application hosting  services |       | 9,374                                           |       | 13,412                                        |       | 18,328 |   | 25,464 |   |
| Consulting services           |       | 2,617                                           |       | 3,098                                         |       | 5,356 |   | 6,524 |   |
| Customer support              |       | 3,348                                           |       | 3,555                                         |       | 6,246 |   | 7,125 |   |
|                          |       |                                            |       |                                          |       |   |   |   |   |
| Total                         |       | $                                               | 24,722     |                                          | $          | 31,534 |   | $ | 48,338 |   | $ | 61,618 |   |

 

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

Customersgenerally have the ability to terminate application hosting, consulting andtraining service agreements upon 30 days notice to the Company. License agreements,multiple element arrangements, including license and service agreements andcertain 

6

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application hostingservices can generally be terminated by either party for material breach ofobligations not corrected within 30 days after notice of the breach.

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

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

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

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

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

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

7

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

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

One customer,GlaxoSmithKline, accounted for approximately 16% of the Company’s totalrevenues in the three months ended June 30, 2006 and 2007, 17% and 16% of theCompany’s total revenues in the six months ended June 30, 2006 and 2007respectively. The same customer accounted for $2,638 and $1,646 or 9% and 6% ofaccounts receivable outstanding as of December 31, 2006 and June 30, 2007,respectively.

The Companydeferred $970 and $731 of set up costs and amortized $554 and $604 of set upcosts in the three months ended June 30, 2006 and 2007, respectively, anddeferred $1,601 and $1,673 of set up costs and amortized $1,028 and $1,164 ofset up costs in the six months ended June 30, 2006 and 2007, respectively.  The amortization of deferred set up costs isa component of cost of services.

        Deferred revenues represent amountsbilled or cash received in advance of revenue recognition.

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

        Inaccordance with EITF Issue No. 01-14, *IncomeStatement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred,* the Company included $254 and $178 of out ofpocket expenses in service revenues and cost of service revenues in the threemonths ended June 30, 2006 and 2007, respectively, and included $321 and $297of out-of-pocket expenses in service revenues and cost of service revenues inthe six months ended June 30, 2006 and 2007, respectively.

**3.   Prepaid SalesCommissions and Royalties**

        Forarrangements where revenues are recognized over the relevant contract period,the Company defers related commissions paid to its direct sales force andsoftware license royalties paid to third parties, and amortizes these expensesover the period in which the related revenues are recognized.

        Commission payments are nonrefundableunless amounts due from a customer are determined to be uncollectible or if thecustomer subsequently changes or terminates the level of service, in which casecommissions paid are recoverable by the Company. The Company deferred $1,193and $1,963 of commissions and amortized to sales and marketing expense $1,052and $1,390 in the three months ended June 30, 2006 and 2007, respectively, anddeferred $2,282 and $3,626 of commissions and amortized to sales and marketingexpense $1,961 and $2,905 in the six months ended June 30, 2006 and 2007,respectively.

        The Company’s royalty obligation isbased upon the license and customer support revenues earned for certainproducts in an arrangement. The Company has the right to recover the royaltiesin the event the arrangement is cancelled. The Company deferred $637 and $796of royalties and amortized to cost of revenues $700 and $579 in the threemonths ended June 30, 2006 and 2007, respectively, and deferred $1,631 and$1,540 of royalties and amortized to cost of revenues $1,524 and $1,267 in thesix months ended June 30, 2006 and 2007, respectively.

**4.   Warranties and Indemnification**

The Company’s softwarelicense arrangements and hosting services are typically warranted to perform ina manner consistent with general industry standards that are reasonablyapplicable and substantially in accordance with the Company’s product documentationunder normal use and circumstances. The Company’s arrangements also includecertain provisions for indemnifying customers against liabilities if itsproducts or services infringe a third party’s intellectual property rights. Seethe discussion of possible indemnification obligations in Note 13.

The Company has enteredinto service level agreements with some of its hosted application customerswarranting certain levels of uptime reliability or other service levels andpermits those customers to receive credits against monthly hosting fees orterminate their agreements in the event that the Company fails to meet thoselevels.

To date, the Company hasnot incurred any material costs as a result of such indemnifications and hasnot accrued any liabilities related to such obligations in the accompanyingconsolidated financial statements.

8

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

On August 25,2005, the Company acquired all of the outstanding capital stock of LincolnTechnologies, Inc. (“Lincoln”), a provider of products and services for drugsafety, clinical trial safety signal detection, and applied datastandards.  The acquired technology andproducts of Lincoln provide the Company with an expanded drug safety offeringand enhance the Company’s ability to offer innovative software and services inthe drug safety market.  The Company paida premium for Lincoln to enable it to expand its offerings in the drug safetymarket and to obtain a valuable workforce.

The aggregatepurchase price was $16,667.  Theacquisition agreement called for additional cash consideration to be paidsubject to achievement of certain financial targets in 2005 and 2006, of up to$2,000 and $4,000, respectively.  Thedefined 2005 financial targets were achieved and, accordingly, the Companyaccrued additional consideration of $2,000 in 2005 which was paid in May2006.  The acquisition agreement wasamended in September 2006 to amend the terms of the remaining contingentearn-out payment for which the security holders of Lincoln could be eligible in2007 under the acquisition agreement.  Pursuant to the amendment, theCompany agreed to pay the security holders of Lincoln an aggregate of $3,500 incash on December 26, 2007 in satisfaction of the Company’s remaining paymentobligations under the acquisition agreement. The $3,500 was accrued as of December 31, 2006. The acquisition ofLincoln was accounted for as a purchase under SFAS No. 141, *Business Combinations*. Accordingly, the results of Lincoln have been included in the auditedconsolidated financial statements since the date of acquisition.

**6.   Net Income Per Share**

Basic net incomeper common share for all periods presented was determined by dividing netincome applicable to common stockholders by the weighted average number ofcommon shares outstanding during the period. Weighted-average common shares outstanding exclude unvested restrictedcommon stock.  Diluted net income pershare includes the effects of all dilutive, potentially issuable common sharesusing the treasury stock method.

 The calculation of basic and diluted netincome per share is as follows:

|                                                                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                        | ** ** | **2007**                                      | ** ** | **2006** | ** ** | **2007** | ** ** |
| Numerator:                                                            |       |                                            |       |                                          |       |   |   |   |   |
| Net income                                                            |       | $                                               | 1,888      |                                          | $          | 4,328 |   | $ | 3,974 |   | $ | 7,809 |   |
|                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Denominator:                                                          |       |                                            |       |                                          |       |   |   |   |   |
| Weighted-average common  shares outstanding                           |       | 34,507,661                                      |       | 37,922,355                                    |       | 34,131,855 |   | 36,748,370 |   |
| Less weighted-average  unvested restricted common shares outstanding  |       | (251,267                                        | )          | (931,467                                      | )          | (125,633 | ) | (933,089 | ) |
| Basic weighted-average  common shares outstanding                     |       | 34,256,394                                      |       | 36,990,888                                    |       | 34,006,222 |   | 35,815,281 |   |
| Dilutive effect of  common stock options                              |       | 1,676,661                                       |       | 1,665,781                                     |       | 1,580,287 |   | 1,631,787 |   |
| Dilutive effect of  unvested restricted common stock awards and units |       | —                                          |       | 340,152                                       |       | — |   | 279,464 |   |
| Diluted  weighted-average common shares outstanding                   |       | 35,933,055                                      |       | 38,996,821                                    |       | 35,586,509 |   | 37,726,532 |   |
|                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Net income per share  applicable to common                            |       |                                            |       |                                          |       |   |   |   |   |
| stockholders:                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                 |       | $                                               | 0.06       |                                          | $          | 0.12 |   | $ | 0.12 |   | $ | 0.22 |   |
|                                                                  |       |                                            |       |                                          |       |   |   |   |   |
| Diluted                                                               |       | $                                               | 0.05       |                                          | $          | 0.11 |   | $ | 0.11 |   | $ | 0.21 |   |

 

In the threemonths ended June 30, 2006 and 2007, diluted weighted-average common sharesoutstanding do not include options outstanding to purchase 113,500 and 0 commonequivalent shares, respectively, as their effect would have been anti-dilutive.

In the six monthsended June 30, 2006 and 2007, diluted weighted-average common sharesoutstanding do not include options outstanding to purchase 390,587 and 2,652common equivalent shares, respectively, as their effect would have beenanti-dilutive.

**7.   Foreign Currency Translation**

        Thefinancial statements of the Company’s foreign subsidiaries are translated inaccordance with SFAS No. 52, *ForeignCurrency Translation.* The reporting currency for the Company is theU.S. dollar. The functional currency of the Company’s 

9

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subsidiaries in theUnited Kingdom, France, Belgium, Germany, Japan and Australia are the localcurrencies of those countries. Accordingly, the assets and liabilities of theCompany’s foreign subsidiaries are translated into U.S. dollars using theexchange rate in effect at each balance sheet date. Revenues and expenseaccounts are translated generally using an average rate of exchange in theperiod. Gains and losses arising from transactions denominated in foreigncurrencies are primarily related to intercompany accounts that have beendetermined to be temporary in nature and cash and accounts receivabledenominated in non-functional currencies. The Company has recorded immaterialforeign currency gains (losses) in the three months ended June 30, 2006 and2007, respectively, and ($61) and ($62) in the six months ended June 30, 2006and 2007, respectively.  Such gains(losses) are included in other income (expense) in the accompanying unaudited condensedconsolidated statements of income.

        Foreign currency translationadjustments are accumulated as a component of other comprehensive income as aseparate component of stockholders’ equity.

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

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

Cash, cashequivalents and short-term investments as of December 31, 2006 and June30, 2007 consist of the following:

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

 

|                                  | ** ** | ** **               | ** ** | **As of June 30, 2007** | ** ** |
|----------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| **Description**                  | ** ** | **Contracted  Maturity** | ** ** | **Amortized Cost**                     | ** ** | **Fair Market  Value** | ** ** |
| Cash                             |       | Demand                   |       | $                                           | 11,096     |   | $ | 11,096 |   |
| Money market funds               |       | Demand                   |       | 134,372                                     |       | 134,372 |   |
|                             |       |                     |       |                                        |       |   |   |
| Total cash and cash  equivalents |       |                     |       | $                                           | 145,468    |   | $ | 145,468 |   |
|                             |       |                     |       |                                        |       |   |   |
| Auction rate securities          |       | 27  years                |       | $                                           | 13,800     |   | $ | 13,800 |   |
| Certificate of deposit           |       | 150  days                |       | 4,650                                       |       | 4,649 |   |
| U.S. agency notes                |       | 332  days                |       | 2,724                                       |       | 2,722 |   |
| Corporate bonds                  |       | 311  days                |       | 12,750                                      |       | 12,743 |   |
|                             |       |                     |       |                                        |       |   |   |
| Total short-term investments     |       |                     |       | $                                           | 33,924     |   | $ | 33,914 |   |

 

The Company hashad no realized gains or losses from the sale of cash equivalents or short-terminvestments.  To date, the Company hasnot recorded any unrealized gains or losses in connection with its auction ratesecurities.

10

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

*Stock-Based Compensation Plans*

The Companycurrently has one plan under which it may grant stock-based compensation awardsto its directors, employees and non-employees. The Company has two additional plans under which there are awardsoutstanding, but under which no future awards may be made.

In 2004, the Boardof Directors and stockholders approved the Phase Forward Incorporated 2004Stock Option and Incentive Plan (the “2004 Plan”) which became effective uponthe closing of the Company’s initial public offering. The Company had reservedfor issuance an aggregate of 1,500,000 shares of common stock under the 2004Plan.  Under the 2004 Plan, the Board ofDirectors may grant stock options and other equity interests in the Company toemployees of the Company and non-employees. The exercise price of each optionis determined by the Board of Directors. Stock options may not be granted with an exercise price less than thefair market value of the stock on the date of grant, as defined by the Board ofDirectors.  Options granted under the2004 Plan generally vest over a four to seven year period and expire ten yearsfrom the grant date.  In February 2005,the Company granted options to certain employees to purchase a total of 419,000shares of common stock that vest upon the earlier of attainment of specifiedmilestones or 7 years from the date of grant. Of these February 2005 option grants, 165,750 options have since vesteddue to the achievement of milestones, 37,500 options were forfeited, and215,750 remain unvested.  Generally, theremainder of equity awards granted was service-based and vests over a period offour years from the date of grant.  OnMay 3, 2006, the Company’s stockholders approved an amendment to the 2004 Planto increase the number of shares available for issuance from 1,500,000 sharesto 3,500,000 shares.  In 2006, theCompany issued 1,113,175 unvested restricted stock awards and restricted stockunits.  A total of 400,000 unvestedrestricted stock awards were granted to the Company’s Chief Executive Officerand vest 25% in three years; 50% in four years and 100% in five years.  Generally, the balances of these unvestedrestricted stock options and units vest 50% in two years; 75% in three yearsand 100% in four years.

On May 2, 2007,the Company’s stockholders approved an amendment to the 2004 Plan to increasethe number of shares available for issuance under the plan by 481,505 shares,bringing total shares authorized for issuance under the 2004 Plan to 3,981,505.  The increase is equal to the number of sharesthat were available for issuance under the Company’s two other stock plans (thePhase Forward Incorporated 1997 Stock Option Plan and the Phase ForwardIncorporated 2003 Non-Employee Director Stock Option Plan) at the date of theamendment.  As part of that amendment,the Company decided that it will no longer issue any further shares under itstwo other plans.  As of June 30, 2007, theCompany had 1,301,406 shares available for grant under the 2004 Plan.

