##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




---

FORM 10-Q

|     |  |                                                                                           
|---- |  | ------------------------------------------------------------------------------------------
|    
|    
|    
|    
|[X]  |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OF
	THE SECURITIES EXCHANGE ACT OF 1934           
|     |  | For the Quarterly Period Ended June 30,
	2001                                             
|    
|    
|    
|    
|[  ] |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
	15(d) OF
	THE SECURITIES EXCHANGE ACT OF 1934
|     |  | For the transition period
	from                to                                         

Commission file number 000-29335



---

WITNESS SYSTEMS, INC.

(Exact name of registrant as specified in its
charter)


|                                                                                       |  |                                     
|-------------------------------------------------------------------------------------- |  | ------------------------------------
|                                                                                      
|                                                                                      
|                                                                                      
|                                                                                      
|Delaware                                                                               |  | 23-2518693                          
|(State or other jurisdiction of incorporation or
	organization)                        |  | (I.R.S. Employer Identification No.)
|                                                                                      
|                                                                                      
|                                                                                      
|                                                                                      
|                                                                                      
|300 Colonial Center Parkway
	Roswell, Georgia(Address of principal executive
	offices) |  | 30076(Zip code)                     

Registrants telephone number, including area code:
770-754-1900



---

Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been
subject to such filing requirements for the past
90 days.  Yes 
x  No 
o

Indicate the number of shares outstanding of each of the
issuers classes of common stock, as of the latest
practicable date.

|                                       |  |                              
|-------------------------------------- |  | -----------------------------
|Class                                  |  | Outstanding at August 3, 2001
|                                       |  |                              
|Common Stock, par value $.01 per share |  | 22,369,186                   









---

TABLE OF CONTENTS



|                             |                                                                                              |                                                      |  |  |  |  |  | 
|---------------------------- | -------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART I FINANCIAL INFORMATION
|                             | Item 1.Financial Statements                                                                 
|                             |                                                                                              | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                             |                                                                                              | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                             |                                                                                              | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                             |                                                                                              | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                             | Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations
|                             | Item 3.Quantitative and Qualitative Disclosures About Market Risk                           
|PART II OTHER INFORMATION   
|                             | Item 4.Submission of Matters to a Vote of Security Holders                                  
|                             | Item 6.Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                  



---



##### Table of Contents



WITNESS SYSTEMS, INC.

FORM 10-Q

INDEX

|           |         |                                                                                                             |                                                                                        |      |   |    | 
|---------- | ------- | ----------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------- | ---- | - | -- | 
|           |         |                                                                                                             |                                                                                        | Page
|           |         |                                                                                                             |                                                                                        |     
|PART I.    |         | FINANCIAL INFORMATION                                                                                       |                                                                                        |      |   |   
|          
|           | Item 1. |                                                                                                             | Financial Statements:                                                                  |      |   |    | 
|          
|          
|          
|          
|          
|           |         | Condensed Consolidated Balance Sheets at
	June 30, 2001 and December 31, 2000                               |                                                                                        |      | 3 |   
|          
|          
|          
|          
|          
|           |         | Condensed Consolidated Statements of
	Operations
	for the three and six months ended June 30, 2001 and 2000 |                                                                                        |      | 4 |   
|          
|          
|          
|          
|          
|           |         | Condensed Consolidated Statements of Cash Flows
	for the six months ended June 30, 2001 and 2000            |                                                                                        |      | 5 |   
|          
|          
|          
|          
|          
|           |         | Notes to the Condensed Consolidated Financial
	Statements                                                   |                                                                                        |      | 6 |   
|          
|          
|          
|          
|          
|           | Item 2. |                                                                                                             | Managements Discussion and Analysis of
	Financial Condition and Results of Operations |      |   | 10 | 
|          
|          
|          
|          
|          
|           | Item 3. |                                                                                                             | Quantitative and Qualitative Disclosures About
	Market Risk                            |      |   | 27 | 
|          
|PART II.   |         | OTHER INFORMATION                                                                                           |                                                                                        |      |   |   
|          
|          
|          
|          
|          
|           | Item 4. |                                                                                                             | Submission of Matters to a Vote of Security
	Holders                                   |      |   | 28 | 
|          
|          
|          
|          
|          
|           | Item 6. |                                                                                                             | Exhibits and Reports on Form 8-K                                                       |      |   | 28 | 
|          
|          
|          
|          
|          
|SIGNATURES |         |                                                                                                             | 29                                                                                     |     

2



---



##### Table of Contents






PART I

FINANCIAL INFORMATION





Item  1.     Financial
Statements

WITNESS SYSTEMS, INC.




CONDENSED CONSOLIDATED BALANCE SHEETS


(in thousands, except share data)


(unaudited)


|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |         |   |        | 
|-------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------- | -------------------------- | ------------ | - | ------ | ------ | ------- | - | ------ | 
|                                 |                                                                                                                                                                             | June 30,                              |                            | December 31,
|                                 |                                                                                                                                                                             | 2001                                  |                            | 2000        
|                                 |                                                                                                                                                                             |                                       |                            |             
|Assets                           |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                
|                                
|                                
|                                
|Current assets:                  |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                
|                                
|                                
|                                
|                                 | Cash and cash equivalents                                                                                                                                                   |                                       | $                          | 42,259       |   |        | $      | 29,590  |  
|                                
|                                
|                                
|                                
|                                 | Short-term investments                                                                                                                                                      |                                       |                            | 14,630       |   |        |        | 34,747  |  
|                                
|                                
|                                
|                                
|                                 | Accounts receivable, net                                                                                                                                                    |                                       |                            | 10,553       |   |        |        | 8,278   |  
|                                
|                                
|                                
|                                
|                                 | Prepaid and other current assets                                                                                                                                            |                                       |                            | 3,314        |   |        |        | 2,775   |  
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                 |                                                                                                                                                                             |                                       | Total current assets       |              |   | 70,756 |        |         |   | 75,390 | 
|                                
|                                
|                                
|                                
|Restricted cash and investments  |                                                                                                                                                                             |                                       | 4,263                      |              |   |        | 3,660  |        
|                                
|                                
|                                
|                                
|Property and equipment, net      |                                                                                                                                                                             |                                       | 5,114                      |              |   |        | 4,907  |        
|                                
|                                
|                                
|                                
|Intangible and other assets, net |                                                                                                                                                                             |                                       | 1,237                      |              |   |        | 2,509  |        
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                 |                                                                                                                                                                             | $                                     | 81,370                     |              |   | $      | 86,466 |        
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                 |                                                                                                                                                                             | Liabilities and Stockholders
	Equity |                            |              |   |        |        |         |   |       
|                                
|                                
|                                
|                                
|Current liabilities:             |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                
|                                
|                                
|                                
|                                 | Accounts payable                                                                                                                                                            |                                       | $                          | 2,745        |   |        | $      | 2,770   |  
|                                
|                                
|                                
|                                
|                                 | Accrued expenses                                                                                                                                                            |                                       |                            | 6,437        |   |        |        | 8,592   |  
|                                
|                                
|                                
|                                
|                                 | Deferred revenue                                                                                                                                                            |                                       |                            | 7,244        |   |        |        | 5,516   |  
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                 |                                                                                                                                                                             |                                       | Total current liabilities  |              |   | 16,426 |        |         |   | 16,878 | 
|                                
|                                
|                                
|                                
|                                 |                                                                                                                                                                             |                                       | Total liabilities          |              |   | 16,426 |        |         |   | 16,878 | 
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|Commitments and contingencies    |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                
|                                
|                                
|                                
|Stockholders equity:            |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                
|                                
|                                
|                                
|                                 | Preferred stock, $0.01 par value; 10,000,0000
	shares authorized, no shares issued or outstanding                                                                           |                                       |                            |             |   |        |        |        |  
|                                
|                                
|                                
|                                
|                                 | Common stock, $.01 par value; 50,000,000 shares
	authorized; 22,334,991 and 21,907,593 shares issued and
	outstanding at June 30, 2001 and December 31, 2000,
	respectively |                                       |                            | 223          |   |        |        | 219     |  
|                                
|                                
|                                
|                                
|                                 | Additional paid-in capital                                                                                                                                                  |                                       |                            | 95,529       |   |        |        | 94,565  |  
|                                
|                                
|                                
|                                
|                                 | Accumulated deficit                                                                                                                                                         |                                       |                            | (28,508      | ) |        |        | (22,805 | )
|                                
|                                
|                                
|                                
|                                 | Notes receivable for stock                                                                                                                                                  |                                       |                            | (2,322       | ) |        |        | (2,413  | )
|                                
|                                
|                                
|                                
|                                 | Accumulated other comprehensive income                                                                                                                                      |                                       |                            | 22           |   |        |        | 22      |  
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                 |                                                                                                                                                                             |                                       | Total stockholders equity |              |   | 64,944 |        |         |   | 69,588 | 
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        
|                                 |                                                                                                                                                                             | $                                     | 81,370                     |              |   | $      | 86,466 |        
|                                 |                                                                                                                                                                             |                                       |                            |              |   |        |        |        

The accompanying notes are an integral part of these condensed
consolidated financial statements.

