**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

** **

**FORM 10-Q**

** **

** **

| x          |   | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                                                              |
|------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   | ** **                                                                                                                                                                                                                                                          |
| ** ** |   | **For the quarterly period ended March 31, 2006**                                                                                                                                                                                                              |
| ** ** |   | ** **                                                                                                                                                                                                                                                          |
| ** ** |   | **OR**                                                                                                                                                                                                                                                              |
| ** ** |   | ** **                                                                                                                                                                                                                                                          |
| o          |   | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE   ACT OF 1934**                                                                                                                                                 |
|       |   | ** **                                                                                                                                                                                                                                                          |
| ** ** |   | **For the  transition period from                to                     ** |

** **

** **

**Commission File Number:000-50839**

** **

** **

**Phase Forward Incorporated**

(Exact name of registrant as specified in its charter)

 

 

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

 

**(888) 703-1122**

(Registrant’s telephone number, including area code)

 

        Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

Yes    x     No **o**

        Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):

Large accelerated filer  o                   Acceleratedfiler  x                       Non-acceleratedfiler  o

        Indicate by check mark whether theregistrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes    **o**     No   x

As of May 1, 2006,the registrant had 33,928,619 shares of Common Stock outstanding.

 

 

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**PHASE FORWARDINCORPORATEDQUARTERLY REPORT ON FORM 10-QFor the quarterly period ended March 31, 2006Table of Contents**
|                                             | ** ** |                                                                                                                                                  | ** ** | **Page  Number** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|
| **Part I—Financial  Information** |       |                                                                                                                                             |
| ** **                                  |       |                                                                                                                                             |
| Item 1.                                     |       | Condensed Consolidated Balance Sheets as of  December 31, 2005 and March 31, 2006 (unaudited)                                          |       | 3                |
|                                        |       | Condensed Consolidated Statements of Operations for the  three months ended March 31, 2005 (unaudited) and March 31, 2006  (unaudited) |       | 4                |
|                                        |       | Condensed Consolidated Statements of Cash Flows for  the three months ended March 31, 2005 (unaudited) and March 31,  2006 (unaudited) |       | 5                |
|                                        |       | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                                |       | 6                |
| Item 2.                                     |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                                      |       | 18               |
| Item 3.                                     |       | Quantitative and Qualitative Disclosures about Market  Risk                                                                                      |       | 29               |
| Item  4.                                    |       | Controls  and Procedures                                                                                                                         |       | 30               |
|                                        |       |                                                                                                                                             |       |             |
| **Part II—Other  Information**    |       |                                                                                                                                             |
| ** **                                  |       |                                                                                                                                             |
| Item 1.                                     |       | Legal Proceedings                                                                                                                                |       | 31               |
| Item 1A                                |       | Risk Factors                                                                                                                                     |       | 31               |
| Item 5.                                     |       | Other Information                                                                                                                                |       | 40               |
| Item 6.                                     |       | Exhibits                                                                                                                                         |       | 41               |
| Signatures                                  |       | 42                                                                                                                                               |
| Exhibit Index                          |       |                                                                                                                                             |
|                                             |            |                                                                                                                                                  |            |                  |  |  |

 

2

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**Part I—FinancialInformation**

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

**Phase ForwardIncorporatedCondensed Consolidated Balance Sheets(unaudited)(in thousands, except per share amounts)**

** **
|                                                                                                      | ** ** | **As of December 31,  2005** | ** ** | **As of March 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------|------------|
| **Assets**                                                                                           | ** ** | ** **                                  | ** ** | ** **                               | ** ** |
| Current assets:                                                                                      |       |                                        |       |                                     |       |
| Cash and cash equivalents                                                                            |       | $                                           | 51,779     |                                     | $          | 53,806 |   |
| Short-term investments                                                                               |       | 8,807                                       |       | 9,499                                    |       |
| Accounts receivable, net of  allowance of $318 and $309 in 2005 and 2006, respectively          |       | 24,923                                      |       | 21,074                                   |       |
| Deferred set up costs, current portion                                                               |       | 1,266                                       |       | 1,189                                    |       |
| Prepaid commissions and  royalties, current portion                                                  |       | 3,710                                       |       | 3,929                                    |       |
| Prepaid expenses and other current assets                                                            |       | 2,248                                       |       | 2,258                                    |       |
| Deferred income taxes                                                                                |       | 4,025                                       |       | 4,028                                    |       |
|                                                                                                 |       |                                        |       |                                     |       |
| Total current assets                                                                                 |       | 96,758                                      |       | 95,783                                   |       |
|                                                                                                 |       |                                        |       |                                     |       |
| Property and equipment, net                                                                          |       | 7,543                                       |       | 7,720                                    |       |
| Deferred set up  costs, net of current portion                                                       |       | 782                                         |       | 1,016                                    |       |
| Prepaid commissions and  royalties, net of current portion                                           |       | 2,386                                       |       | 2,517                                    |       |
| Intangible  assets, net of accumulated amortization of $306 and $524 in 2005 and 2006,  respectively |       | 3,594                                       |       | 3,376                                    |       |
| Goodwill                                                                                             |       | 24,960                                      |       | 24,482                                   |       |
| Deferred income  taxes                                                                               |       | 3,747                                       |       | 3,737                                    |       |
| Other assets                                                                                         |       | 174                                         |       | 176                                      |       |
|                                                                                                 |       |                                        |       |                                     |       |
| Total assets                                                                                         |       | $                                           | 139,944    |                                     | $          | 138,807 |   |
| ** **                                                                                           | ** ** | ** **                                  | ** ** | ** **                               | ** ** |
| **Liabilities and Stockholders’ Equity**                                                        | ** ** | ** **                                  | ** ** | ** **                               | ** ** |
| Current liabilities:                                                                                 |       |                                        |       |                                     |       |
| Accounts payable                                                                                     |       | $                                           | 2,110      |                                     | $          | 2,087 |   |
| Accrued expenses                                                                                     |       | 12,472                                      |       | 11,420                                   |       |
| Accrued earn-out                                                                                     |       | 2,000                                       |       | 2,000                                    |       |
| Accrued litigation settlement                                                                        |       | 8,500                                       |       | —                                   |       |
| Deferred revenue, current  portion                                                                   |       | 43,751                                      |       | 47,860                                   |       |
| Deferred rent, current portion                                                                       |       | 394                                         |       | 422                                      |       |
|                                                                                                      |       |                                        |       |                                     |       |
| Total current  liabilities                                                                           |       | 69,227                                      |       | 63,789                                   |       |
|                                                                                                      |       |                                        |       |                                     |       |
| Deferred  revenue, net of current portion                                                            |       | 2,743                                       |       | 3,802                                    |       |
| Deferred rent, net of  current portion                                                               |       | 1,140                                       |       | 829                                      |       |
| Other long-term  liabilities                                                                         |       | 117                                         |       | 201                                      |       |
|                                                                                                      |       |                                        |       |                                     |       |
| Total liabilities                                                                                    |       | 73,227                                      |       | 68,621                                   |       |
|                                                                                                      |       |                                        |       |                                     |       |
| Contingencies (Note 13)                                                                              |       |                                        |       |                                     |       |
|                                                                                                      |       |                                        |       |                                     |       |
| Stockholders’ equity:                                                                           |       |                                        |       |                                     |       |
| Preferred stock, $.01 par  value:                                                                    |       |                                        |       |                                     |       |
| Authorized—5,000  shares                                                                        |       |                                        |       |                                     |       |
| Issued—0 shares                                                                                 |       | —                                      |       | —                                   |       |
| Common stock,  $.01 par value:                                                                       |       |                                        |       |                                     |       |
| Authorized—100,000 shares                                                                       |       |                                        |       |                                     |       |
| Issued—33,720 and 33,880 shares in 2005 and 2006,  respectively                                 |       | 337                                         |       | 339                                      |       |
| Additional paid-in capital                                                                           |       | 168,947                                     |       | 170,068                                  |       |
| Deferred stock-based compensation                                                                    |       | (611                                        | )          | (476                                     | )          |
| Treasury stock, 37 shares at  cost                                                                   |       | (111                                        | )          | (111                                     | )          |
| Accumulated other comprehensive loss                                                                 |       | (800                                        | )          | (675                                     | )          |
| Accumulated deficit                                                                                  |       | (101,045                                    | )          | (98,959                                  | )          |
|                                                                                                 |       |                                        |       |                                     |       |
| Total stockholders’ equity                                                                      |       | 66,717                                      |       | 70,186                                   |       |
|                                                                                                 |       |                                        |       |                                     |       |
| Total liabilities and  stockholders’ equity                                                     |       | $                                           | 139,944    |                                     | $          | 138,807 |   |

See accompanying notes.

3

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**Phase ForwardIncorporatedCondensed Consolidated Statements of Operations(unaudited)(in thousands, except per share amounts)**

** **
| ** **                                                                                             | ** ** | **Three Months Ended  March 31**, | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
| Revenues:                                                                                              |       |                                             |       |   |   |
| License                                                                                                |       | $                                                | 8,819      |   | $ | 9,025 |   |
| Service                                                                                                |       | 11,743                                           |       | 14,591 |   |
|                                                                                                   |       |                                             |       |   |   |
| Total revenues                                                                                         |       | 20,562                                           |       | 23,616 |   |
| Costs of revenues:                                                                                     |       |                                             |       |   |   |
| License                                                                                                |       | 448                                              |       | 706 |   |
| Service(1)                                                                                             |       | 7,212                                            |       | 8,895 |   |
|                                                                                                   |       |                                             |       |   |   |
| Total cost of  revenues                                                                                |       | 7,660                                            |       | 9,601 |   |
| Gross margin:                                                                                          |       |                                             |       |   |   |
| License                                                                                                |       | 8,371                                            |       | 8,319 |   |
| Service                                                                                                |       | 4,531                                            |       | 5,696 |   |
|                                                                                                   |       |                                             |       |   |   |
| Total gross  margin                                                                                    |       | 12,902                                           |       | 14,015 |   |
|                                                                                                   |       |                                             |       |   |   |
| Operating expenses:                                                                                    |       |                                             |       |   |   |
| Sales and marketing(1)                                                                                 |       | 3,951                                            |       | 4,237 |   |
| Research and development(1)                                                                            |       | 3,281                                            |       | 3,624 |   |
| General and administrative(1)                                                                          |       | 3,804                                            |       | 4,139 |   |
| Restructuring                                                                                          |       | (92                                              | )          | — |   |
|                                                                                                   |       |                                             |       |   |   |
| Total operating  expenses                                                                              |       | 10,944                                           |       | 12,000 |   |
|                                                                                                   |       |                                             |       |   |   |
| Income from  operations                                                                                |       | 1,958                                            |       | 2,015 |   |
| Other income (expense):                                                                                |       |                                             |       |   |   |
| Interest income                                                                                        |       | 348                                              |       | 596 |   |
| Interest expense                                                                                       |       | (144                                             | )          | — |   |
| Other, net                                                                                             |       | (130                                             | )          | (64 | ) |
|                                                                                                   |       |                                             |       |   |   |
| Total other  income                                                                                    |       | 74                                               |       | 532 |   |
|                                                                                                   |       |                                             |       |   |   |
| Income before  provision for income taxes                                                              |       | 2,032                                            |       | 2,547 |   |
| Provision for  income taxes                                                                            |       | 564                                              |       | 461 |   |
|                                                                                                   |       |                                             |       |   |   |
| Net income                                                                                             |       | $                                                | 1,468      |   | $ | 2,086 |   |
|                                                                                                   |       |                                             |       |   |   |
| Net income per share  applicable to common stockholders:                                               |       |                                             |       |   |   |
| Basic                                                                                                  |       | $                                                | 0.05       |   | $ | 0.06 |   |
| Diluted                                                                                                |       | $                                                | 0.04       |   | $ | 0.06 |   |
|                                                                                                   |       |                                             |       |   |   |
| Weighted average number  of common shares used in net income per share calculations:                   |       |                                             |       |   |   |
| Basic                                                                                                  |       | 32,457                                           |       | 33,751 |   |
| Diluted                                                                                                |       | 34,536                                           |       | 35,234 |   |
|                                                                                                   |       |                                             |       |   |   |
| (1)      Amounts include stock-based compensation  expenses, as follows: |       |                                             |       |   |   |
|                                                                                                   |       |                                             |       |   |   |
| Costs of service revenues                                                                              |       | $                                                | 25         |   | $ | 44 |   |
| Sales and marketing                                                                                    |       | (16                                              | )          | 110 |   |
| Research and development                                                                               |       | 55                                               |       | 60 |   |
| General and administrative                                                                             |       | 160                                              |       | 242 |   |
| Total stock-based compensation expenses                                                                |       | $                                                | 224        |   | $ | 456 |   |

 

See accompanying notes.

4

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**Phase ForwardIncorporatedCondensed Consolidated Statements of Cash Flows(unaudited)(in thousands)**
| ** **                                                                         | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                             | ** ** | **2006** | ** ** |
| **Operating activities**                                                           |       |                                                 |       |   |   |
| Net income                                                                         |       | $                                                    | 1,468      |   | $ | 2,086 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                 |       |   |   |
| Depreciation and amortization                                                      |       | 801                                                  |       | 1,260 |   |
| Stock-based compensation                                                           |       | 224                                                  |       | 456 |   |
| Loss on disposal of fixed assets                                                   |       | —                                               |       | 10 |   |
| Foreign currency exchange loss                                                     |       | 112                                                  |       | 62 |   |
| Provision for allowance for doubtful accounts                                      |       | —                                               |       | 54 |   |
| Deferred income taxes                                                              |       | —                                               |       | 7 |   |
| Tax benefit related to exercise of stock options                                   |       | —                                               |       | (248 | ) |
| Non-cash income tax expense                                                        |       | 463                                                  |       | 340 |   |
| Amortization of premiums or discounts on short-term  investments                   |       | —                                               |       | 4 |   |
| Changes in  assets and liabilities:                                                |       |                                                 |       |   |   |
| Accounts receivable                                                                |       | 4,647                                                |       | 4,196 |   |
| Deferred costs                                                                     |       | (308                                                 | )          | (489 | ) |
| Prepaid expenses and other current assets                                          |       | (224                                                 | )          | (14 | ) |
| Accounts payable                                                                   |       | (438                                                 | )          | 29 |   |
| Accrued expenses                                                                   |       | (2,430                                               | )          | (952 | ) |
| Accrued litigation settlement                                                      |       | —                                               |       | (8,500 | ) |
| Deferred revenue                                                                   |       | 6,688                                                |       | 5,285 |   |
| Deferred rent                                                                      |       | 197                                                  |       | (284 | ) |
|                                                                               |       |                                                 |       |   |   |
| Net cash  provided by operating activities                                         |       | 11,200                                               |       | 3,302 |   |
|                                                                               |       |                                                 |       |   |   |
| **Investing activities**                                                           |       |                                                 |       |   |   |
| Proceeds from  maturities of short-term investments                                |       | 1,250                                                |       | 3,022 |   |
| Purchase of  short-term investments                                                |       | (842                                                 | )          | (3,718 | ) |
| Purchase of  property and equipment                                                |       | (611                                                 | )          | (1,207 | ) |
| Decrease in other  assets                                                          |       | 9                                                    |       | — |   |
|                                                                               |       |                                                 |       |   |   |
| Net cash used in  investing activities                                             |       | (194                                                 | )          | (1,903 | ) |
|                                                                               |       |                                                 |       |   |   |
| **Financing activities**                                                           |       |                                                 |       |   |   |
| Payments on  lines of credit and notes payable                                     |       | (4,407                                               | )          | — |   |
| Proceeds from  issuance of common stock                                            |       | 1,128                                                |       | 554 |   |
| Proceeds from  repayment of subscriptions receivable                               |       | 127                                                  |       | — |   |
| Tax benefit  related to exercise of options                                        |       | —                                               |       | 248 |   |
|                                                                               |       |                                                 |       |   |   |
| Net cash (used  in) provided by financing activities                               |       | (3,152                                               | )          | 802 |   |
|                                                                               |       |                                                 |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                      |       | (330                                                 | )          | (174 | ) |
|                                                                               |       |                                                 |       |   |   |
| Net increase in  cash and cash equivalents                                         |       | 7,524                                                |       | 2,027 |   |
| Cash and cash  equivalents at beginning of period                                  |       | 53,485                                               |       | 51,779 |   |
|                                                                               |       |                                                 |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | 61,009                                               |       | 53,806 |   |
| Short-term  investments at end of period                                           |       | 4,327                                                |       | 9,499 |   |
| Total cash, cash  equivalents and short-term investments at end of period          |       | $                                                    | 65,336     |   | $ | 63,305 |   |

 

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 March 31,2006, the results of its operations for the three months ended March 31,2005 and 2006 and its cash flows for the three months ended March 31, 2005and 2006. 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 2005 Annual Report on Form 10-Kfiled with the SEC on March 13, 2006. The results of operations for theinterim periods are not necessarily indicative of the results of operations tobe expected for the year ending December 31, 2006.