In 1997, theCompany adopted the Phase Forward Incorporated 1997 Stock Option Plan (the “1997Plan”).  On May 2, 2007, the Company’sstockholders approved an amendment to the 2004 Plan to increase the number ofshares available for issuance under the plan. As part of that amendment, the Company decided that it will no longerissue any further shares under the 1997 Plan. Prior to the May 2, 2007 amendment to the 2004 Plan, under the 1997Plan, the Board of Directors could grant incentive and nonqualified stockoptions to employees of the Company and non-employees. The exercise price ofeach option was determined by the Board of Directors.  Incentive stock options could not be grantedwith an exercise price less than the fair market value of the stock on the dateof grant, as defined by the Board of Directors. Options granted under the 1997Plan generally vest over four or five year periods and expire ten years fromthe grant date. In January and March 2004, the Company granted options tocertain employees to purchase a total of 205,000 shares of common stock thatvest upon the earlier of 7 years from date of grant or the attainment ofspecified milestones.  Options topurchase 178,750 shares have since either vested upon the attainment ofspecified milestones in accordance with the original provisions of the award orbeen modified to change the vesting provisions to a 4-year service period.Options to purchase 26,250 shares were accelerated in December 2004. There wasno incremental stock-based compensation in excess of the amounts that werepreviously recorded as deferred compensation. There were no shares availablefor future issuance under the 1997 Plan at June 30, 2007.

In 2003, the Boardof Directors and stockholders approved the Phase Forward Incorporated 2003Non-Employee Director Stock Option Plan (the “2003 NED Plan”).  On May 2, 2007, the Company’s stockholdersapproved an amendment to the 2004 Plan to increase the number of sharesavailable for issuance under the plan. As part of that amendment, the Company decided that it will no longerissue any further shares under the 2003 NED Plan.  The Company reserved for issuance anaggregate of 362,000 shares of common stock under the 2003 NED Plan.  Effective April 20, 2004, the 2003 NED Planwas amended to increase the number of shares the Company could grant under thisplan to 562,000 shares.  The 2003 NEDPlan provided solely for the automatic, one-time grant of a nonqualified stockoption to a non-employee director upon initial election to the Company’s Boardof Directors to purchase 100,000 shares of common stock.  On September 23, 2005, the 2003 NED Plan wasamended to reduce the one-time grant from 100,000 to 50,000 stock options.  The exercise price of the options could notbe less than 100% of the fair market value on the grant date.  Options vest fully on the fifth anniversaryof the date of grant, so long as the non-employee director has continuouslyserved on the Board of Directors through such vesting date.  If the non-employee director meets certain boardattendance criteria, options may vest earlier at a rate of one-sixteenth at theend of each fiscal quarter following the date of grant.  There were no shares available for futureissuance under the 2003 Plan at June 30, 2007.

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*Stock Option Activity*

A summary of stock optionactivity under the 1997 Plan, the 2004 Plan and the 2003 NED Plan as of June30, 2007, and changes in the six months ended June 30, 2007, is as follows:

|                                                    | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price  per Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (2)** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding as of  December 31, 2006               |       | 3,440,789                  |       | $                                                          | 4.84       |                                                             | 6.75       |                                     |       |   |
| Granted                                            |       | —                     |       | —                                                     |       |                                                             |       |                                     |       |
| Exercised                                          |       | (191,770                   | )          | 3.94                                                       |       |                                                             |       | $                                        | 2,472      |   |
| Canceled                                           |       | (14,855                    | )          | 7.57                                                       |       |                                                             |       |                                     |       |
|                                               |       |                       |       |                                                       |       |                                                             |       |                                     |       |
| Outstanding as of June  30, 2007                   |       | 3,234,164                  |       | $                                                          | 4.88       |                                                             | 6.30       |                                     | $          | 38,648 |   |
|                                               |       |                       |       |                                                       |       |                                                             |       |                                     |       |
| Exercisable as of June  30, 2007                   |       | 2,463,903                  |       | $                                                          | 4.24       |                                                             | 5.86       |                                     | $          | 31,021 |   |
|                                               |       |                       |       |                                                       |       |                                                             |       |                                     |       |
| Vested or expected to vest as of June  30, 2007(1) |       | 3,060,391                  |       | $                                                          | 4.77       |                                                             | 6.22       |                                     | $          | 36,908 |   |

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(1)             Thevested or expected to vest options at June 30, 2007 include both the vestedoptions and the number of options expected to vest calculated after applying anestimated forfeiture rate to the unvested options.

(2)             Theaggregate intrinsic value was calculated based on the positive differencebetween the estimated fair value per share of the Company’s common stock onJune 30, 2007 of $16.83 or the date of exercise, as appropriate, and theexercise price of the underlying options.

A summary of the statusof the Company’s unvested stock options and changes in the six months endedJune 30, 2007, is as follows:

|                                   | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price  per Share** | ** ** |
|-----------------------------------|------------|------------|------------|-------------------------------------------------------|------------|
| Unvested as of  December 31, 2006 |       | 1,017,842  |       | $                                                     | 6.75       |   |
| Granted                           |       | —     |       | —                                                |       |
| Vested                            |       | (232,726   | )          | 6.05                                                  |       |
| Forfeited                         |       | (14,855    | )          | 7.57                                                  |       |
| Unvested as of  June 30, 2007     |       | 770,261    |       | $                                                     | 6.95       |   |

 

The followingtable summarizes information regarding the Company’s stock options outstandingand exercisable as of June 30, 2007:
| **Options Outstanding**                     | ** ** | **Options Exercisable** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|
| Range of  Exercise Prices              | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted  Average  Exercise Price  per Share** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price  per Share** | ** ** |
| $ 0.10 – 0.60                          |       | 21,834                       |       | 0.90 |   | $ | 0.13 |   | 21,834 |   | $ | 0.13 |   |
|    0.61  – 1.20              |       | 16,850                       |       | 2.30 |   | 1.00 |   | 16,850 |   | 1.00 |   |
|    1.21  – 3.00              |       | 1,592,145                    |       | 5.17 |   | 3.00 |   | 1,573,824 |   | 3.00 |   |
|    3.01  – 4.80              |       | 149,993                      |       | 6.58 |   | 4.50 |   | 111,944 |   | 4.50 |   |
|    4.81  – 5.40              |       | 26,350                       |       | 2.74 |   | 5.00 |   | 26,350 |   | 5.00 |   |
|    5.41  – 6.00              |       | 50,535                       |       | 6.71 |   | 6.00 |   | 33,958 |   | 6.00 |   |
|    6.01  – 7.80              |       | 1,059,077                    |       | 7.61 |   | 6.74 |   | 538,788 |   | 6.80 |   |
|    7.81  – 9.00              |       | 217,380                      |       | 8.17 |   | 7.85 |   | 96,605 |   | 7.84 |   |
|      9.01  – 10.29 |       | 100,000                      |       | 8.40 |   | 10.29 |   | 43,750 |   | 10.29 |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |
|                                             |       | 3,234,164                    |       | 6.30 |   | $ | 4.88 |   | 2,463,903 |   | $ | 4.24 |   |

 

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* *

*Restricted Stock Awards and UnitActivity*

A summary of activity related to restricted commonstock awards and unit awards in the six months ended June 30, 2007, is asfollows:

|                                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value  per Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (2)** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|---------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding as of  December 31, 2006    |       | 1,081,925                  |       | $                                                             | 12.43      |                                                             | 3.75       |                                     | $          | 18,209 |   |
| Awarded                                 |       | 218,000                    |       | 13.31                                                         |       |                                                             |       |                                     |       |
| Exercised                               |       | —                     |       | —                                                        |       |                                                             |       |                                     |       |
| Canceled                                |       | (12,750                    | )          | 13.05                                                         |       |                                                             |       |                                     |       |
|                                    |       |                       |       |                                                          |       |                                                             |       |                                     |       |
| Outstanding as of June  30, 2007        |       | 1,287,175                  |       | $                                                             | 12.57      |                                                             | 3.32       |                                     | $          | 21,663 |   |
|                                    |       |                       |       |                                                          |       |                                                             |       |                                     |       |
| Expected to be free of restrictions (1) |       | 938,320                    |       | $                                                             | 12.57      |                                                             | 3.32       |                                     | $          | 15,792 |   |

----

(1)             Theexpected to be free of restrictions at June 30, 2007 was calculated by applyingan estimated forfeiture rate to the unvested shares.

(2)             Theaggregate intrinsic value is calculated based on the fair value per share ofthe Company’s common stock on June 30, 2007 of $16.83.

A summary of the statusof the Company’s unvested restricted stock awards and units and changes in thesix months ended June 30, 2007, is as follows:

|                                   | ** ** | **Shares** | ** ** | **Weighted Average  Grant Date  Fair Value  Per Share** | ** ** |
|-----------------------------------|------------|------------|------------|-----------------------------------------------------------------------------|------------|
| Unvested as of  December 31, 2006 |       | 1,081,925  |       | $                                                                           | 12.43      |   |
| Granted                           |       | 218,000    |       | 13.31                                                                       |       |
| Vested                            |       | —     |       | —                                                                      |       |
| Forfeited                         |       | (12,750    | )          | 13.05                                                                       |       |
| Unvested as of June 30,  2007     |       | 1,287,175  |       | $                                                                           | 12.57      |   |

 

*Employee Stock Purchase Plan*

In 2004, the Board of Directors and stockholdersapproved the Phase Forward Incorporated 2004 Employee Stock Purchase Plan (the “2004ESPP”). The Company has reserved for issuance under this plan an aggregate of320,000 shares of common stock.  The 2004ESPP allows eligible employees the opportunity to purchase shares of the Company’scommon stock through payroll deductions of up to 10% of a participant’s annualcompensation with a maximum of 5,000 shares available per participant duringeach payment period, subject to statutory limitations.  The first payment period began on September 2,2004 and ended on November 30, 2004. All subsequent payment periods consist of six-month periods commencingon December 1 and June 1 and ending on the last day of May andNovember.

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

*Stock-BasedCompensation Accounting Policy*

OnJanuary 1, 2006, the Company adopted the provisions of SFAS No. 123(R), *Share-based Payment*, which requires theCompany to recognize expense related to the fair value of stock-basedcompensation awards.  Management electedto use the modified prospective transition method as permitted by SFAS No.123(R) and therefore has not restated the Company’s financial results for priorperiods.  Stock-based compensationexpense in the three months ended March 31, 2006 and 2007 includes compensationexpense for all stock-based compensation awards granted on or after March 15,2004 (the filing date for the initial registration 

13

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statement for the Company’sinitial public offering), based on the grant-date fair value estimated inaccordance with the provisions of SFAS No. 123(R).

Stock optionsgranted prior to March 15, 2004, are minimum value options, pursuant toSFAS No. 123. Under the provisions of SFAS No. 123(R), the value ofthese options will not be recorded in the statement of operations subsequent tothe adoption of SFAS No. 123(R). Instead, the Company will continue toaccount for these options using Accounting Principles Board (APB) OpinionNo. 25, *Accounting for Stock Issued toEmployees*, and related Interpretations.

For service-basedoptions, accounted for under SFAS No. 123(R), the Company recognizescompensation expense on a straight-line basis over the requisite service periodof the award.  For performance-basedoptions, the Company recognizes expense on a straight-line basis over theestimated performance period. In addition, SFAS 123(R) requires thebenefits of tax deductions in excess of recognized share-based compensation tobe reported as a financing activity rather than an operating activity in thestatements of cash flows. This requirement reduces net operating cash flows andincreases net financing cash flows in periods after adoption.

Priorto the adoption of SFAS No. 123(R), the Company appliedSFAS No. 123, *Accounting for Stock-BasedCompensation*, amended by SFAS No. 148, *Accounting for Stock-based Compensation —Transition and Disclosure*, which allowed companies to apply theexisting accounting rules under APB Opinion No. 25. Pursuant toAPB Opinion No. 25, the Company accounted for its stock-based awards toemployees using the intrinsic-value method, under which compensation expensewas measured on the date of grant as the difference between the fair value ofthe Company’s common stock and the option exercise price multiplied by thenumber of options granted. Generally, the Company granted stock options withexercise prices equal to the estimated fair value of its common stock; however,to the extent that the fair value of the common stock exceeded the exerciseprice of stock options granted to employees on the date of grant, the Companyrecorded deferred compensation and amortized the expense over the vestingschedule of the options, generally four years. In accordance with APB Opinion No. 25, the Company recordeddeferred stock-based compensation resulting from the grant of employee stockoptions with an exercise price less than the fair value of common stock. As ofJune 30, 2007, the Company had $58 of deferred stock-based compensationremaining to be amortized which is expected to be amortized as follows: $53during the remainder of fiscal 2007 and $5 during fiscal 2008. Upon theadoption of SFAS No. 123(R) on January 1, 2006, the deferred stock-basedcompensation balance was netted against additional paid-in capital on theconsolidated balance sheet and statement of stockholders equity.

For optionsaccounted for under SFAS No. 123(R), the fair value of each option grantis estimated on the date of grant using the Black-Scholes pricing model. Nooptions were granted in the three and six months ended June 30, 2007 or in thethree months ended June 30, 2006.  In thesix months ended June 30, 2006, the weighted-average assumptions used to determinethe estimated fair value for grants were as follows:

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

For purposes of utilizing the Black-Scholes optionpricing model and because there was a limited trading history for its commonstock, the Company determined the expected life and the volatility for optionsbased on an analysis of reported data for a peer group of companies that haveissued stock options with substantially similar terms. The expected life ofoptions granted by the Company has been determined based on the averageexpected life of the options as reported by this peer group of companies duringa similar reporting period. The expected volatility of options granted has beendetermined using an average of the historical volatility measures of this peergroup of companies as well as the historical volatility of the Company’s commonstock beginning in January 2005. The risk-free interest rate is based on atreasury instrument whose term is consistent with the expected life of thestock options. The Company has not paid and does not anticipate paying cashdividends on its shares of common stock; therefore, the expected dividend yieldis assumed to be zero. In addition, while SFAS No. 123 permitted companies torecord forfeitures based on actual forfeitures, which was the Company’shistorical policy under SFAS No. 123, SFAS No. 123(R) requires companies toutilize an estimated forfeiture rate when calculating stock-based compensationexpense in the period.  As a result, theCompany has applied a forfeiture rate of 8%, derived from an analysis of itshistorical data, in determining the expense recorded in the Company’sconsolidated statements of income.