3



---



##### Table of Contents



WITNESS SYSTEMS, INC.




CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(in thousands, except per share data)


(unaudited)


|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |        |        |        |  
|------------------------------------------------------------------ | ----------------------------------------------------------------- | ------------------------------------------------------------- | -------------------------------------------------------------- | ---------------- | ------ | ------ | ----- | ----- | ------ | ------ | ----- | ------ | ------ | ------ | ----- | ------ | ------ | ------ | -
|                                                                   |                                                                   |                                                               |                                                                |                 
|                                                                   |                                                                   | Three months ended                                            |                                                                | Six months ended
|                                                                   |                                                                   | June 30,                                                      |                                                                | June 30,        
|                                                                   |                                                                   |                                                               |                                                                |                 
|                                                                   |                                                                   | 2001                                                          |                                                                | 2000             |        | 2001   |       | 2000 
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |      
|Revenue:                                                           |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | License                                                           |                                                               | $                                                              | 9,010            |        |        | $     | 6,976 |        |        | $     | 19,769 |        |        | $     | 12,194 |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | Services                                                          |                                                               |                                                                | 5,313            |        |        |       | 3,281 |        |        |       | 9,643  |        |        |       | 5,713  |       
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Total revenue                                                  |                  |        | 14,323 |       |       |        | 10,257 |       |        |        | 29,412 |       |        |        | 17,907 |  
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|Cost of revenue:                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | License                                                           |                                                               |                                                                | 135              |        |        |       | 124   |        |        |       | 319    |        |        |       | 185    |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | Services                                                          |                                                               |                                                                | 2,401            |        |        |       | 1,923 |        |        |       | 4,929  |        |        |       | 3,337  |       
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Total cost of revenue                                          |                  |        | 2,536  |       |       |        | 2,047  |       |        |        | 5,248  |       |        |        | 3,522  |  
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Gross profit                                                   |                  |        | 11,787 |       |       |        | 8,210  |       |        |        | 24,164 |       |        |        | 14,385 |  
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|Operating expenses:                                                |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | Sales and marketing                                               |                                                               |                                                                | 7,302            |        |        |       | 5,726 |        |        |       | 14,389 |        |        |       | 9,954  |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | Research and development                                          |                                                               |                                                                | 3,451            |        |        |       | 2,415 |        |        |       | 7,070  |        |        |       | 4,659  |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | General and administrative                                        |                                                               |                                                                | 2,762            |        |        |       | 2,199 |        |        |       | 5,256  |        |        |       | 3,864  |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | Acquired in-process research and development and
	related charges |                                                               |                                                                | 1,100            |        |        |       |      |        |        |       | 4,823  |        |        |       |       |       
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Operating loss                                                 |                  |        | (2,828 | )     |       |        | (2,130 | )     |        |        | (7,374 | )     |        |        | (4,092 | )
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|Interest and other income, net                                     |                                                                   |                                                               | 747                                                            |                  |        |        | 1,151 |       |        |        | 1,755 |        |        |        | 1,640 |       
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Loss before provision for income taxes and
	extraordinary loss |                  |        | (2,081 | )     |       |        | (979   | )     |        |        | (5,619 | )     |        |        | (2,452 | )
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|Provision for income taxes                                         |                                                                   |                                                               |                                                               |                  |        |        |      |       |        |        | 84    |        |        |        |      |       
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Loss before extraordinary loss                                 |                  |        | (2,081 | )     |       |        | (979   | )     |        |        | (5,703 | )     |        |        | (2,452 | )
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|Extraordinary loss on the early extinguishment of
	debt            |                                                                   |                                                               |                                                               |                  |        |        |      |       |        |        |      |        |        |        | (248  | )     
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Net loss                                                       |                  |        | (2,081 | )     |       |        | (979   | )     |        |        | (5,703 | )     |        |        | (2,700 | )
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|Preferred stock accretion and dividends                            |                                                                   |                                                               |                                                               |                  |        |        |      |       |        |        |      |        |        |        | (611  | )     
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Net loss applicable to common stockholders                     |                  | $      | (2,081 | )     |       | $      | (979   | )     |        | $      | (5,703 | )     |        | $      | (3,311 | )
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|Net loss per share (see Note 3 for pro forma net
	loss per share): |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   | Basic and diluted:                                                |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |        |       
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   |                                                                   | Loss before extraordinary loss                                |                                                                | $                | (0.09  | )      |       | $     | (0.05  | )      |       | $      | (0.26  | )      |       | $      | (0.17  | )     
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                   |                                                                   | Extraordinary loss                                            |                                                                |                  |       |        |       |       |       |        |       |        |       |        |       |        | (0.01  | )     
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   |                                                               | Net loss                                                       |                  | $      | (0.09  | )     |       | $      | (0.05  | )     |        | $      | (0.26  | )     |        | $      | (0.18  | )
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       
|                                                                   |                                                                   | Basic and diluted weighted-average common shares
	outstanding |                                                                |                  | 22,187 |        |       |       | 21,649 |        |       |        | 22,119 |        |       |        | 18,176 |       
|                                                                   |                                                                   |                                                               |                                                                |                  |        |        |       |       |        |        |       |        |        |        |       |       

The accompanying notes are an integral part of these condensed
consolidated financial statements.

4



---



##### Table of Contents



WITNESS SYSTEMS, INC.




CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(in thousands)


(unaudited)


