**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM10-Q**

 

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

** **

**For the quarterly periodended March 31, 2007**

** **

**OR**

** **

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

 

**For thetransition period from                          to                         **

**CommissionFile Number: 000-50839**

**PhaseForward Incorporated**

(Exact name ofregistrant as specified in its charter)

| **Delaware**                                               |   | **04-3386549**       |
|------------------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of                           |   | (I.R.S. Employer     |
| incorporation or  organization)                            |   | Identification  No.) |
|                                                       |   |                 |
| **880  Winter Street**                                     |   |                 |
| **Waltham,  Massachusetts**                                |   | **02451**            |
| (Address of  principal executive offices)                  |   | (Zip Code)           |
|                                                       |   | ** **           |
| **(888) 703-1122**                                    |
| (Registrant’s  telephone number, including area code) |

 

        Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

Yes   x     No o

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

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

 

        Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

Yes   o     No x

As of May 1, 2007, theregistrant had 35,636,495 shares of Common Stock outstanding.

 

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**PHASE FORWARD INCORPORATED**

**QUARTERLY REPORT ONFORM 10-Q**

**For thequarterly period ended March 31, 2007**

**Table ofContents**
|                                             | ** ** | ** **                                                                                                                             | ** ** | **Page  Number** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|
| ** **                                  | ** ** | ** **                                                                                                                             | ** ** | ** **       |
| **Part I—Financial  Information** |       |                                                                                                                                   |
| ** **                                  |       |                                                                                                                                   |
| Item 1.                                     |       | Condensed  Consolidated Balance Sheets as of December 31, 2006 (unaudited) and  March 31, 2007 (unaudited)                        |       | 3                |
|                                        |       |                                                                                                                                   |       |             |
|                                        |       | Condensed  Consolidated Statements of Income for the three months ended March 31, 2006  (unaudited) and March 31, 2007 (unaudited)     |       | 4                |
|                                        |       |                                                                                                                                   |       |             |
|                                        |       | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2006 (unaudited) and March 31, 2007 (unaudited) |       | 5                |
|                                        |       |                                                                                                                                   |       |             |
|                                        |       | Notes to  Condensed Consolidated Financial Statements (unaudited)                                                                      |       | 6                |
|                                        |       |                                                                                                                                   |       |             |
| Item 2.                                     |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                            |       | 19               |
|                                        |       |                                                                                                                                   |       |             |
| Item 3.                                     |       | Quantitative  and Qualitative Disclosures about Market Risk                                                                            |       | 31               |
|                                        |       |                                                                                                                                   |       |             |
| Item 4.                                     |       | Controls and  Procedures                                                                                                               |       | 31               |
|                                        |       |                                                                                                                                   |       |             |
| **Part II—Other  Information**    |       |                                                                                                                                   |
| ** **                                  |       |                                                                                                                                   |       |             |
| Item 1.                                     |       | Legal Proceedings                                                                                                                      |       | 32               |
|                                        |       |                                                                                                                                   |       |             |
| Item  1A.                                   |       | Risk  Factors                                                                                                                          |       | 32               |
|                                        |       |                                                                                                                                   |       |             |
| Item 5.                                     |       | Other Information                                                                                                                      |       | 32               |
|                                        |       |                                                                                                                                   |       |             |
| Item  6.                                    |       | Exhibits                                                                                                                               |       | 33               |
|                                        |       |                                                                                                                                   |       |             |
| Signatures                                  |       | 34                                                                                                                                     |
|                                        |       |                                                                                                                                   |       |             |
| Exhibit Index                          |       |                                                                                                                                   |
|                                             |            |                                                                                                                                        |            |                  |  |  |

 

2

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**Part I—Financial Information**

**Item 1.    *Condensed ConsolidatedFinancial Statements (unaudited)***

**Phase Forward Incorporated**

**Condensed Consolidated BalanceSheets**

**(unaudited)**

**(inthousands, except per share amounts)**
| ** **                                                                                              | ** ** | **As of December 31,** | ** ** | **As of March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                              | ** ** | **2007**                           | ** ** |
| **Assets**                                                                                              | ** ** | ** **                            | ** ** | ** **                         | ** ** |
| Current assets:                                                                                         |       |                                  |       |                               |       |
| Cash and cash  equivalents                                                                              |       | $                                     | 42,169     |                               | $          | 55,552 |   |
| Short-term  investments                                                                                 |       | 27,466                                |       | 26,264                             |       |
| Accounts  receivable, net of allowance of $384 and $491 in 2006 and 2007, respectively                  |       | 29,652                                |       | 28,596                             |       |
| Deferred set up  costs, current portion                                                                 |       | 1,649                                 |       | 1,885                              |       |
| Prepaid  commissions and royalties, current portion                                                     |       | 3,570                                 |       | 3,469                              |       |
| Prepaid expenses  and other current assets                                                              |       | 2,972                                 |       | 2,941                              |       |
| Deferred income  taxes                                                                                  |       | 5,158                                 |       | 5,116                              |       |
|                                                                                                    |       |                                  |       |                               |       |
| Total current assets                                                                                    |       | 112,636                               |       | 123,823                            |       |
|                                                                                                    |       |                                  |       |                               |       |
| Property and equipment,  net                                                                            |       | 8,561                                 |       | 10,397                             |       |
| Deferred set up costs,  net of current portion                                                          |       | 1,000                                 |       | 1,146                              |       |
| Prepaid commissions and  royalties, net of current portion                                              |       | 2,670                                 |       | 2,974                              |       |
| Intangible assets, net  of accumulated amortization of $1,176 and $1,394 in 2006 and 2007, respectively |       | 2,724                                 |       | 2,506                              |       |
| Goodwill                                                                                                |       | 27,820                                |       | 27,699                             |       |
| Deferred income taxes                                                                                   |       | 4,988                                 |       | 4,828                              |       |
| Other assets                                                                                            |       | 252                                   |       | 255                                |       |
|                                                                                                    |       |                                  |       |                               |       |
| Total assets                                                                                            |       | $                                     | 160,651    |                               | $          | 173,628 |   |
|                                                                                                    |       |                                  |       |                               |       |
| **Liabilities and Stockholders’  Equity**                                                          | ** ** | ** **                            | ** ** | ** **                         | ** ** |
| Current liabilities:                                                                                    |       |                                  |       |                               |       |
| Accounts payable                                                                                        |       | $                                     | 2,893      |                               | $          | 1,383 |   |
| Accrued expenses                                                                                        |       | 14,183                                |       | 12,174                             |       |
| Accrued earn-out                                                                                        |       | 3,500                                 |       | 3,500                              |       |
| Deferred  revenues, current portion                                                                     |       | 47,128                                |       | 58,535                             |       |
| Deferred rent,  current portion                                                                         |       | 352                                   |       | 439                                |       |
|                                                                                                    |       |                                  |       |                               |       |
| Total current  liabilities                                                                              |       | 68,056                                |       | 76,031                             |       |
|                                                                                                    |       |                                  |       |                               |       |
| Deferred revenues, net  of current portion                                                              |       | 3,527                                 |       | 3,523                              |       |
| Deferred rent, net of  current portion                                                                  |       | 596                                   |       | 434                                |       |
| Other long-term  liabilities                                                                            |       | 451                                   |       | 477                                |       |
|                                                                                                    |       |                                  |       |                               |       |
| Total  liabilities                                                                                      |       | 72,630                                |       | 80,465                             |       |
|                                                                                                    |       |                                  |       |                               |       |
| Contingencies (Note 13)                                                                                 |       |                                  |       |                               |       |
|                                                                                                    |       |                                  |       |                               |       |
| Stockholders’ equity:                                                                              |       |                                  |       |                               |       |
| Preferred stock,  $.01 par value:                                                                       |       |                                  |       |                               |       |
| Authorized—5,000  shares                                                                           |       |                                  |       |                               |       |
| Issued—0 shares                                                                                    |       | —                                |       | —                             |       |
| Common stock,  $.01 par value:                                                                          |       |                                  |       |                               |       |
| Authorized—100,000  shares                                                                         |       |                                  |       |                               |       |
| Issued—35,529  and 35,660 shares in 2006 and 2007, respectively                                    |       | 355                                   |       | 356                                |       |
| Additional paid-in  capital                                                                             |       | 176,545                               |       | 178,073                            |       |
| Treasury stock,  37 shares at cost                                                                      |       | (111                                  | )          | (111                               | )          |
| Accumulated  other comprehensive loss                                                                   |       | (72                                   | )          | 60                                 |       |
| Accumulated  deficit                                                                                    |       | (88,696                               | )          | (85,215                            | )          |
|                                                                                                    |       |                                  |       |                               |       |
| Total stockholders’  equity                                                                        |       | 88,021                                |       | 93,163                             |       |
|                                                                                                    |       |                                  |       |                               |       |
| Total liabilities and  stockholders’ equity                                                        |       | $                                     | 160,651    |                               | $          | 173,628 |   |

 

See accompanying notes.

3

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**Phase Forward Incorporated**

**CondensedConsolidated Statements of Income**

**(unaudited)**

**(inthousands, except per share amounts)**
| ** **                                                                           | ** ** | **Three Months Ended  March 31**, | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| Revenues:                                                                            |       |                                             |       |   |   |
| License                                                                              |       | $                                                | 9,025      |   | $ | 11,036 |   |
| Service                                                                              |       | 14,591                                           |       | 19,048 |   |
|                                                                                 |       |                                             |       |   |   |
| Total revenues                                                                       |       | 23,616                                           |       | 30,084 |   |
| Costs of  revenues:                                                                  |       |                                             |       |   |   |
| License                                                                              |       | 706                                              |       | 605 |   |
| Service(1)                                                                           |       | 8,895                                            |       | 11,527 |   |
|                                                                                 |       |                                             |       |   |   |
| Total cost of  revenues                                                              |       | 9,601                                            |       | 12,132 |   |
| Gross margin:                                                                        |       |                                             |       |   |   |
| License                                                                              |       | 8,319                                            |       | 10,431 |   |
| Service                                                                              |       | 5,696                                            |       | 7,521 |   |
|                                                                                 |       |                                             |       |   |   |
| Total gross  margin                                                                  |       | 14,015                                           |       | 17,952 |   |
| Operating  expenses:                                                                 |       |                                             |       |   |   |
| Sales and marketing(1)                                                               |       | 4,237                                            |       | 5,447 |   |
| Research and development(1)                                                          |       | 3,624                                            |       | 4,632 |   |
| General and administrative(1)                                                        |       | 4,139                                            |       | 4,638 |   |
|                                                                                 |       |                                             |       |   |   |
| Total operating  expenses                                                            |       | 12,000                                           |       | 14,717 |   |
|                                                                                 |       |                                             |       |   |   |
| Income from  operations                                                              |       | 2,015                                            |       | 3,235 |   |
| Other income  (expense):                                                             |       |                                             |       |   |   |
| Interest income                                                                      |       | 596                                              |       | 864 |   |
| Other expense                                                                        |       | (64                                              | )          | (66 | ) |
|                                                                                 |       |                                             |       |   |   |
| Total other  income                                                                  |       | 532                                              |       | 798 |   |
|                                                                                 |       |                                             |       |   |   |
| Income before  provision for income taxes                                            |       | 2,547                                            |       | 4,033 |   |
| Provision for  income taxes                                                          |       | 461                                              |       | 552 |   |
|                                                                                 |       |                                             |       |   |   |
| Net income                                                                           |       | $                                                | 2,086      |   | $ | 3,481 |   |
|                                                                                 |       |                                             |       |   |   |
| Net income per  share applicable to common stockholders:                             | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Basic                                                                                |       | $                                                | 0.06       |   | $ | 0.10 |   |
|                                                                                 |       |                                             |       |   |   |
| Diluted                                                                              |       | $                                                | 0.06       |   | $ | 0.10 |   |
|                                                                                 |       |                                             |       |   |   |
| Weighted average  number of common shares used in net income per share calculations: |       |                                             |       |   |   |
| Basic                                                                                |       | 33,751                                           |       | 34,627 |   |
|                                                                                 |       |                                             |       |   |   |
| Diluted                                                                              |       | 35,234                                           |       | 36,417 |   |

 

----

(1)Amounts include stock-based compensation expense, as follows:
|   | Costs of service  revenues  |   | $   | 44     |   | $      | 110 |   |
|--------|-----------------------------|--------|-----|--------|--------|--------|-----|--------|
|   | Sales and  marketing        |   | 110 |   | 166    |   |
|   | Research and  development   |   | 60  |   | 156    |   |
|   | General and  administrative |   | 242 |   | 600    |   |

 

See accompanying notes.