In the three months endedJune 30, 2006 and 2007, the Company recorded $559 and $1,165 of aggregatestock-based compensation expense, respectively, of which $476 and $1,132,respectively, was a result of the adoption of SFAS No. 123(R).  The remaining stock-based compensationexpense is due to the amortization of stock-based compensation associated withpreviously issued stock options which amounted to $83 and $33, in the threemonths ended June 30, 2006 and 2007, respectively. In the six months endedJune 30, 2006 and 2007, the Company recorded $1,015 and $2,197 of aggregatestock-based compensation expense, respectively, of which $804 and $2,119,respectively, was a result of the adoption of SFAS No. 123(R).  The remaining stock-based compensationexpense is due to the amortization of stock-based compensation associated withpreviously issued stock options which amounted to $211 and $78 in the sixmonths ended June 30, 2006 and 2007, respectively. As of June 30, 2007, therewas $12,507 of 

14

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unrecognizedstock-based compensation expense related to stock-based awards that is expectedto be recognized over a weighted average period of 3.18****years.

Stock-based compensation expense is allocated asfollows:

|                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|-----------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                        | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2007** | ** ** |
| Cost of service  revenues   |       | $                                               | 49         |                                                | $          | 118 |   | $ | 93 |   | $ | 228 |   |
| Sales and marketing         |       | 98                                              |       | 203                                                 |       | 208 |   | 369 |   |
| Research and  development   |       | 67                                              |       | 179                                                 |       | 127 |   | 335 |   |
| General and  administrative |       | 345                                             |       | 665                                                 |       | 587 |   | 1,265 |   |
|                        |       |                                            |       |                                                |       |   |   |   |   |
| Total                       |       | $                                               | 559        |                                                | $          | 1,165 |   | $ | 1,015 |   | $ | 2,197 |   |

 

**10.     Goodwilland Intangible Assets**

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

The goodwillresulting from acquisitions is reviewed for impairment on an annual basis inaccordance with SFAS No. 142,*Goodwill and Other Intangible Assets.*  Consistent with prior years, the Companyconducted its annual impairment test of goodwill in the fourth quarter of2006.  Based on the results of the firststep of the goodwill impairment test, the Company has determined that noimpairment of goodwill existed at December 31, 2006, as the carrying amount ofgoodwill of the reporting unit was less than its fair value and therefore, thesecond step of the goodwill impairment test was not necessary.

A rollforward ofthe net carrying amount of goodwill is as follows:

|                                                                          | ** ** | **Amount** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|
| Balance as of December 31, 2005                                          |       | $          | 24,960     |   |
| Increase associated with the acquisition of Lincoln                      |       | 3,067      |       |
| Release of valuation allowance related to acquired  net operating losses |       | (207       | )          |
| Balance as of December 31, 2006                                          |       | 27,820     |       |
| Release of valuation allowance related to acquired  net operating losses |       | (193       | )          |
| Decrease associated with the acquisition of Lincoln                      |       | (122       | )          |
| Balance as of June 30, 2007                                              |       | $          | 27,505     |   |

 

The utilization ofor release of the valuation allowance related to acquired net operating lossesreflects an actual or anticipated reduction in cash payments to local taxingauthorities for income taxes that are not reflected as a benefit in the incometax provision for financial statement purposes but rather as a reduction togoodwill.  In the year ended December 31,2006, the Company determined that it is more likely than not that the Companywill realize a portion of its deferred tax assets and therefore reduced thevaluation allowance by $5,620.  Thisbenefit of the release in valuation allowance was realized through reductionsto income tax expense of $5,413 and to goodwill of $207. In the six monthsended June 30, 2007, the Company determined that it is more likely than notthat the Company will realize a portion of its deferred tax assets andtherefore reduced the valuation allowance by $2,785.  This benefit of the release in valuationallowance was realized through reductions to income tax expense of $2,592 andto goodwill of $193.

15

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Intangible assets,all of which relate to the acquisition of Lincoln, consist of the following:
| ** **                         | ** ** | ** **                      | ** ** | **As of December 31, 2006** | ** ** | **As of June 30, 2007** | ** ** |
|------------------------------------|------------|---------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------|------------|
| **Description**                    | ** ** | **Estimated  Useful Life** | ** ** | **Gross  Carrying  Value**                      | ** ** | **Accumulated  Amortization**               | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed technology  and know-how |       | 5  years                        |       | $                                               | 1,800      |                                        | $          | 487 |   | $ | 1,800 |   | $ | 667 |   |
| Customer relationships             |       | 5  years                        |       | 1,600                                           |       | 432                                         |       | 1,600 |   | 592 |   |
| Non-compete agreements             |       | 2  years                        |       | 300                                             |       | 203                                         |       | 300 |   | 278 |   |
| Tradename                          |       | 5  years                        |       | 200                                             |       | 54                                          |       | 200 |   | 74 |   |
| Total                              |       |                            |       | $                                               | 3,900      |                                        | $          | 1,176 |   | $ | 3,900 |   | $ | 1,611 |   |

 

Amortizationexpense related to intangible assets in the three months ended June 30, 2006and 2007 was $217, and $435 in the six months ended June 30, 2006 and 2007.

The estimatedremaining amortization expense for each of the four succeeding years is asfollows:

| Year ended December 31, | ** ** | **Amount** | ** ** |
|----------------------------------------|------------|------------|------------|
| 2007 (1)                               |       | $          | 382        |   |
| 2008                                   |       | 720        |       |
| 2009                                   |       | 720        |       |
| 2010                                   |       | 467        |       |
| Total                                  |       | $          | 2,289      |   |

----

(1)             Thisamount reflects amortization expense that the Company anticipates recognizingfrom July 1, 2007 through December 31, 2007.

**11.     AccruedExpenses**

          Accrued expenses consist of the following:

|                                       | ** ** | **As of  December 31,** | ** ** | **As of  June 30,** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2006**                          | ** ** | **2007**                      | ** ** |
| Accrued payroll  and related benefits |       | $                                 | 8,338      |                          | $          | 7,035 |   |
| Accrued other  expenses               |       | 3,720                             |       | 4,163                         |       |
| Accrued  royalties                    |       | 1,553                             |       | 1,470                         |       |
| Accrued income  taxes                 |       | 572                               |       | 825                           |       |
|                                  |       |                              |       |                          |       |
| Total                                 |       | $                                 | 14,183     |                          | $          | 13,493 |   |

 

**12.     Debt**

Prior to August2005, all borrowings under the Company’s $5,000 working capital line of creditwere secured by substantially all assets of the Company.  Under a related negative pledge agreement,the Company was generally prohibited from pledging its intellectual property toothers, subject to certain exceptions.  In August 2005, the workingcapital line of credit was amended to eliminate the security interest in theCompany’s assets and the negative pledge on the Company’s intellectualproperty. The amendment also removed or modified the financial covenants. Effective March 31, 2006, the working capital line of credit was reduced from$5,000 to $2,000.  As of December 31, 2006 and June 30, 2007, therewere no amounts outstanding under the working capital line of credit.  At June 30, 2007, there was $1,500 availableunder the line of credit, and $500 reserved under a letter of credit associatedwith the Company’s leased facility.  AtJune 30, 2007, the Company was in compliance with all financial covenants.

**13.     Contingencies**

From time to timeand in the ordinary course of business, the Company is subject to variousclaims, charges and litigation. Intellectual property disputes often have arisk of injunctive relief which, if imposed against the Company, couldmaterially and adversely affect its financial condition, or results ofoperations. From time to time, third parties have asserted and may in thefuture assert intellectual property rights to technologies that are importantto the Company’s business and have demanded and may in the future demand thatthe Company license their technology. Although the outcome of litigation cannotbe predicted with certainty and some lawsuits, claims or proceedings may bedisposed of unfavorably to the Company, which could materially and adverselyaffect its financial condition or results of operations, the Company does notbelieve that it is currently a party to any material legal proceedings.

16

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Forexample, the Company entered into a Settlement Agreement and related LicenseAgreement with Dr. Mark L. Kozam d/b/a MLK Software and Datasci, LLC. TheSettlement Agreement relates to a lawsuit filed by Datasci in 2004 allegingthat certain of the Company’s products and services and certain products andservices of one of the Company’s customers, Quintiles, Inc., infringe aUnited States patent claimed to be owned by Datasci. Under the SettlementAgreement and related License Agreement, the Company agreed to make a one-time,lump-sum payment to Datasci in the amount of $8,500 to settle the claim andobtain a perpetual, irrevocable, fully paid worldwide, non-exclusive license tothe patent that was the subject of the claim by Datasci.  The confidential settlement, in which neitherparty admits liability, provides for mutual releases and dismissal of allactions between the parties. 

Pursuant to SFASNo. 142, *Goodwill and Other Intangible Assets,*theCompany reviewed the attributes of the license obtained and estimated that thelicense obtained had no value or useful life and that the license would notcontribute to the Company’s future cash flows, either directly orindirectly.  Inaddition, the Company does not anticipate changing any of its productsas a result of the license to this patent. As such, the settlement amount was recorded as a charge tooperations.  Sincethe contingency existed as of December 31, 2005 and the settlement wasconcluded prior to the issuance of the 2005 audited consolidated financialstatements, in accordance with SFAS No. 5, the Company recorded the impact ofthe settlement in 2005 as a charge to operations.  The settlement was paid in the first quarterof 2006.

**14.   Stockholders’ Equity**

Inthe six months ended June 30, 2007, the Company issued 191,770 shares of commonstock in connection with the exercise of stock options resulting in proceeds of$756, and 11,042 shares of common stock under the 2004 ESPP resulting inproceeds of $172.

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

**15.  Comprehensive Income**

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

Comprehensiveincome consists of the following:

|                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                        | ** ** | **2007**                                      | ** ** | **2006** | ** ** | **2007** | ** ** |
| Net income                         |       | $                                               | 1,888      |                                          | $          | 4,328 |   | $ | 3,974 |   | $ | 7,809 |   |
| Cumulative translation  adjustment |       | 306                                             |       | 114                                           |       | 431 |   | 246 |   |
| Comprehensive income               |       | $                                               | 2,194      |                                          | $          | 4,442 |   | $ | 4,405 |   | $ | 8,055 |   |

 

**16.   Forward Foreign Exchange Contracts**

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

The followingtable summarizes the outstanding forward foreign exchange contracts held by theCompany as of December 31, 2006 and June 30, 2007:

 

|               | ** ** | ** **          | ** ** | **As of December 31, 2006** | ** ** | **As of June 30, 2007**   | ** ** |
|---------------|------------|---------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **Currency**  | ** ** | **Hedge Type** | ** ** | **Local  Currency  Amount**                     | ** ** | **Approximate  U.S. Dollar  Equivalent** | ** ** | **Local  Currency  Amount** | ** ** | **Approximate  U.S. Dollar  Equivalent** | ** ** |
| British pound |       | Sale                |       | 6,000                                           |       | $                                             | 11,752     |   | 1,400 |   | $ | 2,809 |   |
| Euro          |       | Sale                |       | 2,000                                           |       | 2,639                                         |       | 1,000 |   | 1,352 |   |
| Japanese yen  |       | Sale                |       | 59,000                                          |       | 496                                           |       | 23,000 |   | 186 |   |
|          |       |                |       |                                            |       | $                                             | 14,887     |   |   |   | $ | 4,347 |   |

 

17

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

Due to the shortperiod of time between entering into the forward foreign exchange contracts andJune 30, 2007, the forward foreign exchange contracts rate approximates theexchange rate as of the end of the reporting period.

        Realizedand unrealized foreign currency gains (losses), net of hedging are accountedfor in non-operating income (expense). Foreign currency gains (losses), net ofhedging, were immaterial in the three months ended June 30, 2006 and 2007,respectively, and ($61) and ($62) in the six months ended June 30, 2006 and2007, respectively.   The Company settlesforward foreign exchange contacts in cash.

**17.**       Income Taxes

The Companyadopted the provisions of FIN 48, an interpretation of SFAS 109, *Accounting for Income Taxes*, on January 1, 2007.  As a result of the implementation of FIN 48,the Company recognized no material adjustment in the liability for unrecognizedincome tax benefits. At the adoption date of January 1, 2007, the Company had$499 of unrecognized tax benefits, all of which would affect the Company’seffective tax rate if recognized.  AtJune 30, 2007, the Company has $502 of unrecognized tax benefits.

The Companyrecognizes interest and penalties related to uncertain tax positions in theprovision for income taxes.  At theadoption date of January 1, 2007, the Company had $50 of accrued interestrelated to uncertain tax provisions.  Asof June 30, 2007, the Company had approximately $58 of accrued interest relatedto uncertain tax positions.

The tax years 2003through 2006 remain open to examination by federal and state tax jurisdictions.

**The Company has variousforeign subsidiaries for which tax years 2000 through 2006 remain open toexamination in certain foreign tax jurisdictions.**

The Company’sprovision for taxes includes foreign and alternative minimum tax.  The Company has utilized available U.S. netoperating losses to offset its primary federal obligations resulting in aneffective tax rate of 18% and 8% in the three months ended June 30, 2006 and2007, respectively and 18% and 11% in the six months ended June 30, 2006 and2007, respectively.  In the six monthsended June 30, 2007, the Company determined that it is more likely than notthat it will realize an additional portion of deferred tax assets and thereforereduced the valuation allowance by $2,785. This benefit of the release in valuation allowance was realized throughreductions to income tax expense of $2,592 and to goodwill of $193.  The Company currently expects to realizerecorded deferred tax assets as of June 30, 2007 of $9,908. The Company’sconclusion that such assets will be recovered is based upon its expectationthat future earnings of the Company will provide sufficient taxable income torealize recorded tax assets. While the realization of the Company’s netrecorded deferred tax assets cannot be assured, to the extent that futuretaxable income against which these tax assets may be applied is not sufficient,some or all of the Company’s net recorded deferred tax assets would not berealizable.