|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |         |       |        |         |  
|------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | ------------------------ | ----------------------------------------------------- | ----- | ------ | ------ | ------- | ----- | ------ | ------- | -
|                                                                                                  |                                                                                                     |                                                                                      
|                                                                                                  |                                                                                                     | Six months ended                                                                     
|                                                                                                  |                                                                                                     | June 30,                                                                             
|                                                                                                  |                                                                                                     |                                                                                      
|                                                                                                  |                                                                                                     | 2001                                                                                  |                          | 2000                                                 
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                      
|Cash flows from operating activities:                                                             |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Loss before extraordinary loss                                                                      |                                                                                       | $                        | (5,703                                                | )     |        | $      | (2,452  | )    
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Adjustments to reconcile loss before
	extraordinary loss to net cash used for operating activities: |                                                                                       |                          |                                                       |       |        |        |         |      
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     | Depreciation and amortization                                                         |                          |                                                       | 1,597 |        |        |         | 388   |       
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     | Other non-cash items                                                                  |                          |                                                       | 551   |        |        |         | 128   |       
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     | Changes in operating assets and liabilities:                                          |                          |                                                       |       |        |        |         |       |       
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     |                                                                                       | Accounts receivable      |                                                       |       | (2,846 | )      |         |       | (2,734 | )      
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     |                                                                                       | Prepaid and other assets |                                                       |       | 430    |        |         |       | (1,009 | )      
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     |                                                                                       | Accounts payable         |                                                       |       | (16    | )      |         |       | 985    |        
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     |                                                                                       | Accrued expenses         |                                                       |       | (2,065 | )      |         |       | (985   | )      
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     |                                                                                       | Deferred revenue         |                                                       |       | 1,732  |        |         |       | (214   | )      
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                  |                                                                                                     |                                                                                       |                          | Net cash used for operating activities                |       |        | (6,320 | )       |       |        | (5,893  | )
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|Cash flows from investing activities:                                                             |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Purchases of property and equipment and other
	assets, net                                          |                                                                                       |                          | (1,629                                                | )     |        |        | (2,233  | )    
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Purchases of investments                                                                            |                                                                                       |                          | (5,500                                                | )     |        |        | (85,176 | )    
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Maturities of investments                                                                           |                                                                                       |                          | 29,450                                                |       |        |        | 30,171  |      
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                  |                                                                                                     |                                                                                       |                          | Net cash provided by (used for) investing
	activities |       |        | 22,321 |         |       |        | (57,238 | )
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|Cash flows from financing activities:                                                             |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Net proceeds from initial public offering                                                           |                                                                                       |                          |                                                      |       |        |        | 73,801  |      
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Proceeds from exercise of stock options                                                             |                                                                                       |                          | 915                                                   |       |        |        | 702     |      
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Repayment of long-term debt                                                                         |                                                                                       |                          |                                                      |       |        |        | (2,862  | )    
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Other                                                                                               |                                                                                       |                          | 16                                                    |       |        |        | (24     | )    
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                  |                                                                                                     |                                                                                       |                          | Net cash provided by financing activities             |       |        | 931    |         |       |        | 71,617  |  
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                  |                                                                                                     |                                                                                       |                          | Net change in cash and cash equivalents               |       |        | 16,932 |         |       |        | 8,486   |  
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|Cash and cash equivalents at beginning of period                                                  |                                                                                                     |                                                                                       | 29,590                   |                                                       |       |        | 2,630  |        
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|Cash and cash equivalents at end of period
	including $5,351 of restricted cash at June 30, 2001. |                                                                                                     | $                                                                                     | 46,522                   |                                                       |       | $      | 11,116 |        
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|Supplemental disclosure of cash flow information:                                                 |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  | Cash paid for interest                                                                              |                                                                                       | $                        |                                                      |       |        | $      | 68      |      
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                  | Cash paid for income taxes                                                                          |                                                                                       | $                        | 155                                                   |       |        | $      |        |      
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                  | Non-cash financing activities:                                                                      |                                                                                       |                          |                                                       |       |        |        |         |      
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     | Series A convertible preferred stock
	exchanged for common stock, including dividends |                          |                                                       |       |        |        | $       | 9,343 |       
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     | Series B convertible preferred stock
	exchanged for common stock                      |                          |                                                       |       |        |        |         | 5,481 |       
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                 
|                                                                                                  |                                                                                                     | Series C convertible preferred stock
	exchanged for common stock                      |                          |                                                       |       |        |        |         | 8,624 |       
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       | $      | 23,448 |        
|                                                                                                  |                                                                                                     |                                                                                       |                          |                                                       |       |        |        |        

The accompanying notes are an integral part of these condensed
consolidated financial statements.

5



---



##### Table of Contents



WITNESS SYSTEMS, INC.




NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


June 30, 2001


(unaudited)


1.  General and basis of presentation

The unaudited interim condensed consolidated financial
statements include the accounts of Witness Systems, Inc. and its
wholly-owned subsidiaries (collectively, the
Company). All material intercompany accounts and
transactions have been eliminated in consolidation.

The Company provides business-driven multimedia recording,
performance analysis and electronic management software that
enables companies to optimize their customer relationships
across multiple communications media and to improve their
customer relationship management. The Company is headquartered
in Roswell, Georgia with other offices in the United States,
Canada, Mexico, the United Kingdom, the Netherlands, Japan and
Australia.

In February 2000, the Company completed its initial public
offering (IPO) in which the Company issued
3.8 million shares at an offering price of $20.00 per
share. Simultaneously, the Companys underwriters exercised
their over-allotment option to issue an additional 570,000
shares (212,269 of which were newly issued and 350,731 of which
were sold by certain stockholders). Net proceeds to the Company
were $74.8 million, after deducting underwriting discounts,
commissions and selling stockholders net proceeds. In
connection with the offering, each outstanding share of the
Companys convertible preferred stock was converted into
1.8 shares of the Companys common stock resulting in
the issuance of 10,409,973 shares of common stock, of which
116,211 shares represented the conversion of certain preferred
stock dividends.

The financial statements herein have been prepared in accordance
with the requirements of Form 10-Q and, therefore, do not
include all information and footnotes required by generally
accepted accounting principles. However, in the opinion of
management, all adjustments (which, except as disclosed
elsewhere herein, consist only of normal recurring accruals)
necessary for a fair presentation of the results of operations
for the relevant periods have been made. Results for the interim
periods are not necessarily indicative of the results to be
expected for the year. These financial statements should be read
in conjunction with the summary of significant accounting
policies and the notes to the consolidated financial statements
included in the Companys Annual Report on Form 10-K
for the fiscal year ended December 31, 2000, filed with the
U.S. Securities and Exchange Commission. Certain
reclassifications have been made to the prior period
presentation to conform to the current period presentation.

2.  Acquired in-process research and development and
related charges

In June 2001, the Company purchased software-based technology
for $1.1 million for research and development activities. The
Company intends to use this technology to develop its on-line
analytical processing and multi-dimensional analysis
capabilities and functionality.

During 2000, the Company entered into an option agreement to
purchase technology for research and development activities. As
of December 31, 2000, the options carrying value was
$650,000 and was classified in intangible and other assets, net
in the accompanying condensed consolidated balance sheet. In
March 2001, the Company paid $2.0 million to exercise this
option. Also, during the first quarter of 2001, the Company
purchased additional technology for research and development
activities. Each of these transactions relate to the development
of electronic-media interaction capture and optimization
technology, and the Company intends to use the components
acquired to develop new products that would further enable
companies to record and monitor their interactions with their
customers.

6



---



##### Table of Contents



WITNESS SYSTEMS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


June 30, 2001


(unaudited)




2.  Acquired in-process research and development and
related charges  (continued)




At the date of the transactions, the results of the acquired
technologies had not progressed to a stage where they met
technological feasibility as defined by Statement of Financial
Accounting Standards (SFAS) No. 86,
Accounting for the Cost of Computer Software to Be Sold,
Leased or Otherwise Marketed. There exists a significant
amount of uncertainty as to the Companys ability to
complete the development projects within a timeframe acceptable
to the market. Additionally, the amount of development required
to enable the acquired technology to integrate with the
Companys primary product is significant, which increases
the uncertainty surrounding its successful development. The
acquired technologies do not have an alternative future use to
the Company. As a result of the above, the Company has recorded
charges in 2001 totaling $4.8 million as acquired in-process
research and development in the accompanying condensed
consolidated statements of operations.

3.  Net loss per share

The Companys historical capital structure in 2000 was not
indicative of its prospective structure due to the automatic
conversion of all shares of convertible preferred stock into
common stock concurrent with the Companys IPO.
Accordingly, a pro forma calculation is presented below,
assuming the weighted effect of the conversion of all
outstanding shares for the six months ended June 30, 2000
of convertible preferred stock into common stock upon the
Companys IPO using the if-converted method from their
respective dates of issuance through February 10, 2000.

