**United States**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-QSB**

 

**ý****        Quarterly Report pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934**

**Forthe quarterly period ended: September 30, 2005**

 

**o****        Transition report pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934**

**Forthe Transition period from                  to                     **

 

**Commission file number: 1-12966**

 

**ClearStory Systems, Inc.**

(Exact name of small business issuer as specified inits charter)

 

| **Delaware**             | ** ** | **06-1302773**                       |
|--------------------------|------------|--------------------------------------|
| (State of incorporation) |       | (IRS employer identification number) |

 

**One Research Drive, Suite 200B**

**Westborough, MA 01581**

(Address of principal executive offices)

 

Issuer’s telephone number, including area code: **(508) 870-4000**

 

Check whetherthe issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes  ý  No  o

 

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

Yes  o  No ý

 

State thenumber of shares outstanding of each of the issuer’s classes of common equity,as of the latest practicable date:

 
| **Title of Each Class**       | ** ** | **Outstanding November 14, 2005** |
|-------------------------------|------------|----------------------------------------|
| Common  Stock, par value $.10 |       | 5,992,287                              |

 

TransitionalSmall Business Disclosure Format (check one)

Yes  o  No ý

 

 

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**ClearStory Systems, Inc.**

 

###### **INDEX**

 
| **PART I**                                                                                                                   | **FINANCIAL INFORMATION** |   |   |
|-----------------------------------------------------------------------------------------------------------------------------------|---------------------------|--------|--------|
|                                                                                                                              |                      |   |
| Item  1. Financial Statements                                                                                                     |                      |   |
|                                                                                                                              |                      |   |
| Condensed Consolidated Balance Sheet as of  September 30, 2005 (Unaudited) and March 31, 2005                           |                      | 3      |
|                                                                                                                              |                      |   |
| Condensed  Consolidated Statements of Operations for the Three and Six Months  Ended September 30, 2005 and 2004 (Unaudited) |                      | 4      |
|                                                                                                                              |                      |   |
| Condensed  Consolidated Statements of Cash Flows for the Six Months  Ended September 30, 2005 and 2004 (Unaudited)           |                      | 5      |
|                                                                                                                              |                      |   |
| Notes to Condensed Consolidated  Financial Statements                                                                             |                      | 6      |
|                                                                                                                              |                      |   |
| Item 2. Management’s Discussion and Analysis or Plan of  Operation                                                           |                      | 10     |
|                                                                                                                              |                      |   |
| Item 3. Controls and Procedures                                                                                                   |                      | 22     |
|                                                                                                                              |                      |   |
| **PART II**                                                                                                                  | **OTHER INFORMATION**     |   |   |
|                                                                                                                              |                      |   |
| Item 6. Exhibits                                                                                                                  |                      | 23     |
|                                                                                                                              |                      |   |
| Signature                                                                                                                         |                      | 23     |

 

2

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**ClearStory Systems, Inc.**

**CONDENSEDCONSOLIDATED BALANCE SHEET**

(In thousands)

 
| ** **                                               | ** ** | **September 30,** | ** ** | **March 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|--------------------|------------|
| ** **                                               | ** ** | **2005**               | ** ** | **2005**           | ** ** |
| **ASSETS**                                               | ** ** | ** **             | ** ** | ** **         | ** ** |
| Current assets:                                          |       |                   |       |               |       |
| Cash  and cash equivalents                               |       | $                      | 222        |               | $          | 849 |   |
| Accounts  receivable, net                                |       | 904                    |       | 917                |       |
| Prepaid  expenses and other current assets               |       | 413                    |       | 439                |       |
| Total  current assets                                    |       | 1,539                  |       | 2,205              |       |
|                                                     |       |                   |       |               |       |
| Property and equipment, net                              |       | 1,236                  |       | 1,439              |       |
| Capitalized software, net                                |       | 1,707                  |       | 1,852              |       |
| Goodwill                                                 |       | 1,223                  |       | 1,223              |       |
| Other assets                                             |       | 595                    |       | 186                |       |
|                                                     |       | $                      | 6,300      |               | $          | 6,905 |   |
|                                                     |       |                   |       |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**            | ** ** | ** **             | ** ** | ** **         | ** ** |
| Current liabilities:                                     |       |                   |       |               |       |
| Accounts  payable and accrued expenses                   |       | $                      | 2,330      |               | $          | 2,665 |   |
| Advances  against accounts receivable sold with recourse |       | 753                    |       | 606                |       |
| Revolving  credit facility                               |       | 1,350                  |       | —             |       |
| Deferred  revenue                                        |       | 2,069                  |       | 2,527              |       |
| Capital  leases, current portion                         |       | 145                    |       | 115                |       |
| Total  current liabilities                               |       | 6,647                  |       | 5,913              |       |
|                                                     |       |                   |       |               |       |
| Long term liabilities:                                   |       |                   |       |               |       |
| Deferred  rent                                           |       | 490                    |       | 494                |       |
| Capital  leases, net of current portion                  |       | 57                     |       | 112                |       |
| Total  long term liabilities                             |       | 547                    |       | 606                |       |
|                                                     |       |                   |       |               |       |
| Commitments and contingencies                            |       |                   |       |               |       |
|                                                     |       |                   |       |               |       |
| Stockholders’ equity:                               |       |                   |       |               |       |
| Series B  Convertible Preferred Stock               |       | 1                      |       | 1                  |       |
| Series C  Convertible Preferred Stock               |       | 40                     |       | 37                 |       |
| 8%  Convertible Preferred Stock                          |       | 1                      |       | 1                  |       |
| Common  Stock                                            |       | 599                    |       | 599                |       |
| Additional  paid-in capital                              |       | 57,174                 |       | 56,139             |       |
| Accumulated  deficit                                     |       | (58,709                | )          | (56,391            | )          |
| Total  stockholders’ equity (deficit)               |       | (894                   | )          | 386                |       |
|                                                     |       | $                      | 6,300      |               | $          | 6,905 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

3

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**ClearStory Systems, Inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS******

**(Unaudited)**

 

(Inthousands, except per share amounts)

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                                        |       |                                  |       |                                |       |   |   |   |   |
| Product                                                         |       | $                                     | 538        |                                | $          | 945 |   | $ | 1,106 |   | $ | 2,170 |   |
| Services                                                        |       | 1,315                                 |       | 1,632                               |       | 2,882 |   | 3,390 |   |
|                                                            |       | 1,853                                 |       | 2,577                               |       | 3,988 |   | 5,560 |   |
| Cost of revenues:                                               |       |                                  |       |                                |       |   |   |   |   |
| Product                                                         |       | 112                                   |       | 63                                  |       | 161 |   | 126 |   |
| Services                                                        |       | 698                                   |       | 936                                 |       | 1,466 |   | 1,763 |   |
|                                                            |       | 810                                   |       | 999                                 |       | 1,627 |   | 1,889 |   |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Gross profit                                                    |       | 1,043                                 |       | 1,578                               |       | 2,361 |   | 3,671 |   |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Operating expenses:                                             |       |                                  |       |                                |       |   |   |   |   |
| Sales  and marketing                                            |       | 596                                   |       | 717                                 |       | 1,314 |   | 1,458 |   |
| Product  development                                            |       | 826                                   |       | 591                                 |       | 1,627 |   | 1,203 |   |
| General  and administrative                                     |       | 640                                   |       | 837                                 |       | 1,205 |   | 1,451 |   |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
|                                                            |       | 2,062                                 |       | 2,145                               |       | 4,146 |   | 4,112 |   |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Operating loss                                                  |       | (1,019                                | )          | (567                                | )          | (1,785 | ) | (441 | ) |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Interest expense, net                                           |       | (105                                  | )          | (28                                 | )          | (150 | ) | (54 | ) |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Net loss                                                        |       | $                                     | (1,124     | )                                   | $          | (595 | ) | $ | (1,935 | ) | $ | (495 | ) |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Net loss per share - basic and diluted                          |       | $                                     | (0.22      | )                                   | $          | (0.12 | ) | $ | (0.39 | ) | $ | (0.13 | ) |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Weighted  average common shares outstanding - basic and diluted |       | 5,992                                 |       | 5,992                               |       | 5,992 |   | 5,992 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