A reconciliationof the federal statutory rate to the Company’s effective tax rate is asfollows:

|                                   | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                        | ** ** | **2006**                         | ** ** | **2007**                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| Federal  statutory rate           |       | 34                               | %          | 34                             | %          | 34 | % | 34 | % |
| State tax                         |       | 3                                |       | 3                              |       | 3 |   | 3 |   |
| Alternative  minimum tax          |       | 1                                |       | 2                              |       | 1 |   | 2 |   |
| Stock-based  compensation expense |       | 12                               |       | 1                              |       | 9 |   | 1 |   |
| Other                             |       | —                           |       | —                         |       | 1 |   | 1 |   |
| Decrease in  valuation allowance  |       | (32                              | )          | (32                            | )          | (30 | ) | (30 | ) |
| Effective tax rate                |       | 18                               | %          | 8                              | %          | 18 | % | 11 | % |

 

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

InSeptember 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*, which defines fair value,establishes a framework for measuring fair value under generally acceptedaccounting principles, and expands disclosures about fair value measurements.SFAS No. 157 applies to other accounting pronouncements that require orpermit fair value measurements. The new guidance is effective for financialstatements issued for fiscal years beginning after November 15, 2007, andfor interim periods within those fiscal years. The Company is currentlyanalyzing the effect, if any, SFAS No. 157 will have on its consolidatedfinancial position and results of operations.

18

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InFebruary 2007, the FASB released SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities,*which is effective for fiscal yearsbeginning after November 15, 2007. This Statement permits entities to choose to measure many financialinstruments and certain other items at fair value. The objective is to improvefinancial reporting by providing entities with the opportunity to mitigatevolatility in reported earnings caused by measuring related assets andliabilities differently without having to apply complex hedge accountingprovisions. The Company is currently analyzing the effect, if any, SFAS No. 159will have on its consolidated financial position and results of operations.

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

**Overview**

Phase Forward Incorporated is a provider of integratedenterprise-level software products, services and hosted solutions for use inour customers’ global clinical trial data management and safety evaluation andmonitoring activities.

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

**Acquisitions**

From time to timewe have expanded our product and service offerings through the acquisition ofother businesses or technologies.  Themost significant of these transactions are the acquisitions of ClinsoftCorporation and Lincoln Technologies, Inc.

*LincolnTechnologies, Inc.*

On August 25,2005, we acquired all of the outstanding capital stock of LincolnTechnologies, Inc. (“Lincoln”), a provider of products and services fordrug safety, clinical trial safety signal detection, and applied datastandards.  Lincoln’s products consistedof *WebVDME, CTSD*and*WebSDM*. The aggregate purchase price was approximately $16.7 million.  The acquisition agreement called foradditional cash consideration to be paid subject to achievement of certainfinancial targets in 2005 and 2006, of up to $2.0 million and $4.0 million,respectively.  The defined 2005 financialtargets were achieved and, accordingly, we accrued additional consideration of$2.0 million in 2005 which was paid in May 2006.  The acquisition agreement was amended inSeptember 2006 to amend the terms of the remaining contingent earn-out paymentfor which the securityholders of Lincoln could be eligible in 2007 under theacquisition agreement.  Pursuant to theamendment, we agreed to pay the securityholders of Lincoln an aggregate of $3.5million in cash on December 26, 2007 in satisfaction of our remaining paymentobligations under the acquisition agreement. The $3.5 million was accrued as of September 30, 2006.  The acquisition of Lincoln was accounted foras a purchase under Statement of Financial Accounting Standards (SFAS) No. 141,*Business Combinations*.  Accordingly, the results of Lincoln have beenincluded in our consolidated financial statements since the date ofacquisition.

*ClinsoftCorporation*

On August 14,2001, we acquired Clinsoft Corporation (“Clinsoft”), a developer, marketer andprovider of clinical data management and adverse event reporting and trackingproducts and services. Clinsoft’s products consisted of *Clintrial*and *Clintrace*.  Theaggregate purchase price was approximately $44.1 million, which consistedof the issuance of 3.9 million shares of our Series D redeemableconvertible preferred stock, the assumption of liabilities and directacquisition costs. The acquisition of the Clinsoft business was accounted foras a purchase under SFAS No. 141. Accordingly, the results of Clinsofthave been included in our consolidated financial statements since the date ofacquisition.

** Litigation Settlement**

InFebruary 2006, we entered into a Settlement Agreement and related LicenseAgreement with Dr. Mark L. Kozam d/b/a MLK Software and Datasci, LLC. TheSettlement Agreement relates to a lawsuit filed by Datasci in 2004 allegingthat certain of our products and services and certain products and services ofone of our customers, Quintiles, Inc., infringe a United States patentclaimed to be owned by Datasci. Under the Settlement Agreement and relatedLicense Agreement, we agreed to make a one-time, lump-sum payment to Datasci inthe amount of $8.5 million to settle the claim and obtain a perpetual,irrevocable, fully paid worldwide, non-exclusive license to the patent that wasthe subject of the claim by Datasci.  Theconfidential settlement, in which neither party admits liability, provides formutual releases and dismissal of all actions between the parties.

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

**Sourcesof Revenues**

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

One customer,GlaxoSmithKline, accounted for approximately 16% of our total revenues in thethree months ended June 30, 2006 and 2007, and 17% and 16% of our totalrevenues in the six months ended June 30, 2006 and 2007 respectively.  The same customer accounted for $2.6 millionand $1.6 million or 9% and 6% of accounts receivable outstanding as of December31, 2006 and June 30, 2007, respectively. Our top 20 customers accounted for approximately 68% of our totalrevenues, net of reimburseable out-of-pocket expenses in the three months endedJune 30, 2006 and 2007, and 67% and 66% of our total revenues, net ofreimburseable out-of-pocket expenses in the six months ended June 30, 2006 and2007, respectively.

* License Revenues*

We derive our licenserevenues from the following products: *InForm*,our Internet-based electronic data capture, or EDC, solution; *Clintrial*, our clinical data managementsolution; and our drug safety solutions, including our *Clintrace*,*WebVDME*, *CTSD*,and *WebSDM* products. Although each of oursoftware solutions is available as a stand-alone enterprise application, weoffer integrated enterprise solutions incorporating certain of our electronicdata capture, data management and drug safety products.

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

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

*ServiceRevenues*

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

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

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

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

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

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

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

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

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

*ConsultingServices.*    Consulting services includethe design and documentation of the processes related to our customers’ use ofour products and services in their clinical trials. Consulting services alsoinclude project planning and management services, guidance on best practices inusing our software products, data management and configuration services fordata mining and reporting, as well as implementation services consisting ofapplication architecture design, systems integration, installation andvalidation.  Revenues from consultingservices included in either a multiple element software license agreement or inan application hosting agreement are recognized ratably over the term of thearrangement. The associated costs are expensed as incurred. Revenues from consultingservices that are not included in a multiple element software licensearrangement are recognized as services are performed. Fixed priced arrangementsare billed based upon contractual milestones, and time-and-materialsarrangements are billed monthly.

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

**Cost ofRevenues and Operating Expenses**

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

*Costof Revenues.*    Cost of license revenues consistsprimarily of the amortization of royalties paid for certain modules within our *Clintrial* software product as well as our *InForm* software product. In addition,costs of revenues include expense for the amortization of acquired technologiesassociated with the acquisition of Lincoln. The cost of license revenues varybased upon the mix of revenues from software licenses for our products. Weoperate our service organization on a global basis as one distinct unit, and donot segment costs for our various service revenue elements. These servicesinclude performing application hosting, consulting and customer supportservices. Costs for these services consist primarily of employee-related costsassociated with these services, amortization of the deferred clinical trial setup costs, allocated overhead, outside contractors, royalties associated withproviding customer support for use with the *Clintrial*and *InForm*software products andreimbursable out-of-pocket expenses. Cost of services also includes hostingcosts that primarily consist of hosting facility fees and server depreciation.

The cost ofservice revenues varies based upon the number of employees in the serviceorganization, the type of work performed, and royalties associated withrevenues derived from providing customer support, as well as costs associatedwith the flexible use of outside contractors to support internal resources. Wesupplement the trial design and set up activity for our *InForm*application hosting servicesthrough the use of outside contractors. This allows us to utilize outsidecontractors in those periods where trial design and set up activity is highestwhile reducing the use of outside contractors in those periods where trialactivity lessens, allowing for a more flexible delivery model. The percentageof the services workforce represented by outside contractors varies from periodto period 

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depending on the volumeof specific support required. The cost of services is significantly higher as apercentage of revenues as compared to our cost of license revenues primarilydue to the employee-related and outside contractor expenses associated withproviding services.

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

*Salesand Marketing.*    Sales and marketingexpenses consist primarily of employee-related expenses, including travel,marketing programs which include product marketing expenses such as tradeshows, workshops and seminars, corporate communications, other brand buildingand advertising, allocated overhead and the amortization of commissions. Inaddition, sales and marketing include expense for the amortization of acquiredtechnologies associated with the acquisition of Lincoln.  We expect that sales and marketing expenseswill continue to increase in absolute dollars as commission expense increaseswith our revenues and as we continue to expand sales coverage and to buildbrand awareness through what we believe are the most cost effective channelsavailable, but may fluctuate quarter over quarter due to the timing ofmarketing programs.

*Researchand Development.*    Research anddevelopment expenses consist primarily of employee-related expenses, allocatedoverhead and outside contractors. We focus our research and development effortson increasing the functionality, performance and integration of our softwareproducts. We expect that in the future, research and development expenses willincrease in absolute dollars as we continue to add features and functionalityto our products, introduce additional integrated software solutions to ourproduct suite and expand our product and service offering.

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

*Stock-BasedCompensation Expenses.*    Our cost ofservice revenues, sales and marketing, research and development, and generaland administrative expenses include stock-based compensation expense.  Stock-based compensation expense is the fairvalue of outstanding stock options and restricted stock awards which arerecognized over the respective stock option and award service periods.  It also includes amortization of the excessof the deemed fair market value over the exercise price of stock optionsgranted prior to when we became a public company.  In the years 2004, 2005 and 2006, we recorded$2.1 million, $607,000 and $3.0 million of aggregate stock-based compensationexpense, respectively.

**ForeignCurrency Translation**

       Withregard to our international operations, we frequently enter into transactionsin currencies other than the U.S. dollar. As a result, our revenues, expensesand cash flows are subject to fluctuations due to changes in foreign currencyexchange rates, particularly changes in the euro, British pound, Australiandollar and Japanese yen.  In the threemonths ended June 30, 2006 and 2007, approximately 50% and 53%, respectively,of our revenues were generated in locations outside the United States.  In the six months ended June 30, 2006 and2007, approximately 49% and 52%, respectively, of our revenues were generatedin locations outside the United States. The majority of these revenues are in currencies other than the U.S.dollar, as are many of the associated expenses. In periods when the U.S. dollardeclines in value as compared to the foreign currencies in which we conductbusiness, our foreign currency-based revenues and expenses generally increasein value when translated into U.S. dollars.

**CriticalAccounting Policies and Estimates**

Our unaudited condensedconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of thesefinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses in the reporting periods. On an ongoing basis,we evaluate our estimates and assumptions with our audit committee, includingthose related to revenue recognition, deferred set up costs, commissions androyalties, accounts receivable reserves, stock-based compensation expenses,long-lived assets, intangibles assets and goodwill, income taxes,restructuring, contingencies and litigation. We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying 

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values of assets andliabilities that are not readily apparent from other sources. There have beenno material changes to these estimates for the periods presented in thisQuarterly Report on Form 10-Q. Our actual results may differ from theseestimates under different assumptions or conditions.

We believe that of oursignificant accounting policies, which are described in Note 2 of thenotes to our consolidated financial statements included in our Annual Report onForm 10-K for the year ended December 31, 2006 and the Notes to our unauditedcondensed consolidated financial statements included in this Quarterly Reporton Form 10-Q, the following accounting policies involve a greater degree ofjudgment and complexity. Accordingly, these are the policies we believe are themost critical to aid in fully understanding and evaluating our consolidatedfinancial condition and results of operations.

*RevenueRecognition and Deferred Set Up Costs.*    Werecognize software license revenues in accordance with Statement of Position(SOP) No. 97-2, *Software RevenueRecognition,* as amended, issued by the American Institute ofCertified Public Accountants, while revenues resulting from applicationservices are recognized in accordance with Emerging Issues Task Force (“EITF”)Issue No. 00-3, *Application of AICPAStatement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware,* Securities andExchange Commission’s (SEC) Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition*and EITF Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables.*

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

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

We generally enterinto software term licenses for our *InForm*,*Clintrial* and *Clintrace* products with our customers for3 to 5 year periods. License agreements for our *WebVDME,CTSD*and*WebSDM*products are generally annual or multi-year terms.  These arrangements typically include multipleelements: software license, consulting services and customer support. We billour customers in accordance with the terms of the underlying contract.Generally, we bill license fees annually in advance for each year of thelicense term. Our payment terms are generally net 30 days.

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

We generally bundle customer support with thesoftware license for the entire term of the arrangement. As a result, wegenerally recognize revenues for all elements, including consulting services,ratably over the term of the software license and support arrangement. Weallocate the revenues recognized for these arrangements to the differentelements based on management’s estimate of the relative fair value of eachelement. For our term-based licenses, we allocate to consulting services theanticipated service effort and value throughout the term of the arrangement atan amount that would have been allocated had those services been soldseparately to the customer. The remaining value is allocated to license andsupport services, with 10% of this amount allocated to support services. Wehave allocated the estimated fair value to our multiple element arrangements toprovide meaningful disclosures about each of our revenue streams. The costsassociated with the consulting and customer support services are expensed asincurred. There are instances in which we sell software licenses based on usagelevels. These software licenses can be based on estimated usage, in which casethe license fee charged to the customer is fixed based on this estimate. Whenthe fee is fixed, the revenues are generally recognized ratably over thecontractual term of the arrangement. If the fee is based on actual usage, andtherefore variable, the revenues are recognized in the period of use. Revenuesfrom certain follow-on consulting services, which are sold separately tocustomers with existing software licenses and are not considered part of amultiple element arrangement, are recognized as the services are performed.