4

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**Phase Forward Incorporated**

**CondensedConsolidated Statements of Cash Flows**

**(unaudited)**

**(inthousands)**
| ** **                                                                         | ** ** | **Three Months Ended  March 31,**                                 | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **      2006      ** | ** ** | **      2007      ** | ** ** |
| **Operating  activities**                                                          | ** ** | ** **                                                                       | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                                                                | 2,086      |   | $ | 3,481 |   |
|                                                                               |       |                                                                             |       |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                                             |       |   |   |
| Depreciation and  amortization                                                     |       | 1,260                                                                            |       | 1,458 |   |
| Stock-based  compensation expense                                                  |       | 456                                                                              |       | 1,032 |   |
| Loss on disposal  of fixed assets                                                  |       | 10                                                                               |       | — |   |
| Foreign currency  exchange loss                                                    |       | 62                                                                               |       | 65 |   |
| Provision for  allowance for doubtful accounts                                     |       | 54                                                                               |       | 107 |   |
| Deferred income  taxes                                                             |       | 7                                                                                |       | (1,078 | ) |
| Tax benefit  related to exercise of stock options                                  |       | (248                                                                             | )          | — |   |
| Non-cash income  tax expense                                                       |       | 340                                                                              |       | 1,401 |   |
| Amortization of  premiums or discounts on short-term investments                   |       | 4                                                                                |       | 11 |   |
| Changes in  assets and liabilities:                                                |       |                                                                             |       |   |   |
| Accounts  receivable                                                               |       | 4,196                                                                            |       | 1,026 |   |
| Deferred costs                                                                     |       | (489                                                                             | )          | (564 | ) |
| Prepaid expenses  and other current assets                                         |       | (14                                                                              | )          | 58 |   |
| Accounts payable                                                                   |       | 29                                                                               |       | (1,514 | ) |
| Accrued expenses                                                                   |       | (952                                                                             | )          | (2,019 | ) |
| Accrued  litigation settlement                                                     |       | (8,500                                                                           | )          | — |   |
| Deferred revenue                                                                   |       | 5,285                                                                            |       | 11,370 |   |
| Deferred rent                                                                      |       | (284                                                                             | )          | (73 | ) |
|                                                                               |       |                                                                             |       |   |   |
| Net cash  provided by operating activities                                         |       | 3,302                                                                            |       | 14,761 |   |
|                                                                               |       |                                                                             |       |   |   |
| **Investing  activities**                                                          | ** ** | ** **                                                                       | ** ** | ** ** | ** ** |
| Proceeds from  maturities of short-term investments                                |       | 3,022                                                                            |       | 18,310 |   |
| Purchase of  short-term investments                                                |       | (3,718                                                                           | )          | (17,119 | ) |
| Purchase of  property and equipment                                                |       | (1,207                                                                           | )          | (3,068 | ) |
|                                                                               |       |                                                                             |       |   |   |
| Net cash used in  investing activities                                             |       | (1,903                                                                           | )          | (1,877 | ) |
|                                                                               |       |                                                                             |       |   |   |
| **Financing  activities**                                                          | ** ** | ** **                                                                       | ** ** | ** ** | ** ** |
| Proceeds from  issuance of common stock                                            |       | 554                                                                              |       | 496 |   |
| Tax benefit  related to exercise of options                                        |       | 248                                                                              |       | — |   |
|                                                                               |       |                                                                             |       |   |   |
| Net cash  provided by financing activities                                         |       | 802                                                                              |       | 496 |   |
|                                                                               |       |                                                                             |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                      |       | (174                                                                             | )          | 3 |   |
|                                                                               |       |                                                                             |       |   |   |
| Net increase in  cash and cash equivalents                                         |       | 2,027                                                                            |       | 13,383 |   |
| Cash and cash  equivalents at beginning of period                                  |       | 51,779                                                                           |       | 42,169 |   |
|                                                                               |       |                                                                             |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | 53,806                                                                           |       | 55,552 |   |
| Short-term  investments at end of period                                           |       | 9,499                                                                            |       | 26,264 |   |
| Total cash, cash  equivalents and short-term investments at end of period          |       | $                                                                                | 63,305     |   | $ | 81,816 |   |

 

See accompanying notes.

5

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**PhaseForward Incorporated Notes to Condensed Consolidated Financial Statements**

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

**1.     Basis of Presentation**

Theaccompanying unaudited condensed consolidated financial statements includedherein have been prepared by Phase Forward Incorporated (the “Company”)pursuant to the rules and regulations of the Securities and ExchangeCommission (“SEC”). Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles in the United States have been condensed or omittedpursuant to such SEC rules and regulations. Management of the Companybelieves that the disclosures herein are adequate to make the informationpresented not misleading. In the opinion of management, the unaudited condensedconsolidated financial statements have been prepared on the same basis as theaudited consolidated financial statements and reflect all material adjustments(consisting only of those of a normal and recurring nature) which are necessaryto present fairly the consolidated financial position of the Company as ofMarch 31, 2007, the results of its operations for the three months ended March31, 2006 and 2007 and its cash flows for the three months ended March 31, 2006and 2007. These unaudited condensed consolidated financial statements and notesthereto should be read in conjunction with the audited consolidated financialstatements and notes thereto included in the Company’s Annual Report onForm 10-K for the year ended December 31, 2006. The results ofoperations for the interim periods are not necessarily indicative of theresults of operations to be expected for the year ending December 31, 2007.

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

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

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

The components ofrevenue are as follows:
|                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| License                       |       | $                                                | 9,025      |   | $ | 11,036 |   |
| Application  hosting services |       | 8,954                                            |       | 12,052 |   |
| Consulting  services          |       | 2,739                                            |       | 3,426 |   |
| Customer support              |       | 2,898                                            |       | 3,570 |   |
|                          |       |                                             |       |   |   |
| Total                         |       | $                                                | 23,616     |   | $ | 30,084 |   |

 

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

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

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

6

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The Company typicallyenters into software term licenses for its *InForm*,*Clintrial* and *Clintrace* products with its customers for3- to 5-year periods. License agreements for its *WebVDME,CTSD*and*WebSDM*productsare generally for annual or multi-year terms. These arrangements typically include multiple elements: softwarelicense, consulting services and customer support. The Company bills itscustomers in accordance with the terms of the underlying contract. Generally,the Company bills license fees annually in advance for each year of the licenseterm. Payment terms are generally net 30 days.

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

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

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

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

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

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

One customer,GlaxoSmithKline accounted for approximately 18% and 17% of the Company’s totalrevenues in the three months

7

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ended March 31, 2006 and2007, respectively, and $2,638 and $1,914 of accounts receivable outstanding asof December 31, 2006 and March 31, 2007, respectively.

The Companydeferred $632 and $942 of set up costs and amortized $475 and $560 during thethree months ended March 31, 2006 and 2007, respectively. The amortization ofdeferred set up costs is a component of cost of services.

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

Provisions forestimated losses on uncompleted contracts are made on a contract-by-contractbasis and are recognized in the period in which such losses become probable andcan be reasonably estimated. To date, the Company has not experienced anymaterial losses on uncompleted application hosting or consulting contracts.

In accordance withEITF Issue No. 01-14, *Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” ExpensesIncurred,* the Company included $67 and $119 of out of pocketexpenses in service revenue and cost of service revenue in the three monthsended March 31, 2006 and 2007, respectively.

**3.****              PrepaidSales Commissions and Royalties**

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

Commissionpayments are nonrefundable unless amounts due from a customer are determined tobe uncollectible or if the customer subsequently changes or terminates thelevel of service, in which case the commissions paid are recoverable by theCompany. The Company deferred $1,089 and $1,663 of commissions and amortized tosales and marketing expense $909 and $1,515 during the three months ended March31, 2006 and 2007, respectively.

The Company’sroyalty obligation is based upon the license and customer support revenuesearned for certain products in an arrangement. The Company has the right torecover the royalties in the event the arrangement is cancelled. The Companydeferred $994 and $232 of royalties and amortized to cost of revenues $824 and$177 during the three months ended March 31, 2006 and 2007, respectively.

**4.****              Warrantiesand Indemnification**

The Company’s softwarelicense arrangements and hosting services are typically warranted to perform ina manner consistent with general industry standards that are reasonablyapplicable and substantially in accordance with the Company’s productdocumentation under normal use and circumstances. The Company’s arrangementsalso include certain provisions for indemnifying customers against liabilities ifits products or services infringe a third party’s intellectual property rights.See the discussion of possible indemnification obligations in Note 13.

The Company has enteredinto service level agreements with some of its hosted application customers warrantingcertain levels of uptime reliability or other service levels and permits thosecustomers to receive credits against monthly hosting fees or terminate theiragreements in the event that the Company fails to meet those levels.

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

**5.****              Acquisitionof Lincoln Technologies, Inc.**

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

The aggregatepurchase price was $16,667.  Theacquisition agreement called for additional cash consideration to be paidsubject to achievement of certain financial targets in 2005 and 2006, of up to$2,000 and $4,000, respectively.  Thedefined 2005 financial targets were achieved and, accordingly, the Companyaccrued additional consideration of $2,000 in 2005 which was paid in May 2006.  The acquisition agreement was amended inSeptember 2006 to amend the terms of the remaining contingent earn-out paymentfor which the security holders of Lincoln could be eligible in 2007 under theacquisition agreement.  Pursuant to the amendment, the Company agreed topay the security holders of Lincoln an aggregate of $3,500 in cash on December26, 2007 in satisfaction of the

8

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Company’s remainingpayment obligations under the acquisition agreement.  The $3,500 was accrued as of December 31,2006.   The acquisition of Lincoln wasaccounted for as a purchase under SFAS No. 141, *BusinessCombinations*.  Accordingly,the results of Lincoln have been included in the audited consolidated financialstatements since the date of acquisition.

**6.     Net Income Per Share**

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

The calculation ofbasic and diluted net income per share is as follows:
|                                                                       | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                             | ** ** | **2007** | ** ** |
| Numerator:                                                            |       |                                                 |       |   |   |
| Net income                                                            |       | $                                                    | 2,086      |   | $ | 3,481 |   |
|                                                                  |       |                                                 |       |   |   |
| Denominator:                                                          |       |                                                 |       |   |   |
| Weighted average  common shares outstanding                           |       | 33,751,249                                           |       | 35,561,344 |   |
| Less weighted  average unvested restricted common shares outstanding  |       | —                                               |       | (934,733 | ) |
|                                                                  |       |                                                 |       |   |   |
| Basic weighted  average common shares outstanding                     |       | 33,751,249                                           |       | 34,626,611 |   |
| Dilutive effect  of common stock options                              |       | 1,482,252                                            |       | 1,574,939 |   |
| Dilutive effect  of unvested restricted common stock awards and units |       | —                                               |       | 215,350 |   |
| Diluted weighted  average common shares outstanding                   |       | 35,233,501                                           |       | 36,416,900 |   |
|                                                                  |       |                                                 |       |   |   |
| Net income per  share applicable to common stockholders:              |       |                                                 |       |   |   |
| Basic                                                                 |       | $                                                    | 0.06       |   | $ | 0.10 |   |
|                                                                  |       |                                                 |       |   |   |
| Diluted                                                               |       | $                                                    | 0.06       |   | $ | 0.10 |   |

 

Diluted weightedaverage common shares outstanding do not include options and awards outstandingto purchase 696,528 and 25,000 common equivalent shares for the three monthsended March 31, 2006 and 2007, respectively, as their effect would have beenanti-dilutive.