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

Asof March 31, 2006, the Company’s significant accounting policies andestimates, which are detailed in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005, have not changed except for theadoption of Financial Accounting Standards Board, or FASB, SFAS No. 123(revised 2004), *Share-Based Payment*. SeeNote 9 for additional information regarding the Company’s adoption ofSFAS No. 123(R).

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

The Company derives revenues from software licensesand services. License revenue is derived principally from the sale of multi-year software term licenses for the Company’s *InFormTM,ClintrialTM* and *Clintrace*TM products and from annual term licenses forthe Company’s *WebVDMETM*, *CTSDTM* and *WebSDMTM*software products. Service revenue is derived from theCompany’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.

The components of revenue are as follows:

|                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------------|------------|
| ** **                    | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
| License                       |       | $                                                | 8,819      |   | $ | 9,025 |   |
| Application  hosting services |       | 6,832                                            |       | 8,954 |   |
| Consulting  services          |       | 1,394                                            |       | 2,739 |   |
| Customer support              |       | 3,517                                            |       | 2,898 |   |
|                          |       |                                             |       |   |   |
| Total                         |       | $                                                | 20,562     |   | $ | 23,616 |   |

 

The Companyrecognizes software license revenue in accordance with Statement of Position (“SOP”)No. 97-2, *Software RevenueRecognition,* as amended, issued by the American Institute ofCertified Public Accountants, while revenue resulting from application hostingservices is recognized in accordance with Emerging Issues Task Force (“EITF”)Issue No. 00-3, *Application ofAICPA Statement of Position 97-2 to Arrangements that include the Rightto Use Software Stored on Another Entity’s Hardware*,  SEC Staff Accounting Bulletin (SAB) No. 104,*Revenue Recognition*, and EITFIssue No. 00-21, *Revenue Arrangements with MultipleDeliverables.*

Customersgenerally have the ability to terminate application hosting, consulting andtraining service agreements upon 30 days notice to the Company. Licenseagreements, multiple element arrangements, including license and serviceagreements and certain application hosting services can generally be terminatedby either party for material breach of obligations not corrected within30 days after notice of the breach.

6

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The Companyrecognizes revenue when all of the following conditions are satisfied: (1) thereis persuasive evidence of an arrangement; (2) the product or service hasbeen provided to the customer; (3) the collection of fees is probable; and(4) the amount of fees to be paid by the customer is fixed ordeterminable.

The Companygenerally enters into software term licenses for its *InForm*, *Clintrial*and *Clintrace* products with itscustomers for 3- to 5-year periods. License agreements for its *WebVDME, CTSD*and*WebSDM*productsare typically for one-year terms. These arrangements typically include multipleelements: software license, consulting services and customer support. TheCompany bills its customers in accordance with the terms of the underlyingcontract. Generally, the Company bills license fees annually in advance foreach year of the license term. Payment terms are generally net 30 days.

The Company’ssoftware license revenue is 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 revenuefor all elements, including consulting services, ratably over the term of thesoftware license and support arrangement. The Company allocates the revenuerecognized for these arrangements to the different elements based on management’sestimate of the relative fair value of each element. For its term-based licenses,the Company allocates to consulting services the anticipated service effort andvalue throughout the term of the arrangement at an amount that would have beenallocated had those services been sold separately to the customer. Theremaining value is allocated to license and support services, with 10% of thisamount allocated to support services. The Company has allocated the estimatedfair value to its multiple element arrangements to provide meaningfuldisclosures about each of its revenue streams. The costs associated with theconsulting and customer support services are expensed as incurred. There areinstances in which the Company sells software licenses based on usage levels.These software licenses can be based on estimated usage, in which case the licensefee charged to the customer is fixed based on this estimate. When the fee isfixed, the revenue is generally recognized ratably over the contractual term ofthe arrangement. If the fee is based on actual usage, and therefore variable,the revenue is recognized in the period of use. Revenue from certain follow-onconsulting services, which are sold separately to customers with existingsoftware licenses and are not considered part of a multiple elementarrangement, is 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 revenue is recognized upondelivery of the software and when all other revenue recognition criteria aremet. Customer support revenues are recognized ratably over the term of theunderlying support arrangement. The Company continues to generate customersupport and maintenance revenue from its perpetual license customer base.Training revenue is 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. Revenue resulting from *InForm *application hosting services consists of threestages for each clinical trial: the first stage involves application set up,including design of electronic case report forms and edit checks,implementation of the system and server configuration; the second stageinvolves application hosting and related support services; and the third stageinvolves services required to close out, or lock, the database for the clinicaltrial. Services provided for the first and third stages are provided on a fixedfee basis based upon the complexity of the trial and system requirements. Servicesfor the second stage are charged separately as a fixed monthly fee. The Companyrecognizes revenue from all stages of the *InForm *hostingservice ratably over the hosting period. Fees charged and costs incurred forthe trial system design, set up and implementation are deferred and capitalizedas applicable, until the start of the hosting period. These fees and costs areamortized and recognized, as applicable, ratably over the estimated hostingperiod. The capitalized costs include incremental direct costs with thirdparties and certain internal direct costs related to the trial and applicationset 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 is the revenue attributable to the software license used by thecustomer.

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

7

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

Two customers,GlaxoSmithKline and Eli Lilly and Company, the holder of record ofapproximately 1% of the Company’s common stock, together accounted forapproximately 23% and 25% of the Company’s total revenues in the three monthsended March 31, 2005 and 2006, respectively, and $5.0 million of accountsreceivable outstanding as of both December 31, 2005 and March 31,2006.

The Companycapitalized $666 and $632 of deferred set up costs and amortized $449 and $475during the three months ended March 31, 2005 and 2006, respectively. Theamortization of deferred set up costs is a component of cost of services.

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

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

In accordance with EITF Issue No. 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred,* the Company included$197 and $67 of out of pocket expenses in service revenue and cost of servicerevenue in the three months ended March 31, 2005 and 2006, respectively.

**3.**                 Prepaid SalesCommissions and Royalties

For arrangements where revenue is recognized over therelevant contract period, the Company capitalizes related commissions paid toits direct sales force and software license royalties paid to third parties,and amortizes these expenses over the period that the related revenues arerecognized.

Commission payments are nonrefundable unless amountsdue from a customer are determined to be uncollectible or if the customersubsequently changes or terminates the level of service, in which casecommissions paid are recoverable by the Company. The Company capitalized $677and $1,089 of commissions and amortized to sales and marketing expense $830 and$909 during the three months ended March 31, 2005 and 2006, respectively.

The Company’s royalty obligation is based upon thelicense and customer support revenues earned for certain products in anarrangement. The Company has the right to recover the royalties in the eventthe arrangement is cancelled. The Company capitalized $822 and $994 ofroyalties and amortized to cost of revenues $571 and $824 during the threemonths ended March 31, 2005 and 2006, respectively.

**4.**                 Warranties andIndemnification

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

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

To date, the Company has not incurred any materialcosts as a result of such indemnifications and has not accrued any liabilitiesrelated to such obligations in the accompanying consolidated financialstatements.

**5.**                 Acquisition ofLincoln Technologies, Inc.

On August 25, 2005, the Company acquired all ofthe outstanding capital stock of Lincoln, a provider of products and servicesfor drug safety, clinical trial safety signal detection, and applied datastandards. The acquired technology and products of Lincoln provide the Companywith an expanded drug safety offering and enhance the Company’s ability tooffer innovative software and services in the drug safety market. The Companypaid a premium for Lincoln to enable it to expand its offerings in the drugsafety market and to obtain a valuable workforce.

The aggregate purchase price was approximately $13,200.The acquisition agreement calls 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 in 2005 and 2006,

8

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 respectively. The2005 financial targets associated with additional cash consideration wereachieved and, accordingly, the Company accrued additional consideration of$2,000 in 2005 which was paid in May 2006. Additional cash considerationassociated with 2006 financial targets will be accrued if and when achievementof certain financial targets is reached and will be included as additionalconsideration towards the purchase price of the acquisition. The acquisition ofLincoln was accounted for as a purchase under SFAS No. 141, *Business Combinations*. Accordingly, the results of Lincolnhave been included in the audited consolidated financial statements since thedate of acquisition.

The components ofthe consideration are as follows:

|                                                                                 | ** ** | **Amount** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|
| Cash paid                                                                       |       | $          | 11,000     |   |
| Acquisition  costs                                                              |       | 167        |       |
| Accrued earn-out                                                                |       | 2,000      |       |
| Total purchase  price to be allocated to acquired asset subject to amortization |       | $          | 13,167     |   |

 

The followingtable summarizes the allocation of the initial purchase price to the fair valueof the assets acquired and liabilities assumed at the date of acquisition,including the $2,000 of additional cash consideration earned in 2005:

|                                                         | ** ** | ** ** | ** ** | **Amount** | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|
| Current assets                                          |       |       |       | $          | 1,486      |   |
| Property, plant  and equipment                          |       |       |       | 263        |       |
| Intangible  assets subject to amortization:             |       |       |       |       |       |
| Developed technology (five year useful life)            |       | $          | 1,800      |       |       |   |
| Customer base (five year useful life)                   |       | 1,600      |       |       |       |
| Other intangible assets (two to five year useful  life) |       | 500        |       |       |       |
|                                                    |       |       |       | 3,900      |       |
| Goodwill                                                |       |       |       | 8,430      |       |
| Total assets  acquired                                  |       |       |       | 14,079     |       |
| Current  liabilities                                    |       |       |       | (912       | )          |
| Net assets  acquired                                    |       |       |       | $          | 13,167     |   |
|                                                         |            |            |            |            |            |  |  |

 

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

A rollforward ofthe liability for lease abandonment costs is as follows:

|                                                                           | ** ** | **Amount** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|
| Provision for  lease abandonment costs as of August 25, 2005         |       | $          | 270        |   |
| Payments made during the year ended  December 31, 2005               |       | (48        | )          |
| Balance as of  December 31, 2005                                     |       | $          | 222        |   |
| Reduction to provision during the three months ended  March 31, 2006 |       | (116       | )          |
| Payments made during the three months ended  March 31, 2006          |       | (28        | )          |
| Balance as of  March 31, 2006                                        |       | $          | 78         |   |

 

The followingtable presents selected unaudited financial information of the Company andLincoln as if the acquisition had occurred on January 1, 2005. Theunaudited pro forma results are not necessarily indicative of the results thatwould have occurred had the acquisition been consummated on January 1,2005.

|                                                                    | ** ** | **Three Months Ended  March 31, 2005** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Pro forma  revenues                                                |       | $                                                          | 21,727     |   |
| Pro forma income  from operations                                  |       | 1,796                                                      |       |
| Pro forma net  income applicable to common stockholders            |       | 1,348                                                      |       |
| Pro forma net  income per share applicable to common stockholders: |       |                                                       |       |
| Basic                                                              |       | $                                                          | 0.04       |   |
| Diluted                                                            |       | $                                                          | 0.04       |   |

 

**6.**                 Net Income PerShare

Basic net income per common share for all periodspresented was determined by dividing net income applicable to commonstockholders by the weighted average number of common shares outstanding duringthe period. Dilutive net income per share includes the effects of all dilutive,potentially issuable common shares.

9

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The followingtable sets forth a reconciliation of basic and diluted shares for the threemonths ended March 31.

 

|                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
| Basic weighted  average common shares outstanding   |       | 32,456,501                                       |       | 33,751,249 |   |
| Weighted average  common equivalent shares          |       | 2,079,975                                        |       | 1,482,252 |   |
| Diluted weighted  average common shares outstanding |       | 34,536,476                                       |       | 35,233,501 |   |

 

Diluted weightedaverage shares outstanding do not include options outstanding to purchase295,000 and 696,528 common equivalent shares for the three months ended March 31,2005 and 2006, respectively, as their effect would have been anti-dilutive.

**7.**                 Foreign CurrencyTranslation

The financial statements of the Company’s foreignsubsidiaries are translated in accordance with SFAS No. 52, *Foreign Currency Translation.* Thereporting currency for the Company is the U.S. dollar. The functional currencyof the Company’s subsidiaries in the United Kingdom, France, Belgium, Germany,Japan and Australia are the local currencies of those countries. Accordingly,the assets and liabilities of the Company’s foreign subsidiaries are translatedinto U.S. dollars using the exchange rate in effect at each balance sheet date.Revenue and expense accounts are translated generally using an average rate ofexchange during the period. Gains and losses arising from transactionsdenominated in foreign currencies are primarily related to intercompanyaccounts that have been determined to be temporary in nature and cash andaccounts receivable denominated in non-functional currencies. The Company hasrecorded foreign currency losses of $112 and $62 for the three months ended March 31,2005 and 2006, respectively, and such losses are included in other income(expense) in the accompanying unaudited condensed consolidated statements ofoperations.

Foreign currency translation adjustments areaccumulated as a component of other comprehensive income (loss) as a separatecomponent of stockholders’ equity.