|           |                                                         |                                                             |                                             |                  |       |        |   |        |       |        |   |        |       |        |   |        |       |        | 
|---------- | ------------------------------------------------------- | ----------------------------------------------------------- | ------------------------------------------- | ---------------- | ----- | ------ | - | ------ | ----- | ------ | - | ------ | ----- | ------ | - | ------ | ----- | ------ | 
|           |                                                         |                                                             |                                             |                 
|           |                                                         | Three months ended                                          |                                             | Six months ended
|           |                                                         | June 30,                                                    |                                             | June 30,        
|           |                                                         |                                                             |                                             |                 
|           |                                                         | 2001                                                        |                                             | 2000             |       | 2001   |   | 2000  
|           |                                                         |                                                             |                                             |                  |       |        |   |       
|           |                                                         |                                                            
|           |                                                         | (in thousands, except per share amounts)                   
|          
|          
|          
|          
|Pro forma: |                                                         |                                                             |                                             |                  |       |        |   |        |       |        |   |        |       |        |   |       
|          
|          
|          
|          
|           | Loss before extraordinary loss                          |                                                             | $                                           | (2,081           | )     |        | $ | (979   | )     |        | $ | (5,703 | )     |        | $ | (2,452 | )    
|           |                                                         |                                                             |                                             |                  |       |        |   |        |       |        |   |        |       |        |   |       
|           | Historical basic and diluted common shares
	outstanding |                                                             |                                             | 22,187           |       |        |   | 21,649 |       |        |   | 22,119 |       |        |   | 18,176 |      
|          
|          
|          
|          
|           | Adjustments to reflect IPO:                             |                                                             |                                             |                  |       |        |   |        |       |        |   |        |       |        |   |        |      
|          
|          
|          
|          
|           |                                                         | Conversion of Series A preferred stock and
	dividends       |                                             |                  |      |        |   |        |      |        |   |        |      |        |   |        | 1,328 |       
|          
|          
|          
|          
|           |                                                         | Conversion of Series B preferred stock                      |                                             |                  |      |        |   |        |      |        |   |        |      |        |   |        | 479   |       
|          
|          
|          
|          
|           |                                                         | Conversion of Series C preferred stock                      |                                             |                  |      |        |   |        |      |        |   |        |      |        |   |        | 538   |       
|          
|          
|          
|          
|           |                                                         | Vesting of restricted common stock                          |                                             |                  |      |        |   |        |      |        |   |        |      |        |   |        | 124   |       
|           |                                                         |                                                             |                                             |                  |       |        |   |        |       |        |   |        |       |        |   |       
|           |                                                         |                                                             | Pro forma diluted common shares outstanding |                  |       | 22,187 |   |        |       | 21,649 |   |        |       | 22,119 |   |        |       | 20,645 | 
|           |                                                         |                                                             |                                             |                  |       |        |   |        |       |        |   |        |       |        |   |       
|           |                                                         | Pro forma diluted loss per share before
	extraordinary loss |                                             | $                | (0.09 | )      |   | $      | (0.05 | )      |   | $      | (0.26 | )      |   | $      | (0.12 | )     
|           |                                                         |                                                             |                                             |                  |       |        |   |        |       |        |   |        |       |        |   |       

7



---



##### Table of Contents



WITNESS SYSTEMS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


June 30, 2001


(unaudited)




3.  Net loss per share  (continued)


The computation of basic and diluted loss per share before
extraordinary loss for the three and six months ended
June 30, 2001 and 2000 are as follows:

|            |                                                                   |                                          |   |                  |   |      |   |        |   |  |   |        |   |  |   |        |  
|----------- | ----------------------------------------------------------------- | ---------------------------------------- | - | ---------------- | - | ---- | - | ------ | - |  | - | ------ | - |  | - | ------ | -
|            |                                                                   |                                          |   |                 
|            |                                                                   | Three months ended                       |   | Six months ended
|            |                                                                   | June 30,                                 |   | June 30,        
|            |                                                                   |                                          |   |                 
|            |                                                                   | 2001                                     |   | 2000             |   | 2001 |   | 2000  
|            |                                                                   |                                          |   |                  |   |      |   |       
|            |                                                                   |                                         
|            |                                                                   | (in thousands, except per share amounts)
|           
|           
|           
|           
|Historical: |                                                                   |                                          |   |                  |   |      |   |        |   |  |   |        |   |  |   |       
|           
|           
|           
|           
|            | Loss before extraordinary loss                                    |                                          | $ | (2,081           | ) |      | $ | (979   | ) |  | $ | (5,703 | ) |  | $ | (2,452 | )
|           
|           
|           
|           
|            | Preferred stock accretion and dividends                           |                                          |   |                 |   |      |   |       |   |  |   |       |   |  |   | (611   | )
|            |                                                                   |                                          |   |                  |   |      |   |        |   |  |   |        |   |  |   |       
|            | Loss before extraordinary loss applicable to
	common stockholders |                                          | $ | (2,081           | ) |      | $ | (979   | ) |  | $ | (5,703 | ) |  | $ | (3,063 | )
|            |                                                                   |                                          |   |                  |   |      |   |        |   |  |   |        |   |  |   |       
|            | Basic and dilutive common shares outstanding                      |                                          |   | 22,187           |   |      |   | 21,649 |   |  |   | 22,119 |   |  |   | 18,176 |  
|            |                                                                   |                                          |   |                  |   |      |   |        |   |  |   |        |   |  |   |       
|            | Basic and diluted loss per share before
	extraordinary loss       |                                          | $ | (0.09            | ) |      | $ | (0.05  | ) |  | $ | (0.26  | ) |  | $ | (0.17  | )
|            |                                                                   |                                          |   |                  |   |      |   |        |   |  |   |        |   |  |   |       

For the three and six months ended June 30, 2001 and the
three months ended June 30, 2000, the Company has excluded
the weighted-average of all outstanding stock options from the
calculation of historical diluted net loss per common share
because all such securities were anti-dilutive. For the six
months ended June 30, 2000, the Company has excluded the
weighted-average of all convertible preferred stock, warrants
for common and preferred shares, nonvested restricted common
shares, and outstanding stock options from the calculation of
historical diluted net loss per common share because all such
securities were anti-dilutive. The total number of shares
excluded from the calculations of diluted net loss per share was
1,614,368 and 1,691,348 for the three and six months ended
June 30, 2001, respectively, and 2,066,202 and 2,323,011
for the three and six months ended June 30, 2000,
respectively.

4.  Comprehensive loss

The components of total comprehensive loss, net of income tax,
are as follows:

|                                                   |                                             |                    |        |                  |   |      |      |        |   |   |        |        |   |   |        |        |  
|-------------------------------------------------- | ------------------------------------------- | ------------------ | ------ | ---------------- | - | ---- | ---- | ------ | - | - | ------ | ------ | - | - | ------ | ------ | -
|                                                   |                                             |                    |        |                 
|                                                   |                                             | Three months ended |        | Six months ended
|                                                   |                                             | June 30,           |        | June 30,        
|                                                   |                                             |                    |        |                 
|                                                   |                                             | 2001               |        | 2000             |   | 2001 |      | 2000  
|                                                   |                                             |                    |        |                  |   |      |      |       
|                                                   |                                             |                   
|                                                   |                                             | (in thousands)    
|                                                  
|                                                  
|                                                  
|                                                  
|Net loss                                           |                                             | $                  | (2,081 | )                |   | $    | (979 | )      |   | $ | (5,703 | )      |   | $ | (2,700 | )     
|                                                  
|                                                  
|                                                  
|                                                  
|Foreign currency translation adjustment            |                                             |                    | (15    | )                |   |      | (18  | )      |   |   | (67    | )      |   |   | (32    | )     
|                                                  
|                                                  
|                                                  
|                                                  
|Unrealized net holding gain (loss) on
	investments |                                             |                    | (15    | )                |   |      | (42  | )      |   |   | 67     |        |   |   | (43    | )     
|                                                   |                                             |                    |        |                  |   |      |      |        |   |   |        |        |   |   |        |       
|                                                   | Total comprehensive loss, net of income tax |                    | $      | (2,111           | ) |      | $    | (1,039 | ) |   | $      | (5,703 | ) |   | $      | (2,775 | )
|                                                   |                                             |                    |        |                  |   |      |      |        |   |   |        |        |   |   |        |       

8



---



##### Table of Contents



WITNESS SYSTEMS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


June 30, 2001


(unaudited)


5.  Relocation of corporate headquarters and restricted
cash

During the second quarter of 2000, the Company adopted a plan to
relocate its corporate headquarters to a larger facility within
the Atlanta metropolitan area. In accordance with the Emerging
Issues Task Forces abstract No. 94-3, the Company
estimated that costs associated with subletting its then
existing facilities, which are under noncancellable leases
expiring on June 30, 2002, would be approximately $525,000.
The Company recorded this obligation during the second quarter
of 2000. During the second quarter of 2001, one of the
sublessees was unable to fulfill its obligations and the
sublease was terminated. As a result, the Company recorded an
additional obligation of $155,000 in the second quarter of 2001
to cover the additional estimated loss. As of June 30,
2001, the accrual balance was $375,000.