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

The financialstatements of the Company’s foreign subsidiaries are translated in accordancewith SFAS No. 52, *Foreign CurrencyTranslation.* The reporting currency for the Company is the U.S.dollar. The functional currency of the Company’s subsidiaries in the UnitedKingdom, France, Belgium, Germany, Japan and Australia are the local currenciesof those countries. Accordingly, the assets and liabilities of the Company’sforeign subsidiaries are translated into U.S. dollars using the exchange ratein effect at each balance sheet date. Revenues and expense accounts aretranslated generally using an average rate of exchange during the period. Gainsand losses arising from transactions denominated in foreign currencies areprimarily related to intercompany accounts that have been determined to betemporary in nature and cash and accounts receivable denominated innon-functional currencies.  The Companyhas recorded foreign currency losses of $62 and $65 for the three months endedMarch 31, 2006 and 2007, respectively, and such losses are included inother income (expense) in the accompanying unaudited condensed consolidatedstatements of income.

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

9

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

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

Cash, cashequivalents and short-term investments as of December 31, 2006 and March31, 2007 consist of the following:
|                                  | ** ** | **December 31, 2006** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| **Description**                  | ** ** | **Contracted  Maturity**        | ** ** | **Amortized Cost** | ** ** | **Fair Market  Value** | ** ** |
| Cash                             |       | Demand                          |       | $ | 15,558 |   | $ | 15,558 |   |
| Certificate of  deposit          |       | 78  days                        |       | 1,950 |   | 1,950 |   |
| Money market  funds              |       | Demand                          |       | 24,661 |   | 24,661 |   |
|                             |       |                            |       |   |   |   |   |
| Total cash and  cash equivalents |       |                            |       | $ | 42,169 |   | $ | 42,169 |   |
|                             |       |                            |       |   |   |   |   |
| Auction rate  securities         |       | 31.4  years                     |       | $ | 3,200 |   | $ | 3,200 |   |
| Certificate of  deposit          |       | 195  days                       |       | 2,550 |   | 2,549 |   |
| U.S. agency  notes               |       | 297  days                       |       | 7,952 |   | 7,952 |   |
| Corporate bonds                  |       | 280  days                       |       | 13,764 |   | 13,760 |   |
|                             |       |                            |       |   |   |   |   |
| Total short-term  investments    |       |                            |       | $ | 27,466 |   | $ | 27,461 |   |

 
|                                  | ** ** | **March 31, 2007** | ** ** |
|----------------------------------|------------|------------------------------|------------|
| **Description**                  | ** ** | **Contracted  Maturity**     | ** ** | **Amortized Cost** | ** ** | **Fair Market  Value** | ** ** |
| Cash                             |       | Demand                       |       | $ | 21,048 |   | $ | 21,048 |   |
| Certificate of deposit           |       | 78 days                      |       | 3,000 |   | 3,000 |   |
| Bank notes                       |       | 57 days                      |       | 500 |   | 500 |   |
| Money market funds               |       | Demand                       |       | 31,004 |   | 31,004 |   |
|                             |       |                         |       |   |   |   |   |
| Total cash and cash  equivalents |       |                         |       | $ | 55,552 |   | $ | 55,552 |   |
|                             |       |                         |       |   |   |   |   |
| Auction rate securities          |       | 32.5 years                   |       | $ | 5,900 |   | $ | 5,900 |   |
| Certificates of deposit          |       | 176 days                     |       | 3,401 |   | 3,401 |   |
| U.S. agency notes                |       | 332 days                     |       | 2,722 |   | 2,738 |   |
| Corporate bonds                  |       | 281 days                     |       | 14,241 |   | 14,391 |   |
|                             |       |                         |       |   |   |   |   |
| Total short-term  investments    |       |                         |       | $ | 26,264 |   | $ | 26,430 |   |

 

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

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

*Stock-Based Compensation Plans*

The Companycurrently has three plans under which it may grant stock-based compensationawards to its directors, employees and non-employees.

In 1997, theCompany adopted the Phase Forward Incorporated 1997 Stock Option Plan (the “1997Plan”).  Under the 1997 Plan, the Boardof Directors may grant incentive and nonqualified stock options to employees ofthe Company and non-employees. The exercise price of each option is determinedby the Board of Directors. Incentive stock options may not be granted with anexercise price less than the fair market value of the stock on the date ofgrant, as defined by the Board of Directors. Options granted under the

10

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1997 Plan generally vestover four or five year periods and expire ten years from the grant date. InJanuary and March 2004, the Company granted options to certain employeesto purchase a total of 205,000 shares of common stock that vest upon theearlier of 7 years from date of grant or the attainment of specified milestones.  Options to purchase 178,750 shares have sinceeither vested upon the attainment of specified milestones in accordance withthe original provisions of the award or been modified to change the vestingprovisions to a 4-year service period. Options to purchase 26,250 shares wereaccelerated in December 2004. There was no incremental stock-based compensationin excess of the amounts that were previously recorded as deferredcompensation. As of March 31, 2007, the Company had 246,630 share optionsavailable for grant under this plan.  TheCompany has not issued options under this plan since its July 2004 initialpublic offering. As of May 2, 2007, the Company will not issue futuregrants under this plan.

In 2004, the Boardof Directors and stockholders approved the Phase Forward Incorporated 2004Stock Option and Incentive Plan (the “2004 Plan”) which became effective uponthe closing of the Company’s initial public offering. The Company had reservedfor issuance an aggregate of 1,500,000 shares of common stock under the 2004Plan.  Under the 2004 Plan, the Board ofDirectors may grant stock options and other equity interests in the Company toemployees of the Company and non-employees. The exercise price of each optionis determined by the Board of Directors. Stock options may not be granted with an exercise price less than thefair market value of the stock on the date of grant, as defined by the Board ofDirectors. Options granted under the 2004 Plan generally vest over a four toseven year period and expire ten years from the grant date. In February 2005,the Company granted options to certain employees to purchase a total of 419,000shares of common stock that vest upon the earlier of attainment of specifiedmilestones or 7 years from the date of grant.  Of these February 2005 option grants, 165,750options have since vested due to the achievement of milestones, 37,500 optionswere forfeited, and 215,750 remain unvested. Generally, the remainder of equity awards granted was service-based andvests over a period of four years from the date of grant.  On May 3, 2006, the Company’s stockholdersapproved an amendment to the 2004 Plan to increase the number of sharesavailable for issuance from 1,500,000 shares to 3,500,000 shares.  In 2006, the Company issued 1,113,175unvested restricted stock awards and restricted stock units.  A total of 400,000 unvested restricted stockawards were granted to the Company’s Chief Executive Officer and vest 25% inthree years; 50% in four years and 100% in five years.  Generally, the balances of these unvestedrestricted stock options and units vest 50% in two years; 75% in three yearsand 100% in four years.  In February 2007,the Company issued 210,000 unvested restricted stock units principally to executiveofficers that vest 50% in two years; 75% in three years and 100% in fouryears.   As of March 31, 2007, theCompany had 818,551 options available for grant under this plan. On May 2,2007, the Company’s stockholders approved an amendment to the 2004 Plan toincrease to 3,981,505 the number of shares available for issuance thereunder,an increase of 481,505 shares, which was the aggregate number of sharesavailable for issuance under the Company’s two other stock plans (the 1997 Planand the 2003 NED Plan) under which no future grants will be issued.

In 2003, the Boardof Directors and stockholders approved the Phase Forward Incorporated 2003Non-Employee Director Stock Option Plan (the “2003 NED Plan”).  The Company reserved for issuance an aggregateof 362,000 shares of common stock under this plan.  Effective April 20, 2004, the 2003 NEDPlan was amended to increase the number of shares the Company may grant underthis plan to 562,000 shares. The 2003 NED Plan provided solely for the automatic,one-time grant of a nonqualified stock option to a non-employee director uponinitial election to the Company’s Board of Directors to purchase 100,000 sharesof common stock.  On September 23, 2005,the 2003 NED Plan was amended to reduce the one-time grant from 100,000 to50,000 stock options.  The exercise priceof the options must not be less than 100% of the fair market value on the grantdate. Options vest fully on the fifth anniversary of the date of grant, so longas the non-employee director has continuously served on the Board of Directorsthrough such vesting date. If the non-employee director meets certain boardattendance criteria, options may vest earlier at a rate of one-sixteenth at theend of each fiscal quarter following the date of grant. As of March 31, 2007,the Company had 234,875 share options available for future grant under thisplan. As of May 2, 2007, the Company will not issue future grants underthis plan.

*Stock Option Activity*

A summary of stock option activity under the 1997 Plan,the 2004 Plan and the 2003 NED Plan as of March 31, 2007, and changes duringthe three months ended March 31, 2007, is as follows:

 
|                                                   | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price per  Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (2)** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding at  December 31, 2006                 |       | 3,440,789                  |       | $                                                      | 4.84       |                                                             |       |                                     |       |   |
| Granted                                           |       | —                     |       | —                                                 |       |                                                             |       |                                     |       |
| Exercised                                         |       | (133,222                   | )          | 3.73                                                   |       |                                                             |       |                                     |       |
| Canceled                                          |       | (11,105                    | )          | 7.57                                                   |       |                                                             |       |                                     |       |
|                                              |       |                       |       |                                                   |       |                                                             |       |                                     |       |
| Outstanding at  March 31, 2007                    |       | 3,296,462                  |       | $                                                      | 4.87       |                                                             | 6.55       |                                     | $          | 27,229 |   |
|                                              |       |                       |       |                                                   |       |                                                             |       |                                     |       |
| Exercisable at  March 31, 2007                    |       | 2,431,780                  |       | $                                                      | 4.16       |                                                             | 6.07       |                                     | $          | 21,813 |   |
|                                              |       |                       |       |                                                   |       |                                                             |       |                                     |       |
| Vested or expected to  vest at March 31, 2007 (1) |       | 3,104,069                  |       | $                                                      | 4.75       |                                                             | 6.46       |                                     | $          | 26,012 |   |

 

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(1)  The vested or expected tovest options at March 31, 2007 include both the vested options and the numberof options expected to vest calculated after applying an estimated forfeiturerate to the unvested options.

(2)  The aggregate intrinsicvalue is calculated based on the positive difference between the estimated fairvalue per share of the Company’s common stock on March 31, 2007 of $13.13 andthe exercise price of the underlying options.