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

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

Revenues resultingfrom *InForm*application hosting servicesconsists of three stages for each clinical trial: the first stage involvesapplication set up, including design of electronic case report forms and editchecks, implementation of the system and server configuration; the second stageinvolves application hosting and related support services; and the third stageinvolves services required to close out, or lock, the database for the clinicaltrial. Services provided for the first and third stages are provided on a fixedfee basis based upon the complexity of the trial and system requirements.Services for the second stage are charged separately as a fixed monthly fee. Werecognize revenues from all stages of the *InForm*hosting service ratably over the hosting period. Fees charged andcosts incurred for the trial system design, set up and implementation aredeferred as applicable, until the start of the hosting period and thenamortized and recognized, as applicable, ratably over the estimated hostingperiod. The deferred costs include incremental direct costs with third partiesand certain internal direct costs related to the trial and application set up,as defined under SFAS No. 91, *Accountingfor Nonrefundable Fees and Costs Associated with Originating or Acquiring Loansand Indirect Costs of Leases*. These costs include salary andbenefits associated with direct labor costs incurred during trial set up, aswell as third-party subcontract fees and other contract labor costs. Workperformed outside the original scope of work is contracted for separately as anadditional fee and is generally recognized ratably over the remaining term ofthe hosting period. Fees for the first and third stages of the services arebilled based upon milestones. Fees for application hosting and related servicesin the second stage are billed quarterly in advance. Bundled into this revenueelement are the revenues attributable to the software license used by thecustomer.

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

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

       Wedeferred $970,000 and $731,000 of set up costs and amortized $554,000 and$604,000 in the three months ended June 30, 2006 and 2007, respectively, anddeferred $1.6 million and $1.7 million of set up costs and amortized $1.0million and $1.2 million in the six months ended June 30, 2006 and 2007,respectively.  The amortization ofdeferred set up costs is a component of cost of services.

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

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

*Accountingfor Prepaid Sales Commissions and Royalties.*    Forarrangements where we recognize revenues over the relevant contract period, wedefer related commission payments to our direct sales force and softwarelicense royalties paid to third parties and amortize these amounts over thesame period that the related revenues are recognized. This is done to bettermatch commission and royalty expenses with the related revenues.  We deferred $1.2 million and $2.0 million ofcommissions and amortized to sales and marketing expense $1.1 million and $1.4million of commissions in the three months ended June 30, 2006 and 2007,respectively, and deferred $2.3 million and $3.6 million of commissions andamortized to sales and marketing expense $2.0 million and $2.9 million ofcommissions in the six months ended June 30, 2006 and 2007, respectively.  Royalties are paid on a percentage of billingsbasis for certain of our products, and we have the right to recover royaltiesin the event an arrangement is cancelled. We deferred $637,000 and $796,000 of royalties and amortized to cost ofrevenues $700,000 and $579,000 of royalties in the three months ended June 30,2006 and 2007, respectively, and deferred $1.6 million and $1.5 million ofroyalties and amortized to cost of revenues $1.5 million and $1.3 million ofroyalties in the six months ended June 30, 2006 and 2007, respectively.

*AccountsReceivable Reserves.*    We maintainallowances for doubtful accounts for estimated losses resulting from theinability of our customers to make required payments. We regularly evaluate thecollectibility of our trade receivables based on a combination of factors,which may include dialogue with the customer to determine the cause ofnon-payment, the use of collection agencies, and/or the use of litigation. Inthe event it is determined that the customer may not be able to meet its fullobligation to us, we record a specific allowance to reduce the relatedreceivable to the amount that we expect to recover given all informationavailable to us. We continuously monitor collections from our customers andmaintain a provision for estimated credit losses based upon our historicalexperience and any specific customer collection issues that we have identified.While such credit losses have historically been within our expectations and theprovisions established, we cannot guarantee that we will continue to experiencethe same credit loss rates in the future. If the financial condition of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required. Our accounts receivablereserves were $384,000 and $477,000 as of December 31, 2006 and 

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June 30, 2007,respectively.

*Accountingfor Income Taxes.*    In connection withpreparing our financial statements, we are required to compute income taxexpense in each jurisdiction in which we operate. This process requires that weproject our current tax liability and estimate our deferred tax assets andliabilities, including net operating loss and tax credit carryforwards. Inassessing the need for a valuation allowance, we have considered our recentoperating results, future taxable income projections and all prudent andfeasible tax planning strategies. Based upon these projections, if it isdetermined that it is more likely than not that we would realize a portion ofour deferred tax assets, we would recognize the benefit, through the release ofthe portion of the deferred tax asset valuation allowance, that we arereasonably confident will be utilized.In 2005, we determined that it was more likely than not that we would realize aportion of our deferred tax assets and therefore reduced the valuationallowance by $7.8 million in December 2005. This benefit of the release invaluation allowance was realized through reductions to income tax expense of$4.5 million and to goodwill of $3.2 million for the realization ofacquired net operating loss carryforwards in the Clinsoft acquisition. In 2006,we determined that it was more likely than not that we would realize anadditional portion of our deferred tax assets and therefore reduced thevaluation allowance by $5.6 million. This benefit of the release invaluation allowance was realized through reductions to income tax expense of$5.4 million and to goodwill of $207,000. Also in 2006, we utilized $3.2 millionof our deferred tax assets to offset 2006 taxable income. In the six monthsended June 30, 2007, we determined that it is more likely than not that wewill realize an additional portion of deferred tax assets and therefore reducedthe valuation allowance by $2.8 million. This benefit of the release invaluation allowance was realized through reductions to income tax expense of$2.6 million and to goodwill of $192,000.

If our currentassumptions underlying the future taxable income projections and tax planningstrategies do not turn out to be substantially accurate, the realization of ourremaining deferred tax assets which are currently subject to a full valuationallowance could be accelerated, which would result in a reduction to income taxexpense in the period when realization of this deferred tax asset is morelikely than not to occur. However, this will be highly dependent upon ouryear-end projection of future income streams. After full realization of thesebenefits, we would expect our reported tax rate to revert to a more normal taxrate, in the range of 35% to 39%.

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

Priorto the adoption of SFAS No. 123(R), we applied SFAS No. 123,amended by SFAS No. 148, *Accountingfor Stock-based Compensation — Transition and Disclosure*, whichallowed companies to apply the existing accounting rules under APB OpinionNo. 25. Pursuant to APB Opinion No. 25, we accounted for our stock-basedawards to employees using the intrinsic-value method, under which compensationexpense was measured on the date of grant as the difference between the fairvalue of our common stock and the option exercise price multiplied by the numberof options granted. Generally, we granted stock options with exercise pricesequal to the estimated fair value of our common stock; however, to the extentthat the fair value of the common stock exceeded the exercise price of stockoptions granted to employees on the date of grant, we recorded deferredcompensation and amortized the expense over the vesting schedule of theoptions, generally four years.  During2003 and 2004, in accordance with APB Opinion No. 25, we recorded deferredstock-based compensation resulting from the grant of employee stock optionswith an exercise price less than the fair value of common stock. As of June 30,2007, we had $58,000 of deferred stock-based compensation remaining to beamortized which we expect to be amortized as follows: $53,000 in the remainderof 2007 and $5,000 during 2008**.**

For all stockoptions granted prior to March 15, 2004, we used the minimum value method,pursuant to SFAS No. 123, *Accounting for Stock-BasedCompensation* for pro forma disclosure. Under the provisions ofSFAS No. 123(R), the value of these options will not be recorded in thestatement of operations subsequent to the date of our adoption of SFAS No.123(R). Instead, we will continue to account for these options using AccountingPrinciples Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related Interpretations.

For service-basedoptions, accounted for under SFAS No. 123(R), we recognize compensationexpense on a straight-line basis over the requisite service period of theaward.  For performance-based options, werecognize expense on a straight-line basis over the estimated performanceperiod. In addition, SFAS 123(R) requires the benefits of tax deductionsin excess of recognized share-based compensation to be reported as a financingactivity rather than an operating activity in the statements of cash flows.This requirement can have the effect of reducing our net operating cash flowsand increasing our net financing cash flows in certain periods.

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

In the three andsix months ended June 30, 2007, we recorded $1.2 million and $2.2 million ofaggregate stock-based compensation expense, of which $1.1 million and $2.1million were a result of the adoption of SFAS No. 123(R). The remainingstock-based compensation expense is due to the amortization of stock-basedcompensation associated with previously issued stock options which amounted to$33,000 and $78,000, in the three and six months ended June 30, 2007,respectively. In the three months ended June 30, 2007, stock-based compensationexpense included $118,000 in cost of revenues, $179,000 in research and 

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development, $203,000 in salesand marketing and $665,000 in general and administrative expense.  In the six months ended June 30, 2007,stock-based compensation expense included $228,000 in cost of revenues,$335,000 in research and development, $369,000 in sales and marketing and $1.3million in general and administrative expense. In the three months ended June 30, 2006 and 2007, stock-basedcompensation expense reduced basic and diluted earnings per share by $0.02 and$0.03, respectively. In the six months ended June 30, 2006 and 2007,stock-based compensation expense reduced diluted earnings per share by $0.03and $0.06, respectively.  As of June 30,2007, we had $12.5 million of unrecognized stock-based compensationexpense related to market-based share awards that we expect to recognize over aweighted average period of 3.18 years.

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

**Overviewof Results of Operations in the Three Months Ended June 30, 2006 and 2007**

Total revenuesincreased by 28% or $6.8 million in the three months ended June, 2007 comparedto the same period in 2006 due to an increase in service revenues of 31%.

Our gross marginincreased by 23% or $3.5 million in the three months ended June 30, 2007compared to the same period in 2006, primarily due to the increase in servicesrevenues.

Operating incomein the three months ended June 30, 2007 of $3.2 million increased 94% or $1.5million compared to the same period in 2006. The operating income in the three months ended June 30, 2006 and 2007also included $559,000 and $1.2 million of stock-based compensation expense,respectively.

The results in thethree months ended June 30, 2007 were impacted by foreign exchange ratefluctuations, resulting in an approximately 3% increase in both revenues andexpenses in the period.

Asof June 30, 2007, we had $179.4 million of cash, cash equivalents andshort-term investments, an increase of $109.8 million from$69.6 million at December 31, 2006. On May 29, 2007, we sold 5,500,000 shares of common stock at $15.00 pershare in a public offering resulting in proceeds of $77.5 million afterdeducting underwriters’ discounts and offering related expenses. We alsogranted the underwriters an option for 30 days to purchase up to an additional825,000 shares to cover over-allotments, if any, which was exercised in full onJune 1, 2007, resulting in net proceeds of $11.7 million after deductingunderwriters’ discounts.  As of June 30,2007, we had no outstanding debt.

*Revenues*
| ** **                    | ** ** | **Three Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                    | ** ** | **2006**                                            | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                          | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                             | ** ** |
| License                       |       | $                                                   | 9,383      |                             | 38         | %          | $          | 11,469 |   | 36 | % | $ | 2,086 |   | 22 | % |
| Application hosting  services |       | 9,374                                               |       | 38                               |       | 13,412     |       | 43 |   | 4,038 |   | 43 |   |
| Consulting services           |       | 2,617                                               |       | 10                               |       | 3,098      |       | 10 |   | 481 |   | 18 |   |
| Customer support              |       | 3,348                                               |       | 14                               |       | 3,555      |       | 11 |   | 207 |   | 6 |   |
| Total                         |       | $                                                   | 24,722     |                             | 100        | %          | $          | 31,534 |   | 100 | % | $ | 6,812 |   | 28 | % |

 

Total revenuesincreased in the three months ended June 30, 2007 as compared to the sameperiod in 2006, primarily due to increases in application hosting and licenserevenues.  The increase in revenuesassociated with our application hosting services in the three months ended June30, 2007 was due to an increase in trials under management, which include bothapplication hosting services trials as well as trials hosted for our *InForm* license customers. The increase in license revenues was primarily the result of additional *InForm*revenue from new and existing customers and, to alesser extent, growth in sales relating to our safety products.  The increase in consulting revenues wasprimarily attributable to additional *InForm* revenueswhich were related to both new and existing customers.  The increase in customer support revenues inthe three months ended June 30, 2007 was due primarily to increases in *InForm*training and customer support revenues.  Our revenues were not significantly impactedby price increases or decreases. Inflation had only a nominal impact on our revenues.

26

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| ** **                          | ** ** | **Three Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2006**                                            | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                          | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                             | ** ** |
| United States                       |       | $                                                   | 12,483     |                             | 50         | %          | $          | 14,765 |   | 47 | % | $ | 2,282 |   | 18 | % |
|                                |       |                                                |       |                             |       |       |       |   |   |   |   |   |   |
| United Kingdom                      |       | 7,940                                               |       | 32                               |       | 12,010     |       | 38 |   | 4,070 |   | 51 |   |
| France                              |       | 2,483                                               |       | 10                               |       | 2,857      |       | 9 |   | 374 |   | 15 |   |
| Asia Pacific                        |       | 1,816                                               |       | 8                                |       | 1,902      |       | 6 |   | 86 |   | 5 |   |
| International  subtotal             |       | 12,239                                              |       | 50                               |       | 16,769     |       | 53 |   | 4,530 |   | 37 |   |
| Total                               |       | $                                                   | 24,722     |                             | 100        | %          | $          | 31,534 |   | 100 | % | $ | 6,812 |   | 28 | % |

 

The increase inrevenues worldwide was due to the increase in application hosting services andlicense revenues associated with our *InForm*product. The increase in U.S. revenues is primarily related to an increase inapplication hosting services and *InForm*license**revenues and, to a lesser, extent additional businessrelationships relating to the *WebVDME*product and services, while the increase in international revenues is primarilythe result of additional application hosting services revenues from both newand existing customers as well as an increase in *InForm*licenserevenues.