In order to secure the new corporate headquarters facility
and furniture leases, the Company executed three irrevocable
standby letters of credit in the aggregate amount of $4.9
million in 2000 and 2001. During the second quarter of 2001, the
Company replaced its pledged short-term investments, serving as
collateral on the letters of credit, with cash equivalents and,
accordingly, reclassified them as restricted cash on the
June 30, 2001 balance sheet. The letters of credit and
related restricted funds have decreasing schedules expiring in
2002 and 2007, which correspond with their classification on the
accompanying balance sheets. As of June 30, 2001, the
Company had restricted cash of $5.4 million, $1.1 million of
which was included in cash and cash equivalents.

6.  Recent accounting pronouncements

In July 2001, the Financial Accounting Standards Board
(FASB) issued Statements of Financial Accounting
Standards (SFAS) No. 141, Business
Combinations, and SFAS No. 142, Goodwill and Other
Intangible Assets, effective for fiscal years beginning
after December 15, 2001. Under the new rules, the
pooling-of-interests method is no longer permitted, and goodwill
and other intangible assets that have indefinite useful lives
will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statements. Most other
intangible assets will continue to be amortized over their
useful lives. Goodwill and intangibles assets acquired after
June 30, 2001 will be subject to the new rules. The Company
is currently evaluating the impact of the adoption of these
standards and has not yet determined the effect of adoption on
its results of operations and financial position.

In June 1998, the FASB issued SFAS No. 133, Accounting
for Derivative Instruments and Hedging Activities. In June
1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities 
Deferral of the Effective Date of SFAS No. 133, which
defers the effective date of SFAS No. 133 until fiscal
years beginning after June 15, 2000. In June 2000, the FASB
issued SFAS No. 138, Accounting for Certain Derivative
Instruments and Certain Hedging Activities,which amended
the accounting and reporting standards of SFAS No. 133 for
certain derivative instruments and certain hedging activities.
The adoption of SFAS No. 133 did not have an impact on the
Companys results of operations or financial position.

9



---



##### Table of Contents






Item  2.     Managements
Discussion and Analysis of Financial Condition and Results of
Operations


This quarterly report on Form 10-Q, contains
forward-looking statements that are not historical facts but
rather are based on current expectations, estimates and
projections about our business and industry, our beliefs and
assumptions. Words such as anticipates,
expects, intends, plans,
believes, seeks, estimates
and variations of these words and similar expressions are
intended to identify forward-looking statements. These
statements are not guarantees of future performance and are
subject to risks, uncertainties and other factors, some of which
are beyond our control, are difficult to predict and could cause
actual results to differ materially from those expressed or
forecasted in the forward-looking statements. Forward-looking
statements that were true at the time made may ultimately prove
to be incorrect or false. Readers are cautioned not to place
undue reliance on forward-looking statements, which reflect our
managements view only as of the date of this report.
Except as required by law, we undertake no obligation to update
any forward-looking statement, whether as a result of new
information, future events or otherwise.

The following Managements Discussion and Analysis of
Financial Condition and Results of Operations should be read in
conjunction with the Condensed Consolidated Financial Statements
and Notes thereto included elsewhere in this report.

Overview

We are a leading global provider of business-driven multimedia
recording, performance analysis and electronic learning
management software that enables companies to optimize their
customer relationships. By enhancing the quality of customer
interactions across multiple communications media 
including the telephone, e-mail and Web chat  our
browser-based softwares enterprise collaboration
architecture enables companies to capture, communicate and
collaborate customer interactions throughout the enterprise
using advanced business rules, notification and annotations. As
a fully integrated, closed-loop performance optimization
solution, our software enables companies to record, evaluate,
analyze and learn from customer contacts, allowing them to
generate additional revenue opportunities, improve
profitability, develop customer sales/service
representatives skill sets, enhance customer retention and
achieve greater customer loyalty. Our software is designed to
integrate with a variety of third-party software, such as
customer relationship management and enterprise resource
planning applications, and with existing telephony and computer
network hardware and software. The majority of our customers are
companies with one or more contact centers that handle voice and
data customer interactions for outbound sales and marketing
operations, inbound service/support lines, or both. We primarily
utilize a direct sales organization and a variety of strategic
marketing alliances to reach our target customer base.

During the first half of 2001, we observed a number of factors
indicating a slowdown in corporate spending for information
technology and in the general economy. At the beginning of the
year, our sales cycle lengthened as our prospects and
customers confidence in the economy deteriorated. During
the second quarter of 2001, while some of our prospects and
customers renewed their commitments to us, others continued to
reevaluate or delay their capital plans due to their own budget
uncertainties. We cannot predict how long these economy related
trends will continue or the extent to which this economic
uncertainty will continue to impact our prospects and customers.
If the economy in general, or the level of corporate spending
for information technology deteriorates further, we may
experience a material adverse effect on our business, financial
condition and results of operations.

10



---



##### Table of Contents



Sources of Revenue and Revenue Recognition Policy

We derive our revenue from licensing our software and providing
related services. Revenue is allocated to each element of the
arrangement based on their relative fair values, which is
established by the price charged when the respective element is
sold separately. License revenue is recognized when persuasive
evidence of an agreement exists, delivery of the product has
occurred, the fee is fixed or determinable and collectibility is
probable. Services include installation, training and
maintenance. Revenue from installation and training are
recognized upon performance of the related services.
Installation and training services are traditionally offered and
billed as separate elements of contracts on a time-and-material
basis. The functionality of the software is not dependent on
installation and training services. Maintenance is offered as a
separate element and includes the right to unspecified upgrades
on a when-and-if available basis. Maintenance revenue is
deferred and recognized ratably over the term of the related
contract, usually one year. Specified upgrades are not typically
offered to customers. Historically, all customers have purchased
an initial maintenance contract for each newly licensed site.
During 2000 and 1999, 98% of our customers renewed their annual
maintenance contracts.

During the three and six months ended June 30, 2001,
approximately 90% and 91%, respectively, of our revenue was
derived from sales within North America. Our operations outside
of North America include the United Kingdom, the Netherlands,
Mexico, Australia and Japan. During the three and six months
ended June 30, 2000, approximately 93% and 95% of our
revenue was derived from sales within North America. We expect
that a greater proportion of future license and professional
services revenue will be derived from international markets and
may be denominated in the currency of the applicable market.

Our license agreements generally provide that customers pay a
software license fee for one or more software products for a
specified number of users. The amount of the license fee varies
based on which software product is licensed, the number of
software products licensed and the number of users licensed.
Customers can subsequently pay additional license fees to allow
additional users to use previously licensed software products or
to license additional software products. Each software product
contains common components, allowing for easy integration of
additional software products as they are licensed from us.
Customers that license our software products usually receive the
software on compact disc.

Cost of Revenue and Operating Expenses

Cost of license revenue primarily consists of royalties due to
third parties and packaging costs. Cost of services revenue
includes salaries and related expenses for installation,
training and maintenance personnel and allocations of overhead,
facilities, communications and depreciation expenses.

Operating expenses are classified into three general categories:
sales and marketing, research and development and general and
administrative. We had 297 full-time employees at June 30,
2001, up from 275 at December 31, 2000. We classify all
charges to these operating expense categories based on the
nature of the expenditures. We allocate the costs for overhead
to each of the functional areas based on use. These allocated
charges include rent for corporate offices, communication
charges and depreciation and amortization expenses for office
furniture, equipment and leasehold improvements. We anticipate
that operating expenses will increase as we increase sales and
marketing operations, develop new distribution channels, fund
ongoing research and development, broaden professional services
offerings, improve operational and financial systems and support
our growth internationally.

Research and development costs are expensed as incurred. Costs
incurred subsequent to establishing technological feasibility
are capitalized and amortized over their estimated useful lives.
To date, software development costs incurred after technological
feasibility has been established have not been material.