4

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**ClearStory Systems, Inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                          | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                          | ** ** | **September 30,** | ** ** |
| ** **                                                                          | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                               |       |                   |       |   |   |
| Net  loss                                                                           |       | $                      | (1,935     | ) | $ | (495 | ) |
| Reconciliation  of net loss to net cash provided by (used in) operating activities: |       |                   |       |   |   |
| Depreciation  and amortization                                                      |       | 439                    |       | 247 |   |
| Deferred  rent                                                                      |       | (4                     | )          | 185 |   |
| Changes  in assets and liabilities:                                                 |       |                   |       |   |   |
| Accounts  receivable                                                                |       | 13                     |       | 464 |   |
| Prepaid  expenses and other current assets                                          |       | 26                     |       | (81 | ) |
| Other  assets                                                                       |       | (20                    | )          | 20 |   |
| Accounts  payable and accrued expenses                                              |       | (338                   | )          | 687 |   |
| Deferred  revenue                                                                   |       | (458                   | )          | (130 | ) |
| Net cash provided by (used in) operating activities                                 |       | (2,277                 | )          | 897 |   |
|                                                                                |       |                   |       |   |   |
| Cash flows from investing activities:                                               |       |                   |       |   |   |
| Capitalized  software                                                               |       | —                 |       | (766 | ) |
| Capital  expenditures                                                               |       | (32                    | )          | (488 | ) |
| Net cash used in investing activities                                               |       | (32                    | )          | (1,254 | ) |
|                                                                                |       |                   |       |   |   |
| Cash flows from financing activities:                                               |       |                   |       |   |   |
| Net  advances (repayments) from sale of receivables                                 |       | 147                    |       | (345 | ) |
| Proceeds  from Revolving Credit Facility                                            |       | 1,350                  |       | — |   |
| Proceeds  from issuance of Note                                                     |       | 750                    |       | — |   |
| Repayment  of Note                                                                  |       | (750                   | )          | — |   |
| Proceeds  from sale and leaseback of equipment                                      |       | —                 |       | 240 |   |
| Payments  on capital leases                                                         |       | (65                    | )          | (45 | ) |
| Proceeds  from issuance of Series C Preferred                                  |       | 250                    |       | 450 |   |
| Net cash provided by financing activities                                           |       | 1,682                  |       | 300 |   |
|                                                                                |       |                   |       |   |   |
| Net decrease in cash                                                                |       | (627                   | )          | (57 | ) |
| Cash, beginning of period                                                           |       | 849                    |       | 751 |   |
| Cash, end of period                                                                 |       | $                      | 222        |   | $ | 694 |   |
|                                                                                |       |                   |       |   |   |
| Supplemental Disclosure of Cash Flow Information:                                   |       |                   |       |   |   |
| Series C  Preferred Stock issued in settlement of dividends                    |       | $                      | 340        |   | $ | 281 |   |
| Equipment  purchased under capital leases                                           |       | 40                     |       | — |   |
| Cash  interest paid                                                                 |       | 125                    |       | 54 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

5

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**ClearStory Systems, Inc.**

**Notes to CondensedConsolidated Financial Statements**

**(Unaudited)**

 

**Natureof Business and Basis of Presentation**

 

ClearStory Systems, Inc. (the “Company” or “ClearStory”) is a leading provider of integrated enterprisecontent management (“ECM”) solutions. ClearStory’s proven technology provides a solid foundation for managingthe full spectrum of enterprise content, from documents to e-mail, and graphicsto video.  By bringing digital assets andbusiness content with a unified Web services platform, ClearStory readilyenables content use in e-commerce, customer service, marketing contentmanagement and regulatory compliance applications. 

 

The consolidated financial statements included in this report have beenprepared by the Company, without audit, pursuant to the rules andregulations of the Securities and Exchange Commission regarding interimfinancial reporting.  In addition,certain information and footnote disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted pursuant to suchrules and regulations relating to interim condensed financialstatements.  However, the Companybelieves that the disclosures contained herein are adequate to make theinformation presented not misleading. The financial statements should be read in conjunction with thefinancial statements and notes thereto included in the Company’s Annual Reporton Form 10-KSB for the fiscal year ended March 31, 2005.  The results for the three and six monthsended September 30, 2005 may not be indicative of the results that may beexpected for the year ending March 31, 2006 or for any other futureperiod.

 

In the opinion of the management of the Company, the accompanyingunaudited financial statements reflect all adjustments that are necessary topresent fairly the financial position of the Company as of September 30,2005 and the results of operations for the three and six months ended September 30,2005 and 2004 and cash flows for the six months ended September 30, 2005and 2004.

 

***Recently Issued Accounting Standards***

 

In December 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Standards (“SFAS”) No. 123 (revised 2004), *Share-Based Payment* (“SFAS No. 123(R)”),which is a revision of SFAS No. 123, Accounting for Stock-basedCompensation (“SFAS No. 123”). SFAS No. 123(R) supersedes AccountingPrinciple Board Opinion (“APB”) No. 25, *Accountingfor Stock Issued to Employees*, and amends FASB Statement No. 95,*Statement of Cash Flows.*Generally, the approach to accounting for share-based payments in SFAS No. 123(R)is similar to the approach described in SFAS No. 123.  However, SFAS No. 123(R) requires allshare–based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values.  Pro forma disclosure of the fair value ofshare-based payments is no longer an alternative to financial statementrecognition.  SFAS No. 123(R) iseffective for small business issuers at the beginning of the first fiscal yearbeginning after December 15, 2005, or effective April 1, 2006 for theCompany.

 

**The Company expects the adoption of SFAS No. 123(R)to have a material effect on its financial statements, in the form ofadditional compensation expense, on a quarterly and annual basis.  It is not possible to precisely determine theexpense impact of adoption since a portion of the ultimate expense that isrecorded will likely relate to awards that have not yet been granted, but arelikely to be granted prior to our April 1, 2006 adoption date.  The expense associated with these futureawards can only be determined based on factors such as the price for theCompany’s common stock, volatility of the Company’s stock price and risk freeinterest rates as measured at the grant date. However, the pro forma disclosures related to SFAS No. 123 includedin the Company’s historic financial statements are relevant data points forgauging the potential level of expense that might be recorded in futureperiods.**

** **

**Earnings (Loss) Per Common Share**

 

Basic and diluted net earnings (loss) per share arepresented in conformity with SFAS No. 128, *Earnings PerShare*(“SFAS No. 128”),for all periods presented. In accordance with SFAS No. 128, basicnet earnings (loss)

 

6

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per common share was determined by dividingnet earnings (loss) applicable to common stockholders by the weighted averagecommon shares outstanding during the period. Basic and diluted net earnings(loss) per share are the same because all outstanding common stock equivalentshave been excluded as they are anti-dilutive.

 

Reconciliation of the Company’s net loss to net loss attributable tocommon shareholders is as follows:

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss - as reported                       |       | $                                          | (1,124     | )                                        | $          | (595 | ) | (1,935 | ) | (495 | ) |
| Preferred stock dividends                    |       | (194                                       | )          | (151                                     | )          | (383 | ) | (296 | ) |
| Net loss attributable to common shareholders |       | $                                          | (1,318     | )                                        | $          | (746 | ) | $ | (2,318 | ) | $ | (791 | ) |
|                                              |            |                                            |            |                                          |            |  |  |  |  |  |  |  |  |

 

For the three and six months ended September 30,2005 and 2004, approximately 20.4million and 17.1 million shares, respectively, from stock options, warrants andconvertible securities were excluded due to their anti-dilutive effect.  

 

## **Stock-BasedCompensation**

 

The Company has elected tofollow APB No. 25, *Accounting for StockIssued to Employees*, and related interpretations in accounting forits employee stock options.  Under APB No. 25,when the exercise price of employee stock options is equal to or greater thanthe market price of the underlying stock on the date of grant no compensationexpense is recorded.  The Companydiscloses information relating to the fair value of stock-based compensationawards in accordance with SFAS No. 123. 

 

The Company computed the pro formadisclosures required under SFAS No. 123 for all stock options granted toemployees and directors of the Company as of September 30, 2005 and 2004,using the Black-Scholes option pricing model prescribed by SFAS No. 123. 

 

## **The effect of applying SFAS No. 123 would be asfollows:**

 

 
| ** **                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                    | ** ** | **(In thousands, except per share data)**  | ** ** |
| Net loss attributable to common shareholders: |       |                                       |       |                                     |       |   |   |   |   |
| As  reported                                  |       | $                                          | (1,318     | )                                        | $          | (746 | ) | $ | (2,318 | ) | $ | (791 | ) |
| Pro  forma - SFAS 123                         |       | $                                          | (1,412     | )                                        | $          | (877 | ) | $ | (2,506 | ) | $ | (1,053 | ) |
|                                          |       |                                       |       |                                     |       |   |   |   |   |
| Basic and diluted net loss per share:         |       |                                       |       |                                     |       |   |   |   |   |
| As  reported                                  |       | $                                          | (0.22      | )                                        | $          | (0.12 | ) | $ | (0.39 | ) | $ | (0.13 | ) |
| Pro  forma - SFAS 123                         |       | $                                          | (0.24      | )                                        | $          | (0.15 | ) | $ | (0.42 | ) | $ | (0.18 | ) |

 

## **Advances against Receivables Sold with Recourse**

 

On November 2,2004, the Company entered into a factoring agreement (“Factoring Agreement”)with Benefactor Funding Corporation (“Benefactor”), which replaced its existingfinancing agreement with another financing company.  Pursuant to the Factoring Agreement, theCompany will sell certain accounts receivable to Benefactor at a purchaseprice, for each accepted account, equal to (i) 98.75% of the face amountof the applicable account receivable less (ii) Benefactor’s fees and theamount of any trade or cash discounts, credits or allowances, set-offs or anyother applicable reductions or adjustments. The Company has also grantedBenefactor a security interest in all of the Company’s assets to secure the paymentand performance of all obligations under the Factoring Agreement.