A summary of the status of the Company’s unvestedstock options as of March 31, 2007, and changes during the three months endedMarch 31, 2007, is as follows:

|                                | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|--------------------------------|------------|------------|------------|--------------------------------------------|------------|
| Unvested at  December 31, 2006 |       | 1,017,842  |       | $                                          | 6.75       |   |
| Granted                        |       | —     |       | —                                     |       |
| Vested                         |       | (142,055   | )          | 5.79                                       |       |
| Forfeited                      |       | (11,105    | )          | 7.57                                       |       |
| Unvested at March 31,  2007    |       | 864,682    |       | $                                          | 6.87       |   |

 

The followingtable summarizes information regarding the Company’s stock options outstandingand exercisable at March 31, 2007:
| Options Outstanding                | ** **         | **Options Exercisable** | ** ** |
|-----------------------------------------|--------------------|------------------------------|------------|
| **Range of Exercise  Prices** | ** **         | **Number of  Shares**   | ** ** | **Weighted  Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $                                       | 0.10 - 0.60        |                         | 21,834     |   | 1.14 |   | $ | 0.13 |   | 21,834 |   | $ | 0.13 |   |
|                                    | 0.61 – 1.20   |                         | 16,850     |   | 2.55 |   | 1.00 |   | 16,850 |   | 1.00 |   |
|                                    | 1.21 - 3.00        |                         | 1,627,561  |   | 5.42 |   | 3.00 |   | 1,591,521 |   | 3.00 |   |
|                                    | 3.01 - 4.80        |                         | 152,540    |   | 6.83 |   | 4.50 |   | 111,567 |   | 4.50 |   |
|                                    | 4.81 - 5.40        |                         | 26,850     |   | 2.99 |   | 5.00 |   | 26,850 |   | 5.00 |   |
|                                    | 5.41 - 6.00        |                         | 50,535     |   | 6.96 |   | 6.00 |   | 30,643 |   | 6.00 |   |
|                                    | 6.01 - 7.80        |                         | 1,082,600  |   | 7.88 |   | 6.74 |   | 511,913 |   | 6.78 |   |
|                                    | 7.81 - 9.00        |                         | 217,692    |   | 8.41 |   | 7.85 |   | 83,102 |   | 7.84 |   |
|                                    |  9.01 - 10.29 |                         | 100,000    |   | 8.65 |   | 10.29 |   | 37,500 |   | 10.29 |   |
|                                    |               |                         | 3,296,462  |   | 6.55 |   | $ | 4.87 |   | 2,431,780 |   | $ | 4.16 |   |

 

*Restricted Stock Awards and UnitActivity*

A summary of activity related to restricted commonstock awards and unit awards during the three months ended March 31, 2007, isas follows:
|                                          | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Price per  Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value (2)** | ** ** |
|------------------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding at  December 31, 2006        |       | 1,081,925                  |       | $                                            | 12.43      |                                                             | 3.75       |                                     | $          | 16,207 |   |
| Awarded                                  |       | 210,000                    |       | 13.23                                        |       |                                                             |       |                                     |       |
| Exercised                                |       | —                     |       | —                                       |       |                                                             |       |                                     |       |
| Canceled                                 |       | (7,150                     | )          | 13.35                                        |       |                                                             |       |                                     |       |
|                                     |       |                       |       |                                         |       |                                                             |       |                                     |       |
| Outstanding at  March 31, 2007           |       | 1,284,775                  |       | $                                            | 12.55      |                                                             | 3.57       |                                     | $          | 16,869 |   |
|                                     |       |                       |       |                                         |       |                                                             |       |                                     |       |
| Expected to be  free of restrictions (1) |       | 932,589                    |       | $                                            | 12.55      |                                                             | 3.57       |                                     | $          | 12,245 |   |

 

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(1)   The expected to be free ofrestrictions at March 31, 2007 was calculated by applying an estimatedforfeiture rate to the unvested shares.

12

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(2)   The aggregate intrinsic value is calculatedbased on the fair value per share of the Company’s common stock on March 31,2007 of $13.13.

*Employee Stock Purchase Plan*

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

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

*Stock-BasedCompensation Accounting Policy*

OnJanuary 1, 2006, the Company adopted the provisions of SFAS No. 123(R), *Share-based Payment*, which requires theCompany to recognize expense related to the fair value of stock-basedcompensation awards. Management elected to use the modified prospectivetransition method as permitted by SFAS No. 123(R) and therefore has notrestated the Company’s financial results for prior periods.  Stock-based compensation expense for thethree months ended March 31, 2006 and 2007 includes compensation expense forall stock-based compensation awards granted on or after March 15, 2004 (thefiling date for the initial registration statement for the Company’s initialpublic offering), based on the grant-date fair value estimated in accordancewith the provisions of SFAS No. 123(R).

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

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

Priorto the adoption of SFAS No. 123(R), the Company appliedSFAS No. 123, *Accounting for Stock-BasedCompensation*, amended by SFAS No. 148, *Accounting for Stock-based Compensation —Transition and Disclosure*, which allowed companies to apply theexisting accounting rules under APB Opinion No. 25. Pursuant toAPB Opinion No. 25, the Company accounted for its stock-based awards toemployees using the intrinsic-value method, under which compensation expensewas measured on the date of grant as the difference between the fair value ofthe Company’s common stock and the option exercise price multiplied by thenumber of options granted. Generally, the Company granted stock options withexercise prices equal to the estimated fair value of its common stock; however,to the extent that the fair value of the common stock exceeded the exerciseprice of stock options granted to employees on the date of grant, the Companyrecorded deferred compensation and amortized the expense over the vestingschedule of the options, generally four years. In accordance with APB Opinion No. 25, the Company recordeddeferred stock-based compensation resulting from the grant of employee stockoptions with an exercise price less than the fair value of common stock. As ofMarch 31, 2007, the Company had $91 of deferred stock-based compensationremaining to be amortized which is expected to be amortized as follows: $86during the remainder of fiscal 2007 and $5 during fiscal 2008. Upon theadoption of SFAS No. 123(R) on January 1, 2006, the deferred stock-basedcompensation balance was netted against additional paid-in capital on theconsolidated balance sheet and statement of stockholders equity.

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Foroptions accounted for under SFAS No. 123(R), the fair value of each optiongrant is estimated on the date of grant using the Black-Scholes pricing model.No options were granted during the three months ended March 31, 2007. For thethree months ended March 31, 2006, assumptions used and the resulting estimatedfair value for grants were as follows:
|                                                           | ** ** | **Three Months  Ended March 31, 2006** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Risk-free  interest rate                                  |       | 4.65                                                       | %          |
| Expected life  (years)                                    |       | 4.28                                                       |       |
| Expected  volatility                                      |       | 53                                                         | %          |
| Weighted-average fair  value per share of options granted |       | $4.21                                                      |       |

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

During the three months ended March 31, 2006 and 2007,the Company recorded $456 and $1,032 of aggregate stock-based compensationexpense, respectively, of which $328 and $986, respectively, was a result ofthe adoption of SFAS No. 123(R).  Theremaining stock-based compensation expense is due to the amortization ofstock-based compensation associated with previously issued stock options whichamounted to $128 and $46, in 2006 and 2007, respectively.   For the three months ended March 31, 2006, stock-basedcompensation expense was allocated as follows; $44 to cost of service revenues,$60 to research and development, $110 to sales and marketing, and $242 togeneral and administrative.  For thethree months ended March 31, 2007, stock-based compensation expense included$110 in cost of revenues, $156 in research and development, $166 in sales andmarketing, and $600 in general and administrative expense.  As of March 31, 2007, there was **$**13,385 of unrecognized stock-based compensation expenserelated to stock-based awards that is expected to be recognized over a weightedaverage period of 3.27****years.

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

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

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

A rollforward ofthe net carrying amount of goodwill is as follows:
|                                                                          | ** ** | **Amount** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|
| Balance as of December 31, 2005                                          |       | $          | 24,960     |   |
| Increase associated with the acquisition of Lincoln                      |       | 3,067      |       |
| Release of valuation allowance related to acquired  net operating losses |       | (207       | )          |
| Balance as of December 31, 2006                                          |       | 27,820     |       |
| Release of valuation allowance related to acquired  net operating losses |       | (121       | )          |
| Balance as of March 31, 2007                                             |       | $          | 27,699     |   |

 

The utilization ofor release of the valuation allowance related to acquired net operating lossesreflects an actual or anticipated reduction in cash payments to local taxingauthorities for income taxes that are not reflected as a benefit in the incometax provision for financial statement purposes but rather as a reduction togoodwill.  In the year ended December 31,2006, the Company determined that it is more likely than not that the Companywill realize a portion of its deferred tax assets and therefore reduced thevaluation

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allowance by $5,620.  This benefit of the release in valuationallowance was realized through reductions to income tax expense of $5,413 andto goodwill of $207. During the three months ending March 31, 2007, the Companydetermined that it is more likely than not that the Company will realize aportion of its deferred tax assets and therefore reduced the valuationallowance by $1,199.  This benefit of therelease in valuation allowance was realized through reductions to income taxexpense of $1,078 and to goodwill of $121.

Intangible assets,all of which relate to the acquisition of Lincoln, consist of the following:
| ** **                         | ** ** | ** **                          | ** ** | **As of December 31, 2006** | ** ** | **As of March 31, 2007** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|----------------------------------------------|------------|
| **Description**                    | ** ** | **Estimated Useful Life** | ** ** | **Gross  Carrying  Value**                      | ** ** | **Accumulated  Amortization**                | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed  technology and know-how |       | 5  years                            |       | $                                               | 1,800      |                                         | $          | 487 |   | $ | 1,800 |   | $ | 577 |   |
| Customer  relationships            |       | 5  years                            |       | 1,600                                           |       | 432                                          |       | 1,600 |   | 513 |   |
| Non-compete  agreements            |       | 2  years                            |       | 300                                             |       | 203                                          |       | 300 |   | 240 |   |
| Trade-name                         |       | 5  years                            |       | 200                                             |       | 54                                           |       | 200 |   | 64 |   |
| Total                              |       |                                |       | $                                               | 3,900      |                                         | $          | 1,176 |   | $ | 3,900 |   | $ | 1,394 |   |

 

Amortizationexpense related to intangible assets for the three months ended March 31, 2006and 2007 was $218 and $218, respectively.

The estimatedremaining amortization expense for each of the five succeeding years is asfollows:
|  Year ended December 31, | ** ** | **Amount** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2007                                         |       | $          | 599        |   |
| 2008                                         |       | 720        |       |
| 2009                                         |       | 720        |       |
| 2010                                         |       | 467        |       |
| Total                                        |       | $          | 2,506      |   |

 

**11.****       Accrued Expenses**

Accrued expensesconsist of the following:
|                                       | ** ** | **As of  December 31,** | ** ** | **As of  March 31,** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **2006**                          | ** ** | **2007**                       | ** ** |
| Accrued payroll  and related benefits |       | $                                 | 8,338      |                           | $          | 6,173 |   |
| Accrued other  expenses               |       | 3,720                             |       | 3,304                          |       |
| Accrued  royalties                    |       | 1,553                             |       | 2,047                          |       |
| Accrued income  taxes                 |       | 572                               |       | 650                            |       |
|                                  |       |                              |       |                           |       |
|  Total                           |       | $                                 | 14,183     |                           | $          | 12,174 |   |

 

**12.  Debt**

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

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**13.****       Contingencies**

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

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

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

**14.**       Stockholders’ Equity

During the threemonths ended March 31, 2007, the Company issued 133,222 shares of common stockin connection with the exercise of stock options, resulting in proceeds of$496.

**15.**       Comprehensive Income

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

Comprehensive incomeconsisted of the following:
|                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| Net income                         |       | $                                                | 2,086      |   | $ | 3,481 |   |
| Cumulative  translation adjustment |       | 125                                              |       | 132 |   |
| Comprehensive income               |       | $                                                | 2,211      |   | $ | 3,613 |   |

 

**16.****       Forward Foreign ExchangeContracts**

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

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The followingtable summarizes the outstanding forward foreign exchange contracts held by theCompany as of December 31, 2006 and March 31, 2007:
|               | ** ** | ** **          | ** ** | **As of December 31, 2006** | ** ** | **As of March 31, 2007**  | ** ** |
|---------------|------------|---------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **Currency**  | ** ** | **Hedge Type** | ** ** | **Local  Currency  Amount**                     | ** ** | **Approximate  U.S. Dollar  Equivalent** | ** ** | **Local  Currency  Amount** | ** ** | **Approximate  U.S. Dollar  Equivalent** | ** ** |
| British pound |       | Sale                |       | 6,000                                           |       | $                                             | 11,752     |   | 1,000 |   | $ | 1,969 |   |
| Euro          |       | Sale                |       | 2,000                                           |       | 2,639                                         |       | — |   | — |   |
| Japanese yen  |       | Sale                |       | 59,000                                          |       | 496                                           |       | 48,000 |   | 408 |   |
|          |       |                |       |                                            |       | $                                             | 14,887     |   |   |   | $ | 2,377 |   |

 

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

Due to the shortperiod of time between entering into the forward foreign exchange contracts andMarch 31, 2007, the forward foreign exchange contract rate approximates theexchange rate as of the end of the reporting period.