11



---



##### Table of Contents



Results of Operations

The following table sets forth the results of operations for the
three and six months ended June 30, 2001 and 2000 expressed
as a percentage of total revenue.

|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |      |       |   
|------------------------------ | ----------------------------------------------------------------- | -------------------------------------------------------------- | --- | ---------------- | ----- | ---- | ---- | ---- | ----- | -- | --- | ---- | ----- | -- | ---- | ---- | ----- | --
|                               |                                                                   |                                                                |     |                 
|                               |                                                                   | Three months ended                                             |     | Six months ended
|                               |                                                                   | June 30,                                                       |     | June 30,        
|                               |                                                                   |                                                                |     |                 
|                               |                                                                   | 2001                                                           |     | 2000             |       | 2001 |      | 2000
|                               |                                                                   |                                                                |     |                  |       |      |      |     
|Revenue:                       |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                              
|                              
|                              
|                              
|                               | License                                                           |                                                                |     | 62.9             | %     |      |      | 68.0 | %     |    |     | 67.2 | %     |    |      | 68.1 | %    
|                              
|                              
|                              
|                              
|                               | Services                                                          |                                                                |     | 37.1             |       |      |      | 32.0 |       |    |     | 32.8 |       |    |      | 31.9 |      
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                               |                                                                   | Total revenue                                                  |     |                  | 100.0 |      |      |      | 100.0 |    |     |      | 100.0 |    |      |      | 100.0 |   
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|Cost of revenue:               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                              
|                              
|                              
|                              
|                               | License                                                           |                                                                |     | 0.9              |       |      |      | 1.2  |       |    |     | 1.1  |       |    |      | 1.0  |      
|                              
|                              
|                              
|                              
|                               | Services                                                          |                                                                |     | 16.8             |       |      |      | 18.8 |       |    |     | 16.7 |       |    |      | 18.7 |      
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                               |                                                                   | Total cost of revenue                                          |     |                  | 17.7  |      |      |      | 20.0  |    |     |      | 17.8  |    |      |      | 19.7  |   
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                               |                                                                   | Gross profit                                                   |     |                  | 82.3  |      |      |      | 80.0  |    |     |      | 82.2  |    |      |      | 80.3  |   
|                              
|                              
|                              
|                              
|Operating expenses:            |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                              
|                              
|                              
|                              
|                               | Sales and marketing                                               |                                                                |     | 50.9             |       |      |      | 55.8 |       |    |     | 49.0 |       |    |      | 55.6 |      
|                              
|                              
|                              
|                              
|                               | Research and development                                          |                                                                |     | 24.1             |       |      |      | 23.5 |       |    |     | 24.0 |       |    |      | 26.0 |      
|                              
|                              
|                              
|                              
|                               | General and administrative                                        |                                                                |     | 19.3             |       |      |      | 21.4 |       |    |     | 17.9 |       |    |      | 21.6 |      
|                              
|                              
|                              
|                              
|                               | Acquired in-process research and development and
	related charges |                                                                |     | 7.7              |       |      |      |     |       |    |     | 16.4 |       |    |      |     |      
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                               |                                                                   | Operating loss                                                 |     |                  | (19.7 | )    |      |      | (20.7 | )  |     |      | (25.1 | )  |      |      | (22.9 | ) 
|                              
|                              
|                              
|                              
|Interest and other income, net |                                                                   |                                                                | 5.2 |                  |       |      | 11.2 |      |       |    | 6.0 |      |       |    | 9.2  |     
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                               |                                                                   | Loss before provision for income taxes and
	extraordinary loss |     |                  | (14.5 | )    |      |      | (9.5  | )  |     |      | (19.1 | )  |      |      | (13.7 | ) 
|                              
|                              
|                              
|                              
|Provision for income taxes     |                                                                   |                                                                |    |                  |       |      |     |      |       |    | 0.3 |      |       |    |     |     
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                               |                                                                   | Loss before extraordinary loss                                 |     |                  | (14.5 | )    |      |      | (9.5  | )  |     |      | (19.4 | )  |      |      | (13.7 | ) 
|                              
|                              
|                              
|                              
|Extraordinary loss             |                                                                   |                                                                |    |                  |       |      |     |      |       |    |    |      |       |    | (1.4 | )   
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     
|                               |                                                                   | Net loss                                                       |     |                  | (14.5 | )%   |      |      | (9.5  | )% |     |      | (19.4 | )% |      |      | (15.1 | )%
|                               |                                                                   |                                                                |     |                  |       |      |      |      |       |    |     |      |       |    |      |     

Revenue

Total revenue increased 40% to $14.3 million in the second
quarter of 2001 from $10.3 million in the second quarter of
2000. For the six months ended June 30, 2001, total revenue
increased 64% to $29.4 million from $17.9 million in
the same year ago period. These increases were attributable to
the growth in customer sites to 717 at the end of the second
quarter of 2001 from 444 at the end of the second quarter of
2000.

License revenue increased 29% to $9.0 million in the second
quarter of 2001 from $7.0 million in the second quarter of
2000. For the six months ended June 30, 2001, license
revenue increased 62% to $19.8 million from
$12.2 million in the same year ago period. License revenue
as a percentage of total revenue decreased to 62.9% in the
second quarter of 2001 from 68.0% in the second quarter of 2000.
For the six months ended June 30, 2001, license revenue as
a percentage of total revenue decreased to 67.2% from 68.1% in
the same year ago period. The growth in license revenue in
absolute dollars was primarily due to a growing market awareness
of our products, an increased average selling price per site and
an expanded sales force. During the second quarters of 2001 and
2000, license revenue attributable to new customers was 29% and
58%, respectively. For the six months ended June 30, 2001
and 2000, license revenue attributable to new customers was 54%
and 60%, respectively.

12



---



##### Table of Contents



Services revenue, consisting of installation, training and
maintenance services, increased 62% to $5.3 million in the
second quarter of 2001 from $3.3 million in the second quarter
of 2000. For the six months ended June 30, 2001, services
revenue increased 69% to $9.6 million from $5.7 million in the
same year ago period. Services revenue in absolute dollars
increased due to the addition of new customer sites and renewals
of annual maintenance contracts from existing customer sites. As
a percentage of total revenue, services revenue increased to
37.1% for the second quarter of 2001 from 32.0% in the second
quarter of 2000 due primarily to maintenance revenue from new
customer sites and the compounding effect of renewals of annual
maintenance contracts from existing customer sites, and to a
lesser extent, from an increase in the number of installations.
For the six months ended June 30, 2001, services revenue as
a percentage of total revenue increased slightly to 32.8% from
31.9% in the same year ago period.

Cost of Revenue

Total cost of revenue increased 24% to $2.5 million in the
second quarter of 2001 from $2.0 million in the second quarter
of 2000. For the six months ended June 30, 2001, total cost
of revenue increased 49% to $5.2 million from $3.5 million in
the same year ago period. Gross profit margins increased to
82.3% in the second quarter of 2001 from 80.0% in the second
quarter of 2000. For the six months ended June 30, 2001,
gross profit margins increased to 82.2% from 80.3% in the same
year ago period. These increases were driven by improved
services margins that resulted from the increase in maintenance
services revenue. We expect gross profit margins to remain
relatively constant.

Cost of license revenue increased 9% to $135,000 in the second
quarter of 2001 from $124,000 in the second quarter of 2000,
representing 0.9% and 1.2% of total revenue, respectively. For
the six months ended June 30, 2001, cost of license revenue
increased 72% to $319,000 from $185,000 in the same year ago
period, representing 1.1% and 1.0% of total revenue,
respectively. We expect cost of license revenue in absolute
dollars, and as a percentage of total revenue, to increase as a
greater proportion of revenue is originated from products
containing third-party software components.