 

7

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**10% Convertible Promissory Note**

** **

On June 16, 2005, the Company, issueda 10% Convertible Promissory Note (the “Note”) to SCP Private Equity PartnersII, L.P. (“SCP”). The Note was issued in the amount of $750,000, and was payableon demand at any time. Pursuant to the terms of the Note, the Note wasconvertible upon demand into up to 386,678 shares of the Company’s Series CConvertible Preferred Stock, par value $.01 per share (“Series C Preferred”)or other equity securities of the Company. The Note could be pre-paid by theCompany at any time without penalty.  On September 8,2005, the Company utilized borrowings from its Revolving Credit Facility torepay the Note.  

 

**Revolving Credit Facility**

 

On August 25,2005, the Company entered into a Loan and Security Agreement (“Revolver’) withSilicon Valley Bank (“SVB”) which provides for the Company to borrow up to$1,500,000 for general corporate purposes for the next two years at the prime interestrate plus 0.5%, payable monthly.  TheCompany granted SVB a second security interest in all of the Company’s assetsto secure the payment and performance of all obligations under the Revolver. TheRevolver also contains certain financial covenants and was guaranteed bySCP.  In consideration for the guaranteeby SCP, the Company issued a warrant to SCP to purchase 232,007 shares of Series C Preferred at $1.9396 per share. Theterm of the warrant expires on August 25, 2015.  The Company has valued the warrant at $408,000utilizing the Black-Scholes option pricing model.  The Company will amortize this cost alongwith $41,000 of legal and other fees incurred over the term of the Revolver.  On September 8, 2005, the Company utilizedborrowings under the Revolver to repay its Note with SCP.  

 

Based upon the results for the six monthsended September 30, 2005 and its current outlook for the remainder of theyear, the Company was and will continue to be in violation of its financialcovenants set forth in the Revolver. While SVB has indicated that it would consider amending the financialcovenants to levels consistent with the Company’s expectations for the remainingterm of the Revolver, there can be no assurance that SVB will agree to amendthese financial covenants or that the Company will be successful in complyingwith these covenants.  If the Company isunsuccessful in amending these financial covenants, or is unable to comply withthese covenants, SVB could declare the loan in default and require the Company,or SCP under its guarantee, to repay all outstanding amounts under the Revolverin full. 

 

**Series C****Convertible Preferred Stock**

 

On January 28,2005, the Company entered into a Series C Convertible Preferred StockPurchase Agreement with SCP and CSSMK, LLC (“CSSMK”), whereby the Company sold257,785 shares of Series C Preferred at $1.9396 per share to SCP for thesum of $500,000 and sold an additional 51,557 shares of Series C Preferredto CSSMK at $1.9396 per share for the sum of $100,000.  Pursuant to the agreement, SCP, or at thediscretion of SCP, CIP Capital LP (“CIP”), agreed to purchase a minimum of77,336 additional shares of Series C Preferred at $1.9396 per share forthe sum of $150,000, on or before April 15, 2005 (the “Second Closing”).  In addition, SCP could, at its solediscretion, expand the number of shares to be purchased at the Second Closingto a maximum of 128,893 shares of Series C Preferred for $250,000.  SCP elected to purchase 128,893 shares of Series CPreferred for $250,000 on April 15, 2005.

 

For the sixmonths ended September 30, 2005, the Company issued a total of 42,021shares of Series C Preferred in settlement of dividends of $82,000 on its Series BConvertible Preferred Stock (“Series B Preferred”).  The Company also issued 154,261 shares of Series CPreferred in settlement of dividends of $299,000 on its Series C PreferredStock.  The Company has recorded anadditional $50,000 in accrued dividends associated with its Series BPreferred and Series C Preferred at September 30, 2005. 

 

**Liquidity**

 

As of September 30, 2005, the Company had a cash balance of $222,000,the ability to sell certain accounts receivable for additionalfunds of approximately $250,000 pursuant to its Factoring Agreement and$150,000 of available funds under its Revolver. Based upon the Company’s current operating outlook for the remainder ofthe current fiscal year, the Company needs additional financial resources tomeet its short term liquidity requirements.  The Company is currently indiscussions with its major shareholders and SVB regarding the need to either increase

 

8

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the borrowing capacity under the Revolver, or raisecapital from other sources.  The increasein the Company’s borrowing capacity under the Revolver is subject to a numberof risks and uncertainties and to various contingencies, including theagreement of SCP to guarantee the Company’s obligations under the expandedRevolver.  The Company can make noassurances it will be successful in its efforts to expand its borrowingcapacity under its Revolver, or to raise capital from other sources.

 

The Company will need additional financing, beyondthat which is contemplated above, to further supplement its liquidity needs,especially for intra-quarter liquidity requirements that depend on the timingand amount of monthly cash receipts that are anticipated by its currentoperating outlook. Additionalfinancing could take the form of equity or debt offerings, spin-offs, jointventures or other collaborative relationships that may require the Company toissue shares or share revenue.  Sinceits acquisition of WebWare in September 2003, the Company has incurredoperating losses and negative cash flows which have historically been fundedthrough the issuance of additional capital from its major stockholders. Basedupon its latest operating outlook, the Company expects to incur losses for the remainderof the fiscal year due in part to significant investments in its direct salesand marketing efforts, the establishment of new sales distribution channels andthe development and release of its products. There can be no assurances that the Company will be able to achieverevenue levels or sufficiently reduce expenses to allow the Company to becomeprofitable without detrimentally affecting its long-term revenues or marketposition.  Additionally, the Companyalready has a working capital deficit of $5,108,000 as of September 30,2005, compared to a working capital deficit of $3,708,000 as of March 31,2005, which increases the need for the Company to successfully execute anddeliver on its current business plan. The Company expects its working capital deficit to increase, as theCompany anticipates incurring operating losses for the remaining quarters of fiscal2006. In the event that the Company’s plans or assumptions change or prove tobe inaccurate (due to revenue shortfalls, unanticipated expenses, difficulties,delays or otherwise), the Company may have insufficient funds to support itsoperations. Over the past several years, the Company has been successful inraising additional funds from its major shareholders, and these funds haveallowed the Company to continue to make certain strategic investments.  However, the Company’s ability to garnercontinued financial support from these, or other investors, should the needarise, cannot be assured. 

 

**Geographic Information**

 

The Company operates as a single reportable segment asa developer and distributor of software solutions for the ECM market.

 

Revenue was derived from customers in the following geographic areas:

 
| ** **    | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|---------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **    | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| North America |       | $                                          | 1,691      |                                     | $          | 2,274 |   | $ | 3,562 |   | $ | 4,980 |   |
| Europe        |       | 100                                        |       | 195                                      |       | 264 |   | 387 |   |
| Other         |       | 62                                         |       | 108                                      |       | 162 |   | 193 |   |
|          |       | $                                          | 1,853      |                                     | $          | 2,577 |   | $ | 3,988 |   | $ | 5,560 |   |

 

9

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**Item 2.****    Management’sDiscussion and Analysis or Plan of Operations**

 

***The following discussion ofresults of operations for the three months (“Second Quarter of Fiscal 2006”)and the six months (“First Half of Fiscal 2006”) ended September 30, 2005and the three months (“Second Quarter of Fiscal 2005”) and the six months (“FirstHalf of Fiscal 2005”) ended September 30, 2004 and the discussion of theCompany’s financial condition at September 30, 2005 should be read inconjunction with the financial statements and the related notes theretoincluded elsewhere in this Form 10-QSB and the audited financialstatements and notes thereto and Management’s Discussion and Analysis ofFinancial Condition and Results of Operations included in our Annual Report on Form 10-KSBfor the year ended March 31, 2005, which has been filed with theSecurities and Exchange Commission (the “SEC”). The following discussion contains forward-looking statements thatreflect our business, plans, estimates and beliefs.  Our results could differ materially fromthose discussed in the forward-looking statements***.