Realized andunrealized foreign currency losses, net of hedging are accounted for innon-operating income. Foreign currency losses, net of hedging, were $62 and $65for the three months ended March 31, 2006 and 2007, respectively. The Companysettles forward foreign exchange contracts in cash.

**17.**       Income Taxes

The Companyadopted the provisions of FIN 48, an interpretation of SFAS 109, *Accounting for Income Taxes*, on January 1, 2007.  As a result of the implementation of FIN 48,the Company recognized no material adjustment in the liability for unrecognizedincome tax benefits. At the adoption date of January 1, 2007, the Company had$499 of unrecognized tax benefits, all of which would affect the Company’seffective tax rate if recognized.  AtMarch 31, 2007, the Company has $499 of unrecognized tax benefits.

The Companyrecognizes interest and penalties related to uncertain tax positions in theprovision for income taxes.  At theadoption date of January 1, 2007, the Company had $50 of accrued interestrelated to uncertain tax positions. As of March 31, 2007, the Companyhad $55 of accrued interest related to uncertain tax positions.

The tax years2003-2006 remain open to examination by federal and state tax jurisdictions.

The Company hasvarious foreign subsidiaries for which tax years 2000-2006 remain open toexamination in certain foreign tax jurisdictions.

**The Company’s provision fortaxes includes foreign and alternative minimum tax.  The Company has utilized available U.S. netoperating losses to offset its primary federal obligations resulting in aneffective tax rate of 18% and 14% for the three months ended March 31, 2006 and2007, respectively.  The Companycurrently expects to realize recorded deferred tax assets as of March 31,2007 of approximately $9,900. The Company’s conclusion that such assets will berecovered is based upon its expectation that future earnings of the Company willprovide sufficient taxable income to realize recorded tax assets. While therealization of the Company’s net recorded deferred tax assets cannot beassured, to the extent that future taxable income against which these taxassets may be applied is not sufficient, some or all of the Company’s netrecorded deferred tax assets would not be realizable.**

A reconciliationof the federal statutory rate to the Company’s effective tax rate is asfollows:
|                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| Federal  statutory rate           |       | 34                                               | %          | 34 | % |
| State tax                         |       | 3                                                |       | 3 |   |
| Alternative  minimum tax          |       | 1                                                |       | 2 |   |
| Stock-based  compensation expense |       | 7                                                |       | 2 |   |
| Other                             |       | 1                                                |       | — |   |
| Decrease in  valuation allowance  |       | (28                                              | )          | (27 | ) |
|                              |       |                                             |       |   |   |
| Effective tax rate                |       | 18                                               | %          | 14 | % |

 

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

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

InFebruary 2007, the FASB released SFAS No. 159, *“The Fair Value Option for Financial Assets and Financial Liabilities”*andis effective for fiscal years beginning after November 15, 2007.  This Statement permits entities to choose tomeasure many financial instruments and certain other items at fair value. Theobjective is to improve financial reporting by providing entities with theopportunity to mitigate volatility in reported earnings caused by measuringrelated assets and liabilities differently without having to apply complexhedge accounting provisions. The Company is currently analyzing the effect, ifany, SFAS No. 159 will have on its consolidated financial position and resultsof operations.

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

**Overview**

Phase ForwardIncorporated is a provider of integrated enterprise-level software products,services and hosted solutions for use in our customers’ global clinical trialand drug safety monitoring activities. Our customers include pharmaceutical,biotechnology and medical device companies, as well as academic institutions,governmental regulatory agencies, clinical research organizations, or CROs, andother entities engaged in clinical trial and drug safety monitoring activities.By automating essential elements of the clinical trial and drug safetymonitoring processes, we believe our products allow our customers to acceleratethe market introduction of new medical therapies and corresponding revenues,reduce overall research and development expenditures, enhance existing dataquality control efforts, increase drug safety compliance and reduce clinicaland economic risk.

**Acquisitions**

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

*LincolnTechnologies, Inc.*

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

*ClinsoftCorporation*

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

**Litigation Settlement**

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

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

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**Sourcesof Revenues**

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

One customer,GlaxoSmithKline; accounted for approximately 18% and 17% of our total revenuesin the three months ended March 31, 2006 and 2007, respectively and $2.6million and $1.9 million of accounts receivable outstanding as of December 31,2006 and March 31, 2007, respectively. Our top 20 customers accounted for approximately 68% and 67% of ourtotal revenues in the three months ended March 31, 2006 and 2007, respectively,net of reimbursable out-of-pocket expenses.

* License Revenues*

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

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

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

*ServiceRevenues*

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

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

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

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

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

Services providedfor the first and third stages are provided on a fixed fee basis depending uponthe complexity of the trial and system requirements. Services for the secondstage are charged separately as a fixed monthly fee. We recognize revenues fromall stages of the hosting service ratably over the hosting period. Fees chargedand costs incurred for the trial system design, set up and implementation aredeferred until the start of the hosting period and are amortized and recognizedratably over the estimated hosting period. The deferred costs include directcosts related to the trial and application set up. Fees for the first and thirdstages of the

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services are billed basedupon milestones. Fees for application hosting and related services in thesecond stage are generally billed quarterly in advance. Bundled into thisrevenue element are the revenues attributable to the software license used by thecustomer.

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

Revenues resultingfrom hosting services for our *WebVDME*,*CTSD* and *WebSDM* products consist of installationand server configuration, application hosting and related support services.  Services for this offering are chargedmonthly as a fixed fee.  Revenues arerecognized ratably over the period of the service.

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

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

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

**Cost ofRevenues and Operating Expenses**

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

*Costof Revenues.*    Cost of license revenuesconsists primarily of the amortization of royalties paid for certain moduleswithin our *Clintrial* softwareproduct as well as our *InForm*software product. In addition, costs of revenues include expense for the amortizationof acquired technologies associated with the acquisition of Lincoln. The costof license revenues vary based upon the mix of revenues from software licensesfor our products. We operate our service organization on a global basis as onedistinct unit, and do not segment costs for our various service revenueelements. These services include performing application hosting, consulting andcustomer support services. Costs for these services consist primarily ofemployee-related costs associated with these services, amortization of thedeferred clinical trial set up costs, allocated overhead, outside contractors,royalties associated with providing customer support for use with the *Clintrial* and *InForm*softwareproducts and reimbursable out-of-pocket expenses. Cost of services alsoincludes hosting costs that primarily consist of hosting facility fees andserver depreciation.

The cost ofservice revenues varies based upon the number of employees in the serviceorganization, the type of work performed, and royalties associated withrevenues derived from providing customer support, as well as costs associatedwith the flexible use of outside contractors to support internal resources. Wesupplement the trial design and set up activity for our *InForm*application hosting servicesthrough the use of outside contractors. This allows us to utilize outsidecontractors in those periods where trial design and set up activity is highestwhile reducing the use of outside contractors in those periods where trialactivity lessens, allowing for a more flexible delivery model. The percentageof the services workforce represented by outside contractors varies from periodto period depending on the volume of specific support required. The cost ofservices is significantly higher as a percentage of revenues as compared to ourcost of license revenues primarily due to the employee-related and outsidecontractor expenses associated with providing services.

*GrossMargin.*    Our gross margin on licenserevenues varies based on the mix of royalty- and non-royalty-bearing licenserevenues and the amount of amortization of acquired technologies. Our grossmargin on service revenues varies primarily due to variations in theutilization levels of the professional service team and the timing of expenseand revenue recognition under our service arrangements. In situations where theservice revenues are recognized ratably over the software license term our costsassociated with delivery of the services are recognized as the services areperformed, which is typically during the first 6 to 12 months of thecontract

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period. Accordingly, ourgross margin on service revenues will vary significantly over the life of acontract due to the timing, amount and type of service required in deliveringcertain projects. In addition, consolidated gross margin will vary depending uponthe mix of license and service revenues.

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

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

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

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

**ForeignCurrency Translation**

With regard to ourinternational operations, we frequently enter into transactions in currenciesother than the U.S. dollar. As a result, our revenues, expenses and cash flowsare subject to fluctuations due to changes in foreign currency exchange rates,particularly changes in the euro, British pound, Australian dollar and Japaneseyen. In the three months ended March 31, 2006 and 2007, approximately 49% and50%, respectively, of our revenues were generated in locations outside theUnited States. The majority of these revenues are in currencies other than theU.S. dollar, as are many of the associated expenses. In periods when the U.S.dollar declines in value as compared to the foreign currencies in which weconduct business, our foreign currency-based revenues and expenses generallyincrease in value when translated into U.S. dollars.

**CriticalAccounting Policies and Estimates**

Our unaudited condensedconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of thesefinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. On an ongoingbasis, we evaluate our estimates and assumptions with our audit committee,including those related to revenue recognition, deferred set up costs,commissions and royalties, accounts receivable reserves, stock-based compensationexpenses, long-lived assets, intangibles assets and goodwill, income taxes,restructuring, contingencies and litigation. We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. There have been no material changes tothese estimates for the periods presented in this Quarterly Report on Form10-Q. Our actual results may differ from these estimates under differentassumptions or conditions.

We believe that of oursignificant accounting policies, which are described in Note 2 of thenotes to our consolidated financial statements included in our Annual Report onForm 10-K for the year ended December 31, 2006 and in the Notes to ourunaudited condensed consolidated financial statements included in thisQuarterly Report on Form 10-Q, the following accounting policies involve agreater degree of judgment and complexity. Accordingly, these are the policieswe believe are the most critical to aid in fully understanding and evaluatingour consolidated financial condition and results of operations.

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*RevenueRecognition and Deferred Set Up Costs.*    Werecognize software license revenues in accordance with Statement of Position(SOP) No. 97-2, *Software RevenueRecognition,* as amended, issued by the American Institute ofCertified Public Accountants, while revenues resulting from applicationservices are recognized in accordance with Emerging Issues Task Force (“EITF”)Issue No. 00-3, *Application of AICPAStatement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware* and Securities andExchange Commission’s (SEC) Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition*. On August 1,2003, we adopted EITF Issue No. 00-21, *RevenueArrangements with Multiple Deliverables.* The adoption of EITF IssueNo. 00-21 did not have a material impact on our financial position orresults of operations.

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

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

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

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

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

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

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

Revenues resultingfrom *InForm*application hosting servicesconsists of three stages for each clinical trial: the first stage involvesapplication set up, including design of electronic case report forms and editchecks, implementation of the system and server configuration; the second stageinvolves application hosting and related support services; and the third stageinvolves services required to close out, or lock, the database for the clinicaltrial. Services provided for the first and third stages are provided on a fixedfee basis based upon the complexity of the trial and system requirements.Services for the second stage are charged separately as a fixed monthly fee. Werecognize revenues from all stages of the *InForm*hosting service ratably over the hosting period. Fees charged andcosts incurred for the trial system design, set up and implementation aredeferred as applicable, until the start of the hosting period and

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then amortized andrecognized, as applicable, ratably over the estimated hosting period. Thedeferred costs include incremental direct costs with third parties and certaininternal direct costs related to the trial and application set up, as definedunder SFAS No. 91, *Accounting forNonrefundable Fees and Costs Associated with Originating or Acquiring Loans andIndirect Costs of Leases*. These costs include salary and benefitsassociated with direct labor costs incurred during trial set up, as well asthird-party subcontract fees and other contract labor costs. Work performedoutside the original scope of work is contracted for separately as anadditional fee and is generally recognized ratably over the remaining term ofthe hosting period. Fees for the first and third stages of the services arebilled based upon milestones. Fees for application hosting and related servicesin the second stage are billed quarterly in advance. Bundled into this revenueelement are the revenues attributable to the software license used by thecustomer.