**8.**                 Cash, CashEquivalents and Short-term Investments

The Company accounts for its investments in accordancewith SFAS No. 115, *Accounting forCertain Investments in Debt and Equity Securities*. Under SFAS No. 115,securities that the Company has the intent and ability to hold to maturity arereported at amortized cost, which approximates market value, and are classifiedas held-to-maturity. The Company considers all highly liquid investments withoriginal maturities of 90 days or less at the time of purchase to be cashequivalents and investments with original maturities of between 91 daysand one year to be short-term investments.

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

 

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

 

10

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|                                  | ** ** | ** **                       | ** ** | **March 31, 2006** | ** ** |
|----------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| **Description**                  | ** ** | **Contracted  Maturity  (days)** | ** ** | **Amortized  Cost**          | ** ** | **Fair  Market  Value** | ** ** |
| Cash                             |       | Demand                           |       | $                            | 12,396     |   | $ | 12,396 |   |
| U.S. agency  notes               |       | 31                               |       | 2,149                        |       | 2,149 |   |
| Certificate of  deposit          |       | 90                               |       | 425                          |       | 425 |   |
| Money market  funds              |       | Demand                           |       | 38,836                       |       | 38,836 |   |
|                             |       |                             |       |                         |       |   |   |
| Total cash and  cash equivalents |       |                             |       | $                            | 53,806     |   | $ | 53,806 |   |
|                             |       |                             |       |                         |       |   |   |
| Certificate of  deposit          |       | 298                              |       | $                            | 400        |   | $ | 399 |   |
| U.S. agency  notes               |       | 202                              |       | 4,302                        |       | 4,299 |   |
| Corporate bonds                  |       | 290                              |       | 4,797                        |       | 4,789 |   |
|                             |       |                             |       |                         |       |   |   |
| Total short-term  investments    |       |                             |       | $                            | 9,499      |   | $ | 9,487 |   |

 

The Company has had no realized gains or losses todate from the sale of money market accounts or short-term investments.

**9.**                 Stock-BasedCompensation

On December 16,2004 the FASB issued SFAS No. 123(R), which is a revision of SFAS No. 123,*Accounting for Stock-Based Compensation*.SFAS No. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25,*Accounting for Stock Issued to Employees*,and amends SFAS No. 95, *Statement of Cash Flows*.Generally, the approach under SFAS No. 123(R) is similar to theapproach described in SFAS No. 123. However, SFAS No. 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the income statement based on their fair values.Pro forma disclosure is no longer an alternative.

SFAS No. 123(R) mustbe adopted for fiscal years starting after June 15, 2005. As a result, theCompany adopted SFAS No. 123(R) starting in its fiscal first quarterof 2006, which began on January 1, 2006.

As permitted bySFAS 123, the Company historically accounted for share-based payments toemployees using the APB Opinion No. 25 intrinsic value method and, assuch, generally recognized no compensation cost for employee stock optionsother than the amortization of deferred stock-based compensation costassociated with stock options granted at a discount from the deemed fair marketvalue. The Company adopted the “modified prospective” method outlined in SFAS No. 123(R).Under the “modified prospective” method, compensation cost is recognized in theincome statement beginning on the adoption date of SFAS No. 123(R): (a) basedon the requirements of SFAS No. 123(R) for all share-based paymentsgranted on or after the adoption date;  (b) basedon the requirements of SFAS 123 for all share-based payments that are un-vestedas of December 31, 2005, and (c) excludes those options issued priorto the Company becoming a public entity which were valued using the “minimumvalue method”. Therefore, in accordance with the modified prospective method,the Company is amortizing the unamortized stock-based compensation expenserelated to those stock options that remained unvested as of December 31,2005, whose fair value was calculated utilizing a Black-Scholes option pricingmodel.

In accordance withthe modified prospective method of adoption, the Company’s results ofoperations and financial position for prior periods have not been restated.

**StockOption Plans**

In 1997, theCompany adopted the Phase Forward Incorporated 1997 Stock Option Plan (the “1997Option Plan”). Under the 1997 Option Plan, the Board of Directors may grantincentive and nonqualified stock options to employees of the Company andnon-employees. The exercise price of each option is determined by the Board ofDirectors. Incentive stock options may not be granted with an exercise priceless than the fair market value of the stock on the date of grant, as definedby the Board of Directors. Options granted under the 1997 Option Plan generallyvest over four or five year periods and expire ten years from the grant date.In January and March 2004, the Company granted options to certain employeesto purchase a total of 205,000 shares of common stock that vest upon theearlier of 7 years from date of grant or the attainment of specifiedmilestones. As of March 31, 2006, the Company had 231,131 share optionsunissued under this plan. The Company has not issued options under this plansince its July 2004 initial public offering, but may do so in the future.

In 2004, the Boardof Directors and stockholders approved the Phase Forward Incorporated 2004Stock Option and Incentive Plan (the “2004 Option Plan”) which became effectiveupon the closing of the Company’s initial public offering. The Company hadreserved for issuance an aggregate of 1.5 million shares of common stock underthe 2004 Option Plan. Under the 2004 Option Plan, the Board of Directors maygrant stock options and other equity interests in the Company to employees ofthe Company and non-employees. The exercise price of each option is determinedby the Board of Directors. Incentive stock options may not be granted with anexercise price less than the fair market value of the stock on the date ofgrant, as defined by the Board of Directors. Options granted under the 2004Option Plan generally vest over a four to seven year period and expire tenyears from the grant date. In February 2005,

11

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 the Companygranted options to certain employees to purchase a total of 419,000 shares ofcommon stock that vest upon the earlier of attainment of specified milestonesor 7 years from the date of grant. The remainder of the stock options grantedin 2005 were service-based options and vest over a period of four years fromthe date of grant. As of March 31, 2006, the Company had 60,500 shareoptions available for future grant under this plan. On May 3, 2006, theCompany’s shareholders approved an amendment to the 2004 Option Plan toincrease the number of shares available for issuance from 1.5 million shares to3.5 million shares.

In 2003, the Board of Directors and stockholders approvedthe Phase Forward Incorporated 2003 Non-Employee Director Stock Option Plan(the “2003 NED Plan”). The Company reserved for issuance an aggregate of362,000 shares of common stock under this plan. Effective April 20, 2004,the 2003 NED Plan was amended to increase the number of shares the Company maygrant under this plan to 562,000 shares. The 2003 NED Plan provided solely forthe automatic, one-time grant of a nonqualified stock option to a non-employeedirector upon initial election to the Company’s Board of Directors to purchase100,000 shares of common stock. On June 23, 2005, the 2003, NED Plan wasamended to reduce the one-time grant from 100,000 to 50,000 share options. Theexercise price of the options must not be less than 100% of the fair marketvalue on the grant date. Options vest fully on the fifth anniversary of thedate of grant, so long as the non-employee director has continuously served onthe Board of Directors through such vesting date. If the non-employee directormeets certain board attendance criteria, options may vest earlier at a rate ofone-sixteenth at the end of each fiscal quarter following the date of grant. Asof March 31, 2006, the Company had 234,875 share options available forfuture grant under this plan.

**EmployeeStock Purchase Plan**

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

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).

**GrantDate Fair Value**

Effective with theadoption of SFAS No. 123(R), the Company has elected to use theBlack-Scholes option pricing model to determine the weighted average fair valueof options granted.

The Company has a limited trading history for itscommon stock as it began trading on the NASDAQ National Market on July 15,2004. Accordingly, the Company has determined the expected life and thevolatility for options granted in 2005 based on an analysis of reported datafor a peer group of companies that have issued stock options with substantiallysimilar terms. The expected life of options granted by the Company has beendetermined based on the average expected life of the options as reported bythis peer group of companies during a similar reporting period. The expectedvolatility of options granted has been determined using an average of thehistorical volatility measures of this peer group of companies as well as thehistorical volatility of its own common stock beginning with January 2005.The risk-free interest rate is based on a treasury instrument whose term isconsistent with the expected life of the stock options. The Company has notpaid and does not anticipate paying cash dividends on its shares of commonstock; therefore, the expected dividend yield is assumed to be zero. In addition,SFAS No. 123(R) requires companies to utilize an estimated forfeiturerate when calculating the expense for the period, whereas, SFAS No. 123permitted companies to record forfeitures based on actual forfeitures, whichwas the Company’s historical policy under SFAS No. 123. As a result, theCompany has applied an estimated forfeiture rate of 4.3% in the first quarterof 2006 in determining the expense recorded in the Company’s consolidatedstatement of income.

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The weightedaverage fair value of options granted during the three months ended March 31,2005 and March 31, 2006, under the Black-Scholes option pricing model, was$3.31 and $4.21, respectively. The weighted-average assumptions utilized todetermine the above values are indicated in the following table:

 

|                           | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|
| ** **                | ** ** | **2005**                                             | ** ** | **2006** | ** ** |
| Risk-free  interest rate  |       | 4.08                                                 | %          | 4.65 | % |
| Expected  volatility      |       | 62                                                   | %          | 53 | % |
| Expected life  (in years) |       | 4.17                                                 |       | 4.28 |   |
| Expected Dividend yield   |       | —                                               |       | — |   |

 

**Expense**

During the quarterended March 31, 2006, the Company recorded $456 of stock-basedcompensation expense, of which $328 was as a result of the adoption of SFAS No. 123(R).The remaining stock-based compensation expense is due to the amortization ofpreviously recorded deferred compensation. The stock-based compensation expenseincluded $44 in cost of revenues, $60 in research and development, $110 insales and marketing and $242 in general and administrative expense for thethree months ended March 31, 2006. The compensation expense reduced bothbasic and diluted earnings per share by $0.01. As of March 31, 2006, therewas $4,039 of unrecognized compensation expense related to non-vestedmarket-based share awards that is expected to be recognized over aweighted-average period of 2.83 years.

Prior to adoptingSFAS No. 123(R), the Company accounted for stock-based compensation underAPB Opinion No. 25. The following table illustrates the effect on netincome and earnings per share if the fair value based method had been appliedto the year-ago period.

 

|                                                                                                                    | ** ** | **Three  Months  Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2005**                                 | ** ** |
| Net income as  reported                                                                                            |       | $                                        | 1,468      |   |
| Add: Stock-based  compensation expense included in reported net income                                             |       | 224                                      |       |
| Less: Stock-based  employee compensation determined under the fair value based method, net of  related tax effects |       | (549                                     | )          |
| Net income — pro  forma                                                                                       |       | $                                        | 1,143      |   |
|                                                                                                               |       |                                     |       |
| Income per common  equivalent share:                                                                               |       |                                     |       |
| Basic — as reported                                                                                           |       | $                                        | 0.05       |   |
|                                                                                                               |       |                                     |       |
| Diluted — as reported                                                                                         |       | $                                        | 0.04       |   |
|                                                                                                               |       |                                     |       |
| Basic — pro forma                                                                                             |       | $                                        | 0.04       |   |
|                                                                                                               |       |                                     |       |
| Diluted — pro forma                                                                                           |       | $                                        | 0.03       |   |

 

The assumptions used to calculate the SFAS No. 148,*Accounting for Stock-Based Compensation —Transition and Disclosures,*pro forma disclosure for sharespurchased under the 2004 ESPP under the Black-Scholes option pricing model forthe period ended March 31, 2005 were as follows:

 

|                           | ** ** | **Three   Months  Ended  March 31,** | ** ** |
|---------------------------|------------|------------------------------------------------|------------|
| ** **                | ** ** | **2005**                                       | ** ** |
| Risk-free  interest rate  |       | 2.40                                           | %          |
| Expected  volatility      |       | 60                                             | %          |
| Expected life  (in years) |       | 0.5                                            |       |
| Expected dividend yield   |       | —                                         |       |

 

 

13

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**Stock Option Activity**

Asummary of stock option activity under the three plans as of March 31,2006, and changes during the three month period ended March 31, 2006, is asfollows:

 

| Options                                                | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  December 31, 2005                 |       | 4,331,775  |       | $                                       | 4.64       |                                                              |       | ** **                          | ** ** | ** ** |
| Granted                                                |       | 13,500     |       | 8.90                                    |       |                                                              |       |                                |       |
| Exercised                                              |       | (159,974   | )          | 3.46                                    |       |                                                              |       |                                |       |
| Cancelled                                              |       | (15,211    | )          | 5.70                                    |       |                                                              |       |                                |       |
| Outstanding at  March 31, 2006                    |       | 4,170,090  |       | 4.70                                    |       | 7.37                                                              |       | $                                   | 26,875     |   |
|                                                   |       |       |       |                                    |       |                                                              |       |                                |       |
| Exercisable at  March 31, 2006                    |       | 2,309,751  |       | 3.53                                    |       | 6.43                                                              |       | 17,577                              |       |
|                                                   |       |       |       |                                    |       |                                                              |       |                                |       |
| Vested or  expected to vest at March 31, 2006 (1) |       | 4,013,818  |       | $                                       | 4.63       |                                                              | 7.31       |                                | $          | 26,136 |   |

----

(1)             Thevested or expected to vest options at March 31, 2006 include both thevested options and the number of options expected to vest which has beencalculated by applying an estimated forfeiture rate to the unvested options.

Asummary of the status of the Company’s non-vested stock option shares at March 31,2006, and changes during the three month period ended March 31, 2006, is asfollows:

 

| Un-vested Shares                       | ** ** | **Shares** | ** ** | **Weighted-  Average Grant-  Date Fair Value** | ** ** |
|---------------------------------------------|------------|------------|------------|---------------------------------------------------------------|------------|
| Un-vested Shares  at December 31, 2005 |       | 2,055,245  |       | $                                                             | 5.98       |   |
| Granted                                     |       | 13,500     |       | 8.90                                                          |       |
| Vested                                      |       | (193,210   | )          | 4.67                                                          |       |
| Forfeited                                   |       | (15,196    | )          | 5.71                                                          |       |
| Un-vested at  March 31, 2006           |       | 1,860,339  |       | $                                                             | 6.14       |   |

 

The followingtable summarizes information regarding the Company’s stock options outstandingand exercisable at March 31, 2006:

 
| ** **                              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                                   | ** ** |
|-----------------------------------------|------------|------------------------------|------------|--------------------------------------------------------------------------------|------------|
| **Range of Exercise  Prices** | ** ** | **Number of  Shares**   | ** ** | **Weighted Average  Remaining  Contractual   Life  (in Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $0.10  - 0.60                      |       | 27,351                       |       | 2.30                                                                           |       | $ | 0.14 |   | 27,351 |   | $ | 0.14 |   |
| 0.61 -  1.20                       |       | 30,650                       |       | 3.54                                                                           |       | 1.00 |   | 30,650 |   | 1.00 |   |
| 1.21 -  2.40                       |       | 7,500                        |       | 3.72                                                                           |       | 2.00 |   | 7,500 |   | 2.00 |   |
| 2.41 -  3.00                       |       | 2,190,835                    |       | 6.35                                                                           |       | 3.00 |   | 1,820,447 |   | 3.00 |   |
| 3.01 -  4.80                       |       | 171,459                      |       | 7.83                                                                           |       | 4.50 |   | 66,710 |   | 4.50 |   |
| 4.81 -  5.40                       |       | 71,200                       |       | 3.99                                                                           |       | 5.00 |   | 71,200 |   | 5.00 |   |
| 5.41 -  6.00                       |       | 90,055                       |       | 7.95                                                                           |       | 6.00 |   | 39,690 |   | 6.00 |   |
| 6.01 -  7.80                       |       | 1,240,040                    |       | 8.89                                                                           |       | 6.74 |   | 233,703 |   | 6.93 |   |
| 7.81 -  9.00                       |       | 241,000                      |       | 9.43                                                                           |       | 7.87 |   | — |   | — |   |
| 9.01 - 10.29                            |       | 100,000                      |       | 9.65                                                                           |       | 10.29 |   | 12,500 |   | 10.29 |   |
|                                    |       | 4,170,090                    |       | 7.37                                                                           |       | $ | 4.70 |   | 2,309,751 |   | $ | 3.53 |   |

** **

**Deferred Compensation**

        Prior to the adoption of SFAS No. 123(R),the Company recorded deferred stock-based compensation in the amount by whichthe exercise price of an option is less than the deemed fair value of ourcommon stock at the date of grant. Because there had been no public market forthe Company’s stock prior to the July 2004 initial public offering, theCompany’s Board of Directors had determined the fair value of the common stockbased upon several factors, including, but not limited to, the Company’soperating and financial performance, issuance of convertible preferred stock,the rights and preferences of all securities senior to common stock and 

14

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the anticipated offering price of the Company’s commonstock in connection with the initial public offering.