 

We were founded to capture andpreserve high volumes of mission critical business information.  Our product offering includes web-basedpresentment capabilities for documents such as bank statements, 401(k)statements, customer and vendor statements, explanation of benefits (“EOB”)statements, and transaction confirmation documents.  We have expanded our product offerings toinclude e-mail archiving and notification capabilities as well as the abilityto capture, store and deliver high value digital assets such as video, voice ondemand, graphics and presentations subsequent to our acquisition of certainassets and liabilities of WebWare Corp. on September 5, 2003.  These offerings provide our customers withthe ability to improve internal communication, enhance productivity andincrease customer satisfaction and communication.  With the March 2005 release of RadiantEnterprise Media Server (“Radiant EMS”), our next generation software platform,coupled with our ActiveMedia product offerings, we have substantially expandedour digital archive and rich media asset management capabilities and supportbusiness efforts such as video and voice on demand, and brand and channelmanagement.

 

We distribute our products through a combination ofour direct sales force and through our Alliance Partners.  Revenue is net of discounts and allowancesgiven to our Alliance Partners.  Wealso market and license our products on an international basis through ourAlliance Partners.  We havereseller relationships with Unisys, and Xerox Global Services, and originalequipment manufacturer (“OEM”) agreements with Agfa Corporation, Ascent MediaGroup, Inc., and Sunguard Shareholder Systems, Inc. In addition, on March 30,2005, we signed an agreement with IBM, representing a new distributionopportunity for our recently released platform, Radiant EMS. We consider the development of a successful AlliancePartner program as a key element for our future growth. In Fiscal 2005, wederived approximately 46% of our total revenues from our Alliance Partners.  Sales to new end-users generallyinclude a software license, professional services, and maintenancecontracts.  Additionally, our Radiant EMSand Active Media products are also offered under a hosting contract pursuant towhich we are an application service provider (“ASP”).  ASP sales typically include monthly recurringrevenues that are recognized as earned.

 

## **Significant Accounting Policies**

 

Financial Reporting Release No. 60, which was recently issued bythe SEC, requires all registrants to discuss critical accounting policies ormethods used in the preparation of the financial statements. The notes to theconsolidated financial statements included in our Annual Report on Form 10-KSBfor the year ended March 31, 2005 includes a summary of the significantaccounting policies and methods used in the preparation of our consolidatedfinancial statements, the most significant of which are revenue recognition,capitalization of software, and income taxes. 

 

Further, we havemade a number of estimates and assumptions that affect reported amounts ofassets, liabilities, revenues and expenses, and actual results may differ fromthose estimates. The areas that require the greatest degree of managementjudgment are the assessment of the recoverability of long-lived assets,primarily goodwill and capitalized software costs.  Capitalized software costs, which consistprimarily of payroll and related expenses, are capitalized once technologicalfeasibility, which is defined as completion of beta testing, is established.  It is then amortized when the product isreleased over an estimated useful life of three to five years. 

 

10

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We believe that full consideration has beengiven to all relevant and material circumstances to which we may be subject,and the financial statements accurately reflect our best estimate of theresults of operations, financial position and cash flows for the periodspresented.

 

**RESULTS OF OPERATIONS**

 

**SecondQuarter of Fiscal 2006 Compared to Second Quarter of Fiscal 2005:**

 

**Revenues**

 

The following tables compare total revenues for theperiods indicated (in thousands):

 
| ** **                                | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **% Change** | ** ** |
| Product revenues                          |       | $                                         | 538        |   | $ | 945 |   | -43 | % |
| Professional services                     |       | 153                                       |       | 323 |   | -53 | % |
| Maintenance and hosting contract revenues |       | 1,162                                     |       | 1,309 |   | -11 | % |
| Total  revenues                           |       | $                                         | 1,853      |   | $ | 2,577 |   | -28 | % |

 

Revenues for the Second Quarter of Fiscal 2006decreased by $724,000, or 28%, to $1,853,000 as compared to revenues of $2,577,000for the Second Quarter of Fiscal 2005. Product revenues decreased by $407,000, or 43%, to $538,000 in the SecondQuarter of Fiscal 2006 as compared to $945,000 in the Second Quarter of Fiscal2005.  The decrease in product revenueswas primarily attributable to lower product revenue associated with Radiant BDS.Professional service revenues decreased by $170,000, or 53%, to $153,000 in theSecond Quarter of Fiscal 2006 as compared to $323,000 in the Second Quarter ofFiscal 2005. The decrease in professional service revenues was due to thedecline in product revenues which have historically resulted in the initiationof service engagements.  Maintenance andhosting revenues decreased by $147,000, or 11%, to $1,162,000 in the SecondQuarter of Fiscal 2006 as compared to $1,309,000 in the Second Quarter ofFiscal 2005. The decrease in maintenance and hosting revenues was due primarilyto a decline in hosting revenues as a large hosting customer moved itsapplication in-house.

 

**GrossProfit**

 

Gross profit for the Second Quarter of Fiscal 2006decreased by $535,000, or 34%, to $1,043,000 as compared to gross profit of $1,578,000for the Second Quarter of Fiscal 2005. The decrease in gross profit is related to the decrease in product andservice revenue as discussed above. Gross margin percentage decreased to 56% for the Second Quarter ofFiscal 2006 from 61% for the Second Quarter of Fiscal 2005. The decrease in thegross margin percentage was primarily the result of lower product revenue,which has higher gross profit margins, and lower professional service marginsdue to lower productivity from fewer service engagements.

 

**Salesand Marketing**

 

Sales and marketing expenses for the Second Quarter ofFiscal 2006 decreased by $121,000, or 17%, to $596,000, as compared to $717,000for the Second Quarter of Fiscal 2005. The decrease is primarily due to lowercommissions earned due to the decline in revenues and in marketing costs fromthose incurred in the Second Quarter of Fiscal 2005 associated with there-branding of our suite of products along with our company name change toClearStory.

 

Sales and marketing expenses expressed as a percentageof sales increased to 32% in the Second Quarter of Fiscal 2006 compared to 28%in the Second Quarter of Fiscal 2005, primarily due to a decrease in revenues.

 

**ProductDevelopment**

 

Productdevelopment expenses, net of capitalized software, for the Second Quarter ofFiscal 2006 increased by $235,000, or 40%, to $826,000 as compared to $591,000for the Second Quarter of Fiscal 2005. We capitalized

 

11

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$391,000 ofproduct development costs associated with the development of our nextgeneration platform, Radiant EMS, in the Second Quarter of Fiscal 2005 with nocapitalization occurring in the Second Quarter of Fiscal 2006. Radiant EMSachieved technological feasibility in the fourth quarter of Fiscal 2004 and wasreleased in March 2005. Excluding the impact of the softwarecapitalization, total product development expenses for the Second Quarter ofFiscal 2006 would have decreased by $156,000, or 16%, to $826,000 as comparedto $982,000 for the Second Quarter of Fiscal 2005.  The decrease in product development costs isattributable to reduced costs associated with Radiant BDS and a reduction inexternal development costs associated with the development of Radiant EMS.

 

Productdevelopment expenses, excluding the impact of the software capitalization,expressed as a percentage of revenues was 45% in the Second Quarter of Fiscal2006, compared to 38% in the Second Quarter of Fiscal 2005.

 

## **General and Administrative**

 

General and administrative expenses for the Second Quarter of Fiscal2006 decreased by $197,000, or 24%, to $640,000 as compared to $837,000 for the Second Quarter of Fiscal 2005.  General andadministrative expenses decreased primarily as a result of reduced facility costs as we moved into a new corporate facility onMarch 1, 2004, but continued to be obligated on our prior facility throughSeptember 2004.

 

General and administrative expense,expressed as a percentage of revenues, was 35% for the Second Quarter of Fiscal2006, compared to 32% in the Second Quarter of Fiscal 2005.

 

**InterestExpense, net**

 

Interestexpense, net for the Second Quarter of Fiscal 2006 increased by $77,000 to $105,000as compared to $28,000 for the Second Quarter ofFiscal 2005.  The increase ininterest expense, net was primarily due to our issuance of the Note and ourentering into the Revolver. 

 

**Provisionfor Taxes**

 

No provision for or benefit from federal, state orforeign income taxes was recorded for the Second Quarter of Fiscal 2006 or forthe Second Quarter of Fiscal 2005 because we incurred net operating losses andfully reserved our deferred tax assets as their future realization could not bedetermined.  