*Cost ofRevenues*
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** | ** **                                | ** ** | ** ** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2006**                                            | ** ** | **2007**                                  | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                          | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                             | ** ** |
| License                         |       | $                                                   | 597        |                                      | 6          | %          | $          | 529 |   | 5 | % | $ | (68 | ) | (11 | )% |
| Services                        |       | 9,007                                               |       | 59                                        |       | 12,359     |       | 62 |   | 3,352 |   | 37 |   |
| Total                           |       | $                                                   | 9,604      |                                      | 39         | %          | $          | 12,888 |   | 41 | % | $ | 3,284 |   | 34 | % |

 

The cost oflicense revenues decreased in the three months ended June 30, 2007 primarilydue to a $113,000 decrease in cost of royalties associated with our *InForm*software product. The increase in cost of services in the three months ended June 30, 2007was due primarily to increases in employee-related and contractor expense of$1.2 million and $796,000, respectively, associated with a headcount increaseof 30 people and the delivery of increased services revenues.  We also had expense increases for computerrelated expenses of $360,000, which includes hardware and software supportagreements, computer accessories and equipment rentals for our trainingclasses.  We also had expense increasesin depreciation, facilities and telephone expense of $301,000, $216,000 and$96,000, respectively.  In addition,there were also increases in travel and stock-based compensation expense of$96,000 and $69,000, respectively. Further expense increases of $290,000 related to an increase in thenumber of arrangements in the hosting phase.

*GrossMargin*
| ** **            | ** ** | **Three Months Ended June 30,** | ** ** | ** **                                | ** ** | ** ** | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                            | ** ** | **2007**                                  | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                          | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                             | ** ** |
| License               |       | $                                                   | 8,786      |                                      | 94         | %          | $          | 10,940 |   | 95 | % | $ | 2,154 |   | 25 | % |
| Services              |       | 6,332                                               |       | 41                                        |       | 7,706      |       | 38 |   | 1,374 |   | 22 |   |
| Total                 |       | $                                                   | 15,118     |                                      | 61         | %          | $          | 18,646 |   | 59 | % | $ | 3,528 |   | 23 | % |

 

The license grossmargin percentage increased in the three months ended June 30, 2007 due to adecrease in royalty expense relating to our *InForm*software.  The services gross margin percentagedecreased in the three months ended June 30, 2007, as our expense increaseoutpaced our revenues growth.  Theoverall gross margin decreased in the three months ended June 30, 2007 due tothe decline in services gross margin.  Itis likely that gross margin, as a percentage of revenues will fluctuate quarterby quarter due to the timing and mix of license and service revenues, and thetype, amount and timing of service required in delivering certainprojects.  For example, when services areperformed on a time and material basis, the timing of expense and revenuerecognition is more closely aligned than when services are performed underbundled arrangements, where the revenues are recognized ratably over thelicense period, while the expenses are recognized as incurred.

27

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*Operating Expenses*
| ** **                  | ** ** | **Three Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                            | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                          | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                             | ** ** |
| Sales and marketing         |       | $                                                   | 5,184      |                             | 21         | %          | $          | 5,775 |   | 18 | % | $ | 591 |   | 11 | % |
| Research and  development   |       | 3,860                                               |       | 16                               |       | 4,922      |       | 16 |   | 1,062 |   | 28 |   |
| General and  administrative |       | 4,448                                               |       | 18                               |       | 4,787      |       | 15 |   | 339 |   | 8 |   |
| Total                       |       | $                                                   | 13,492     |                             | 55         | %          | $          | 15,484 |   | 49 | % | $ | 1,992 |   | 15 | % |

 

*Salesand Marketing.*    Sales and marketingexpenses increased in the three months ended June 30, 2007 primarily due to a $338,000increase in commission expense due to an increase in revenues.  We also had increases in stock-basedcompensation expense in the amount of $105,000. In addition, there was an increase in outside contractors and travel of$59,000 and $41,000, respectively.  Weexpect that our sales and marketing expense will continue to increase inabsolute dollars as commission expense increases with our revenues and as wecontinue to expand sales coverage and to build brand awareness through what webelieve are the most cost effective channels available, but may fluctuatequarter over quarter due to the timing of marketing programs.

*Researchand Development.*    Research anddevelopment expenses increased in the three months ended June 30, 2007primarily due to employee-related expenses of $467,000 related to a headcountincrease of 15 people.  We alsoexperienced additional expenses related to outside contractors and stock-basedcompensation of $268,000 and $112,000, respectively.  In addition, depreciation expense increased$107,000, facilities expense grew by $49,000 and computer related, whichincludes hardware and software support agreements and computer accessories,increased by $42,000. We expect that our research and development costs willcontinue to increase in absolute dollars as we continue to add features andfunctionality to our products and expand our product and service offerings.

*Generaland Administrative.*    General andadministrative expenses increased in the three months ended June 30, 2007primarily due to an increase in stock-based compensation expense of $320,000.In addition, employee-related expenses increased $201,000 related to aheadcount increase of 3 people.  We alsohad expense increases in computer related and taxes and fees of $81,000 and$52,000, respectively.  Furthermore,recruiting expense increased by $46,000 and depreciation expense grew by$41,000.  These expense increases werepartially offset by an overall decrease in professional fees of $331,000, whichincluded an elimination of expense related to an acquisition opportunity thatwas evaluated during the three months ended June 30, 2006 and was notpursued.  We also had expense savings inoutside contractors in the amount of $143,000. We expect that in the future our general and administrative expenseswill increase in absolute dollars as we add personnel and incur additionalcosts related to the growth of our business and operations.

*OperatingIncome*
| ** **       | ** ** | **Three Months Ended June 30,** | ** ** | ** **                       | ** ** |
|------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **       | ** ** | **2006**                                            | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Amount**                                          | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                             | ** ** |
| Operating income |       | $                                                   | 1,626      |                             | 7          | % | $ | 3,162 |   | 10 | % | $ | 1,536 |   | 94 | % |
|                  |            |                                                     |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

*OperatingIncome.*   The increase in operating income inthe three months ended June 30, 2007 was primarily due to an increase in grossmargin and the reduction in operating expenses as a percentage of revenues.

28

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*OtherIncome (Expense)*
| ** **              | ** ** | **Three Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **              | ** ** | **2006**                                            | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                          | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                             | ** ** |
| Other income (expense): |       |                                                |       |                             |       |       |       |   |   |   |   |   |   |
| Interest income         |       | $                                                   | 679        |                             | 3          | %          | $          | 1,532 |   | 5 | % | $ | 853 |   | 126 | % |
| Other, net              |       | —                                              |       | —                           |       | 4          |       | — |   | 4 |   | NM |   |
| Total other income      |       | $                                                   | 679        |                             | 3          | %          | $          | 1,536 |   | 5 | % | $ | 857 |   | 126 | % |

 

*Other Income (Expense).*    Theincrease in interest income in the three months ended June 30, 2007 wasprimarily due to an increase in cash and cash equivalents available forinvestment, short-term investments and, an to a lesser extent, an increase inthe yield on investment.

*Provision for Income Taxes*
| ** **                  | ** ** | **Three Months Ended June 30,** | ** ** | ** **                       | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2006**                                            | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                          | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                             | ** ** |
| Provision for income  taxes |       | $                                                   | 417        |                             | 2          | % | $ | 370 |   | 1 | % | $ | (47 | ) | (11 | )% |
|                             |            |                                                     |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

*Provisionfor Income Taxes.   * Our provision for taxes includesforeign and alternative minimum tax.  We have utilized available U.S. netoperating loss (NOL) carryforwards to offset our primary federal obligationsresulting in an effective tax rate of 18% and 8% in the three months ended June30, 2006 and 2007, respectively.  In the three months ended June 30,2007, we determined that it is more likely than not that we will realizeadditional amounts of our NOL carryforwards and therefore reduced the valuationallowance by $1.6 million.  This benefit of the release in valuationallowance was realized through reductions to income tax expense of $1.5 millionand to goodwill of $71,000. We currently expect to realize recorded deferredtax assets as of June 30, 2007 of approximately $9.9 million.

In assessing theneed for a valuation allowance, we have considered our recent operatingresults, future taxable income projections and all prudent and feasible taxplanning strategies. Based upon these projections, if it is determinedthat it is more likely than not that we would realize a portion of our deferredtax assets, we would recognize the benefit, through the release of the portionof the deferred tax asset valuation allowance, that we are reasonably confidentwill be utilized.

If our currentassumptions underlying the future taxable income projections and tax planningstrategies do not turn out to be substantially accurate, the realization of ourremaining deferred tax assets which are currently subject to a full valuationallowance could be accelerated, which would result in a reduction to income taxexpense in the period when realization of this deferred tax asset is morelikely than not to occur. However, this will be highly dependent upon ouryear-end projection of future income streams. After full realization of thesebenefits, we would expect our reported tax rate to revert to a more normal taxrate, in the range of 35% to 39%.

**Overviewof Results of Operations in the Six Months Ended June 30, 2006 and 2007**

Total revenuesincreased by 27% or $13.3 million in the six months ended June, 2007 comparedto the same period in 2006 due to an increase in service revenues of 31%.

Our gross marginincreased by 26% or $7.5 million in the six months ended June 30, 2007compared to the same period in 2006, primarily due to the increase in servicesrevenues.

Operating incomein the six months ended June 30, 2007 of $6.4 million increased 76% or $2.8million compared to the same period in 2006. The operating income in the six months ended June 30, 2006 and 2007 alsoincluded $1.0 million and $2.2 million of stock-based compensation expense,respectively.

The results in thesix months ended June 30, 2007 were impacted by foreign exchange ratefluctuations, resulting in an approximately 3% increase in both revenues andexpenses in the period.

29

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* *

*Revenues*
| ** **                    | ** ** | **Six Months Ended June 30,** | ** ** | ** **                       | ** ** |
|-------------------------------|------------|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                    | ** ** | **2006**                                          | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                        | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                           | ** ** |
| License                       |       | $                                                 | 18,408     |                             | 38         | % | $ | 22,505 |   | 37 | % | $ | 4,097 |   | 22 | % |
| Application hosting  services |       | 18,327                                            |       | 38                               |       | 25,464 |   | 41 |   | 7,137 |   | 39 |   |
| Consulting services           |       | 5,357                                             |       | 11                               |       | 6,524 |   | 11 |   | 1,167 |   | 22 |   |
| Customer support              |       | 6,246                                             |       | 13                               |       | 7,125 |   | 11 |   | 879 |   | 14 |   |
| Total                         |       | $                                                 | 48,338     |                             | 100        | % | $ | 61,618 |   | 100 | % | $ | 13,280 |   | 27 | % |

 

Totalrevenues increased in the six months ended June 30, 2007 as compared to thesame period in 2006, primarily due to increases in application hosting andlicense revenues.  The increase inrevenues associated with our application hosting services in the six monthsended June 30, 2007 was due to an increase in trials under management, whichinclude both application hosting services trials as well as trials hosted forour *InForm* license customers.  The increase in license revenues wasprimarily the result of additional *InForm*revenuesto both new and existing customers to a lesser extent growth in sales relatingto our safety products .  The increase inconsulting revenues was primarily attributable to additional *InForm* revenues which were related to both new and existingcustomers.  The increase in customersupport revenues in the three months ended June 30, 2007 was due primarily toincreases in *InForm*training and customersupport revenues.  Our revenues were notsignificantly impacted by price increases or decreases.  Inflation had only a nominal impact on ourrevenues.
| ** **                          | ** ** | **Six Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------------------|------------|---------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2006**                                          | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                        | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                           | ** ** |
| United States                       |       | $                                                 | 24,507     |                             | 51         | %          | $          | 29,713 |   | 48 | % | $ | 5,206 |   | 21 | % |
|                                |       |                                              |       |                             |       |       |       |   |   |   |   |   |   |
| United Kingdom                      |       | 15,460                                            |       | 32                               |       | 22,920     |       | 37 |   | 7,460 |   | 48 |   |
| France                              |       | 4,856                                             |       | 10                               |       | 5,375      |       | 9 |   | 519 |   | 11 |   |
| Asia Pacific                        |       | 3,515                                             |       | 7                                |       | 3,610      |       | 6 |   | 95 |   | 3 |   |
| International  subtotal             |       | 23,831                                            |       | 49                               |       | 31,905     |       | 52 |   | 8,074 |   | 34 |   |
| Total                               |       | $                                                 | 48,338     |                             | 100        | %          | $          | 61,618 |   | 100 | % | $ | 13,280 |   | 27 | % |

 

The increase inrevenues worldwide was due to the increase in application hosting services andlicense revenues associated with our *InForm*product. The increase in U.S. revenues is primarily related to an increase in *InForm*revenues across all of our categories, while theincrease in international revenues is primarily the result of additionalapplication hosting services revenues to both new and existing customers aswell as an increase in *InForm*licenserevenues.

*Costsof Revenues*
| ** **                      | ** ** | **Six Months Ended June 30,** | ** ** | ** **                                | ** ** | ** ** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2006**                                          | ** ** | **2007**                                  | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                        | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                           | ** ** |
| License                         |       | $                                                 | 1,303      |                                      | 7          | %          | $          | 1,134 |   | 5 | % | $ | (169 | ) | (13 | )% |
| Services                        |       | 17,902                                            |       | 60                                        |       | 23,886     |       | 61 |   | 5,984 |   | 33 |   |
| Total                           |       | $                                                 | 19,205     |                                      | 40         | %          | $          | 25,020 |   | 41 | % | $ | 5,815 |   | 30 | % |

 

The costs of license revenues decreased in the six monthsended June 30, 2007 primarily due to a $113,000 decrease in cost ofroyalties associated with our *InForm*softwareproduct. The increase in cost of services in the six months ended June 30, 2007was primarily due to increases in employee-related and contractor expenses of$2.5 million and $1.4 million, respectively, associated with deliveringincreased services revenues.  We also hadexpense increases for depreciation, facilities and computer related expenses of$368,000, $311,000 and $768,000, respectively. Computer related expenses include hardware and software supportagreements as well as computer accessories. In addition, there were also increases in travel and recruiting expenseof $205,000 and $193,000, respectively. Further expense increases included telephone and stock-basedcompensation of  $170,000 and $135,000,respectively.