Cost of services revenue increased 25% to $2.4 million in the
second quarter of 2001 from $1.9 million in the second quarter
of 2000. For the six months ended June 30, 2001, cost of
services revenue increased 48% to $4.9 million from $3.3 million
in the same year ago period. These increases were a result of
increases in the number of employees engaged in installation,
training and customer maintenance services. Cost of services
revenue as a percentage of services revenue decreased to 45.2%
in the second quarter of 2001 from 58.6% in the second quarter
of 2000. For the six months ended June 30, 2001, cost of
services revenue as a percentage of services revenue decreased
to 51.1% from 58.4% in the same year ago period. These decreases
resulted primarily from the increase in maintenance services
revenue. We expect to continue growing our customer services
organization and the related costs as our customer base expands,
and we anticipate that cost of services revenue in absolute
dollars will continue to increase.

Operating Expenses

Sales and Marketing. Sales and marketing expenses
increased 28% to $7.3 million in the second quarter of 2001 from
$5.7 million in the second quarter of 2000. For the six months
ended June 30, 2001, sales and marketing expenses increased
45% to $14.4 million from $10.0 million in the same year ago
period. These increases relate primarily to increases in sales
and marketing personnel, marketing programs and the
establishment of additional sales offices in Europe, Asia
Pacific and Latin America. As a percentage of total revenue,
sales and marketing expenses decreased to 50.9% in the second
quarter of 2001 from 55.8% in the second quarter of 2000. For
the six months ended June 30, 2001, sales and marketing
expenses as a percentage of total revenue decreased to 49.0%
from 55.6% in the same year ago period. We expect sales and
marketing expenses to continue to increase in absolute dollars.

13



---



##### Table of Contents



Research and Development. Research and development
expenses increased 43% to $3.5 million in the second quarter of
2001 from $2.4 million in the second quarter of 2000,
representing 24.1% and 23.5% of total revenue, respectively. For
the six months ended June 30, 2001, research and
development expenses increased 52% to $7.1 million from $4.7
million in the same year ago period, representing 24.0% and
26.0% of total revenue, respectively. These increases were
primarily due to an increase in the number of employees and
consultants engaged in worldwide research and development
activities. We expect research and development expenses to
increase in absolute dollars as we continue to commit
substantial resources to enhance existing product functionality
and to developing new products.

General and Administrative. General and administrative
expenses increased 26% to $2.8 million in the second quarter of
2001 from $2.2 million in the second quarter of 2001. For the
six months ended June 30, 2001, general and administrative
expenses increased 36% to $5.3 million from $3.9 million in the
same year ago period. The quarterly increase was primarily due
to an increase in the allowance for doubtful accounts. The
remaining quarterly and six month increases were due to
increased corporate expenses in the executive, finance and
administrative functions to support a larger organization. As a
percentage of total revenue, general and administrative expenses
decreased to 19.3% in the second quarter of 2001 from 21.4% in
the second quarter of 2000. For the six months ended
June 30, 2001, general and administrative expenses as a
percentage of total revenue decreased to 17.9% from 21.6% in the
same year ago period. We expect general and administrative
expenses to increase in absolute dollars as we continue to add
infrastructure to support a growing organization and continue to
invest in our international expansion.

In-Process Research and Development and Related Charges.
In June 2001, we purchased software-based technology for $1.1
million for research and development activities. We intend to
use this technology to develop our on-line analytical processing
and multi-dimensional analysis capabilities and functionality.

During 2000, we entered into an option agreement to purchase
technology for research and development activities. As of
December 31, 2000, the options carrying value was
$650,000 and was classified in intangible and other assets, net
in the accompanying condensed consolidated balance sheet. In
March 2001, we paid $2.0 million to exercise this option. Also,
during the first quarter of 2001, we purchased additional
technology for research and development activities. Each of
these transactions relate to the development of electronic-media
interaction capture and optimization technology, and we intend
to use the components acquired to develop new products that
would further enable companies to record and monitor their
interactions with their customers.

At the date of the transactions, the results of the acquired
technologies had not progressed to a stage where they met
technological feasibility as defined by Statement of Financial
Accounting Standards (SFAS) No. 86,
Accounting for the Cost of Computer Software to Be Sold,
Leased or Otherwise Marketed. There exists a significant
amount of uncertainty as to our ability to complete the
development projects within a timeframe acceptable to the
market. Additionally, the amount of development required to
enable the acquired technologies to integrate with our primary
product is significant, which increases the uncertainty
surrounding its successful development. The acquired
technologies do not have an alternative future use to us. As a
result of the above, we have recorded charges in 2001 totaling
$4.8 million as acquired in-process research and development
(IPR&D) in the accompanying condensed
consolidated statements of operations.

Interest and Other Income, Net

Interest and other income, net decreased to $747,000 in the
second quarter of 2001 from $1.2 million in the second quarter
of 2000. This decrease was due to lower yields, related to the
recent decline in short-term interest rates in 2001 and the
decrease in our short-term investments. For the six months ended
June 30, 2001, interest and other income, net increased to
$1.8 million from $1.6 million for the same year ago period.
This increase was due to six months of interest earned in 2001
compared to less than five months in 2000 as a result of the
initial public offering (IPO) proceeds received in
February 2000.

14



---



##### Table of Contents



Provision for Income Taxes

For the first quarter of 2001, we recorded a provision for
federal and state income taxes. No provision for federal, state
or foreign income taxes was recorded in the second quarter of
2001 and 2000, respectively, due to net operating losses and
cumulative net operating loss carryforwards. We have recorded a
full valuation allowance against the deferred tax asset
generated as a result of these net operating loss carryforwards,
as the future realization of the tax benefit is not currently
considered more likely than not.

Liquidity and Capital Resources

Net cash used for operating activities was $6.3 million for the
six months ended June 30, 2001 as compared to $5.9 million
in the same year ago period. This increase was due primarily to
the acquisition of in-process research and development and, to a
lesser extent, an increase in working capital.

Net cash provided by investing activities was $22.3 million for
six months ended June 30, 2001 as compared to net cash used
for investing activities of $57.2 million in the same year ago
period. Investing activities consisted of capital expenditures
totaling $1.6 million and $2.2 million for the second quarter of
2001 and 2000, respectively, used to acquire furniture and
equipment and other assets. We expect to have total capital
expenditures, excluding other assets, of approximately $3.5
million in the year 2001. These expenditures include costs
associated with the build-out of the new facility plus computer
costs associated with a growing employee base. We anticipate
that our capital expenditures will increase over the next
several years as we expand our facilities and acquire equipment
to support expansion of our sales and marketing and research and
development activities. Investing activities for the six months
ended June 30, 2001 also included net maturities of
marketable securities of $24.0 million. For the six months ended
June 30, 2000, investing activities included net purchases
of marketable securities of $55.0 million resulting from our
IPO. We intend to use these investments primarily to fund our
sales and marketing and research and development expenses,
operating deficits and other working capital needs and for
general corporate purposes, including the development of our
product lines through acquisitions of products, technologies and
businesses.

Net cash provided by financing activities for the six months
ended June 30, 2001 and 2000 was $931,000 and $71.6 million,
respectively. This decrease was due to the receipt of proceeds
from our IPO in February 2000. We recorded an extraordinary loss
on the early extinguishment of debt of $248,000 during the
second quarter of 2000 due to the write-off of unamortized debt
discount and deferred financing fees and a prepayment penalty.

At June 30, 2001, we had $61.2 million of cash and cash
equivalents, restricted cash and short-term investments and
$54.3 million of working capital. In order to secure the new
corporate headquarters facility and furniture leases, we
executed three irrevocable standby letters of credit in the
aggregate amount of $4.9 million. During the second quarter of
2001, we replaced our pledged short-term investments, serving as
collateral on the letters of credit, with cash equivalents and,
accordingly, reclassified them as restricted cash on the
June 30, 2001 balance sheet. The letters of credit and
related restricted funds have decreasing schedules expiring in
2002 and 2007, which correspond with their classification on the
accompanying balance sheets. Our interest income is sensitive to
changes in the general level of U.S. interest rates,
particularly since the majority of our investments are in
short-term instruments. Due to the nature of our short-term
instruments, we do not have material market risk exposure.