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

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

We deferred$632,000 and $942,000 of set up costs and amortized $475,000 and $560,000during the three months ended March 31, 2006 and 2007, respectively. Theamortization of deferred set up costs is a component of cost of services.

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

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

*Accountingfor Prepaid Sales Commissions and Royalties.*    Forarrangements where we recognize revenue over the relevant contract period, wedefer related commission payments to our direct sales force and softwarelicense royalties paid to third parties and amortize these amounts over thesame period that the related revenues are recognized. This is done to bettermatch commission and royalty expenses with the related revenues. During thethree months ended March 31, 2006 and 2007, we deferred $1.1 million and$1.7 million, respectively, of commissions and amortized $909,000 and $1.5million, respectively, to sales and marketing expense. Royalties are paid on apercentage of billings basis for certain of our products, and we have the rightto recover royalties in the event an arrangement is cancelled. During the threemonths ended March 31, 2006 and 2007, we deferred $994,000 and $232,000,respectively, of royalty expenditures and amortized $824,000 and $177,000,respectively, to cost of license and service revenues.

*AccountsReceivable Reserves.*    We maintainallowances for doubtful accounts for estimated losses resulting from theinability of our customers to make required payments. We regularly evaluate thecollectibility of our trade receivables based on a combination of factors,which may include dialogue with the customer to determine the cause ofnon-payment, the use of collection agencies, and/or the use of litigation. Inthe event it is determined that the customer may not be able to meet its fullobligation to us, we record a specific allowance to reduce the relatedreceivable to the amount that we expect to recover given all informationavailable to us. We continuously monitor collections from our customers andmaintain a provision for estimated credit losses based upon our historicalexperience and any specific customer collection issues that we have identified.While such credit losses have historically been within our expectations and theprovisions established, we cannot guarantee that we will continue to experiencethe same credit loss rates in the future. If the financial condition of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required. Our accounts receivablereserves were $384,000 and $491,000 as of December 31, 2006 and March 31,2007, respectively.

*Accountingfor Income Taxes.*    In connection withpreparing our financial statements, we are required to compute income taxexpense in each jurisdiction in which we operate.  This process requires that we project ourcurrent tax liability and estimate our deferred tax assets and liabilities,including net operating loss and tax credit carryforwards.  In assessing the need for a valuationallowance, we have considered our recent operating results, future taxableincome projections and all prudent and feasible tax planning strategies.  In 2005, we determined that it was morelikely than not that we would realize a portion of our deferred tax assets andtherefore reduced the valuation allowance by $7.8 million in December2005.  This benefit of the release invaluation allowance was realized through reductions to income tax expense of$4.5 million and to goodwill of $3.2 million for the realization of acquirednet operating loss carryforwards in the Clinsoft acquisition.  In 2006, we determined that it was morelikely than not that we would realize an additional portion of our deferred taxassets and therefore reduced the valuation allowance by $5.6 million.  This benefit of the release in valuationallowance was realized through reductions to income tax expense of $5.4 millionand to goodwill of $207,000.  Also in2006, we utilized $3.2 million of our deferred tax assets to offset 2006taxable income.  During the three monthsending March 31, 2007, we determined that it is more likely than not that wewill realize an additional portion of deferred tax assets and therefore reducedthe valuation allowance by $1.2 million. This benefit of the release in valuation allowance was realized throughreductions to income tax expense of $1.1 million and to goodwill of $121,000.

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

Stock optionsgranted prior to March 15, 2004, are minimum value options, pursuant toSFAS No. 123, *Accounting for Stock-BasedCompensation*. Under the provisions of SFAS No. 123(R), thevalue of these options will not be recorded in the statement of operationssubsequent to the date of our adoption of SFAS No. 123(R). Instead, wewill continue to account for these options using Accounting Principles Board(APB) Opinion No. 25, *Accounting forStock Issued to Employees*, and related Interpretations.

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

Priorto the adoption of SFAS No. 123(R), we applied SFAS No. 123,amended by SFAS No. 148, *Accountingfor Stock-based Compensation — Transition and Disclosure*, whichallowed companies to apply the existing accounting rules under APB OpinionNo. 25. Pursuant to APB Opinion No. 25, we accounted for our stock-basedawards to employees using the intrinsic-value method, under which compensationexpense was measured on the date of grant as the difference between the fairvalue of our common stock and the option exercise price multiplied by thenumber of options granted. Generally, we granted stock options with exerciseprices equal to the estimated fair value of our common stock; however, to theextent that the fair value of the common stock exceeded the exercise price ofstock options granted to employees on the date of grant, we recorded deferredcompensation and amortized the expense over the vesting schedule of the options,generally four years.  During 2003 and2004, in accordance with APB Opinion No. 25, we recorded deferredstock-based compensation resulting from the grant of employee stock optionswith an exercise price less than the fair value of common stock. As of March31, 2007, we had $91,000 of deferred stock-based compensation remaining to beamortized which we expect to be amortized as follows: $86,000 during theremainder of 2007 and $5,000 during 2008**.**

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

During the threemonths ending March 2006 and 2007, we recorded $456,000 and $1,032,000 ofaggregate stock-based compensation expense respectively, of which $328,000 and$986,000, respectively, was a result of the adoption of SFAS No. 123(R). Theremaining stock-based compensation expense is due to the amortization ofstock-based compensation associated with previously issued stock options whichamounted to $128,000 and $46,000, in 2006 and 2007, respectively. For 2006, weallocated stock-based compensation expense as follows: $44,000 to cost ofservice revenues, $60,000 to research and development, $110,000 to sales andmarketing, and $242,000 to general and administrative.  For 2007, we allocated stock-basedcompensation expense as follows: $110,000 in cost of revenues, $156,000 inresearch and development, $166,000 in sales and marketing and $600,000 ingeneral and administrative expense.  Forthe three months ending March 31, 2006 and March 31, 2007, stock-basedcompensation expense reduced basic and diluted earnings per share by $0.01 and$0.03, respectively.   As of March 31,2007, we had $13.4 million of unrecognized stock-based compensation expenserelated to market-based share awards that we expect to recognize over aweighted average period of 3.27 years.

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

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**Overviewof Results of Operations for the Three Months Ended March 31, 2006 and2007**

Total revenuesincreased by 27% or $6.5 million in the three months ended March 31, 2007compared to the same period in 2006 due to an increase in service revenues of31%.

Our gross marginincreased by 28% or $3.9 million in the three months ended March 31,2007 compared to the same period in 2006, primarily due to the increase inservices revenues.

Operating incomefor the three months ended March 31, 2007 of $3.2 million increased 60% or $1.2million compared to the same period in 2006. The operating income for the three months ended March 31, 2006 and 2007also included $456,000 and $1.0 million of stock-based compensation expense,respectively.

The results forthe three months ended March 31, 2007 were impacted by foreign exchange ratefluctuations, resulting in an approximately 4.8% decrease in both revenues andexpenses for the period.

As of March 31,2007, we had $81.8 million of cash, cash equivalents and short-terminvestments, an increase of $12.2 million from $69.6 million at December 31,2006.  As of March 31, 2007, we had nooutstanding debt.

*Revenues*
|                               | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                    | ** ** | **2006**                                             | ** ** | **2007**                        | ** ** | **Change** | ** ** |
| **Revenues**                  | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(in thousands)**                              | ** ** |
| License                       |       | $                                                    | 9,025      |                            | 38         | %          | $          | 11,036 |   | 37 | % | $ | 2,011 |   | 22 | % |
| Application  hosting services |       | 8,954                                                |       | 38                              |       | 12,052     |       | 40 |   | 3,098 |   | 35 |   |
| Consulting  services          |       | 2,739                                                |       | 12                              |       | 3,426      |       | 11 |   | 687 |   | 25 |   |
| Customer support              |       | 2,898                                                |       | 12                              |       | 3,570      |       | 12 |   | 672 |   | 23 |   |
|                          |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total                         |       | $                                                    | 23,616     |                            | 100        | %          | $          | 30,084 |   | 100 | % | $ | 6,468 |   | 27 | % |

 

Total revenuesincreased in the three months ended March 31, 2007 as compared to the sameperiod in 2006, primarily due to increases in application hosting and licenserevenues.  The increase in revenues associatedwith our application hosting services in the three months ended March 31, 2007was due to an increase in trials under management, which include bothapplication hosting services trials as well as trials hosted for our *InForm* license customers. The increase in license revenues was primarily the result of additional *InForm*revenues to both new and existing customers.  The increase in consulting revenues wasprimarily attributable to additional *InForm* revenueswhich were related to both new and existing customers.  The increase in customer support revenues inthe three months ended March 31, 2007 was due primarily to increases in *InForm*training and customer support revenues.  Our revenues were not significantly impactedby price increases or decreases. Inflation had only a nominal impact on our revenues.
|                           | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                | ** ** | **2006**                                             | ** ** | **2007**                        | ** ** | **Change** | ** ** |
| **Revenues by Geography** | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                | ** ** | **(in thousands)**                              | ** ** |
| United States             |       | $                                                    | 12,023     |                            | 51         | %          | $          | 14,979 |   | 50 | % | $ | 2,956 |   | 25 | % |
|                      |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| United Kingdom            |       | 7,519                                                |       | 32                              |       | 10,910     |       | 36 |   | 3,391 |   | 45 |   |
| France                    |       | 2,374                                                |       | 10                              |       | 2,487      |       | 8 |   | 113 |   | 5 |   |
| Asia Pacific              |       | 1,700                                                |       | 7                               |       | 1,708      |       | 6 |   | 8 |   | — |   |
|                      |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| International subtotal    |       | 11,593                                               |       | 49                              |       | 15,105     |       | 50 |   | 3,512 |   | 30 |   |
|                      |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total                     |       | $                                                    | 23,616     |                            | 100        | %          | $          | 30,084 |   | 100 | % | $ | 6,468 |   | 27 | % |

 

The increase inrevenues worldwide was due to the increase in application hosting services andlicense revenues associated with our *InForm*product. The increase in U.S. revenue is primarily related to new an increasein *InForm*revenues across all of ourcategories and to a lesser extent additional business relationships relating tothe *WebVDME* product we beganoffering after the August 2005 acquisition of Lincoln, while the increase ininternational revenues is primarily the result of additional applicationhosting services revenues to both new and existing customers as well as anincrease in *InForm*license revenues.

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*Cost ofRevenues*
|                       | ** ** | **Three Months Ended March 31,** | ** ** | ** **                               | ** ** | ** ** | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                             | ** ** | **2007**                                 | ** ** | **Change** | ** ** |
| **Cost of  Revenues** | ** ** | **Amount**                                           | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **            | ** ** | **(in thousands)**                              | ** ** |
| License               |       | $                                                    | 706        |                                     | 8          | %          | $          | 605 |   | 5 | % | $ | (101 | ) | (14 | )% |
| Services              |       | 8,895                                                |       | 61                                       |       | 11,527     |       | 61 |   | 2,632 |   | 30 |   |
|                  |       |                                                 |       |                                     |       |       |       |   |   |   |   |   |   |
| Total                 |       | $                                                    | 9,601      |                                     | 41         | %          | $          | 12,132 |   | 40 | % | $ | 2,531 |   | 26 | % |

 

The cost oflicense revenues decreased in the three months ended March 31, 2007 primarilydue to a $110,000 decrease in cost of royalties associated with our *InForm*software product. The increase in cost of services in the three months ended March 31,2007 was due primarily to increases in employee-related and contractor expense of$1.3 million and $624,000, respectively, associated with a headcount increaseof 28 people and the delivery of increased services revenues.  We also had expense increases for computerrelated expenses of $408,000, which includes hardware and software supportagreements, computer accessories and equipment rentals for our trainingclasses.  We also had expense increasesin recruiting, travel and telephone expense of $168,000, $109,000 and $74,000,respectively.  In addition, there werealso increases in stock-based compensation and depreciation expense of $65,000and $67,000, respectively.  Theseincreases were partially offset by a decrease in expense of $224,000 relatingto the number of arrangements in the hosting phase.  Expenses in the hosting phase include actualcosts incurred as well as the amortization of costs that were previously deferredduring the set up phase.