 

**FirstHalf of Fiscal 2006 Compared to First Half of Fiscal 2005:**

 

**Revenues**

 
| ** **                                | ** ** | **Six Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                | ** ** | **2005**                                | ** ** | **2004** | ** ** | **% Change** | ** ** |
| Product revenues                          |       | $                                       | 1,106      |   | $ | 2,170 |   | -49 | % |
| Professional services                     |       | 395                                     |       | 751 |   | -47 | % |
| Maintenance and hosting contract revenues |       | 2,487                                   |       | 2,639 |   | -6 | % |
| Total  revenues                           |       | $                                       | 3,988      |   | $ | 5,560 |   | -28 | % |

 

Revenues for the First Half of Fiscal 2006 decreasedby $1,572,000, or 28%, to $3,988,000 as compared to revenues of $5,560,000 forthe First Half of Fiscal 2005.  Productrevenues decreased by $1,064,000, or 49%, to $1,106,000 in the First Half ofFiscal 2006 as compared to $2,170,000 in the First Half of Fiscal 2005.  The decrease in product revenues wasprimarily attributable to lower product revenue associated with Radiant BDS andwith longer sales cycles and delays in purchase decisions associated with our RadiantEMS product. Professional service revenues decreased by $356,000, or 47%, to $395,000in the First Half of Fiscal 2006 as compared to $751,000 in the First Half ofFiscal 2005. The decrease in professional services revenues was due to thedecline in product revenues which have historically resulted in the initiationof service engagements.  Maintenance andhosting revenues decreased by $152,000, or 6%, to $2,487,000 in the First Halfof Fiscal 2006 as compared to $2,639,000 in the First Half of Fiscal 2005. Thedecrease in maintenance and hosting revenues was due primarily to a decline in hostingrevenues as a large hosting customer moved its application in-house.

 

12

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**GrossProfit**

 

Gross profit for the First Half of Fiscal 2006decreased by $1,310,000, or 36%, to $2,361,000 as compared to gross profit of $3,671,000for the First Half of Fiscal 2005.  Thedecrease in gross profit is related to the decrease in product and servicerevenue as previously discussed.  Grossmargin percentage decreased to 59% for the First Half of Fiscal 2006 from 66%for the First Half of Fiscal 2005. The decrease in the gross margin percentagewas primarily the result of lower product revenue, which has higher grossprofit margins, and lower service margins due to lower productivity from fewerservice engagements.

 

**Salesand Marketing**

 

Sales and marketing expenses for the First Half ofFiscal 2006 decreased by $144,000, or 10%, to $1,314,000, as compared to $1,458,000for the First Half of Fiscal 2005. The decrease is primarily due to lowercommissions earned due to the decline in revenues and a decrease in marketingcosts incurred in the Second Quarter of Fiscal 2005 associated with there-branding of our suite of products, along with our company name change toClearStory.

 

Sales and marketing expenses expressed as a percentageof sales increased to 33% in the First Half of Fiscal 2006 compared to 26% inthe First Half of Fiscal 2005, primarily due to the decrease in revenues.

 

**ProductDevelopment**

 

Productdevelopment expenses, net of capitalized software, for the First Half of Fiscal2006 increased by $424,000, or 35%, to $1,627,000 as compared to $1,203,000 forthe First Half of Fiscal 2005.  Wecapitalized $766,000 of product development costs associated with thedevelopment of our next generation platform, Radiant EMS, in the First Half ofFiscal 2005 with no capitalization occurring in the First Half of Fiscal 2006.Radiant EMS achieved technological feasibility in the fourth quarter of Fiscal2004 and was released in March 2005. Excluding the impact of the softwarecapitalization, total product development expenses for the First Half of Fiscal2006 would have decreased by $342,000, or 17%, to $1,627,000 as compared to $1,969,000for the First Half of Fiscal 2005.  Thedecrease in product development costs is attributable to reduced costsassociated with Radiant BDS and a reduction in external development costsassociated with the development of Radiant EMS.

 

Productdevelopment expenses, excluding the impact of the software capitalization,expressed as a percentage of revenues was 41% in the First Half of Fiscal 2006,compared to 35% in the First Half of Fiscal 2005.

 

## **General and Administrative**

 

General and administrative expenses for the First Half of Fiscal 2006decreased by $246,000, or 17%, to $1,205,000 as compared to $1,451,000 for the First Half of Fiscal 2005.  General andadministrative expenses decreased primarily as a result of reduced facility costs as we moved into a new corporate facility onMarch 1, 2004 but continued to be obligated on our prior facility through September 2004.

 

General and administrative expense, expressedas a percentage of revenues, was 30% for the First Half of Fiscal 2006,compared to 26% in the First Half of Fiscal 2005.

 

**InterestExpense, net**

 

Interestexpense, net for the First Half of Fiscal 2006 increased by $96,000 to $150,000as compared to $54,000 for the First Half of Fiscal2005.  The increase in interestexpense, net was primarily due to our issuance of the Note and our enteringinto the Revolver. 

 

13

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**Provisionfor Taxes**

 

No provision for or benefit from federal, state orforeign income taxes was recorded for the First Half of Fiscal 2006 or for theFirst Half of Fiscal 2005 because we incurred net operating losses and fullyreserved our deferred tax assets as their future realization could not bedetermined.  

 

## **Liquidity and CapitalResources**

 

As of September 30, 2005, we had a cash balance of $222,000, theability to sell certain accounts receivable for additionalfunds of approximately $250,000 pursuant to our Factoring Agreement and $150,000of available funds under our Revolver. Based upon our current operating outlook for the remainder of thecurrent fiscal year, we need additional financial resources to meet our shortterm liquidity requirements.  We are currently in discussions withour major shareholders and SVB regarding the need to either increase our borrowingcapacity under the Revolver, or raise capital from other sources.  The increase in the borrowing capacity underthe Revolver is subject to a number of risks and uncertainties and to variouscontingencies, including the agreement of SCP to guarantee our obligationsunder the expanded Revolver.  We can makeno assurances it will be successful in our efforts to expand our borrowingcapacity under our Revolver, or to raise capital from other sources.

 

We will need additional financing, beyond that whichis contemplated above, to further supplement our liquidity needs, especiallyfor intra-quarter liquidity requirements that depend on the timing and amountof monthly cash receipts that are anticipated by our current operating outlook.Additional financing could take theform of equity or debt offerings, spin-offs, joint ventures or othercollaborative relationships that may require us to issue shares or sharerevenue.  Sinceour acquisition of WebWare in September 2003, we have incurred operatinglosses and negative cash flows which have historically been funded through theissuance of additional capital from our major stockholders. Based upon ourlatest operating outlook, we expect to incur losses for the remainder of the fiscalyear due in part to significant investments in our direct sales and marketingefforts, the establishment of new sales distribution channels and thedevelopment and release of our products. There can be no assurances that we will be able to achieve revenuelevels or sufficiently reduce expenses to allow us to become profitable withoutdetrimentally affecting our long-term revenues or market position.  Additionally, we already have a workingcapital deficit of $5,108,000 as of September 30, 2005, compared to aworking capital deficit of $3,708,000 as of March 31, 2005, whichincreases the need for us to successfully execute and deliver on our currentbusiness plan.  We expect our workingcapital deficit to increase, as we anticipate incurring operating losses forthe remaining quarters of fiscal 2006. In the event that our plans orassumptions change or prove to be inaccurate (due to revenue shortfalls,unanticipated expenses, difficulties, delays or otherwise), we may haveinsufficient funds to support our operations. Over the past several years, wehave been successful in raising additional funds from our major shareholders, andthese funds have allowed us to continue to make certain strategicinvestments.  However, our ability togarner continued financial support from these, or other investors, should theneed arise, cannot be assured. 

 

Our cash flows are summarized below for the periodsindicated: (in thousands)

 
| ** **                  | ** ** | **Six Months Ended**   | ** ** |
|-----------------------------|------------|------------------------|------------|
| ** **                  | ** ** | **September 30,** | ** ** |
| ** **                  | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Cash provided by (used in): |       |                   |       |   |   |
| Operating  activities       |       | $                      | (2,277     | ) | $ | 897 |   |
| Investing  activities       |       | (32                    | )          | (1,254 | ) |
| Financing  activities       |       | 1,682                  |       | 300 |   |
| Net decrease in cash        |       | (627                   | )          | (57 | ) |
| Cash, beginning of period   |       | 849                    |       | 751 |   |
| Cash, end of period         |       | $                      | 222        |   | $ | 694 |   |

 

Netcash used in operating activities was $2,277,000 in the First Half of Fiscal 2006 compared to net cash provided byoperating activities of $897,000 in the prior comparable period.  The decrease in cash from operations isprimarily due to our higher net loss for the First Half of Fiscal 2006, adecrease in accounts payable and accrued expenses due to the timing of paymentsand a decrease in deferred revenue.  For the Second Quarter of Fiscal 2006, the day’ssales outstanding (“DSO”) was 44 compared to a DSO of 74 for the Second Quarterof Fiscal 2005.