During the three months ended March 31, 2005 and2006, the Company recorded no deferred stock-based compensation and recordedstock-based compensation expense of $224 and $128, respectively, related tothese awards.

As of March 31, 2006, there was an aggregate of$476 of deferred stock-based compensation remaining to be amortizedapproximately as follows: $247 in the remaining three quarters of 2006; $157 inthe year ended December 31, 2007; $41 in the year ended December 31,2008; $20 in the year ended December 31, 2009; and $11 through December 31,2011. The Company amortizes the deferred compensation charges over the vestingperiod of the underlying option awards in accordance with FASB Interpretation No. 28,*Accounting for Stock Appreciation Rights and OtherVariable Stock Option or Award Plans*.

In the past, the Company awarded a limited number ofstock options to non-employees. For these options, the Company recognizes thestock-based compensation expense over the vesting periods of the underlyingawards, based on an estimate of their fair value on the vesting dates using theBlack-Scholes option-pricing model.

**10.   Goodwill and Intangible Assets**

Goodwill and intangible assets that have indefinitelives are not amortized but are evaluated for impairment annually or wheneverevents or changes in circumstances indicate the carrying value may not berecoverable. Intangible assets that have finite lives are amortized over theiruseful lives.

The goodwill resulting from acquisitions is reviewedfor impairment on an annual basis in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets.*Consistentwith prior years, the Company conducted its annual impairment test of goodwillduring the fourth quarter of 2005 and determined that no impairment of goodwillexisted at December 31, 2005.

A rollforward of the net carrying amount of goodwillis as follows:

 

|                                                                                          | ** ** | **Amount** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------|------------|
| Balance as of December 31, 2004                                                     |       | $          | 21,817     |   |
| Utilization of acquired net  operating losses — Clinsoft                            |       | (2,057     | )          |
| Increase associated with the  acquisition of Lincoln                                     |       | 8,430      |       |
| Release of valuation  allowance related to acquired net operating losses — Clinsoft |       | (3,230     | )          |
| Balance as of December 31, 2005                                                     |       | $          | 24,960     |   |
| Decrease associated with the  acquisition of Lincoln                                     |       | (386       | )          |
| Release of valuation  allowance related to acquired net operating losses — Clinsoft |       | (92        | )          |
| Balance as of March 31, 2006                                                        |       | $          | 24,482     |   |

 

The utilization ofor release of the valuation allowance related to acquired net operating lossesreflects an actual or anticipated reduction in cash payments to local taxingauthorities for income taxes that are not reflected as a benefit in the incometax provision for financial statement purposes but rather as a reduction togoodwill. In the year ended December 31, 2005, the Company determined thatit is more likely than not that the Company will realize a portion of itsdeferred tax assets and therefore reduced the valuation allowance by $7,772 in December 2005.This benefit of the release in valuation allowance was realized throughreductions to income tax expense of $4,542 and to goodwill of $3,230. Duringthe three months ending March 31, 2006, adjustments totaling $386 wererecorded as decreases to goodwill associated with the acquisition of Lincoln.The Company received payment of $147 for previously written-off accountsreceivable, deferred revenue was reduced by $123 due to the completion of twoservices engagements and $116 was related to the sublease of the abandonedLincoln facility.

Intangible assets,all of which relate to the acquisition of Lincoln, consist of the following asof December 31, 2005 and March 31, 2006:

 
| ** **                         | ** ** | ** **                      | ** ** | **As of December 31, 2005** | ** ** | **As of March 31, 2006** | ** ** |
|------------------------------------|------------|---------------------------------|------------|-------------------------------------------------|------------|----------------------------------------------|------------|
| **Description**                    | ** ** | **Estimated  Useful Life** | ** ** | **Gross  Carrying  Value**                      | ** ** | **Accumulated  Amortization**                | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed  technology and know-how |       | 5 years                         |       | $                                               | 1,800      |                                         | $          | 127 |   | $ | 1,800 |   | $ | 217 |   |
| Customer  relationships            |       | 5 years                         |       | 1,600                                           |       | 112                                          |       | 1,600 |   | 193 |   |
| Non-compete  agreements            |       | 2 years                         |       | 300                                             |       | 53                                           |       | 300 |   | 90 |   |
| Tradename                          |       | 5 years                         |       | 200                                             |       | 14                                           |       | 200 |   | 24 |   |
| Total                              |       |                            |       | $                                               | 3,900      |                                         | $          | 306 |   | $ | 3,900 |   | $ | 524 |   |

 

Amortization expense related to intangible assets forthe three months ended March 31, 2005 and 2006 was $0 and $218,respectively.

15

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The estimatedremaining amortization expense for each of the five succeeding fiscal years:

 

| Year ended December 31, | ** ** | **Amount** | ** ** |
|----------------------------------------|------------|------------|------------|
| 2006                                   |       | $          | 652        |   |
| 2007                                   |       | 817        |       |
| 2008                                   |       | 720        |       |
| 2009                                   |       | 720        |       |
| 2010                                   |       | 467        |       |
| Total                                  |       | $          | 3,376      |   |

 

**11.   Accrued Expenses**

Accrued expenses consist of the following:

|                                       | ** ** | **As of  December 31,  2005** | ** ** | **As of  March 31,  2006** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|--------------------------------------|------------|
| Accrued payroll  and related benefits |       | $                                       | 5,327      |                                 | $          | 4,382 |   |
| Accrued other  expenses               |       | 4,037                                   |       | 3,392                                |       |
| Accrued  royalties                    |       | 2,411                                   |       | 3,079                                |       |
| Accrued income  taxes                 |       | 697                                     |       | 567                                  |       |
|                                  |       |                                    |       |                                 |       |
|                                  |       | $                                       | 12,472     |                                 | $          | 11,420 |   |

 

**12.   Debt**

Effective March 31, 2004, the Company renewed itsworking capital line of credit with a bank and increased the amount which itcould borrow to $5,000. Borrowings under the working capital line of creditwere secured by substantially all assets of the Company. The Company enteredinto a negative pledge agreement that, subject to certain exceptions, generallyprohibited the Company from pledging its intellectual property to others. In August of2005, the working capital line of credit was amended to eliminate the securityinterest in the Company’s assets and the negative pledge on the Company’sintellectual property. The amendment also removed or modified the financialcovenants. Effective March 31, 2006 the working capital line of credit wasreduced from $5,000 to $2,000. As of December 31, 2005 and March 31,2006, $0 was outstanding under the working capital line of credit. At March 31,2006, there was $700 available under the line of credit, and $1,300 reservedunder a letter of credit associated with the Company’s leased facility. In April 2006,the letter of credit was reduced to $500. At March 31, 2006, the Companywas 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. The outcome of litigation cannot bepredicted 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.

On February 15,2006, 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 the Company’s customers, Quintiles, Inc., infringe a UnitedStates patent claimed to be owned by Datasci. Under the Settlement Agreementand related License Agreement, the Company agreed to make a one-time, lump sumpayment to Datasci in the amount of $8,500 to settle the claim and obtain aperpetual, irrevocable, fully-paid, worldwide, non-exclusive license to thepatent that was the subject of the claim by Datasci. The confidentialsettlement, in which neither party admits liability, provides for mutualreleases and dismissal of all actions between the parties. Since thecontingency existed as of December 31, 2005 and the settlement wasconcluded prior to the issuance of the Company’s 2005 audited consolidatedfinancial statements, in accordance with SFAS No. 5, *Accountingfor Contingencies,*the Company recorded the impact of the settlementin 2005 as a charge to operations.  Thesettlement was paid during the three months ending March 31, 2006. TheCompany does not anticipate changing any of its products as a result of thelicense to this patent.

**14.   Stockholders’ Equity**

During the threemonths ended March 31, 2006, the Company issued 159,974 shares of commonstock in connection with the exercise of stock options, resulting in proceedsof $554.

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**15.   ComprehensiveIncome**

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

Comprehensiveincome consisted of the following:

|                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
| Net income                         |       | $                                                | 1,468      |   | $ | 2,086 |   |
| Cumulative  translation adjustment |       | (165                                             | )          | 125 |   |
| Comprehensive income               |       | $                                                | 1,303      |   | $ | 2,211 |   |

 

**16.   ForwardForeign 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 March 31, 2005 and 2006:

 
| ** **    | ** ** | ** **      | ** ** | **As of  December 31,  2005** | ** ** | **As of  March 31,   2006** | ** ** |
|---------------|------------|-----------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **Hedge  Type** | ** ** | **Local Currency  Amount**         | ** ** | **Approximate  U.S.  Dollar  Equivalent**  | ** ** | **Local Currency  Amount** | ** ** | **Approximate  U.S.  Dollar   Equivalent** | ** ** |
| British pound |       | Sale            |       | 6,000                                   |       | $                                          | 10,303     |   | 1,600 |   | $ | 2,783 |   |
| Euro          |       | Purchase        |       | (500                                    | )          | (592                                       | )          | (300 | ) | (364 | ) |
| Japanese yen  |       | Sale            |       | 156,000                                 |       | 1,317                                      |       | 68,000 |   | 587 |   |
|          |       |            |       |                                    |       | $                                          | 11,028     |   |   |   | $ | 3,006 |   |

 

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

Due to the shortperiod of time between entering into the forward foreign exchange contracts andMarch 31, 2006, the forward foreign exchange contract rate approximatesthe exchange rate as of the end of the reporting period.

Realized andunrealized foreign currency gains (losses), net of hedging are accounted for innon-operating income (expense). Foreign currency losses, net of hedging, were$112, and $62 for the three months ended March 31, 2005 and 2006,respectively. The Company settles forward foreign exchange contacts in cash.

**17.   **Income Taxes

The Company’seffective tax rates for the three months ended March 31, 2005 and 2006**were 28% and 18%, respectively, which were lower than theCompany’s statutory federal and state rate of 40.0% due to the utilization ofpreviously unrecognized net operating losses. The Company currently expects torealize recorded deferred tax assets as of March 31, 2006 of approximately$7.8 million. The Company’s conclusion that such assets will be recovered isbased upon its expectation that future earnings of the Company combined withtax planning strategies available to the Company will provide sufficienttaxable income to realize recorded tax assets. Such tax strategies includeestimates and involve judgment. 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.

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

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

**Overview**

Phase ForwardIncorporated is a provider of integrated enterprise-level software products,services and hosted solutions for use in our customers’ global clinical trialand safety monitoring activities. Our customers include pharmaceutical,biotechnology and medical device companies, as well as academic institutions,governmental regulatory agencies, clinical research organizations, or CROs, andother entities engaged in clinical trial and safety monitoring activities. Byautomating essential elements of the clinical trial and safety monitoringprocesses, we believe our products allow our customers to accelerate the marketintroduction of new medical therapies and corresponding revenue, reduce overallresearch and development expenditures, enhance existing data quality controlefforts, increase drug safety compliance 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. The most significant of these transactionsare the acquisitions of Clinsoft Corporation (“Clinsoft”) and LincolnTechnologies, Inc. (“Lincoln”), which are described below.

*LincolnTechnologies, Inc.*

On August 25, 2005, we acquired all of theoutstanding capital stock of Lincoln, a provider of products and services fordrug safety, clinical trial safety signal detection, and applied data standards.Lincoln’s products consist of *WebVDME, CTSD*and*WebSDM.*

The aggregate purchase price was approximately $13.2million. The acquisition agreement calls for additional cash consideration, tobe paid subject to achievement of certain financial targets in 2005 and 2006,of up to $2.0 million and $4.0 million in 2005 and 2006, respectively. The 2005financial targets associated with additional cash consideration were achievedand, accordingly, we  accrued additionalconsideration of $2.0 million in 2005 which was paid in May of 2006. Additionalcash consideration associated with 2006 financial targets will be accrued ifand when achievement of certain financial targets is reached and will beincluded as additional consideration towards the purchase price of theacquisition. The acquisition of Lincoln was accounted for as a purchase underStatement of Financial Accounting Standards (SFAS) No. 141, *Business Combinations*. Accordingly, the results of Lincolnhave been included in our consolidated financial statements since the date ofacquisition.

*Clinsoft Corporation*

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

**Litigation Settlement**

On February 15,2006, we entered into a Settlement Agreement and related License Agreement withDr. Mark L. Kozam d/b/a MLK Software and Datasci, LLC. The SettlementAgreement relates to a lawsuit filed by Datasci in 2004 alleging that certainof our products and services and certain products and services of one of ourcustomers, Quintiles, Inc., infringe a United States patent claimed to beowned by Datasci. Under the Settlement Agreement and related License Agreement,we agreed to make a one-time, lump-sum payment to Datasci in the amount of $8.5million to settle the claim and obtain a perpetual, irrevocable, fully-paid,worldwide, non-exclusive license to the patent that was the subject of theclaim by Datasci. The confidential settlement, in which neither party admitsliability, provides for mutual releases and dismissal of all actions betweenthe parties. 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. We do not anticipate changing any of our products asa result of the license to this patent. During the three months ended March 31,2006, we incurred expense of $373,000 relating to our defense in this suit,which is included in general and administrative expenses.

**Sourcesof Revenues**

We derive our revenues from software licenses andservices. License revenue is derived principally from the sale of multi-yearsoftware term licenses for our *InForm,Clintrial* and *Clintrace*products and from annual term licensesfor our *WebVDME,**CTSD* and *WebSDM*software products. Service revenue is derived principallyfrom our delivery of the hosted solution of our *InForm,**WebVDME*, *CTSD*and *WebSDM* softwareproducts, and consulting services and customer support, including training, forall of our products. We generally recognize revenues ratably over the life of alicense or service contract. This allows us to maintain a backlog that providesmulti-year visibility in revenue.