*GrossMargin*
|                  | ** ** | **Three Months Ended March 31,** | ** ** | ** **                               | ** ** | ** ** | ** ** |
|------------------|------------|------------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| ** **       | ** ** | **2006**                                             | ** ** | **2007**                                 | ** ** | **Change** | ** ** |
| **Gross Margin** | ** ** | **Amount**                                           | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                              | ** ** |
| License          |       | $                                                    | 8,319      |                                     | 92         | %          | $          | 10,431 |   | 95 | % | $ | 2,112 |   | 25 | % |
| Services         |       | 5,696                                                |       | 39                                       |       | 7,521      |       | 40 |   | 1,825 |   | 32 |   |
|             |       |                                                 |       |                                     |       |       |       |   |   |   |   |   |   |
| Total            |       | $                                                    | 14,015     |                                     | 59         | %          | $          | 17,952 |   | 60 | % | $ | 3,937 |   | 28 | % |

 

The license grossmargin percentage increased in the three months ended March 31, 2007 due to a decreasein royalty expense relating to our *InForm*software.  The services gross margin percentage increasedslightly during the three months ended March 31, 2007, as revenues grew atapproximately the same rate as expenses. The overall gross margin increased in the three months ended March 31,2007 due the increase in license gross margin. It is likely that gross margin, as a percentage of revenue willfluctuate quarter by quarter due to the timing and mix of license and servicerevenues, and the type, amount and timing of service required in deliveringcertain projects.  For example, whenservices are performed on a time and material basis, the timing of expense andrevenue recognition is more closely aligned than when services are performed underbundled arrangements, where the revenues are recognized ratably over thelicense period, while the expenses are recognized as incurred.

*Operating Expenses*
|                            | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                 | ** ** | **2006**                                             | ** ** | **2007**                        | ** ** | **Change** | ** ** |
| **Operating Expenses**     | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | **(in thousands)**                              | ** ** |
| Sales and marketing        |       | $                                                    | 4, 237     |                            | 18         | %          | $          | 5,447 |   | 18 | % | $ | 1,210 |   | 29 | % |
| Research and development   |       | 3,624                                                |       | 15                              |       | 4,632      |       | 15 |   | 1,008 |   | 28 |   |
| General and administrative |       | 4,139                                                |       | 18                              |       | 4,638      |       | 15 |   | 499 |   | 12 |   |
|                       |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total                      |       | $                                                    | 12,000     |                            | 51         | %          | $          | 14,717 |   | 49 | % | $ | 2,717 |   | 23 | % |

 

*Salesand Marketing.*    Sales and marketingexpenses increased in the three months ended March 31, 2007 primarily due to a$600,000 increase in commission expense due to an increase in revenues.  We also experienced a $145,000 increase inemployee-related expenses related to a headcount increase of 6 people.  In addition there were also expense increasesin travel, marketing programs and stock-based compensation of $235,000, $65,000and $56,000, respectively.  We expectthat our sales and marketing expense will continue to increase in absolutedollars as commission expense increases with our revenues and as we continue toexpand sales coverage and to build brand awareness through what we believe arethe most cost effective channels available, but may fluctuate

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quarter over quarter dueto the timing of marketing programs.

*Researchand Development.*    Research anddevelopment expenses increased in the three months ended March 31, 2007primarily due to employee-related expenses of $435,000 related to a headcountincrease of 3 people.  We also hadexpense increases related to outside contractors and stock-based compensationof $275,000 and $96,000, respectively. In addition, depreciation expense increased $84,000 and facilitiesexpense grew by $49,000. We expect that our research and development costs willcontinue to increase in absolute dollars as we continue to add features andfunctionality to our products and expand our product and service offerings.

*Generaland Administrative.*    General andadministrative expenses increased in the three months ended March 31, 2007primarily due to an increase in stock-based compensation expense of $358,000.In addition, employee-related expenses increased $192,000 related to aheadcount increase of 3 people. Furthermore, bad debt expense increased by $53,000.  These expense increases were partially offsetby an overall decrease in professional fees of $343,000, which included areduction of legal expense associated with defending our intellectualproperty.  We expect that in the futureour general and administrative expenses will increase in absolute dollars as weadd personnel and incur additional costs related to the growth of our businessand operations.

*OperatingIncome*
|                  | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **       | ** ** | **2006**                                             | ** ** | **2007**                        | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands)**                              | ** ** |
| Operating income |       | $                                                    | 2,015      |                            | 9          | %          | $          | 3,235 |   | 11 | % | $ | 1,220 |   | 61 | % |
|                  |            |                                                      |            |                                 |            |            |            |  |  |  |  |  |  |  |  |  |

 

*OperatingIncome.*   The increase in operating income inthe three months ended March 31, 2007 was primarily due to the increase intotal gross margin and a reduction in operating expenses as a percentage ofrevenues.

*OtherIncome (Expense)*
|                         | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **              | ** ** | **2006**                                             | ** ** | **2007**                        | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **              | ** ** | **(in thousands)**                              | ** ** |
| Other income (expense): |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Interest income         |       | $                                                    | 596        |                            | 3          | %          | $          | 864 |   | 3 | % | $ | 268 |   | 45 | % |
| Other expense           |       | (64                                                  | )          | —                          |       | (66        | )          | — |   | (2 | ) | (3 | ) |
|                    |       |                                                 |       |                            |       |       |       |   |   |   |   |   |   |
| Total other income      |       | $                                                    | 532        |                            | 3          | %          | $          | 798 |   | 3 | % | $ | 266 |   | 50 | % |

 

*OtherIncome.*    The increase in interestincome in the three months ended March 31, 2007 was primarily due to anincrease in cash and cash equivalents available for investment.

*Provision for Income Taxes*
|                            | ** ** | **Three Months Ended March 31,** | ** ** | ** **                      | ** ** | ** ** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|------------|------------|
| ** **                 | ** ** | **2006**                                             | ** ** | **2007**                        | ** ** | **Change** | ** ** |
| ** **                 | ** ** | **Amount**                                           | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | **(in thousands)**                              | ** ** |
| Provision for income taxes |       | $                                                    | 461        |                            | 2          | %          | $          | 552 |   | 2 | % | $ | 91 |   | 20 | % |
|                            |            |                                                      |            |                                 |            |            |            |  |  |  |  |  |  |  |  |  |

 

***Provisionfor Income Taxes.***** Our provision for taxes includes foreign and alternative minimumtax.  We have utilized available U.S. netoperating losses to offset its primary federal obligations resulting in aneffective tax rate of 18% and 14% for the three months ended March 31, 2006 and2007, respectively. We currently expect to realize recorded deferred tax assetsas of March 31, 2007 of approximately $9.9 million. Our conclusion thatsuch assets will be recovered is based upon our expectation that futureearnings will provide sufficient taxable income to realize recorded tax assets.While the realization of our net recorded deferred tax assets cannot beassured, to the extent that future taxable income against which these taxassets may be applied is not sufficient, some or all of our net recordeddeferred tax assets would not be realizable.

28

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**Liquidityand Capital Resources**

Our principalsources of liquidity were cash, cash equivalents and short-term investmentstotaling $69.6 million and $81.8 million at December 31, 2006 andMarch 31, 2007, respectively, and accounts receivable of$29.7 million and $28.6 million, respectively.

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

Net cash providedby operating activities was $14.8 million in the three months ended March31, 2007, which was greater than net income of $3.5 million. Thisdifference is primarily due to $1.5 million of non-cash depreciation andamortization, $1.4 million of non-cash income tax expense, an increase indeferred revenue of $11.4 million, partially offset by decreases in accountspayable of $1.5 million and accrued expenses of $2.0 million.

Net cash used ininvesting activities was $1.9 million during the three months ending March31, 2007, which was primarily due to the purchase of short-term investments of$17.1 million and capital expenditures associated with the expansion ofour hosting facility and purchases of computer equipment to support ourexpanding work force of $3.1 million partially offset by$18.3 million of proceeds from maturities of short-term investments.

Net cash providedby financing activities was $496,000 in the three months ended March 31, 2007,consisting of proceeds from the exercise of stock options.

At December 31,2006 and March 31, 2007, we had a $1.3 million and $500,000, respectively,outstanding letter of credit related to our facility.  The letter of credit reduces the amountavailable under our line of credit with a bank.

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

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

The followingtable of our material contractual obligations as of December 31, 2006summarizes the aggregate effect that these obligations are expected to have onour cash flows in the periods indicated:
| ** **                       | ** ** | **Payments Due by Period**     | ** ** |
|----------------------------------|------------|-----------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **   Total   ** | ** ** | **1 year or        less      ** | ** ** | **      2-3 years      ** | ** ** | **      4-5 years      ** | ** ** | **More  than 5        years      ** | ** ** |
| ** **                       | ** ** | **(in thousands)**                       | ** ** |
| Operating lease  obligations     |       | $                                             | 10,138     |   | $ | 3,474 |   | $ | 4,664 |   | $ | 1,659 |   | $ | 341 |   |
| Income tax  liabilities          |       | 499                                           |       | 499 |   | — |   | — |   | — |   |
| Total                            |       | $                                             | 10,637     |   | $ | 3,973 |   | $ | 4,664 |   | $ | 1,659 |   | $ | 341 |   |

 

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

At December 31,2006, we had $76.1 million of net operating loss carryforwards that may be usedto offset future U.S. federal taxable income of which approximately $18.6million of net operating loss were acquired in the Clinsoft acquisition. Theseattributes may reduce our future cash tax liability.  Approximately $51.1 million of these netoperating losses are subject to a full valuation allowance.  When realization of this deferred tax assetis more likely than not to occur, the benefit will result in a reduction ofincome tax expense of $13.1 million and a reduction to goodwill of $5.9million.   In addition, we hadapproximately $3.3 million of net

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operating lossesresulting from excess tax deductions related to stock-based compensation.  We will realize the benefit of these lossesthrough increases to stockholder’s equity in the periods in which the lossesare utilized to reduce tax payments.  Inaddition, we had approximately $6.2 million of federal research and developmenttax credit carryforwards that may be used to offset future U.S. federal taxableincome of which approximately $2.8 million were acquired in the Clinsoftacquisition and have an unlimited carryforward period.  The net operating loss and tax credit carryforwardperiod extends through 2023 and 2026, respectively, and both are subject toreview and possible adjustment by the taxing authorities.  Also, the Internal Revenue Code containsprovisions that may limit the net operating loss and tax credit carryforwardsavailable in any given year in the event of certain changes in the ownershipinterests of significant stockholders. In addition, we also had $2.8 million of foreign net operating losscarryforwards that may be used to offset future foreign taxable income.  These foreign net operating losscarryforwards have an unlimited carryforward period.  We currently expect to realize recordeddeferred tax assets as of March 31, 2007 of $9.9 million.  Our conclusion that such assets will berecovered is based upon our expectation that our future earnings will providesufficient taxable income to realize recorded tax assets.

We believe ourexisting cash, cash equivalents, short-term investments and cash provided byoperating activities and our debt facility will be sufficient to meet ourworking capital and capital expenditure needs over the next 12 months. Ourfuture capital requirements will depend on many factors, including our rate ofrevenue growth, the expansion of our marketing and sales activities, the timingand extent of spending to support product development efforts, the timing ofintroductions of new products and services and enhancements to existingproducts and services and the continuing market acceptance of our products andservices.  To the extent that existingcash and securities and cash from operations are insufficient to fund ourfuture activities, we may need to raise additional funds through public orprivate equity or debt financing.  Fromtime to time, we may also enter into agreements with respect to potentialinvestments in, or acquisitions of, businesses, services or technologies, whichcould also require us to seek additional equity or debt financing.