 

14

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Netcash used in investing activities was $32,000 in the First Half of Fiscal 2006compared to $1,254,000 in the prior comparable period.  For the First Half of 2005, we utilized fundsof $766,000 for capitalized software development costs and $4881,000 of fundsfor capital expenditures for the completion of our hosted data center, otherequipment relating to the relocation of corporate facilities and computerequipment and software associated with our product development activities. 

 

Netcash provided by financing activities was $1,682,000 in the First Half ofFiscal 2006 compared to net cash provided by financing activities of $300,000 inthe prior comparable period.  Cash provided by financing activities in the First Half ofFiscal 2006 was a result of the proceeds from the issuance of $250,000 of Series CPreferred, the proceeds of $1,350,000 under our new Revolver and $147,000 ofadvances against account receivables under our Factoring Agreement.  Cash provided by financing activities in theFirst Half of Fiscal 2005 was a result of the proceeds from the issuance of$450,000 of Series C Preferred, the proceeds of $240,000 under a sale andleaseback transaction, partially offset by a decline in advances againstaccounts receivable under our Factoring Agreement.

 

**QuarterlyResults**

 

# Quarterly revenues and results of operations mayfluctuate as the result of a variety of factors, including the lengthy salescycle for our products, the proportion of revenues attributable to softwarelicense fees versus services, the amount of revenue generated by alliances withother companies distributing our products, demand for our products andservices, the size and timing of individual license transactions, theintroduction of new products and product enhancements by us or our competitors,changes in customer budgets and capital expenditures, competitive conditions inthe industry and general economic conditions. Additionally, the sale of our products generally involves a significantcommitment of capital by our customers and may be delayed due to time-consumingauthorization procedures within an organization.  Other factors affecting our operating resultsinclude our ability to design and introduce on a timely basis new productswhich compete effectively on the basis of price and performance, productobsolescence, technological changes, competition and competitive pressures onprice, the ability to hire and retain qualified personnel and general economicconditions affecting the investment by potential customers in technology basedinvestments.  There is no assurance thatwe can maintain or increase our sales volume going forward or that we will beable to achieve a profit in the marketing of our products.

#  

#### **Off-Balance Sheet Arrangements**

 

The Company does not have any off-balance sheet arrangements that havenot been disclosed.

 

**“Forward-Looking”Statements Under The Private Securities Litigation Reform Act**

 

This Quarterly Report on Form 10-QSB containsstatements which constitute forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. These statements appear in a number of places in this Quarterly Reportand include all statements that are not statements of historical fact regardingthe intent, belief or expectations of theCompany and its management.  Thesestatements are based upon a number of assumptions and estimates, which aresubject to significant uncertainties, many of which are beyond ourcontrol.  Words such as “may,” “would,” “could,”“will,” “expect,” “anticipate,” “believe,” “intend,” “plan” and “estimate” aremeant to identify such forward-looking statements.  Such forward-looking statements are notguarantees and actual results may differ materially from those expressed orimplied by such forward-looking statements. Factors that could cause actual results to differ materially include,but are not limited to, our ability to achieve or maintain growth orprofitability, our ability to execute our business strategy successfully, ourability to obtain financing and to pay off our existing liabilities and to fundour working capital needs, our relationship with our existing lenders, ourrelationship with our customers and suppliers, increased competition, possiblesystem failures and rapid changes in technology and other factors discussed inthis Quarterly Report on Form 10-QSB and in our other filings with theSEC.

 

**BusinessRisks**

 

An investment in ourcommon stock involves a high degree of risk. Current and potential investors should carefully consider the followingrisks, and consult with their legal, tax and financial advisors when consideringan investment in the Company.

 

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*We Need AdditionalFinancing To Fund Our Operations.*

* *

We are actively exploring alternative sources of capital,which could result in additional financing arrangements. The opinion of ourindependent auditors on our audited financial statements for the year ended March 31,2005 is subject to a “going concern” qualification and states that ouraccumulated deficit resulting from recurring losses from operations and aworking capital deficiency raises substantial doubt about our ability tocontinue as a going concern.    If we areunable to obtain additional financing or attain profitability within the nextthree to six months, we may be unable to continue operating as an independententity.  There is no assurance that wewill be successful. Further, additional financing could take the form of equityor debt offerings, spin-offs, joint ventures or other collaborativerelationships that may require us to issue shares or share revenue.  Any such financing strategies would likelyimpose operating restrictions on us and be dilutive to holders of our commonstock, and may not be available on attractive terms or at all.  Further, any additional financing we enterinto would be subject to approval by SCP. 

 

*We Have A History Of Losses AndOur Ability To Be Profitable Depends On A Number Of Factors That We May BeUnable To Control.*

* *

We have incurred substantial operating lossessince our inception, which has resulted in an accumulated deficit of $58,709,000,as of September 30, 2005. For the years ended March 31, 2005 and March 31,2004, we incurred net losses of $1,242,000 and $2,324,000, respectively, and weincurred additional net losses of $1,935,000 for the six months ended September 30,2005.  We expect this working capital deficit to further increase aswe anticipate incurring additional losses for the remainder of fiscal 2006. Sinceour acquisition of certain assets and liabilities of WebWare on September 3,2003, we have experienced operating losses as we focused our efforts onintegration and market enhancement initiatives and the development of our nextgeneration platform, Radiant EMS.  Therecan be no assurance that revenues will continue to increase from current levelsto allow us to become profitable or that any expense reduction actions we maytake will allow us to become profitable, or not affect our future revenues ormarket position.  

 

Our quarterly sales and operating results have variedsignificantly, and may vary in the future, as a result of several factors suchas:

 

•                  Size and timing of software license orders

•                  Adoption of recently introduced products

•                  Sales mix of installed versus hosted license revenues

•                  License revenues as a percentage of our revenues 

•                  Completion of backlog orders

•                  Successful implementation of a direct sales model

•                  Acceptance and sign off of service contracts

•                  Maintenance contract renewal rates

•                  Seasonality

•                  Customer budgetary constraints and timelines

•                  Availability of embedded third party products or tool sets

•                  Availability of Alliance Partner products

•                  Financial condition of Alliance Partners

•                  Variations of Alliance Partner strategies

•                  Competitive pricing

•                  Changes in product distribution channels

•                  Execution of a direct sales strategy

•                  Variations in expense levels

•                  General technology trends

•                  Change of business strategy

•                  General economic conditions

•                  Changes in accounting pronouncements

 

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A significant amount of our license and servicerevenues are derived from a limited number of customers.  Such orders are typically placed within thespecific financial quarter when revenue is recognized, and we expect this trendto continue.  The placement of suchorders is typically at the end of a fiscal quarter requiring shipment.  The sales cycle is typically lengthy for anew licensed customer and shorter for an existing customer.  Revenue recognition for service contractsrequires the acceptance and sign off from a customer.  The amount of licensed product and servicebacklogs at the end of a quarter is typically immaterial.  We experience variations in product demanddue to customer budgetary constraints that may be imposed within a fiscal year.  Additionally, we may experience changes inproduct demand due to changes in budgetary timelines.  As a consequence, we experience difficulty inforecasting license and service revenues, particularly at the beginning of thefiscal quarter. 

 

Licenserevenue gross margins are substantially higher than other revenue sources.  The percentage of license revenues to theoverall revenues in a fiscal period may materially affect the overall grossmargins and profitability for any period. Variations in expense levels compared to other periods may result inchanges in operating income within a fiscal period.

 

*Execution Of Our BusinessPlan Will Require The Successful Implementation Of Our Direct Sales Strategy.*

* *

Historically, we have significantly relied on theindirect sales channel for sales leads and product revenues.  We have invested, and expect to continue toinvest, in the development and growth of a direct sales channel.  To the extent that we are not successful insuch efforts, future revenue growth and operating margins may be adverselyaffected.

* *

*Because We Have Experienced LossesWe May Need Additional Working Capital To Implement Our Business Plan.*

* *

We experienced losses from operations of $1,242,000 and $2,324,000 forthe fiscal years ended March 31, 2005 and 2004, respectively, and we incurred additional netlosses of $1,935,000 for the six months ended September 30, 2005. These losses were funded partially through additional equityofferings and most recently debt offerings. Based upon our current operating outlook for the remainder of thecurrent fiscal year, we need additional financial resources to meet our shortterm liquidity requirements.  We are currently in discussions withour major shareholders and SVB regarding the need to either increase ourborrowing capacity under the Revolver, or raise capital from othersources.  The increase in our borrowingcapacity under our Revolver is subject to a number of risks and uncertaintiesand to various contingencies, including the agreement of SCP to guarantee ourobligations under the expanded Revolver. We can make no assurances that we will be successful in our efforts toexpand our borrowing capacity under our Revolver, or to raise capital fromother sources.