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Two customers,GlaxoSmithKline and Eli Lilly and Company, the holder of record ofapproximately 1% of our common stock, together accounted for approximately 23%and 25% of our total revenues in the three months ended March 31, 2005 and2006, respectively and $5.0 million of accounts receivable outstanding as ofboth December 31, 2005 and March 31, 2006. Our top 20 customersaccounted for approximately 71% and 68% of our total revenues in the threemonths ended March 31, 2005 and 2006, respectively, net of reimbursableout-of-pocket expenses.

* License Revenue*

We derive our license revenues from the followingproducts: *InForm*, our Internetbased electronic data capture solution; *Clintrial*,our clinical data management solution; and our drug safety solutions, including*Clintrace*, and our recently acquired *WebVDME*, *CTSD*, and *WebSDM* products. Although each of our software solutions areavailable as stand-alone enterprise applications, we offer integratedenterprise solutions incorporating certain of our electronic data capture, datamanagement and drug safety products.

License revenues for our *InForm *electronic data capture software solution,either on a stand-alone or integrated basis, are determined primarily by thenumber, complexity and duration of the clinical trials and the number ofparticipants in each clinical trial. License revenues for our *Clintrial,**Clintrace,**WebVDME*, *CTSD* and *WebSDM* softwaresolutions are determined primarily by the number of users accessing thesoftware solution. Except as discussed below, we enter into software licenseagreements for our *InForm*, *Clintrial* and *Clintrace* products**with terms generally of three tofive years with payment terms generally annually in advance. License agreementsfor our *WebVDME, CTSD*and*WebSDM*products are typically annual with payment terms generally in advance. Licenserevenues are recognized ratably over the duration of the software term licenseagreement, to the extent that amounts are fixed or determinable andcollectable.

Following our acquisition of Clinsoft in August 2001,we began converting holders of Clinsoft perpetual software licenses to oursoftware term license arrangements. We continue to sell perpetual licenses ofthese products in certain situations to our existing customers with the optionto purchase customer support, and may in the future do so for new customersbased on customer requirements or market conditions. We recognize revenue onthe perpetual licenses upon delivery of the software. We continue to provideand charge for maintenance and support on our products to those customers whodo not convert to our software term license arrangements. We generally charge18% of the perpetual license fee for customer support. We will continue ourefforts to convert the remaining former Clinsoft customer base to software termlicense arrangements. However, we anticipate that some customers will notconvert and instead will continue to make annual customer support payments.

*ServiceRevenue*

*ApplicationHosting Services.*  In addition to making oursoftware products available to customers through licenses, we offer our *InForm*,*WebVDME, CTSD*and*WebSDM*software as hosted application solutions delivered through a standardweb-browser, with customer support and training services. Services revenue fromapplication hosting services is derived principally from our *InForm *hosted solution.

Revenue resultingfrom the *InForm *hostingservice consists of three stages for each clinical trial:

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

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

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

Services provided for the first and third stages areprovided on a fixed fee basis depending upon the complexity of the trial andsystem requirements. Services for the second stage are charged separately as afixed monthly fee. We recognize revenue from all stages of the hosting serviceratably over the hosting period. Fees charged and costs incurred for the trialsystem design, set up and implementation are deferred until the start of thehosting period and then amortized ratably over the estimated hosting period.The deferred costs include direct costs related to the trial and applicationset up. Fees for the first and third stages of the services are billed basedupon milestones. Fees for application hosting and related services in thesecond stage are billed quarterly in advance. Bundled into this revenue elementis the revenue attributable to the software license used by the customer.

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

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

In addition,application hosting services revenue includes hosting services associated withterm license customers and reimbursable out-of-pocket expenses.

*        ConsultingServices.*  Consulting services include the designand documentation of the processes related to our customers’ use of ourproducts 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 consulting services included in either a multipleelement software license agreement or in an application hosting agreement arerecognized ratably over the term of the arrangement. The associated costs areexpensed as incurred. Revenues from consulting services that are not includedin a multiple element software license arrangement are recognized as servicesare performed. Fixed priced arrangements are billed based upon contractualmilestones, and time-and-materials arrangements are billed monthly.

*        CustomerSupport.*  We have a multinational servicesorganization to support our software products and hosted solutions worldwide.Customer support includes telephone support, software maintenance and training.We bundle customer support in our software term licenses and allocate 10% ofthe value of the license to customer support revenue. Our customer supportrevenue also consists of customer support fees paid by perpetual licensecustomers. Customer support revenue is recognized ratably over the period ofthe customer support or term license agreement, with payment terms generallyannually in advance.

**Cost ofRevenues and Operating Expenses**

        Weallocate overhead expenses such as rent and occupancy charges and employeebenefit costs to all departments based on headcount. As such, general overheadexpenses are reflected in cost of service revenues and in the sales andmarketing, research and development, and general and administrative 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 additionto these costs we have also incurred expense for the amortization of acquiredtechnologies associated with the acquisition of Lincoln. The cost of licenserevenue varies based upon the mix of revenue from software licenses for ourproducts. We operate our service organization on a global basis as one distinctunit, and do not segment costs for our various service revenue elements. Theseservices include performing application hosting, consulting and customersupport services, and costs consist primarily of employee-related costs associatedwith these services, amortization of the deferred clinical trial set up costs,allocated overhead, outside contractors, royalties associated with providingcustomer 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 of service revenue varies based upon thenumber of employees in the service organization, the type of work performed,and royalties associated with revenue derived from providing customer support,as well as costs associated with the flexible use of outside contractors tosupport internal resources. We supplement the trial design and set up activityfor *InForm *applicationhosting services through the use of outside contractors. This allows us toutilize outside contractors in those periods where trial design and set upactivity is highest while reducing the use of outside contractors in thoseperiods where trial activity lessens, allowing for a more flexible deliverymodel. The percentage of the services workforce represented by outsidecontractors varies from period to period depending on the volume of specificsupport required. The cost of services is significantly higher as a percentageof revenue as compared to our cost of license revenue primarily due to theemployee-related and outside contractor expenses associated with providingservices.

*        GrossMargin.*  Our gross margin on license revenuevaries based on the mix of royalty- and non-royalty-bearing license revenue andthe amount of amortization of acquired technologies. Our gross margin onservice revenue varies primarily due to variations in the utilization levels ofthe professional service team and the timing of expense and revenue recognitionunder our service arrangements. In situations where the service revenue isrecognized ratably over the software license term, typically three to fiveyears, our costs associated with delivery of the services are recognized as theservices are performed, which is typically during the first 6 to 12 monthsof the contract period. Accordingly, our gross margin on service revenue willvary significantly over the life of a contract due to the timing, amount andtype of service required in delivering certain projects. In addition,consolidated gross margin will vary depending upon the mix of license andservice revenue.

*        Salesand Marketing.*  Sales and marketing expensesconsist primarily of employee-related expenses, including travel, marketingprograms (which include product marketing expenses such as trade shows,workshops and seminars, corporate communications, other brand building andadvertising), allocated overhead and the amortization of commissions. We expectthat sales and marketing 

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expenses will continue toincrease in absolute dollars as commission expense increases with our revenuesand as we continue to expand sales coverage and to build brand awarenessthrough what we believe are the most cost effective channels available, but mayfluctuate quarter over quarter due to the timing of marketing programs.

*        Researchand Development.*  Research and developmentexpenses consist primarily of employee-related expenses, allocated overhead andoutside contractors. We focus our research and development efforts onincreasing the functionality, performance and integration of our softwareproducts. We expect that in the future, research and development expenses willincrease in absolute dollars as we introduce additional integrated softwaresolutions to our product suite.

*        Generaland Administrative.*  General 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, general and administrative expenses will fluctuatequarter by quarter due to the timing of outside contractor and professionalfees associated with Sarbanes-Oxley compliance, as well as legal services.

*Restructuring.*  We recorded a $4.5 million restructuringcharge in 2003 which related to the relocation of our corporate headquarters.This charge includes approximately $2.5 million relating to the estimatedfuture obligation under the non-cancelable lease and an approximate$2.0 million write-off of the related abandoned leasehold improvements andfixed assets. As of March 31, 2005, payments for all remaining expenseswere completed and as a result we recorded a restructuring benefit of $92,000representing the elimination of accrued expenses associated with therestructuring charge.

*Stock-BasedCompensation Expenses.*  Our sales and marketing,research and development, and general and administrative cost of servicerevenues include stock-based compensation expenses related to the fair value ofoptions issued to non-employees and option grants to employees in situationswhere the exercise price is determined to be less than or equal to the deemedfair value of our common stock at the date of grant.

**ForeignCurrency Translation**

        Withregard to our international operations, we frequently enter into transactionsin currencies other than the U.S. dollar. As a result, our revenues, expensesand cash flows are subject to fluctuations due to changes in foreign currencyexchange rates, particularly changes in the euro, British pound, Australiandollar and Japanese yen. In the three months ended March 31, 2005 and2006, approximately 48% and 49%, respectively, of our revenues were generatedin locations outside the United States. The majority of these revenues are incurrencies other than the U.S. dollar, as are many of the associated expenses.In periods when the U.S. dollar declines in value as compared to the foreigncurrencies in which we conduct business, our foreign currency-based revenuesand expenses generally increase in value when translated into U.S. dollars.

**CriticalAccounting Policies and Estimates**

Our unaudited condensedconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of thesefinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. On an ongoingbasis, we evaluate our estimates and assumptions with our audit committee,including those related to revenue recognition, deferred set up costs,commissions and royalties, accounts receivable reserves, stock-basedcompensation, 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 values of assets and liabilities that arenot readily apparent from other sources. There have been no material changes tothese estimates for the periods presented in this Quarterly Report on Form 10-Q.Our actual results may differ from these estimates under different assumptionsor conditions.

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

*        RevenueRecognition and Deferred Set Up Costs.*  Werecognize software license revenue 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 ofAICPA Statement of Position 97-2 to Arrangements that Include the Rightto Use Software*

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*Storedon Another Entity’s Hardware* and Securities and ExchangeCommission’s (SEC) Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition*. On August 1,2003, we adopted EITF Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables.* Theadoption of EITF Issue No. 00-21 did not have a material impact onour financial position or results of operations.

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

        Werecognize revenue when all of the following conditions are satisfied: (1) thereis persuasive evidence of an arrangement; (2) the product or service hasbeen provided to the customer; (3) the collection of our fees is probable;and (4) the amount of fees to be paid by the customer is fixed ordeterminable.

        Wegenerally enter into software term licenses for our *InForm*, *Clintrial*and *Clintrace* products with ourcustomers for 3- to 5-year periods. License agreements for our *WebVDME, CTSD*and*WebSDM*products are typically for one-year terms. These arrangements typically includemultiple elements: software license, consulting services and customer support.We bill our 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.

        Oursoftware license revenue is 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.

We generally bundle customer support with thesoftware license for the entire term of the arrangement. As a result, wegenerally recognize revenue for all elements, including consulting services,ratably over the term of the software license and support arrangement. Weallocate the revenue 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 revenue is generally recognized ratably over thecontractual term of the arrangement. If the fee is based on actual usage, andtherefore variable, the revenue is recognized in the period of use. Revenuefrom certain follow-on consulting services, which are sold separately tocustomers with existing software licenses and are not considered part of amultiple element arrangement, is recognized as the services are performed.

        Wecontinue to sell perpetual licenses for the *Clintrial*and *Clintrace* software productsin certain situations to our existing customers with the option to purchasecustomer support and may in the future do so for new customers based oncustomer requirements or market conditions. We have established vendor specificobjective evidence of fair value for the customer support. Accordingly, licenserevenue is recognized upon delivery of the software and when all other revenuerecognition criteria are met.  Customersupport revenues are recognized ratably over the term of the underlying supportarrangement. We continue to generate customer support and maintenance revenuefrom our perpetual license customer base. Training revenue is recognized asearned.

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

Revenue 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 revenue from all stages of the *InForm *hostingservice ratably over the hosting period. Fees charged and costs incurred forthe trial system design, set up and implementation are deferred and capitalizedas applicable, until the start of the hosting period and then amortized andrecognized, as applicable, ratably over the estimated hosting period. Thecapitalized costs include incremental direct costs with third parties andcertain internal direct costs related to the trial and application set up, asdefined 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 

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as an additional fee and is generally recognizedratably over the remaining term of the hosting period. Fees for the first andthird stages of the services are billed based upon milestones. Fees forapplication hosting and related services in the second stage are billedquarterly in advance. Bundled into this revenue element is the revenueattributable to the software license used by the customer.

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

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

        Wecapitalized $666,000 and $632,000 of deferred set up costs and amortized$449,000 and $475,000 during the three months ended March 31, 2005 and2006, respectively. The amortization of deferred set up costs is a component ofcost of services.

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

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

*        Accountingfor Prepaid Sales Commissions and Royalties.*  Forarrangements where we recognize revenue 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. During thethree months ended March 31, 2005 and 2006, we deferred $677,000 and$1.1 million, respectively, of commissions and amortized $830,000 and$909,000, respectively, to sales and marketing expense. Royalties are paid on apercentage of billings basis for certain of our products. During the threemonths ended March 31, 2005 and 2006, we deferred $822,000 and $994,000,respectively, of royalty expenditures and amortized $571,000 and $824,000,respectively, to cost of license and service revenue.

*        AccountsReceivable Reserves.*  We maintain allowances fordoubtful accounts for estimated losses resulting from the inability of ourcustomers to make required payments. We regularly evaluate the collectibilityof our trade receivables based on a combination of factors, which may includedialogue with the customer to determine the cause of non-payment, the use ofcollection agencies, and/or the use of litigation. In the event it isdetermined that the customer may not be able to meet its full obligation to us,we record a specific allowance to reduce the related receivable to the amountthat we expect to recover given all information available to us. Wecontinuously monitor collections from our customers and maintain a provisionfor estimated credit losses based upon our historical experience and anyspecific customer collection issues that we have identified. While such creditlosses have historically been within our expectations and the provisionsestablished, we cannot guarantee that we will continue to experience the samecredit loss rates in the future. If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required. Our accounts receivablereserves were $318,000 and $309,000 as of December 31, 2005 and March 31,2006, respectively.

*Accountingfor Income Taxes.*  In connection with preparing ourfinancial statements, we are required to estimate income tax expense in eachjurisdiction in which we operate. This process requires that we project ourcurrent tax liability and estimate our deferred tax assets and liabilities,including net operating loss and tax credit carryforwards. In assessing theneed for a valuation allowance, we have considered our recent operatingresults, future taxable income projections and all prudent and feasible taxplanning strategies. In the year ended December 31, 2005, we determinedthat it is more likely than not that we will realize a portion of our deferredtax assets and reduced the valuation allowance by $7.8 million in December 2005.This benefit of the release in valuation allowance was realized throughreductions to income tax expense of $4.5 million and to goodwill of $3.2million. During the three months ended March 31, 2006 the Company releaseda portion of its valuation allowance, resulting in a reduction in income taxexpense of $700,000.