30

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* *

*GrossMargin*
| ** **            | ** ** | **Six Months Ended June 30,** | ** ** | ** **                                | ** ** |
|-----------------------|------------|---------------------------------------------------|------------|-------------------------------------------|------------|
| ** **            | ** ** | **2006**                                          | ** ** | **2007**                                  | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                        | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                           | ** ** |
| License               |       | $                                                 | 17,105     |                                      | 93         | % | $ | 21,371 |   | 95 | % | $ | 4,266 |   | 25 | % |
| Services              |       | 12,028                                            |       | 40                                        |       | 15,227 |   | 39 |   | 3,199 |   | 27 |   |
| Total                 |       | $                                                 | 29,133     |                                      | 60         | % | $ | 36,598 |   | 59 | % | $ | 7,465 |   | 26 | % |

 

The license grossmargin percentage increased in the six months ended June 30, 2007 due to adecrease in royalty expense relating to our *InForm*software.  The services gross margin percentage decreasedslightly in the six months ended June 30, 2007, as our expense increaseoutpaced our revenues growth.  Theoverall gross margin decreased in the six months ended June 30, 2007 due to thedecline in services gross margin.

*Operating Expenses*
| ** **                  | ** ** | **Six Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                          | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                        | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                           | ** ** |
| Sales and marketing         |       | $                                                 | 9,421      |                             | 20         | %          | $          | 11,222 |   | 18 | % | $ | 1,801 |   | 19 | % |
| Research and  development   |       | 7,484                                             |       | 15                               |       | 9,554      |       | 16 |   | 2,070 |   | 28 |   |
| General and  administrative |       | 8,587                                             |       | 18                               |       | 9,425      |       | 15 |   | 838 |   | 10 |   |
| Total                       |       | $                                                 | 25,492     |                             | 53         | %          | $          | 30,201 |   | 49 | % | $ | 4,709 |   | 18 | % |

 

*Salesand Marketing.*    Salesand marketing expenses increased in the six months ended June 30, 2007primarily due to a $937,000 increase in commission expense due to both anincrease in revenues and an increase in the effective commission rate and a$149,000 increase in employee-related expenses related to a headcount increaseof two people.  We also experienced increasesin travel, stock-based compensation expense and outside contractor expense of$276,000, $161,000 and $77,000, respectively. In addition, there was an increase in telephone and facilities expenseof $58,000 and $51,000, respectively.

*Researchand Development.*    Research anddevelopment expenses increased in the six months ended June 30, 2007 primarilydue to employee-related expenses of $901,000 related to a headcount increase of15 people.  In addition, outsidecontractors, stock-based compensation and depreciation expense increased$542,000, $208,000 and $189,000 respectively. Further, there was an increase in facilities and telephone expense of$98,000 and $51,000, respectively.

*Generaland Administrative.*    General andadministrative expenses increased in the six months ended June 30, 2007primarily due to an increase in stock-based compensation expense of $678,000and employee-related expenses of $393,000 related to a headcount increase of 3people.  Further,computer related expenses, taxes and fees and depreciation expense increased$126,000, $83,000 and $88,000, respectively. Additionally, we experienced expense increases in employee development,telephone and facilities in the amount of $59,000, $42,000 and $42,000,respectively.  These expenseincreases were partially offset by a decrease in professional fees of $674,000which included an elimination of expense related to an acquisition opportunitythat was evaluated in the six months ended June 30, 2006, and was not pursuedand outside contractor expense of $122,000.

*OperatingIncome*
| ** **       | ** ** | **Six Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|------------------|------------|---------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **       | ** ** | **2006**                                          | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Amount**                                        | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                           | ** ** |
| Operating income |       | $                                                 | 3,641      |                             | 8          | %          | $          | 6,397 |   | 10 | % | $ | 2,756 |   | 76 | % |
|                  |            |                                                   |            |                                  |            |            |            |  |  |  |  |  |  |  |  |  |

 

*OperatingIncome.*   The increase in operating income inthe three months ended June 30, 2007 was primarily due to the reduction inoperating expenses as a percentage of revenues.

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* *

*OtherIncome (Expense)*
| ** **              | ** ** | **Six Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-------------------------|------------|---------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **              | ** ** | **2006**                                          | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                        | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                           | ** ** |
| Other income (expense): |       |                                              |       |                             |       |       |       |   |   |   |   |   |   |
| Interest income         |       | $                                                 | 1,275      |                             | 3          | %          | $          | 2,396 |   | 4 | % | $ | 1,121 |   | 88 | % |
| Other, net              |       | (64                                               | )          | —                           |       | (62        | )          | — |   | 2 |   | 3 |   |
| Total other income      |       | $                                                 | 1,211      |                             | 3          | %          | $          | 2,334 |   | 4 | % | $ | 1,123 |   | 93 | % |

 

*Other Income (Expense).*    Theincrease in interest income in the six months ended June 30, 2007 was primarilydue to an increase in cash and cash equivalents available for short-terminvestments.

*Provision for Income Taxes*
| ** **                  | ** ** | **Six Months Ended June 30,** | ** ** | ** **                       | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                          | ** ** | **2007**                         | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                        | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **Percentage  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                           | ** ** |
| Provision for income  taxes |       | $                                                 | 878        |                             | 2          | %          | $          | 922 |   | 2 | % | $ | 44 |   | 5 | % |
|                             |            |                                                   |            |                                  |            |            |            |  |  |  |  |  |  |  |  |  |

 

* Provisionfor Income Taxes.   *Our provision for taxes includesforeign and alternative minimum tax.  We have utilized available U.S. netoperating loss (NOL) carryforwards to offset our primary federal obligationsresulting in an effective tax rate of 18% and 11% in the six months ended June30, 2006 and 2007, respectively.  In the six months ended June 30, 2007,we determined that it is more likely than not that we will realize additionalamounts of our NOL carryforwards and therefore reduced the valuation allowanceby $2.8 million.  This benefit of the release in valuation allowance wasrealized through reductions to income tax expense of $2.6 million and togoodwill of $193,000.  We currently expect to realize recorded deferredtax assets as of June 30, 2007 of approximately $9.9 million.

In assessing theneed for a valuation allowance, we have considered our recent operatingresults, future taxable income projections and all prudent and feasible taxplanning strategies. Based upon these projections, if it is determined thatit is more likely than not that we would realize a portion of our deferred taxassets, we would recognize the benefit, through the release of the portion ofthe deferred tax asset valuation allowance, that we are reasonably confident will be utilized.

If our currentassumptions underlying the future taxable income projections and tax planningstrategies do not turn out to be substantially accurate, the realization of ourremaining deferred tax assets which are currently subject to a full valuationallowance could be accelerated, which would result in a reduction to income taxexpense in the period when realization of this deferred tax asset is morelikely than not to occur. However, this will be highly dependent upon ouryear-end projection of future income streams. After full realization of thesebenefits, we would expect our reported tax rate to revert to a more normal taxrate, in the range of 35% to 39%.

Liquidityand Capital Resources

Our principalsources of liquidity were cash, cash equivalents and short-term investmentstotaling $69.6 million and $179.4 million at December 31, 2006 andJune 30, 2007, respectively, and accounts receivable of $29.7 million and$26.0 million, respectively.

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

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

Net cash providedby operating activities was $25.9 million in the six months ended June 30,2007, which was greater than net income of $7.8 million. This differenceis primarily due to $3.2 million of non-cash depreciation andamortization, $2.2 million of stock-based compensation, $3.0 million ofnon-cash income tax expense, a decrease in accounts receivable of $3.6 million,an increase in deferred revenues of $11.0 million, partially offset by decreasesin deferred income tax of $2.6 million, increases in deferred costs of $1.4million and increases in prepaid expense and other current assets of $561,000.

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Net cash used byinvesting activities was $12.6 million in the six months ended June 30, 2007,which was primarily due to the purchase of short-term investments of$51.9 million and capital expenditures associated with the expansion ofour hosting facility of $6.1 million partially offset by$45.4 million of proceeds from maturities of short-term investments.

Netcash provided by financing activities was $90.1 million in the six months endedJune 30, 2007, consisting of net proceeds from the issuance of commonstock.  On May 29, 2007, we sold5,500,000 shares of common stock at $15.00 per share in a public offeringresulting in proceeds of $77.5 million after deducting underwriters’ discountsand offering related expenses. We also granted the underwriters an option for30 days to purchase up to an additional 825,000 shares to cover over-allotments,if any, which was exercised in full on June 1, 2007, resulting in net proceedsof $11.7 million after deducting underwriters’ discounts.  Proceeds of $756,000 were received from theexercise of stock options.

At December 31,2006 and June 30, 2007, we had a $500,000 outstanding letter of credit relatedto our facility.  The letter of creditreduces the amount available under our line of credit with a bank.

Substantially allof our long-lived assets at December 31, 2006 and June 30, 2007 arelocated in the United States and in the United Kingdom.

We generally donot enter into long-term binding purchase commitments.  Our principal commitments consist ofobligations under non-cancelable operating leases for office space.

The followingtable of our material contractual obligations as of December 31, 2006summarizes the aggregate effect that these obligations are expected to have onour cash flows in the periods indicated:

 
| ** **                       | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **1 year or less** | ** ** | **2-3 years** | ** ** | **4-5 years** | ** ** | **More  than 5  years** | ** ** |
| ** **                       | ** ** | **(in thousands)**                        | ** ** |
| Operating lease  obligations     |       | $                                         | 10,138     |   | $ | 3,474 |   | $ | 4,664 |   | $ | 1,659 |   | $ | 341 |   |
| Income tax liabilities           |       | 499                                       |       | 499 |   | — |   | — |   | — |   |
| Total                            |       | $                                         | 10,637     |   | $ | 3,973 |   | $ | 4,664 |   | $ | 1,659 |   | $ | 341 |   |

 

Prior to August2005, all borrowings under our $5.0 million working capital line of credit weresecured by substantially all our assets. Under a related negative pledge agreement we were generally prohibitedfrom pledging our intellectual property to others, subject to certainexceptions.  In August 2005, the working capital line of credit wasamended to eliminate the security interest in our assets and the negativepledge on our intellectual property.  Theamendment also removed or modified the financial covenants.  EffectiveMarch 31, 2006, the working capital line of credit was reduced from $5.0million to $2.0 million. As of December 31, 2006 and June 30, 2007, therewere no amounts outstanding under the working capital line of credit.  At June 30, 2007, there was $1.5 millionavailable under the line of credit and $500,000 reserved under a letter ofcredit associated with our leased facilities. At June 30, 2007, we were in compliance with all financial covenants.

AtDecember 31, 2006, we had $76.1 million of net operating loss carryforwardsthat may be used to offset future U.S. federal taxable income of whichapproximately $18.6 million of net operating loss were acquired in the Clinsoftacquisition. These attributes may reduce our future cash tax liability.  Approximately $51.1 million of these netoperating losses are subject to a full valuation allowance.  When realization of this deferred tax assetis more likely than not to occur, the benefit will result in a reduction ofincome tax expense of $13.1 million and a reduction to goodwill of $5.9million.   In addition, we hadapproximately $3.3 million of net operating losses resulting from excess taxdeductions related to stock-based compensation. We will realize the benefit of these losses through increases tostockholder’s equity in the periods in which the losses are utilized to reducetax payments.  In addition, we hadapproximately $6.2 million of federal research and development tax creditcarryforwards that may be used to offset future U.S. federal taxable income ofwhich approximately $2.8 million were acquired in the Clinsoft acquisition andhave an unlimited carryforward period. The net operating loss and tax credit carryforward period extendsthrough 2023 and 2026, respectively, and both are subject to review andpossible adjustment by the taxing authorities. Also, the Internal Revenue Code contains provisions that may limit thenet operating loss and tax credit carryforwards available in any given year inthe event of certain changes in the ownership interests of significantstockholders.  In addition, we also had$2.8 million of foreign net operating loss carryforwards that may be used tooffset future foreign taxable income. These foreign net operating loss carryforwards have an unlimitedcarryforward period.  We currently expectto realize recorded deferred tax assets as of June 30, 2007 of $9.9million.  Our conclusion that such assetswill be recovered is based upon our expectation that our future earnings willprovide sufficient taxable income to realize recorded tax assets.

We believe ourexisting cash, cash equivalents, short-term investments and cash provided byoperating activities and our debt facility will be sufficient to meet ourworking capital and capital expenditure needs over the next 12 months. Ourfuture capital 

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requirements will dependon many factors, including our rate of revenue growth, the expansion of ourmarketing and sales activities, the timing and extent of spending to supportproduct development efforts, the timing of introductions of new products andservices and enhancements to existing products and services and the continuingmarket acceptance of our products and services. To the extent that existing cash and securities and cash from operationsare insufficient to fund our future activities, we may need to raise additionalfunds through public or private equity or debt financing.  From time to time, we may also enter intoagreements with respect to potential investments in, or acquisitions of,businesses, services or technologies, which could also require us to seekadditional equity or debt financing.

**Recently Issued AccountingPronouncement**

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

In February 2007,the FASB released SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities,*which is effective for fiscal yearsbeginning after November 15, 2007. This Statement permits entities to choose to measure many financial instrumentsand certain other items at fair value. The objective is to improve financialreporting by providing entities with the opportunity to mitigate volatility inreported earnings caused by measuring related assets and liabilitiesdifferently without having to apply complex hedge accounting provisions. We arecurrently analyzing the effect, if any, SFAS No. 159 will have on ourconsolidated financial position and results of operations.