 

We will needadditional financing, beyond that which is contemplated above, to furthersupplement our liquidity needs, especially for intra-quarter liquidityrequirements that depend on the timing and amount of monthly cash receipts thatare anticipated by our current operating outlook.  Additional financing couldtake the form of equity or debt offerings, spin-offs, joint ventures or othercollaborative relationships that may require us to issue shares or sharerevenue.  As of September 30, 2005, we had aworking capital deficit of $5,108,000 compared to a working capital deficit of$3,708,000 as of March 31, 2005.

 

If additional funds are raised by issuance of equitysecurities, dilution to our stockholders will result.  There can be no assurances, however, that wewill be successful in obtaining funds from any equity sources.  If additional funds are not available, we maybe forced to eliminate or curtail certain of our projects, sell assets, takeadditional steps to conserve cash and modify the execution of our businessplan. These actions may adversely affect our results of operations.

 

*Our Inability To Raise Additional Capital OnAcceptable Terms In The Future May Limit Our Growth.*

* *

If our capital resources become insufficient to meet futurerequirements, we will have to raise additional funds to continue theoperations, development and commercialization of our technologies. Ourinability to raise capital would seriously harm our business and developmentefforts. In addition, we may choose to raise additional capital due to marketconditions or strategic considerations even if we believe we have sufficientfunds for our current or future operations. These funds may not be available onfavorable terms, or at all. If adequate funds are not available on attractiveterms, we may have to restrict our operations significantly or obtain funds byentering into

 

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agreements on unattractive terms. Further, to theextent that additional capital is raised through the sale of equity orconvertible debt securities, the issuance of these securities could result indilution to our stockholders. 

 

*Our Existing Common StockShareholders Face Substantial Dilution Upon the Conversion of Our Outstanding Series BConvertible Preferred Stock and Series C Convertible Preferred Stock.*

* *

Our stock is traded on the Over the Counter BulletinBoard (OTCBB) under the symbol “CSYS”. As of September 30, 2005, we have 5,992,287 common sharesoutstanding.  As of September 30,2005, the Company’s Series B Convertible Preferred Stock is convertibleinto 8,634,080 shares of common stock while the Company’s Series CConvertible Preferred Stock is convertible into approximately 7,982,200 sharesof common stock.

 

*The Members Of Our Board OfDirectors Own A Significant Percentage Of Our Common Stock And Can InfluenceMatters Requiring The Vote Of Shareholders.*

* *

As of September 30, 2005, our directors andofficers, assuming the conversion of all outstanding preferred stock intocommon stock, owned approximately 17.8 million shares of common stock,representing approximately 79% of the outstanding common stock.  Based on their ownership, our directors andofficers have the ability to influence matters requiring a stockholder vote,including the election of directors, the amendment of charter documents, themerger or dissolution of the Company and the sale of all or substantially allof its assets.  Their voting power alsomay discourage or prevent any proposed takeover.

 

*OurPreferred Stockholders Have Senior Rights In The Event Of Our Liquidation,Dissolution Or Winding-Up.*

 

Our preferred stockholders have senior rightsin the event of our liquidation, dissolution or winding-up, including our saleto a third party.  In the event that anyliquidation, dissolution or winding-up occurs, our common stockholders wouldnot be entitled to any proceeds of such liquidation, dissolution or winding-upuntil the liquidation preference of our preferred stockholders is fullysatisfied.  As a result, we can provideno assurances that our common stockholders will receive any proceeds in theevent of our liquidation, dissolution or winding-up to the extent that theliquidation preference of our preferred stockholders is not fullysatisfied.  As of September 30, 2005,the aggregate liquidation preference for all series of preferred stock,excluding the conversion of the outstanding Series C Preferred warrantissued in connection with the guarantee by SCP of our Revolver, was approximately$19.8 million.

 

*The Potential Issuance OfAdditional Shares Of Preferred Stock May Negatively Affect The MarketPrice Of Our Common Stock And Shareholder Rights.*

* *

 Our certificateof incorporation empowers the board of directors with the right to determinethe designations, rights, preferences and privileges of the holders of one ormore series of preferred stock.  The boardof directors can issue, without stockholder approval, preferred stock withvoting, dividend, conversion, liquidation or other rights, which couldadversely affect the voting power and equity interest of common stockholders.  

 

*Because Our Common Stock HasHistorically Had Limited Trading Volumes, Our Shareholders May ExperienceLiquidity Issues.*

* *

The average daily trading volume for the three-monthtrading period ended September 30, 2005 on the OTC bulletin board wasapproximately 3,000 shares of common stock. This may impair the ability of our shareholders to achieve liquiditywithin certain periods of trading.  

 

*Our Former Independent Public Accountants,Goldstein & Morris PC, Resigned Effective October 20, 2004.*

* *

On October 20, 2004, Goldstein &Morris PC (“Goldstein & Morris”) informed us that they were resigningas our independent registered public accounting firm.  Prior to October 20, 2004, Goldstein &Morris had not previously advised management or our audit committee of itsintention to resign its engagement as our independent registered publicaccounting firm.  The resignation was notsought or recommended by our audit committee.

 

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 Following this resignation, the Company’saudit committee engaged a new independent public accounting firm. 

 

OnMay 25, 2005, the Public Company Accounting Oversight Board took actionagainst Goldstein & Morris by revoking its registration and barringits managing partner, Edward B. Morris, from associating with a registeredaccounting firm for violating the auditor independence rules of theSarbanes-Oxley Act with respect to two public companies unrelated to theCompany.

 

SEC rules require theCompany to present historical audited financial statements in various SECfilings, such as registration statements, along with Goldstein &Morris’s consent to the inclusion of their audit report in those filings.Despite our best efforts, we have not been able to obtain the consent ofGoldstein & Morris to the inclusion of their audit report in theCompany’s current filing and, most likely, future filings. The SEC haspreviously provided relief to allow companies to file reports without therequirement to file a consent of its formerindependent registered public accounting firm in certain circumstances,but purchasers of securities sold under the registration statements, which werenot filed with the consent of former independentregistered public accounting firm’s audit report, would not be able tosue the former independent registered publicaccounting firm pursuant to Section 11(a)(4) of the SecuritiesAct, and therefore, the purchasers’ right of recovery under that section maybe limited as a result of the Company’s inability to obtain Goldstein &Morris’s consent. 

 

* *Our businessand our results of operations may be adversely impacted by Goldstein &Morris’s resignation in that:

 

•                  We have and expect to continue to incur substantial additional legaland accounting fees relating to disclosure and other regulatory compliance mattersassociated with the resignation of Goldstein & Morris; and

 

•                  Our management has already spent, and is expected to continue tospend, considerable time and effort on matters related to the resignation ofGoldstein & Morris.

 

*Our Business Greatly Depends OnIndirect Sales.*

* *

We depend upon introductions to potential customers bycompanies with which we maintain strategic alliances for a significantpercentage of our sales.  Although wehave written agreements with our Alliance Partners and other value addedresellers, the agreements do not require customer introductions nor do theyprovide for minimum required purchases of our products. If any of the companieswith which we maintain strategic alliances decide not to refer potentialcustomers to us, our sales may be reduced and operating losses increased.  In addition, there is no assurance that wewill be able to maintain our strategic alliances on current terms.  If our Alliance Partners’ strategy, productofferings or financial condition change, or if there are material changes intheir sales force or customer support, or if their hardware or softwareproducts are unavailable, our revenues may be affected.

 

*We Are Dependent On LicensedTechnology.*

* *

We depend on certain software products that arelicensed from third parties, which are embedded and used in our products.  We believe that there are replacementalternatives for such third party products; however, the interruption of theavailability of such products may have an adverse impact on the delivery of ourproducts.  Additionally, we expect ourthird party vendors to maintain and continually improve their products.  To the extent that such products becameobsolete or inoperable with other industry standard applications, we mayexperience an adverse effect on revenues, operating results and a decrease incustomer satisfaction. 

 

*WeChanged The Name Of The Company And Initiated A New Product Branding.*

 

At the Annual Stockholder Meeting held on October 28,2004, our stockholders approved a proposal to change the name of the Company toClearStory Systems, Inc. from INSCI Corp. We believe that the name change better reflects our current positioningwithin the ECM market. The name change has required and may continue to requireincreased expense for legal matters, as well as promotional, marketing andcommunication materials. We have also initiated an effort to establish a commonbrand for our products within the ECM market with a new naming convention forcertain of our products. To the extent that the name change and productbranding cause

 

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confusion within our target market or client base, wemay experience a decrease in revenues and/or an increase in overall expenses.