**RecentlyIssued Accounting Pronouncements**

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

InFebruary 2007, the FASB released SFAS No. 159, *“The Fair Value Option for Financial Assets and Financial Liabilities”*andis effective for fiscal years beginning after November 15, 2007.  This Statement permits entities to choose tomeasure many financial instruments and certain other items at fair value. Theobjective is to improve financial reporting by providing entities with theopportunity to mitigate volatility in reported earnings caused by measuringrelated assets and liabilities differently without having to apply complexhedge accounting provisions. We are currently analyzing the effect, if any,SFAS No. 159 will have on our consolidated financial position and resultsof operations.

**Off-Balance Sheet Arrangements**

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

**SpecialNote Regarding Forward-Looking Statements**

In addition to historical consolidated financialinformation, this Quarterly Report on Form 10-Q containsforward-looking statements **withinthe meaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities and Exchange Act of 1934, as amended, andare intended to be covered by the “safe harbor” created by those sections. **All statements, otherthan statements of historical facts, included in this Quarterly Report on Form10-Q regarding our strategy, future operations, future financial position,future net sales, projected costs, projected expenses, prospects and plans andobjectives of management are forward-looking statements. The words “anticipates,”“believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,”“would” and similar expressions are intended to identify forward-lookingstatements, although not all forward-looking statements contain theseidentifying words.

We may not actually achieve the plans, intentions orexpectations disclosed in our forward-looking statements and you should notplace undue reliance on our forward-looking statements. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. Although we believe that the expectations underlying any of ourforward-looking statements are reasonable, these expectations may prove to beincorrect, and all of these statements are subject to risks and uncertainties.We discuss many of the risks that we believe could cause actual results orevents to differ materially from these forward-looking statements in greaterdetail in the section entitled “Risk Factors” in **our Annual**Report on**Form10-K for the year ended December 31, 2006. **We urge you to considerthe risks and uncertainties described in Item 1A of our Annual**Reporton**Form 10-K for the year ended

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December31, 2006**in evaluating ourforward-looking statements.**Should one or more of theserisks and uncertainties materialize, or should underlying assumptions,projections or expectations prove incorrect, actual results, performance orfinancial condition may vary materially and adversely from those anticipated,estimated or expected. Our forward-looking statements do not reflect thepotential impact of any future acquisitions, mergers, dispositions, jointventures or investments we may make.

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

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

*ForeignCurrency Exchange Risk*

Our results ofoperations and cash flows are subject to fluctuations due to changes in foreigncurrency exchange rates, particularly changes in the euro, British pound,Australian dollar and Japanese yen. During the three months ended March 31,2006 and 2007, 49% and 50%, respectively, of our revenues were generated inlocations outside the United States. The majority of these revenues aredenominated in currencies other than the U.S. dollar, as are many of theassociated expenses. Except for revenue transactions in Japan, we enter intotransactions directly with substantially all of our foreign customers. Thiscreates a foreign currency exchange risk for us.

As of March 31,2007, we had $7.5 million of receivables denominated in currencies other thanthe U.S. dollar. If the foreign exchange rates fluctuated by 10% as of March31, 2007, our foreign exchange receivable exposure would have fluctuated byapproximately $750,000.  In addition,although our foreign subsidiaries have intercompany accounts that eliminateupon consolidation, such accounts expose us to foreign currency rate movements.Exchange rate fluctuations on short-term intercompany accounts are recorded inour consolidated statements of operations under “other income (expense)”, whileexchange rate fluctuations on long-term intercompany accounts are recorded inour consolidated balance sheets under “accumulated other comprehensive loss” instockholders’ equity. We also maintain cash accounts denominated in currenciesother than the local currency which expose us to foreign exchange ratemovements.

We haveimplemented a risk management program under which we measure foreign currencyexchange risk monthly and manage those exposures through the use of variousinternal controls and the use of forward foreign exchange contracts. Thisprocess is designed to minimize foreign currency translation exposures thatcould otherwise affect consolidated results of operations. As of March 31,2007, we entered into contracts to hedge approximately $2.4 million, ofreceivables, intercompany accounts and cash balances denominated in currenciesother than the U.S. dollar.

*InterestRate Sensitivity*

We hadunrestricted cash, cash equivalents and short term investments totaling $81.8million at March 31, 2007.  Investmentsin securities are invested primarily in high quality securities of a shortduration and are not materially affected by fluctuations in interest rates. Theunrestricted cash and cash equivalents are held for working capital purposes.We do not enter into investments for trading or speculative purposes. Due tothe short-term nature of these investments, we believe that we do not have anymaterial exposure to changes in the fair value of our investment portfolio as aresult of changes in interest rates. Declines in interest rates, however, wouldreduce future investment income.

We have a workingcapital line of credit which bears interest based upon the prime rate. AtDecember 31, 2006 and March 31, 2007, there were no amounts outstandingunder our working capital line of credit. At March 31, 2007, there was $1.5million available under the line of credit and $500,000 reserved under a letterof credit associated with our leased facilities.

**Item4.**                          *Controls and Procedures*

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

As of March 31, 2007, wecarried out an evaluation, under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosure

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controls and procedures,as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in enabling us to record, process,summarize and report information required to be included in our periodic SECfilings within the required time period.

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

**Part II—OtherInformation**

**Item 1.          *Legal Proceedings***

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

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

**CertainFactors Which May Affect Future Results**

*From time to time we update, revise and supplement therisk factors described under the title “Risk Factors” in our Annual Report onForm 10-K for the year ended December 31, 2006. There are no material changes to the risk factors described in the “RiskFactors” section in our Annual Report on Form 10-K for the year endedDecember 31, 2006.*

*We operate in a rapidly changing environment that involves a number ofrisks, some of which are beyond our control.  The risks and uncertaintiesthat we believe are most important for you to consider are described under thetitle “Risk Factors” in our Annual Report on Form 10-K  for the year endedDecember 31, 2006.  Additional risks and uncertainties not presently knownto us, which we currently deem immaterial or which are similar to those facedby other companies in our industry or business in general, may also impair ourbusiness operations.  If any of the foregoing risks or uncertaintiesactually occurs, our business, financial condition and operating results wouldlikely suffer.*

**Item 5.          *Other Information***

Our policygoverning transactions in our securities by directors, officers and employeespermits our officers, directors and certain other persons to enter into tradingplans complying with Rule 10b5-1 under the Securities Exchange Act of1934, as amended. We have been advised that our Vice President, HumanResources, Victor P. Becker; our Chairman and Chief Strategy Officer, Paul A.Bleicher; our Senior Vice president, Steven J. Rosenberg; and our President andChief Executive Officer, Robert K. Weiler****have eachentered into a trading plan covering periods after the date of this QuarterlyReport in accordance with Rule 10b5-1 and our policy governing transactions inour securities.  Generally, under thesetrading plans, the individual relinquishes control over the transactions oncethe trading plan is put into place. Accordingly, sales under these plans may occur at any time, includingpossibly before, simultaneously with, or immediately after significant eventsinvolving our company.

**Weanticipate that, as permitted by Rule 10b5-1 and our policy governingtransactions in our securities, some or all of our officers, directors andemployees may establish trading plans in the future. We intend to disclose thenames of executive officers and directors who establish a trading plan in compliancewith Rule 10b5-1 and the requirements of our policy governing transactionsin our securities in our future quarterly and annual reports on Form 10-Qand 10-K filed with the Securities and Exchange Commission. However, weundertake no obligation to update or revise the information provided herein,including for revision or termination of an established trading plan, otherthan in such quarterly and annual reports.**

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**Item 6.    Exhibits.**
| Exhibit | ** **   | ** **                                                                                                                                                                                                                                                |
|---------|--------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **No.** | ** **   | **Description**                                                                                                                                                                                                                                           |
| 10.1    | +            | Phase Forward 2007 Management Incentive Compensation  Plan (Incorporated by reference herein to Exhibit 10.1 of the Company’s  Current Report on Form 8-K filed with the SEC on March 6, 2007).                                            |
| 10.2    | +            | Phase Forward 2007 Global Sales Executive Incentive  Compensation Plan (Incorporated by reference herein to Exhibit 10.2 of  the Company’s Current Report on Form 8-K filed with the SEC on March 6,  2007).                               |
| 10.3    | +            | Form of Restricted Stock Unit pursuant to Amended  and Restated 2004 Stock Option and Incentive Plan (Incorporated by reference  herein to Exhibit 10.3 of the Company’s Current Report on Form 8-K  filed with the SEC on March 6, 2007). |
| 10.4    | +*           | Amendment No. 1 to the 2004 Stock Option and  Incentive Plan as Amended and Restated March 2006.                                                                                                                                                     |
| 31.1    | *** *** | Certification of CEO pursuant to  Rule 13a-14(a) and 15d-14(a) under the Securities Exchange Act  of 1934.                                                                                                                                 |
| 31.2    |         | Certification of CFO pursuant to  rules 13a-14(a) and 15d-14(a) under the Securities Exchange  Act of 1934.                                                                                                                                |
| 32.1    |         | Certification of CEO pursuant to 18 U.S.C. 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                              |
| 32.2    |         | Certification of CFO pursuant to 18 U.S.C. 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                              |

----

+                    Indicatesa management contract or any compensatory plan, contract or arrangement.

*                    Filedherewith.

33

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**Signatures**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                        | ** ** | ** ** | **PHASE FORWARD INCORPORATED** |
|------------------------|------------|------------|--------------------------------|
| ** **             | ** ** | ** ** | ** **                     |
|                   |       |       | By:                            | /s/ ROBERT K. WEILER |
|                   |       |       |                           | Robert K. Weiler |
|                   |       |       |                           | *Chief Executive Officer* |
|                   |       |       |                           | *(Duly authorized officer)* |
|                   |       | * *   |                           |   |
|                   |       |       | By:                            | /s/ RODGER WEISMANN |
|                   |       |       |                           | Rodger Weismann |
|                   |       |       |                           | *Chief Financial Officer* |
|                   |       |       |                           | *(Duly authorized officer and  principal financial officer)* |
|                   |       | * *   |                           |   |
| Date: May 3, 2007 |       |       |                           |

 

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**EXHIBIT INDEX**
| Exhibit | ** **   | ** **                                                                                                                                                                                                                                                |
|---------|--------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **No.** | ** **   | **Description**                                                                                                                                                                                                                                           |
| 10.1+   |         | Phase Forward 2007 Management Incentive Compensation  Plan (Incorporated by reference herein to Exhibit 10.1 of the Company’s  Current Report on Form 8-K filed with the SEC on March 6, 2007).                                            |
| 10.2+   |         | Phase Forward 2007 Global Sales Executive Incentive  Compensation Plan (Incorporated by reference herein to Exhibit 10.2 of  the Company’s Current Report on Form 8-K filed with the SEC on March 6,  2007).                               |
| 10.3+   |         | Form of Restricted Stock Unit pursuant to Amended  and Restated 2004 Stock Option and Incentive Plan (Incorporated by reference  herein to Exhibit 10.3 of the Company’s Current Report on Form 8-K  filed with the SEC on March 6, 2007). |
| 10.4*+  |         | Amendment No. 1 to the 2004 Stock Option  and Incentive Plan as Amended and Restated March 2006.                                                                                                                                           |
| 31.1    | *** *** | Certification of CEO pursuant to  Rule 13a-14(a) and 15d-14(a) under the Securities Exchange Act  of 1934.                                                                                                                                 |
| 31.2    |         | Certification of CFO pursuant to  rules 13a-14(a) and 15d-14(a) under the Securities Exchange  Act of 1934.                                                                                                                                |
| 32.1    |         | Certification of CEO pursuant to 18 U.S.C. 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                              |
| 32.2    |         | Certification of CFO pursuant to 18 U.S.C. 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                              |

 

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+                    Indicatesa management contract or any compensatory plan, contract or arrangement.

*                    Filedherewith.

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