*Accountingfor Stock-Based Awards.* On December 16, 2004, theFASB issued SFAS No. 123 (revised 2004), *Share-BasedPayment* (SFAS No. 123(R)) which is a revision of SFAS No. 123,*Accounting for Stock-Based Compensation*.SFAS No. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25,*Accounting for Stock Issued to Employees*,and amends SFAS No. 95, *Statement of Cash Flows*.Generally, the approach under SFAS No. 123(R) is similar to theapproach described in SFAS 123. However, SFAS No. 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative.

SFAS No. 123(R) mustbe adopted for fiscal years starting after June 15, 2005. As a result, weadopted SFAS No. 123(R) starting in our fiscal first quarter of 2006,which began on January 1, 2006.

 

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As permitted bySFAS 123, we historically accounted for share-based payments to employees usingthe APB Opinion No. 25 intrinsic value method and, as such, generallyrecognized no compensation cost for employee stock options other than theamortization of deferred stock-based compensation cost associated with stockoptions granted at a discount from the deemed fair market value. We adopted the“modified prospective” method, outlined in SFAS No. 123(R). Under the “modifiedprospective” method compensation cost is recognized in the income statementbeginning on the adoption date of SFAS No. 123(R):  (a) based on the requirements of SFAS No. 123(R) forall share-based payments granted on or after the adoption date;  (b) based on the requirements of SFAS123 for all share-based payments that are un-vested as of December 31,2005; and (c) excludes those options issued prior to the Phase Forwardbecoming a public entity which were valued using the “minimum value method”. Therefore,in accordance with the modified prospective method, we are amortizing theunamortized stock-based compensation expense related to those stock optionsthat remained unvested as of December 31, 2005, whose fair value wascalculated utilizing a Black-Scholes option pricing model.

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

Effective with theadoption of SFAS No. 123(R), we have elected to use the Black-Scholesoption pricing model to determine the weighted average fair value of optionsgranted.

       We have alimited trading history for our common stock as it began trading on the NASDAQNational Market on July 15, 2004. Accordingly, we have determined theexpected life and the volatility for options granted in 2005 based on ananalysis of reported data for a peer group of companies that issued optionswith substantially similar terms. The expected life of options we granted hasbeen determined based on the average expected life of the options as reportedby this peer group of companies. The expected life of options granted duringthe three months ended March 31, 2006 was 4.28 years. The expectedvolatility of options granted has been determined using an average of thehistorical volatility measures of this peer group of companies as well as theweighted average historical volatility of our own common stock beginning with January 2005.The expected volatility for options granted during the three months ended March 31,2006 was 53%. The risk-free interest rate is based on a treasury instrumentwhose term is consistent with the expected life of the stock options. We havenot paid and do not anticipate paying cash dividends on our shares of commonstock; therefore, the expected dividend yield is assumed to be zero. Inaddition, SFAS No. 123(R) requires companies to utilize an estimatedforfeiture rate when calculating the expense for the period, whereas, SFAS No. 123permitted companies to record forfeitures based on actual forfeitures, whichwas our historical policy under SFAS No. 123. As a result, we have appliedan estimated forfeiture rate of 4.3% in the first quarter of  2006 in determining the expense recorded inour consolidated statement of income.

During the quarter ended March 31, 2005, werecorded $224,000 of stock-based compensation expense due to the amortizationof previously recorded deferred compensation. During the quarter ended March 31,2006, we recorded $456,000 of stock-based compensation expense, of which$328,000 was as a result of the adoption of SFAS No. 123(R). The remainingstock-based compensation expense is due to the amortization of previouslyrecorded deferred compensation. The stock-based compensation expense included$44,000 in cost of revenues, $60,000 in research and development, $110,000 inselling and marketing and $242,000 in general and administrative expense forthe three months ended March 31, 2006. The compensation expense reducedboth basic and diluted earnings per share by $0.01. As of March 31, 2006,there was $4.0 million of unrecognized compensation expense related tonon-vested market-based share awards that is expected to be recognized over aweighted-average period of 2.83 years.

Prior to theadoption of SFAS No. 123(R), we recorded deferred stock-based compensationin the amount by which the exercise price of an option is less than the deemedfair value of our common stock at the date of grant. Because there had been nopublic market for the our stock prior to the July 2004 initial publicoffering, our Board of Directors had determined the fair value of the commonstock based upon several factors, including, but not limited to, our operatingand financial performance, issuance of convertible preferred stock, the rightsand preferences of all securities senior to common stock and the anticipatedoffering price of our common stock in connection with the initial publicoffering.

       During the three months ended March 31,2005 and 2006, we recorded stock-based compensation expense of $224,000 and $128,000,respectively, related to these awards.

       Asof March 31, 2006, there was an aggregate of $476,000 of deferredstock-based compensation remaining to be amortized approximately as follows:$247,000 in the remaining three quarters of 2006; $157,000 in the year ended December 31,2007; $41,000 in the year ended December 31, 2008; $20,000 in the yearended December 31, 2009; and $11,000 through December 31, 2011. Weamortize the deferred compensation charges over the vesting period of theunderlying option awards in accordance with FASB Interpretation No. 28, *Accounting for Stock Appreciation Rights and Other Variable StockOption or Award Plans*.

        Inthe past, we awarded a limited number of stock options to non-employees. Forthese options, we recognize the stock-based compensation over the vestingperiods of the underlying awards, based on an estimate of their fair value onthe vesting dates using the Black-Scholes option-pricing model.

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*OtherSignificant Estimates*

* Goodwilland Intangible Assets Impairment.*  We review thecarrying value of goodwill and intangible assets periodically based upon theexpected future discounted operating cash flows of our business. Our cash flowestimates are based on historical results adjusted to reflect our best estimateof our operating results in future periods. Actual results may differmaterially from these estimates. The timing and size of impairment charges, ifany, involves the application of management’s judgment regarding the estimatesand could significantly affect our operating results.

**Overviewof Results of Operations for the Three Months Ended March 31, 2005 and2006**

        Totalrevenues increased by 15% or $3.1 million in the three months ended March 31,2006 compared to the same period in 2005 due to an increase in service revenuesof 24%.

        Ourgross margin increased by 9% or $1.1 million in the three months ended March 31,2006 compared to the same period in 2005, primarily due to the increase inservices revenues.

Operating incomefor the three months ended March 31, 2006 of $2.0 million increased 3% or$57,000 compared to the same period in 2005. Operating income in the firstquarter of 2005 included a restructuring benefit of $92,000. The operatingincome for the three months ended March 31, 2005 and 2006 also included$224,000 and $456,000 of stock-based compensation expense, respectively.

The results forthe three months ended March 31, 2006 were impacted by foreign exchangerate fluctuations, resulting in an approximately 3% decrease in both revenuesand expenses for the period.

        As of March 31, 2006, we had$63.3 million of cash, cash equivalents and short-term investments, anincrease of $2.7 million from $60.6 million at December 31, 2005.As of March 31, 2006, we had no outstanding debt.

*Revenues*
| ** **                    | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                    | ** ** | **2005**                                             | ** ** | **2006**                        | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                              | ** ** |
| License                       |       | $                                                    | 8,819      |                            | 43         | %          | $          | 9,025 |   | 38 | % | $ | 206 |   | 2 | % |
| Application  hosting services |       | 6,832                                                |       | 33                              |       | 8,954      |       | 38 |   | 2,122 |   | 31 | % |
| Consulting  services          |       | 1,394                                                |       | 7                               |       | 2,739      |       | 12 |   | 1,345 |   | 96 | % |
| Customer support              |       | 3,517                                                |       | 17                              |       | 2,898      |       | 12 |   | (619 | ) | (18 | )% |
|                          |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total                         |       | $                                                    | 20,562     |                            | 100        | %          | $          | 23,616 |   | 100 | % | $ | 3,054 |   | 15 | % |

 

        Totalrevenues increased in the three months ended March 31, 2006 as compared tothe same period in 2005, primarily due to increases in application hosting andconsulting services revenues. The increase in revenue associated with ourapplication hosting services in the three months ended March 31, 2006 wasdue to an increase in trials under management, which include both applicationhosting services trials as well as trials hosted for our *InForm *licensecustomers. The increase in consulting revenue was primarily attributable toservices relating to new business relationships relating to the *WebVDME* product we began offering afterthe August 2005 acquisition of Lincoln as well as additional *InForm *consulting revenue which was primarily relatedto our existing customer base. The decrease in customer support revenue in thethree months ended March 31, 2006 was due primarily to a reduction in *Clintrial* and *InForm *trainingrevenues as well as decreases in *Clintrace*and*InForm *customer support revenues. Our revenues werenot significantly impacted by price increases or decreases. Inflation had onlya nominal impact on our revenues. In the future, we anticipate that the percentage oflicense revenues and service revenues will fluctuate as a percentage of totalrevenues, primarily due to changes in the type, amounts and delivery schedulesof license and service orders, which are based on the requirements of ourcustomers.

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| ** **                          | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2005**                                             | ** ** | **2006**                        | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage of  Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                          | ** ** | **(in thousands)**                              | ** ** |
| United States                       |       | $                                                    | 10,745     |                            | 52         | %          | $          | 12,023 |   | 51 | % | $ | 1,278 |   | 12 | % |
|                                |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| United Kingdom                      |       | 6,146                                                |       | 30                              |       | 7,519      |       | 32 |   | 1,373 |   | 22 | % |
| France                              |       | 2,282                                                |       | 11                              |       | 2,374      |       | 10 |   | 92 |   | 4 | % |
| Asia Pacific                        |       | 1,389                                                |       | 7                               |       | 1,700      |       | 7 |   | 311 |   | 22 | % |
|                                |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| International  subtotal             |       | 9,817                                                |       | 48                              |       | 11,593     |       | 49 |   | 1,776 |   | 18 | % |
|                                |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total                               |       | $                                                    | 20,562     |                            | 100        | %          | $          | 23,616 |   | 100 | % | $ | 3,054 |   | 15 | % |

 

        Theincrease in revenues worldwide was due to the increase in application hostingservices revenue associated with our *InForm *product,as well as an increase in consulting services. The increase in U.S. revenue isprimarily related to new business relationships relating to the *WebVDME* product we began offering afterthe August 2005 acquisition of Lincoln, while the increase ininternational revenues is primarily the result of additional enterprise-wideservice agreements with one customer.

*Cost ofRevenues*
| ** **                      | ** ** | **Three Months Ended March 31,** | ** ** | ** **                               | ** ** | ** ** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2005**                                             | ** ** | **2006**                                 | ** ** | **Change** | ** ** |
| **Costs of Revenues** | ** ** | **Amount**                                           | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(in thousands)**                              | ** ** |
| License                         |       | $                                                    | 448        |                                     | 5          | %          | $          | 706 |   | 8 | % | $ | 258 |   | 58 | % |
| Services                        |       | 7,212                                                |       | 61                                       |       | 8,895      |       | 61 |   | 1,683 |   | 23 | % |
|                            |       |                                                 |       |                                     |       |       |       |   |   |   |   |   |   |
| Total                           |       | $                                                    | 7,660      |                                     | 37         | %          | $          | 9,601 |   | 41 | % | $ | 1,941 |   | 25 | % |

 

        Thecost of license revenue increased in the three months ended March 31, 2006primarily due to a $170,000 increase in cost of royalties associated withour *InForm *software product and to alesser extent certain modules of our *Clintrial*software product. In addition, amortization expense from acquired technologiesrelating to our recent acquisition of Lincoln increased by $90,000. Theincrease in cost of services in the three months ended March 31, 2006 wasdue primarily to increases in contractor and employee-related expenses of$701,000 and $505,000, respectively, associated with delivering increasedservices revenues. We also had expense increases for depreciation and computerrelated expenses of $174,000 and $193,000, respectively, which were the resultof an increase in trials under management in the three months ended March 31,2006 as compared to the same period in 2005. Computer related expenses includehardware and software support agreements as well as computer accessories. Inaddition, there were also expense increases in travel and royalty expense of$99,000 and $84,000, respectively. These increases were partially offset by adecrease in pass through expense of $130,000.

*GrossMargin*
| ** **            | ** ** | **Three Months Ended March 31,** | ** ** | ** **                               | ** ** | ** ** | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2005**                                             | ** ** | **2006**                                 | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                           | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                              | ** ** |
| License               |       | $                                                    | 8,371      |                                     | 95         | %          | $          | 8,319 |   | 92 | % | $ | (52 | ) | (1) | % |
| Services              |       | 4,531                                                |       | 39                                       |       | 5,696      |       | 39 |   | 1,165 |   | 26 | % |
|                  |       |                                                 |       |                                     |       |       |       |   |   |   |   |   |   |
| Total                 |       | $                                                    | 12,902     |                                     | 63         | %          | $          | 14,015 |   | 59 | % | $ | 1,113 |   | 9 | % |

 

        Thelicense gross margin percentage declined in the three months ended March 31,2006 due to an increase in royalty expense relating to our *InForm *softwareand certain modules of the *Clintrial*software as well as amortization expense relating to our acquisition of Lincoln.The services gross margin percentage was unchanged during the three monthsended March 31, 2006, as revenues grew at approximately the same rate asexpenses. The overall gross margin decreased in the three months ended March 31,2006 due to the combination of additional license royalties and less licenserevenue as a percentage of total revenues. It is likely that 

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gross margin, as apercentage of revenue will fluctuate quarter by quarter due to the timing andmix of license and service revenues, and the type, amount and timing of servicerequired in delivering certain projects. For example, when services areperformed on a time and material basis, the timing of expense and revenue recognitionis more closely aligned than when services are performed under bundledarrangements, where the revenue is recognized ratably over the license period,while the expenses are recognized as incurred.

*Operating Expenses*
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2005**                                             | ** ** | **2006**                        | ** ** | **Change** | ** ** |
| **Operating Expenses** | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                              | ** ** |
| Sales and  marketing        |       | $                                                    | 3,951      |                            | 19         | %          | $          | 4,237 |   | 18 | % | $ | 286 |   | 7 | % |
| Research and  development   |       | 3,281                                                |       | 16                              |       | 3,624      |       | 15 |   | 343 |   | 10 | % |
| General and  administrative |       | 3,804                                                |       | 18                              |       | 4,139      |       | 18 |   | 335 |   | 9 | % |
| Restructuring               |       | (92                                                  | )          | —                          |       | —     |       | — |   | 92 |   | 100 | % |
|                        |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total                       |       | $                                                    | 10,944     |                            | 53         | %          | $          | 12,000 |   | 51 | % | $ | 1,056 |   | 10 | % |

 

*        Salesand Marketing.*  Sales and marketing expensesincreased in the three months ended March 31, 2006 primarily due to a$148,000 increase in employee-related expenses related to a headcount increaseof 6 people and a $126,000 increase in stock-based compensation expense. Wealso experienced a $79,000 increase in commission expense due to an increase inrevenues. These expense increases were partially offset by a decrease inoccupancy expense of $43,000. We expect that our sales and marketing expensewill 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 and developmentexpenses increased in the three months ended March 31, 2006 primarily dueto employee-related expenses of $301,000 relating to a headcount increase of 9people.  In addition, travel expenseincreased $37,000 and amortization expense related to acquired intangibleassets added $30,000. 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 and administrativeexpenses increased in the three months ended March 31, 2006 primarily dueto an increase of $151,000 in outside contractor expenses. Further expenseincreases included depreciation and computer related expenses of $69,000 and$63,000. Computer related expenses include hardware and software supportagreements as well as computer accessories. In addition, stock-basedcompensation expense increased $82,000.  These expense increases were partially offsetby a decrease in professional fees of $173,000 associated with legal feesrelated to defending our intellectual property.