**Off-Balance Sheet Arrangements**

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

**SpecialNote Regarding Forward-Looking Statements**

In addition to historical consolidated financialinformation, this Quarterly Report on Form 10-Q containsforward-looking statements **withinthe meaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities and Exchange Act of 1934, as amended, andare intended to be covered by the “safe harbor” created by those sections. **All statements, otherthan statements of historical facts, included in this Quarterly Report on From10-Q regarding our strategy, future operations, future financial position,future net sales, projected costs, projected expenses, prospects and plans andobjectives of management are forward-looking statements. The words “anticipates,”“believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,”“would” and similar expressions are intended to identify forward-lookingstatements, although not all forward-looking statements contain these identifyingwords.

We may not actually achieve the plans, intentions orexpectations disclosed in our forward-looking statements and you should notplace undue reliance on our forward-looking statements. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. Although we believe that the expectations underlying any of ourforward-looking statements are reasonable, these expectations may prove to beincorrect, and all of these statements are subject to risks and uncertainties.We discuss many of the risks that we believe could cause actual results orevents to differ materially from these forward-looking statements in greaterdetail in the section entitled “Risk Factors” in **our Annual**Report on**Form10-K for the year ended December 31, 2006. **We urge you to considerthe risks and uncertainties described in Item 1A of our Annual**Reporton**Form 10-K for the year ended December31, 2006, as updated in this Quarterly Report on Form 10-Q,**in evaluating ourforward-looking statements.**Should one or more of theserisks and uncertainties materialize, or should underlying assumptions,projections or expectations prove incorrect, actual results, performance orfinancial condition may vary materially and adversely from those anticipated,estimated or expected. Our forward-looking statements do not reflect thepotential impact of any future acquisitions, mergers, dispositions, jointventures or investments we may make.

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

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

*Foreign CurrencyExchange Risk*

Our results ofoperations and cash flows are subject to fluctuations due to changes in foreigncurrency exchange rates, particularly changes in the euro, British pound,Australian dollar and Japanese yen. In the six months ended June 30, 2006 and2007, 49% and 52%, respectively, of our revenues were generated in locationsoutside the United States.  The majorityof these revenues are denominated in currencies other than the U.S. dollar, asare many of the associated expenses. Except for revenue transactions in Japan,we enter into transactions directly with substantially all of our foreigncustomers. This creates a foreign currency exchange risk for us.

As of June 30,2007, we had $7.6 million, of receivables denominated in currencies other thanthe U.S. dollar.  We also maintain cashaccounts denominated in currencies other than the local currency which exposeus to foreign exchange rate movements. 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, as they are considered partof our net investment and hence do not give rise to gains or losses.  We also maintain cash accounts denominated incurrencies other than the local currency which expose us to foreign exchangerate movements.

We haveimplemented a risk management program under which we measure foreign currencyexchange risk monthly and manage those exposures through the use of variousoperating strategies.  As more fullydescribed in Note 2 of the notes to our consolidated financial statementsincluded in our Annual Report on Form 10-K, we regularly hedge ournon-U.S. dollar-based exposures by entering into short-term forwardforeign exchange contracts. This process is designed to minimize foreigncurrency translation exposures that could otherwise affect consolidated resultsof operations.  The terms of thesecontracts are for periods generally ranging from one to two months. Theshort-term nature of these contracts has resulted in these instruments havinginsignificant fair values at December 31, 2006 and June 30, 2007.

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

As of June 30,2006 and 2007 we entered into contracts to hedge approximately $2.5 million and$4.3 million, respectively, of receivables, intercompany accounts and cashbalances denominated in currencies other than the U.S. dollar.

*InterestRate Sensitivity*

We hadunrestricted cash, cash equivalents and short-term investments totaling $179.4million at June 30, 2007.  Investments insecurities are invested primarily in high quality securities of a shortduration and are not materially affected by fluctuations in interest rates. Theunrestricted cash and cash equivalents are held for working capital purposes.We do not enter into investments for trading or speculative purposes. Due tothe short-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 workingcapital line of credit which bears interest based upon the prime rate. AtDecember 31, 2006 and June 30, 2007, there were no amounts outstanding underour working capital line of credit.  AtJune 30, 2007, there was $1.5 million available under the line of credit and$500,000 reserved under a letter of credit associated with our leasedfacilities.

**Item4.   *Controls and Procedures***

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

As of June 30, 2007, wecarried out an evaluation, under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in enabling us to record, process,summarize and report information required to be included in our periodic SECfilings within the required time period.

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

**Part II—OtherInformation**

**Item 1.   *Legal Proceedings***

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

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

**CertainFactors Which May Affect Future Results**

*From time to time we update, revise and supplement therisk factors described under the title “Risk Factors” in our Annual Report onForm 10-K for the year ended December 31, 2006. Except with respect to a change in our risk factor entitled “Ouroperating results may fluctuate and could cause the market price of our commonstock to fall rapidly and without notice.” as set forth below, there are nomaterial changes to the risk factors described in the “Risk Factors” section inour Annual Report on Form 10-K for the year ended December 31, 2006.*

*We operate in a rapidly changing environment that involves a number ofrisks, some of which are beyond our control.  The risks and uncertaintiesthat we believe are most important for you to consider are described under thetitle “Risk Factors” in our Annual Report on Form 10-K for the year ended December31, 2006.  Additional risks and uncertainties not presently known to us,which we currently deem immaterial or which are similar to those faced by othercompanies in our industry or business in general, may also impair our businessoperations.  If any of the foregoing risks or uncertainties actuallyoccurs, our business, financial condition and operating results would likelysuffer.*

***Our operatingresults may fluctuate and could cause the market price of our common stock tofall rapidly and without notice.***

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

·       the timing and mix oflicense and services revenues, and the amount and type of service required indelivering certain projects;

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

·       changes in and timing ofour operating expenses;

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

·       an increased book tax rateupon the full utilization of U.S. net operating loss carryforwards;

·       our ability to introduce newproducts and services and enhancements to our existing products and services ona timely basis;

·       new competitors andintroduction of enhanced products from new or existing competitors;

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

·       our ability to hire andretain qualified personnel;

·       changes in the regulatoryenvironment related to the clinical trial and safety monitoring market;

·       changes in our customers’purchasing patterns;

·       the financial condition ofour current and potential customers; and

·  unforeseen legal expenses, includinglitigation costs.

A significant portion of our operating expense isrelatively fixed in nature and planned expenditures are based in part onexpectations regarding future revenues. Accordingly, unexpected revenueshortfalls or operating expenses may decrease our gross margins and could causesignificant changes in our operating results from quarter to quarter. Changesin our effective tax rate for financial reporting purposes, or book tax rate,will also impact our operating results. In 2006 we had an effective tax benefitof 2%. Our book tax rate depends, in part, on our ability to utilize our U.S.net operating loss carryforwards to offset tax obligations in future periods.The timing of the utilization of our net operating loss carryforwards isuncertain and some portion or all of these carryforwards may not be availableto offset any future taxable income, in which case we could be subject to asignificant increase in our book tax rate. Significant increases in our booktax rate could materially harm our operating results. Results of operations inany quarterly period should not be considered indicative of the results to beexpected for any future period. In addition, our future quarterly operatingresults may fluctuate and may not meet

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the expectations ofsecurities analysts or investors. If this occurs, the trading price of ourcommon stock could fall substantially either suddenly or over time.

**Item 4.   *Submission of Matters to aVote of Security Holders***

At the annualmeeting of our stockholders held May 2, 2007, our stockholders took thefollowing actions:

Our stockholderselected Axel Bichara, Paul A. Bleicher, Richard D’Amore, James I.Cash, Jr., Gary E. Haroian, Dennis R. Shaughnessy, Dr. Eve E. Slater,and Robert K. Weiler as directors, each to serve for a one-year term and untiltheir successors have been duly elected and qualified or until their earlierdeath, resignation or removal. The directors were elected by a plurality of thevotes cast at the 2007 annual meeting, as follows:

| Nominee                  | ** ** | **Votes  For** | ** ** | **Shares  Withheld** | ** ** |
|--------------------------|------------|----------------|------------|----------------------|------------|
|                     |       |           |       |                 |       |
| Axel Bichara             |       | 32,794,288     |       | 160,206              |       |
| Paul A. Bleicher         |       | 32,739,212     |       | 215,282              |       |
| Richard D’Amore     |       | 32,775,320     |       | 179,174              |       |
| James I.  Cash, Jr. |       | 32,692,369     |       | 262,125              |       |
| Gary E. Haroian          |       | 30,887,672     |       | 2,066,822            |       |
| Dennis R.  Shaughnessy   |       | 32,831,042     |       | 123,453              |       |
| Eve E. Slater            |       | 32,831,542     |       | 122,952              |       |
| Robert K. Weiler         |       | 32,826,756     |       | 127,738              |       |

 

No other personswere nominated, nor received votes, for election as a director at the 2007annual meeting. On March 27, 2007, Dr. Slater advised us that, as a resultof her decision to accept a management position at a large pharmaceuticalcompany which required that she relinquish all of her directorships, sheintended to resign as a director.  Dr. Slater’s resignation, whichtook effect on August 1, 2007, was not in connection with any knowndisagreement with us on any matter relating to our operations, policies orpractices.

Our stockholdersapproved the selection of Ernst & Young LLP as our independentregistered public accounting firm for the fiscal year ending December 31,2007. The votes cast at the 2007 annual meeting were as follows: 32,869,513shares voted for, 80,250 shares voted against and 4,731 shares abstained fromvoting.

Atthe annual meeting, our stockholders approved an amendment to our amended andrestated 2004 Stock Option and Incentive Plan to increase to 3,981,505 thenumber of shares available for issuance thereunder, an increase of 481,505shares. The increase is equal to the number of shares that were available forissuance under the Company’s two other stock plans (the Phase ForwardIncorporated 1997 Stock Option Plan and the Phase Forward Incorporated 2003Non-Employee Director Stock Option Plan) at the date of the amendment.  As part of the amendment, the Company decidedthat it will no longer issue any further shares under these two other plans.  The votes cast at the 2007 annual meetingwere as follows: 18,664,530 shares voted for, 11,749,093 shares voted againstand 26,867 shares abstained from voting. There were 2,514,004 broker non-votes.

**Item 5.   *Other Information***

Our policygoverning transactions in our securities by directors, officers and employeespermits our officers, directors and certain other persons to enter into tradingplans complying with Rule 10b5-1 under the Securities Exchange Act of1934, as amended. We have been advised that our Vice President, HumanResources, Victor P. Becker; our Senior Vice President and General Counsel, D.Ari Buchler; our Vice President of Worldwide Sales, Stephen J. Powell; ourPresident and Chief Executive Officer, Robert K. Weiler; and our Senior VicePresident and Chief Financial Officer, Rodger Weismann****haveeach entered into a trading plan covering periods after the date of thisQuarterly Report in accordance with Rule 10b5-1 and our policy governingtransactions in our securities. Generally, under these trading plans, the individual relinquishescontrol over the transactions once the trading plan is put into place.  Accordingly, sales under these plans mayoccur at any time, including possibly before, simultaneously with, orimmediately after significant events involving our company.

**Weanticipate that, as permitted by Rule 10b5-1 and our policy governingtransactions in our securities, some or all of our officers, directors andemployees may establish trading plans in the future. We intend to disclose thenames of executive officers and directors who establish a trading plan incompliance with Rule 10b5-1 and the requirements of our policy governingtransactions in our securities in our future quarterly and annual reports onForm 10-Q and 10-K filed with the Securities and Exchange Commission.However, we undertake no obligation to update or revise the informationprovided herein, including for revision or termination of an establishedtrading plan, other than in such quarterly and annual reports.**

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** **

**Item 6.****   *Exhibits*.**
| Exhibit | ** ** | ** **                                                                                                                                                                         | ** ** |
|---------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **No.** | ** ** | **Description**                                                                                                                                                                    | ** ** |
| 1.1     |       | Underwriting Agreement dated May 22, 2007  (Incorporated by reference herein to Exhibit 1.1 of the Company’s Current  Report on Form 8-K filed with the SEC on May 23, 2007). |       |
| 31.1    |       | Certification of CEO pursuant to Rule 13a-14(a) and  15d-14(a) under the Securities Exchange Act of 1934.                                                           |       |
| 31.2    |       | Certification of CFO pursuant to  rules 13a-14(a) and 15d-14(a) under the Securities Exchange  Act of 1934.                                                         |       |
| 32.1    |       | Certification of CEO pursuant to 18 U.S.C. 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                       |       |
| 32.2    |       | Certification of  CFO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                      |       |

** **

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**Signatures**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                      | **PHASE FORWARD  INCORPORATED** |
|----------------------|---------------------------------|
|                 |                            |
|                 | By:                             | /s/ ROBERT  K. WEILER |
|                 |                            | Robert K. Weiler*Chief Executive Officer  (Duly authorized officer)* |
|                 |                            |   |
|                 | By:                             | /s/ RODGER  WEISMANN |
|                 |                            | Rodger Weismann*Chief Financial Officer  (Duly authorized officer and  principal financial officer)* |
| Date: August 7, 2007 |                            |

 

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**EXHIBIT INDEX**

** **
| Exhibit | ** ** | ** **                                                                                                                                                                          | ** ** |
|---------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **No.** | ** ** | **Description**                                                                                                                                                                     | ** ** |
| 1.1     |       | Underwriting  Agreement dated May 22, 2007 (Incorporated by reference herein to Exhibit 1.1  of the Company’s Current Report on Form 8-K filed with the SEC on May 23,  2007). |       |
| 31.1    |       | Certification  of CEO pursuant to Rule 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934.                                                           |       |
| 31.2    |       | Certification  of CFO pursuant to rules 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934.                                                          |       |
| 32.1    |       | Certification  of CEO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                       |       |
| 32.2    |       | Certification of CFO  pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                       |       |

 

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