 

*We Are Offering Our Customers AHosted Solution.*

* *

We host certain of our applications in our hosted datacenter. The success of the hosted application business model has not beenclearly demonstrated, and market acceptance of the hosted center is notensured.  To the extent that we experiencetechnological problems or challenges, certain of our customers may seek amarket alternative, which may limit market adoption of the hosted model. 

 

*Our Products And Services AreDependent On Internet Acceptance, Accessibility, Infrastructure And Security.*

* *

We have developed and realized revenues from ourInternet-based products and related services. The Internet is a recent product delivery platform, and as such, ischaracterized by rapid technology changes, evolving standards and adoptionrates.  Future revenues and services aredependent upon the acceptance of the Internet as a recognized method ofconducting business.

 

The accessibility of the Internet has expanded overthe last several years.  Technologyenhancements and improvements have accelerated the availability of Internetaccess.  To the extent that continueddevelopments in communications, communication standards, availability andaccessibility do not continue to expand, the rate of adoption may decline.  Additionally, the expansion of the Internetas a commercial communications platform typically requires continued capitalinvestment and infrastructure support. To the extent that capital investment declines or funding forInternet-based programs is reduced, the accessibility and necessary supportinginfrastructure may reduce the adoption and performance of the Internet. 

 

If there is an increase in the use of the Internet, orno increase in bandwidth, the infrastructure may not be able to effectivelysupport demand and result in a degradation of commercial acceptance.  Reduced response times may also affect theacceptance of the Internet. 

 

*Rapid Technology Changes In OurIndustry May Adversely Affect Our Business.*

* *

Our business is subject to technological advances andpossible product obsolescence.  Themarket for our products is characterized by rapidly changing technology,intense competition, technological complexity and evolving industrystandards.  We must ensure that ourproducts are compatible with those products offered by third-party vendors,including server platforms for our software and various storage devices andplatforms.  We have no contracts withthird-party vendors; therefore, there is no assurance that we will be able tomake our software products compatible with new products that are introduced byothers.

 

*We Have Recently Released TheNext Generation Of Our Product.*

* *

We recently announced the release of our nextgeneration software platform, Radiant EMS, based upon a pure J2EEarchitecture.  We have also embraced aWeb services technology model for the user interfaces and application programinterface.  There can be no assurancethat such technologies will not be replaced by more contemporary offerings inthe marketplace.

 

The market acceptance of the architecture and related applicationscannot be ensured. To the extent that we experience certain product issues orthat acceptance is limited, we may incur increased expense to maintainadditional product lines and may not realize anticipated savings with thetechnology model. The performance and market adoption of this platform mayalter future product development strategies, which may result in delays tosubsequent product introductions. In addition, customers may delay upgradingand migrating to new products. As a result of the above, we may experiencereduced revenues and increased expenses in future periods. 

 

*Quality Assurance And ProductStability.*

* *

We have invested to establish a quality assurancefunction to limit certain errors, omissions and support incidents. While we believethat we have implemented industry standards and procedures to minimize issues,there

 

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can be no assurance that released versionsof the product will not contain certain issues, the consequence of which cannotbe fully determined.

 

*We Depend On ProprietaryTechnology, Which Is Not Protected By Patents.*

* *

Our business depends on proprietary softwaretechnology for which we have no patent protection.  Although we require our employees and othersto whom we disclose proprietary information to sign non-disclosure agreements,this protection may not be sufficient. Our business will be adversely affected if anyone improperly uses ordiscloses our proprietary software or other proprietary information.

 

We do not hold any patents and rely on copyright andtrade secret laws, non-disclosure agreements and contractual provisions toprotect our proprietary technology. These methods afford only limited protection.  Despite the precautions we take, unauthorizedparties may attempt to copy or otherwise obtain and use our proprietarytechnologies, ideas, know-how and other proprietary information withoutauthorization or may independently develop technologies similar or superior toour technologies. Policing unauthorized use of our products may be difficultand costly.  Also, the laws of someforeign countries may not protect our proprietary rights to the same extent asthe laws of the United States. Therefore, we are unable to predict whether our means of protecting ourproprietary rights will be adequate. 

 

We believe that our technologies have been developed independent ofothers.  Nevertheless, third parties mayassert infringement claims against us and our technologies may be determined toinfringe on the intellectual property rights of others.  We could become liable for damages, or berequired to modify our technologies or obtain a license if our technologies aredetermined to infringe upon the intellectual property rights of others.  We may not be able to modify our technologiesor obtain a license in a timely manner, if required, or have the financial orother resources necessary to defend an infringement action.  We would be materially adversely affected ifwe fail to do any of the foregoing.

 

*Because Of The High Cost, We LackProduct Liability Insurance.*

* *

We develop, market, install and service enterprisecontent management and digital asset management systems.  Failure of our products may result in a claimagainst us.  Because of the high cost ofproduct liability insurance, we do not maintain insurance to protect againstclaims associated with the use of our products. Any claim against us may result in costs to us in defendinglitigation.  Further, any claim mayrequire management’s time and the use of certain of our resources.

 

*We Depend Upon Certain KeyEmployees To Develop Our Products.*

* *

We do not have the financial resources to compete withlarger more established companies to attract and retain certain keytechnological employees.  The loss ofcurrent technological employees or our inability to recruit and retainemployees with certain key technology skills could have an adverse effect onproduct development and our business.

 

*Because Of Certain Provisions InOur By-Laws, Change In Control May Be Difficult.*

* *

Our by-laws and the Delaware General Corporation Law contain provisionsthat may make a change in control of the Company more difficult or delayattempts by others to obtain control of us, even when this may be in theinterests of stockholders.  The DelawareGeneral Corporation Law also imposes conditions on certain businesscombinations with “interested stockholders”, as defined by Delaware law.  Under certain agreements with key personnel,we also have provided the acceleration of vesting of stock options in the eventof a change of control and severance payments in the event that the employmentof such personnel is terminated without cause following a change incontrol.  Additionally, we have providedthat if a change of control occurs, certain directors will receive immediatevesting of stock options granted under our 1992 and 2004 Directors OptionPlans.

 

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**Item 3.****    Controls and Procedures**

 

As of the end of the period covered by this report, wecarried out an evaluation, under the supervision and with the participation ofour management, including our President and Chief Executive Officer and ourChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures, as defined in Exchange Act Rule 15(d)-15(e).Based upon that evaluation, we believe that our disclosure controls andprocedures are effective in enabling us to record, process, summarize andreport information required to be disclosed in our periodic SEC filings withinthe required time periods.  Ourdisclosure controls and procedures include, without limitation, controls andprocedures designed to ensure that information required to be disclosed by usin the periodic reports filed with the SEC is accumulated and communicated toour management, including our principal executive and principal financialofficers, or persons performing similar functions, as appropriate to allowtimely decisions regarding required disclosure.

 

During the period covered by this report, there havebeen no changes in our internal control over financial reporting that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II****OTHERINFORMATION**

 

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

 

**(a)****          Exhibits**

10.1               Loan and SecurityAgreement, dated as of August 25, 2005, by and between ClearStory Systems, Inc.and Silicon Valley Bank.*

10.2               Unconditional Guaranty,dated as of August 25, 2005, made by SCP Private Equity Partners II, L.P.in favor of ClearStory Systems, Inc.*

10.3               Series CConvertible Preferred Stock Purchase Warrant, dated as of August 25, 2005,issued by ClearStory Systems, Inc. to SCP Private Equity Partners II, L.P.*

31.1    Certificate pursuant to 18 U.S.C. Section 1350as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

31.2               Certificate pursuant to 18U.S.C. Section 1350 as adopted pursuant to Section 302 of theSarbanes-Oxley Act of 2002.*

32.1               Certificate pursuant to 18U.S.C. Section 1350 as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002.**

32.2               Certificate pursuant to 18U.S.C. Section 1350 as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002.**

 

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*              Filedherewith.

**           Furnishedherewith.

 

**SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this Report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|   | **ClearStory Systems, Inc.**                            |
|--------|--------------------------------------------------------------|
|   |                                                         |
| Dated: | November 14,2005                                        |   | By: /s/ HENRY F. NELSON |   |
|   | Henry F. Nelson, President and Chief Executive  Officer      |
|   |                                                         |
|   |                                                         |
| Dated: | November 14,2005                                        |   | By: /s/ STEPHEN A. READ |   |
|   | Stephen A. Read, Vice President and Chief Financial  Officer |

 

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