*OperatingIncome, Other Income (Expense)*
| ** **             | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **             | ** ** | **2005**                                             | ** ** | **2006**                        | ** ** | **Change** | ** ** |
| ** **             | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage of  Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **             | ** ** | **(in thousands)**                              | ** ** |
| Operating income       |       | $                                                    | 1,958      |                            | 10         | %          | $          | 2,015 |   | 9 | % | $ | 57 |   | 3 | % |
|                   |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Other income (expense) |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Interest income        |       | 348                                                  |       | 2                               |       | 596        |       | 3 |   | 248 |   | 71 | % |
| Interest expense       |       | (144                                                 | )          | (1                              | )          | —     |       | — |   | 144 |   | 100 | % |
| Other, net             |       | (130                                                 | )          | (1                              | )          | (64        | )          | — |   | 66 |   | 51 | % |
|                   |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total other income     |       | $                                                    | 74         |                            | 0          | %          | $          | 532 |   | 3 | % | $ | 458 |   | 619 | % |
|                   |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |

 

* OperatingIncome.* The increase in operating income in the threemonths ended March 31, 2006 was primarily due to the increase in totalgross margin which was partially offset by an increase in operating expenses.

*        OtherIncome (Expense).*  The increase in interest incomein the three months ended March 31, 2006 was primarily due to an increasein cash and cash equivalents available for investment, short term investmentsand an increase in the yield on investment. The 

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decrease in interestexpense was due to the pay off of our debt in the quarter ended March 31,2005. Other, net expense decreased primarily due to a decrease in foreignexchange losses compared to the same period in 2005.

*Provision for Income Taxes*
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2005**                                             | ** ** | **2006**                        | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **(in thousands)**                              | ** ** | ** **                      | ** ** |
| Provision for  income taxes |       | $                                                    | 564        |                            | 3          | %          | $          | 461 |   | 2 | % | $ | (103 | ) | (18 | )% |
|                             |            |                                                      |            |                                 |            |            |            |  |  |  |  |  |  |  |  |  |

 

*Provisionfor Income Taxes.*The provision for income taxes in 2005 and2006 represents income taxes payable in both our U.S. and foreign operationsthat cannot be offset through loss carryforwards. The effective tax rate for2006 decreased to 18% compared to an effective tax rate of 28% for 2005. Thedecrease in our effective tax rate is primarily due to a reduction in U.S.income taxes payable, partially offset by an increase in taxes payable for ourU.K. operations. The reduction to U.S. income tax payable is due to a reductionin the amount of net operating losses utilized to reduce tax expense and therelease of a portion of our deferred tax asset valuation allowance of $700,000,which was recognized through a reduction to income tax expense. The increase intax payable for our U.K. operations, was due to a reduction in our netoperating loss carryforwards which can be used to offset taxable income. Inutilizing our net operating loss carryforwards, we are required to use our netoperating losses in the order they were incurred. The utilization of theacquired net operating losses reduces the amount of income taxes payable tolocal tax authorities, but does not reduce the amount of income tax expense forfinancial reporting purposes as it is recorded as a reduction to goodwill.

**Liquidityand Capital Resources**

        Ourprincipal sources of liquidity were cash, cash equivalents, and short-terminvestments totaling $60.6 million and $63.3 million at December 31,2005 and March 31, 2006, respectively, and accounts receivable of$24.9 million and $21.1 million, respectively.

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 revenue are primarily related to the timing of billingsof our term license customers and the associated revenue recognition. Movementsin deferred costs are related to the volume and stages of hosted clinicaltrials and movements in accrued expenses and accounts payable are due to thetiming of certain transactions.

Net cash providedby operating activities was $3.3 million in the three months ended March 31,2006, which was greater than net income of $2.1 million. This differenceis primarily due to $1.3 million of non-cash depreciation andamortization, $456,000 of stock-based compensation, an increase in deferredrevenue of $5.3 million, and a decrease in accounts receivable of $4.2 million,partially offset by the payment of accrued litigation settlement of $8.5million, an increase in deferred costs of $489,000 and a reduction of accruedexpenses of $952,000.

Net cash used byinvesting activities was $1.9 million during the three months ending March 31,2006, which was primarily due to the purchase of short-term investments of$3.7 million and capital expenditures associated with expansion of ourhosting facility and purchase of computer equipment to support of our expandingwork force of $1.2 million partially offset by $3.0 million ofproceeds from maturities of short-term investments.

Net cash used infinancing activities was $802,000 in the three months ended March 31,2006, consisting of $554,000 of proceeds from the exercise of common stockoptions and $248,000 from the tax benefit associated with the exercise ofoptions.

At December 31,2005 and March 31, 2006, we had a $1.3 million of outstanding letter ofcredit related to our facility. The letter of credit reduces the amountavailable under our line of credit with a bank. In April, 2006, the letter ofcredit was reduced to $500,000.

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

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

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The followingtable of our material contractual obligations as of December 31, 2005summarizes the aggregate effect that these obligations are expected to have onour cash flows in the periods indicated:

 
| **Contractual Obligations** | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **Total**                                 | ** ** | **1 year or   less** | ** ** | **2-3 years** | ** ** | **4-5 years** | ** ** | **More than  5 years** | ** ** |
| ** **                       | ** ** | **(in thousands)**                   | ** ** |
| Operating lease  obligations     |       | $                                         | 7,960      |   | $ | 3,091 |   | $ | 4,676 |   | — |   | — |   |
| Total                            |       | $                                         | 7,960      |   | $ | 3,091 |   | $ | 4,676 |   | — |   | — |   |

 

        EffectiveMarch 31, 2004, we renewed our working capital line of credit with a bankand increased the amount which we could borrow to $5.0 million  Borrowings under the working capital line of credit were secured bysubstantially all our assets. We entered into a negative pledge agreement that,subject to certain exceptions, generally prohibited us from pledging ourintellectual property to others. In August of 2005, the working capitalline of credit was amended to eliminate the security interest in our assets andthe negative pledge on our intellectual property. The amendment also removed ormodified the financial covenants. Under the terms of this credit line, we arerequired to comply with certain financial covenants. Effective March 31,2006 the working capital line of credit was reduced from $5.0 million to $2.0million. As of December 31, 2005 and March 31, 2006, $0 wasoutstanding under the working capital line of credit. At March 31, 2006,there was $700,000 available under the line of credit and $1.3 million reservedunder a letter of credit associated with our leased facilities. In April 2006,the letter of credit was reduced to $500,000. At March 31, 2006, we werein compliance with all financial covenants.

        AtDecember 31, 2005, we had $81.8 million of net operating losscarryforwards and $6.0 million of federal research and development tax creditcarryforwards that may be used to offset future U.S. federal taxable income.Approximately $17.2 million and $3.0 million of net operating loss and taxcredit carryforwards were acquired in the Clinsoft acquisition. Theseattributes may reduce our future cash tax liability; however this benefit willbe reflected through reductions to goodwill and not as reductions to income taxexpense. Additionally, we had $3.9 million of foreign net operating losscarryforwards. The net operating loss and tax credit carryforward periodextends through 2024 and both are subject to review and possible adjustment by thetaxing authorities. Also, the Internal Revenue Code contains provisions thatmay limit the net operating loss and tax credit carryforwards available in anygiven year in the event of certain changes in the ownership interests ofsignificant stockholders.

        Webelieve our existing cash, cash equivalents, short-term investments and cashprovided by operating activities and our various debt facilities will besufficient to meet our working capital and capital expenditure needs over thenext 12 months. Our future capital requirements will depend on manyfactors, including our rate of revenue growth, the expansion of our marketingand sales activities, the timing and extent of spending to support productdevelopment efforts, the timing of introductions of new services andenhancements to existing services, and the continuing market acceptance of ourservices. To the extent that existing cash and securities and cash fromoperations are insufficient to fund our future activities, we may need to raiseadditional funds through public or private equity or debt financing. From timeto time, we may also enter into agreements with respect to potentialinvestments in, or acquisitions of, businesses, services or technologies, whichcould also require us to seek additional equity or debt financing.

**Off-Balance Sheet Arrangements**

We do not have any special purpose entities oroff-balance sheet arrangements.

**Item 3.    *Quantitative andQualitative Disclosures about Market Risk***

*ForeignCurrency Exchange Risk*

Our results of operationsand cash flows are subject to fluctuations due to changes in foreign currencyexchange rates, particularly changes in the euro, British pound, Australiandollar and Japanese yen. During the three months ended March 31, 2005 and2006, 48% and 49%, respectively, of our revenues were generated in locationsoutside the United States. The majority of these revenues are denominated incurrencies other than the U.S. dollar, as are many of the associated expenses.Except for revenue transactions in Japan, we enter into transactions directlywith substantially all of our foreign customers. This creates a foreigncurrency exchange risk for us.

As of March 31,2006, we had $4.9 million of receivables denominated in currencies other thanthe U.S. dollar. If the foreign exchange rates fluctuated by 10% as of March 31,2006, our foreign exchange receivable exposure would have fluctuated byapproximately $490,000. In addition, although our foreign subsidiaries haveintercompany accounts that eliminate upon consolidation, such accounts exposeus to foreign currency rate movements. Exchange rate fluctuations on short-termintercompany accounts are recorded in our consolidated statements of operationsunder “other income (expense)”, while exchange rate fluctuations on long-termintercompany accounts are recorded in our consolidated balance sheets under “accumulatedother comprehensive loss” in stockholders’ equity. We also maintain cashaccounts denominated in currencies other than the local currency which exposeus to foreign exchange rate movements.

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We haveimplemented a risk management program under which we measure foreign currencyexchange risk monthly and manage those exposures through the use of variousinternal controls and the use of forward foreign exchange contracts. Thisprocess is designed to minimize foreign currency translation exposures thatcould otherwise affect consolidated results of operations. As of March 31,2006, we entered into contracts to hedge approximately $3.0 million, ofreceivables, intercompany accounts and cash balances denominated in currenciesother than the U.S. dollar.

*InterestRate Sensitivity*

We hadunrestricted cash, cash equivalents and short term investments totaling $63.3million at March 31, 2006. Investments in securities are investedprimarily in high quality securities of a short duration and are not materiallyaffected by fluctuations in interest rates. The unrestricted cash and cashequivalents are held for working capital purposes. We do not enter intoinvestments for trading or speculative purposes. Due to the short-term natureof these investments, we believe that we do not have any material exposure tochanges in the fair value of our investment portfolio as a result of changes ininterest rates. Declines in interest rates, however, would reduce futureinvestment income.

We have a workingcapital line of credit which bears interest based upon the prime rate. At December 31,2005 and March 31, 2006, there were no amounts outstanding under ourworking capital line of credit. At March 31, 2006, there was $700,000available under the line of credit and $1.3 million reserved under a letter ofcredit associated with our leased facilities. In April 2006, the letter ofcredit was reduced to $500,000.

**Item4.**                       *Controls and Procedures*

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourSecurities Exchange Act reports is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms, and thatsuch information is accumulated and communicated to our management, includingour Chief Executive Officer and Chief Financial Officer, as appropriate, toallow timely decisions regarding required disclosure. In designing and evaluatingthe disclosure controls and procedures, management recognized that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, as ours aredesigned to do, and management necessarily was required to apply its judgmentin evaluating the cost-benefit relationship of possible controls andprocedures.

As of March 31, 2006, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in enabling us to record, process,summarize and report information required to be included in our periodic SECfilings within the required time period.

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

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**Part II—OtherInformation**

**Item 1.          *Legal Proceedings***

From time to timeand in the ordinary course of business, we are subject to various claims,charges and litigation, including the litigation described in Note 13 of theunaudited condensed consolidated financial statements included in thisQuarterly Report on Form 10-Q. The outcome of litigation cannot bepredicted with certainty and some lawsuits, claims or proceedings may bedisposed of unfavorably to us, which could materially affect our financialcondition or results of operations.

On April 26,2004, Datasci, LLC (“Datasci”) filed suit (Civil Action No. 04-1328(MJG))in the United States District Court for the District of Maryland (GreenbeltDivision) against Phase Forward Incorporated and Quintiles Inc., one ofour customers. Datasci asserted that our *InForm,Clintrial* and *ClintrialIntegration Solution* products and our services, and the products andservices of Quintiles, infringe a United States patent claimed to be owned byDatasci (Patent No. 6,496,827). Datasci sought separate injunctions andunspecified damages from each of us and Quintiles. We filed an Answer andCounterclaim, on May 4, 2004, to Datasci’s complaint denying that weinfringe the patent which Datasci claimed to own. The Answer also challengedthe validity of the patent and asserted numerous affirmative defenses. OurCounterclaim sought a declaratory judgment that we do not infringe the patentclaimed to be owned by Datasci. Datasci responded by denying all theallegations in our Counterclaim. On or about June 7, 2004, Datasci filed amotion to dismiss its complaint against us and Quintiles. In its filing,Datasci disclosed that it did not exist when it filed its complaint against usand Quintiles. Also on or about June 7, 2004, Dr. Mark L. Kozam,doing business under the name MLK Software and claiming to be the owner of thepatent, filed suit (Civil Action No. 04-CV-1787 (MJG)) againstus and Quintiles in the same court where Datasci filed its initial complaint. Dr. Kozam’scomplaint contained the same allegations and sought the same remedies that werecontained in the Datasci complaint. On June 22, 2004, we filed an Answerand Counterclaim to Dr. Kozam’s complaint denying that we infringe thepatent which Dr. Kozam claims to own. Our Answer also challenged thevalidity of the patent and asserted numerous affirmative defenses. OurCounterclaim sought a declaratory judgment that we do not infringe the patentclaimed to be owned by Dr. Kozam. Dr. Kozam responded by denying allthe allegations in our Counterclaim.

On February 15,2006, we entered into a Settlement Agreement and related License Agreement withDr. Mark L. Kozam d/b/a MLK Software and Datasci, LLC to settle thismatter. Under the Settlement Agreement and related License Agreement, we agreedto make a one-time, lump-sum payment to Datasci in the amount of $8.5 millionto settle the claim and obtain a perpetual, irrevocable, fully-paid, worldwide,non-exclusive license to the patent that was the subject of the claim byDatasci. The confidential settlement, in which neither party admits liability,provides for mutual releases and dismissal of all actions between the parties.

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

**CertainFactors Which May Affect Future Results**

*There are no material changes to the risk factorsdescribed in the “Risk Factors” section in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2005 other than the inclusionherein of an additional Risk Factor below entitled “Consolidation among ourclients could cause use to lose clients, decrease the market for our productsand result in a reduction of our revenues.”*

**Risks Related to Our Industry**

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

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

•                    the discoveryof safety issues with approved products or products in clinical development;

•                    the assertionof product liability claims;

•                    changes inthird-party reimbursement practices;

•                    changes inmedical practices; and

•                    changes in thepurchasing patterns of entities conducting clinical research and monitoringsafety.

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

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

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

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

***Changing customer or prospective customer requirements coulddecrease the demand for our products and services, which would adversely affectour revenues and operating results.***

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

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

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

In addition, anyfailure to conform our software products, services and hosted solutions todomestic or international changes in regulations and regulatory guidanceapplicable to our customers or potential customers and the approval process fortheir products may result in our inability to continue to do business. Changingour software products, services and hosted solutions to allow our customers tocomply with future changes in regulation or regulatory guidance, eitherdomestically or internationally, could cause us to incur substantial costs. Wecannot assure you that our product and service offerings will allow our customersand potential customers to stay in compliance with regulations and regulatoryguidance as they develop. If our product and service offerings fail to allowour customers and potential customers to operate in a manner that is compliantwith applicable regulations and regulatory guidance, clinical trial sponsorsand other entities engaged in clinical trial and safety monitoring activitiesmay be unwilling to use our software products, services and hosted solutions.

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

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

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

Our customer basecould decline because of consolidation, and we may not be able to expand salesof our products and services to new clients. Consolidation in thepharmaceutical, biotechnology and medical device industries and among CROs hasaccelerated in recent years, and we expect this trend to continue. In addition,new companies or organizations that result from such consolidation may decidethat our products and services are no longer needed because of their owninternal processes or the use of alternative systems. As these entitiesconsolidate, competition to provide products and services to industryparticipants will become more intense and the importance of establishing relationshipswith large industry participants will become greater. These industryparticipants may try to use their market power to negotiate price reductionsfor our products and services. Also, if consolidation of larger currentcustomers occur, the combined organization may represent a larger percentage ofbusiness for us and, as a result, we are likely to rely more significantly onthe combined organization’s revenues to continue to achieve growth.

**Risks Related to Our Company**

 ***Our software products andhosted solutions are at varying stages of market acceptance and the failure ofany of our products to achieve or maintain wide acceptance would harm ouroperating results.***

*** ***We beganoffering our*InForm *electronicdata capture software solution for clinical trials in December 1998.Although the*Clintrial* and*Clintrace* products were introduced over10 years ago, we did not begin offering these products until after ouracquisition of Clinsoft Corporation in 2001. We only began begin offering our *WebVDME, CTSD*and*WebSDM* products after our August 2005acquisition of Lincoln. Continued use of our *InForm*,*Clintrial* and*Clintrace* software products, and broad and timelyacceptance of our*WebVDME, CTSD*and*WebSDM*products, as well as integratedsolutions combining one or more of our software products, is critical to ourfuture success and is subject to a number of significant risks, some of whichare outside our control. These risks include:

·                    our customers’and prospective customers’ desire for and acceptance of our electronic datacapture, management and safety software solutions;

·                    our softwareproducts and hosted solutions’ ability to support large numbers of users andmanage vast amounts of data;

·                    our customers’ability to use our software products and hosted solutions, train theiremployees and successfully deploy our technology in their clinical trial andsafety monitoring activities;

·                    our ability tomeet product development and release schedules; and

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

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

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

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

·                    the timing ofour product sales and the length of our sales and implementation cycles;

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•                    the timing andmix of license and services revenues, and the amount and type of servicerequired in delivering certain projects;

•                    changes in andtiming of our operating expenses;

•                    the extent towhich our software products, services and hosted solutions achieve or maintainmarket acceptance;

•                    our ability tointroduce new products and services and enhancements to our existing productsand services on a timely basis;

•                    thecompetitive environment in which we operate;

•                    our ability tohire and retain qualified personnel;

•                    changes in theregulatory environment related to the clinical trial and safety monitoringmarket;

•                    changes in ourcustomers’ purchasing patterns;

•                    the financialcondition of our current and potential customers; and

•                    the timing,size and integration success of potential future acquisitions.

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

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

Our top fivecustomers accounted for approximately 39% of our revenues during the threemonths ended March 31, 2006. Two customers, Eli Lilly and Company andGlaxoSmithKline, together accounted for approximately 25% of our total revenuesfor the same period. The loss of any of our major customers could have amaterial adverse effect on our results of operations or financial condition. Wemay not be able to maintain our customer relationships, and our customers maynot renew their agreements with us, which could adversely affect our results ofoperations or financial condition. A significant change in the liquidity orfinancial position of any of these customers could also have a material adverseeffect on the collect ability of our accounts receivables, our liquidity andour future operating results.

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

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

***We have incurred substantial losses in the past and may notcontinue to be profitable in the future.***

We incurredsignificant losses in each year from our inception in September 1997through 2003 and we may incur significant

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operating losses in the future. As a result of ouroperating losses and accretion of preferred dividends, we had an accumulateddeficit of $99.0 million at March 31, 2006. You should not considerrecent revenue growth as indicative of our future performance as our operatingresults may fluctuate significantly from quarter to quarter. In addition, weexpect our development, sales and other operating expenses to increase in thefuture. If our revenue does not grow to offset these expected increasedexpenses, we may not continue to be profitable. In fact, in future quarters wemay not have any revenue growth and our revenue could decline. Furthermore, ifour operating expenses exceed our expectations, our financial performance willbe adversely affected.

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

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

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

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

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

•                    the price wepay or other resources that we devote may exceed the value we eventuallyrealize or the value we could have realized if we had allocated the purchaseprice or other resources to another opportunity;

•                    potential lossof key employees, customers and strategic alliances from either our currentbusiness or the target company’s business;

•                    managing therisks of entering markets or types of businesses in which we have limited or nodirect experience;

•                    the diversionof management’s attention from other business concerns; and

•                    assumption ofunanticipated problems or latent liabilities, such as problems with the qualityof the target company’s products.

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

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

We have been, andmay in the future be, subject to claims that our technologies infringe upon theintellectual property or other proprietary rights of a third party. Forinstance, we recently settled a lawsuit filed in 2004 by Dr. Mark L.Kozam, doing business under the name MLK Software and Datasci, LLC against usand one of our customers which alleged that we infringed a patent claimed to beowned by them. We incurred substantial professional fees in connection withthis claim and agreed to make a one-time payment of $8.5 million to Datasci inorder to settle this litigation and to obtain a non-exclusive, fully paid-uplicense to the patent on a going forward basis. In addition, the vendors whoprovide us with technology that we use in our technology could become subjectto similar infringement claims. Although we believe that our software solutionsdo not infringe the patents of any third party, we cannot assure you that ourtechnology does not infringe patents held by others or that they will not inthe future. Any future claims of infringement could cause us to incursubstantial costs defending against the claim, even if the claim is withoutmerit, and could distract our management from our business. Moreover, anysettlement or adverse judgment resulting from the claim could require us to paysubstantial amounts or obtain a license to continue to use the technology thatis the subject of the claim, or otherwise restrict or 

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prohibit our use of the technology. There can be noassurance that we would be able to obtain a license from the third partyasserting the claim on commercially reasonable terms, if at all, that we wouldbe able to successfully develop alternative technology on a timely basis, if atall, or that we would be able to obtain a license from another provider ofsuitable alternative technology to permit us to continue offering, and ourcustomers to continue using, the applicable technology. In addition, wegenerally provide in our customer agreements that we will indemnify ourcustomers against third-party infringement claims relating to our technologyprovided to the customer, which could obligate us to fund significant amounts.Infringement claims asserted against us or our vendors may have a materialadverse effect on our business, results of operations or financial condition.

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

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

***Interruptions or delays in service from our third-party providerscould impair the delivery of our hosted solutions and harm our business.***

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

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

We have beenexperiencing a period of rapid growth that is placing a significant strain onour operational and financial resources and our personnel. From January 1,1999 to March 31, 2006, the number of our employees increased from 35 to421. To manage our anticipated future growth effectively, we must continue tomaintain and may need to enhance our information technology infrastructure,financial and accounting systems and controls and manage expanded operations ingeographically distributed locations. We will also be required to attract,integrate, train and retain a significant number of qualified sales andmarketing personnel, professional services personnel, software engineers andother management personnel. Our failure to manage our rapid growth effectivelycould have a material adverse effect on our business, operating results orfinancial condition.

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

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

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 ***The global nature of our businessexposes us to multiple risks.***

For the three months ended March 31,2006, approximately 49% of our revenues were derived from internationaloperations. We expect that our international operations will continue toaccount for a significant portion of our revenues. As a result of ourinternational operations, we are exposed to many risks and uncertainties,including:

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

•                    tariff andinternational trade barriers;

•                    fewer legalprotections for intellectual property and contract rights abroad;

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

•                    governmentcurrency control and restrictions on repatriation of earnings;

•                    fluctuationsin foreign currency exchange and interest rates; and

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

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

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

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

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

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

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

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

***We and our products and services could be subjected to governmentalregulation, requiring us to incur significant compliance costs or to ceaseoffering our products and services.***

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

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

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

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

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

•                    hireadditional personnel;

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

•                    enhance ouroperating infrastructure;

•                    acquirebusinesses or technologies; or

•                    otherwiserespond to competitive pressures.

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

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**RisksRelated to our Common Stock**

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

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

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

•                    financialresults that are below estimate of such results;

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

•                    changes inmarket valuations of similar companies;

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

•                    litigationinvolving our company or our general industry or both;

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

•                    success ofcompetitive products and technologies;

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

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

•                    regulatorydevelopments in the United States and foreign countries;

•                    additions ordepartures of key personnel;

•                    investors’general perception of us; and

•                    changes ingeneral economic, industry and market conditions.

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

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

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

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

At March 31,2006, our directors and executive officers and their affiliates beneficiallycontrolled approximately 24% of our outstanding common stock. As a result, thesestockholders, if they act together, are able to influence our management andaffairs and all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions. Thisconcentration of ownership may have the effect of delaying or preventing achange in control of our company and might affect the market price of ourcommon stock.

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

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

•                    limitations onthe removal of directors;

•                    advance noticerequirements for stockholder proposals and nominations;

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

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

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

In addition, Section 203of the Delaware General Corporation Law prohibits a publicly held Delawarecorporation from engaging in a business combination with an interestedstockholder, generally a person which together with its affiliates owns, orwithin the last three years has owned, 15% of our voting stock, for a period ofthree years after the date of the transaction in which the person became aninterested stockholder, unless the business combination is approved in aprescribed manner.

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

**Item 5.          *Other Information***

Our policygoverning transactions in our securities by directors, officers and employeespermits our officers, directors and certain other persons to enter into tradingplans complying with Rule 10b5-1 under the Securities Exchange Actof 1934, as amended. We have been advised that our Vice President, HumanResources, Victor P. Becker; our Chairman and Chief Strategy Officer, Paul A.Bleicher; our Vice President, General Counsel and Secretary, D. Ari Buchler; ourVice President of Worldwide Sales, Stephen J. Powell; our Senior VicePresident, Steven J. Rosenberg; and our President and Chief Executive Officer,Robert K. Weiler have each entered into a trading plan covering periods afterthe date of this Quarterly Report in accordance with Rule 10b5-1 andour policy governing transactions in our securities. Generally, under thesetrading plans, the individual relinquishes control over the transactions oncethe 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 policygoverning transactions in our securities, some or all of our officers,directors and employees may establish trading plans in the future. We intend todisclose the names of executive officers and directors who establish a tradingplan in compliance with Rule 10b5-1 and the requirements of ourpolicy governing transactions in our securities in our future quarterly andannual reports on Form 10-Q and 10-K filed with the Securitiesand Exchange Commission. However, we undertake no obligation to update orrevise the information provided herein, including for revision or terminationof an established trading plan, other than in such quarterly and annualreports.**

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**Item 6.**     Exhibits.

 
| **ExhibitNo**. | ** ** | **Description**                                                                                                                                                                                                                 | ** ** |
|----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 10.1+          |       | 2006 Global Sales Executive Incentive Compensation  Plan.                                                                                                                                                                       |       |
| 10.2+          |       | 2006 Management Incentive Plan.                                                                                                                                                                                                 |       |
| 10.3+          |       | Summary of cash compensation practices for  non-employee directors. (Incorporated by reference herein to  Exhibit 10.19 of the Company’s Annual Report on Form 10-K  filed with the SEC on March 13, 2006). |       |
| 10.4           |       | Settlement Agreement by and among Mark L. Kozam  d/b/a MLK Software and Datasci, LLC, the Company, and Quintiles, Inc.                                                                                                          |       |
| 10.5           |       | License Agreement by and among Mark L. Kozam d/b/a  MLK Software and Datasci, LLC, and the Company.                                                                                                                             |       |
| 10.6           |       | Seventh Loan Modification Agreement with Silicon  Valley Bank.                                                                                                                                                                  |       |
| 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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+                    Indicatesa management contract or any compensatory plan, contract or arrangement.

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** **

**Signatures**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to besigned on its behalf by the undersigned thereunto duly authorized.
|                         | ** ** | **Phase Forward Incorporated**                                                                  | ** ** |
|-------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **              | ** ** | ** **                                                                                      | ** ** |
| ** **              | ** ** | ** **                                                                                      | ** ** |
|                    | By:        | /s/ Robert K. Weiler                                                                       |       |
|                    |       | Robert K. Weiler*   Chief Executive Officer   (Duly authorized officer)*                   |       |
|                    |       |                                                                                            |       |
|                    | By:        | /s/ Rodger Weismann                                                                        |       |
|                    |       | Rodger Weismann                                                                                 |       |
|                    |       | *Chief Financial Officer (Duly authorized officer and   principal financial officer)* |       |
| Date:  May 9, 2006 |       |                                                                                            |       |

** **

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**EXHIBITINDEX**
| ExhibitNo. | ** ** | **Description**                                                                                                                                                                                                                 |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1+      |       | 2006 Global Sales Executive Incentive Compensation  Plan.                                                                                                                                                                       |
| 10.2+      |       | 2006 Management Incentive Plan.                                                                                                                                                                                                 |
| 10.3+      |       | Summary of cash compensation practices for  non-employee directors. (Incorporated by reference herein to  Exhibit 10.19 of the Company’s Annual Report on Form 10-K  filed with the SEC on March 13, 2006). |
| 10.4       |       | Settlement Agreement by and among Mark L. Kozam  d/b/a MLK Software and Datasci, LLC, the Company, and Quintiles, Inc.                                                                                                          |
| 10.5       |       | License Agreement by and among Mark L. Kozam d/b/a  MLK Software and Datasci, LLC, and the Company.                                                                                                                             |
| 10.6       |       | Seventh Loan Modification Agreement with Silicon  Valley Bank.                                                                                                                                                                  |
| 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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+                    Indicatesa management contract or any compensatory plan, contract or arrangement.

43

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