We believe that our existing cash and cash equivalents and
short-term investments, offset by any cash used in operating
activities, will be sufficient to meet our anticipated cash
needs for working capital and capital expenditures for the next
12 months. If cash generated from operations is
insufficient to satisfy our liquidity requirements, we may seek
to sell additional equity or debt securities or establish new
financing arrangements. The sale of additional equity or
convertible debt securities could result in additional dilution
to our stockholders. We cannot assure that any financing
arrangements will be available in sufficient amounts or on
acceptable terms.

15



---



##### Table of Contents



Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board
(FASB) issued Statements of Financial Accounting
Standards (SFAS) No. 141, Business
Combinations, and SFAS No. 142, Goodwill and Other
Intangible Assets, effective for fiscal years beginning
after December 15, 2001. Under the new rules, the
pooling-of-interests method is no longer permitted, and goodwill
and other intangible assets that have indefinite useful lives
will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statements. Most other
intangible assets will continue to be amortized over their
useful lives. Goodwill and intangibles assets acquired after
June 30, 2001 will be subject to the new rules. We are
currently evaluating the impact of the adoption of these
standards and have not yet determined the effect of adoption on
our results of operations and financial position.

In June 1998, the FASB issued SFAS No. 133, Accounting
for Derivative Instruments and Hedging Activities. In June
1999, the FASB issued SFAS No. 137, Accounting for Derivative
Instruments and Hedging Activities  Deferral of the
Effective Date of SFAS No. 133, which defers the
effective date of SFAS No. 133 until fiscal years beginning
after June 15, 2000. In June 2000, the FASB issued SFAS
No. 138, Accounting for Certain Derivative Instruments
and Certain Hedging Activities,which amended the accounting
and reporting standards of SFAS No. 133 for certain
derivative instruments and certain hedging activities. The
adoption of SFAS No. 133 did not have an impact on our
results of operations or financial position.

Factors That May Affect Future Results and Market Price of
Stock

Our future operating results may vary substantially from period
to period. The price of our common stock will fluctuate in the
future, and an investment in our common stock is subject to a
variety of risks, including but not limited to the specific
risks identified below. Inevitably, some investors in our
securities will experience gains while others will experience
losses depending on the prices at which they purchase and sell
securities. Prospective and existing investors are strongly
urged to carefully consider the various cautionary statements
and risks set forth in this report and our other public filings.

Important factors currently known to our management that could
cause actual results to differ materially from those in
forward-looking statements include the disclosures contained in
this report as well as the following risks:



| |                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Although we have achieved net profitability in certain
	quarters, we have not yet achieved profitability from operations
	and we may experience losses in the future

We have incurred substantial losses since our inception and we
may continue to suffer losses in the future. As a result of our
accumulated operating losses, we had an accumulated deficit of
$28.5 million as of June 30, 2001. In addition, we expect
to continue to devote substantial resources to research and
development, professional services and sales and marketing
activities. As a result, we will need to generate significant
revenue to sustain profitability in any future period, and we
may never be able to do so. If we do not achieve profitability
from operations, or if we do not remain profitable on a net
basis, we will need to obtain additional financing. The
financing from other sources upon which we have historically
relied may not be available to us on acceptable terms. If we
fail to remain profitable, it will materially and adversely
affect the market price of our stock.

16



---



##### Table of Contents





| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | We may make acquisitions or investments that are not
	successful and that adversely affect our ongoing operations

We may acquire or make investments in companies, products,
services and technologies which complement our software and
services. Because of the proliferation of new customer
interaction mediums such as the Internet and e-mail, we believe
that it may be important for us to acquire complementary
technology to quickly bring new products to market. We have very
limited experience in making acquisitions and investments. As a
result, our ability to identify prospects, conduct acquisitions
and to properly manage the integration of acquisitions is
unproven. If we fail to properly evaluate and execute
acquisitions or investments, it may seriously harm our business
and operating results. In making or attempting to make
acquisitions or investments, we face a number of risks,
including:



| |   |                                                                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the difficulty of identifying suitable acquisition or investment
	candidates, performing appropriate due diligence, identifying
	potential liabilities and negotiating acceptable terms for
	acquisitions and investments;
| |  | the potential distraction of our management, diversion of our
	resources and disruption of our business;                                                                                                                  
| |  | our retention and motivation of key employees of the acquired
	companies;                                                                                                                                                 
| |  | our entry into geographic markets in which we have little or no
	prior experience;                                                                                                                                        
| |  | competition for acquisition opportunities with competitors that
	are larger than us or have greater financial and other resources
	than we have;                                                                          
| |  | our inability to accurately forecast the financial impact of an
	acquisition or investment;                                                                                                                               
| |  | our inability to maintain good relations with the customers and
	suppliers of the acquired company; and                                                                                                                   
| |  | our inability to effectively integrate acquisition or
	investments into the company and achieve expected synergies.                                                                                                       

In addition, if we make or finance acquisitions using
convertible debt or equity securities with terms different from
our common stock, our existing stockholders may be diluted,
which could cause the market price of our stock to decline.



| |                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our quarterly revenue, expenses and operating results have
	fluctuated and are likely to continue to fluctuate, which may
	cause our stock price to decline

Our quarterly revenue, expenses and operating results could vary
significantly from period to period. In particular, we derive a
significant portion of our software license revenue in each
quarter from a small number of relatively large orders. A delay
in the recognition of revenue from one of these orders may cause
our results of operations during a quarter to be lower than we
expect. The delay or failure to close anticipated sales in a
particular quarter could reduce our revenue in that quarter and
subsequent quarters over which revenue for the sale would likely
be recognized. In addition, because our revenue from
implementation, maintenance and training services largely
correlates with our license revenue, a decline in license
revenue could also cause a decline in our services revenue in
the same quarter or in subsequent quarters. Our revenue,
expenses and operating results may vary significantly in
response to the risk factors described in this section, as well
as the following factors, some of which are beyond our control:



| |   |                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a decrease in demand for our software or, more generally, for
	products that record and analyze the interactions between a
	business and its customers and/or provide electronic learning;
| |  | announcements or introductions of new products and services by
	our competitors;                                                                                                          
| |  | product pricing decisions by our competitors;                                                                                                                                             
| |  | the timely payment of fees due to us by our customers;                                                                                                                                    
| |  | our ability to develop, market and manage new software, software
	enhancements and services;                                                                                              
| |  | the deferral of orders for our software or delays in the
	implementation of our software from one quarter to a later
	quarter;                                                            
| |  | how quickly we are able to develop new software, software
	enhancements and services that our customers require;                                                                          
| |  | how much money we have to spend to improve our software,
	services and operations;                                                                                                        
| |  | delays in installments of our software;                                                                                                                                                   

17



---



##### Table of Contents



| |   |                                                                                                                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the lengthiness and unpredictability of sales cycles for our
	software;                                                                                                                                                                    
| |  | the mix of revenue generated by software licenses and related
	services;                                                                                                                                                                   
| |  | spending limitations imposed on our customers or potential
	customers because of economic factors and decreased capital
	spending budgets, including limitations imposed after the sales
	cycle has begun but before a deal is consummated;
| |  | the timing and size of our capital expenditures and changes in
	our working capital; and                                                                                                                                                   
| |  | general economic factors and changes in technology that could
	cause our existing and potential customers to decrease what they
	spend on customer relationship management software.                                                       

Due to the foregoing factors, we believe that quarter-to-quarter
comparisons of our operating results may not be a good
indication of our future performance, and you should not rely on
them to predict our future performance or the future performance
of our stock price. Historically, our revenue growth has
fluctuated from as low as 1% to as high as 58% from one quarter
to the next. If our future revenue or operating results fall
below the expectations of investors or securities analysts, the
price of our common stock would likely decline.



| |                                                                                                            
| | -----------------------------------------------------------------------------------------------------------
| | Our software has a long sales cycle which makes it difficult
	to plan our expenses and forecast our results

Although it typically takes three to twelve months from the time
we qualify a sales lead until we sign a contract with the
customer, we occasionally experience a longer sales cycle. It is
therefore difficult to predict the quarter in which a particular
sale will occur. If our sales cycle unexpectedly lengthens for
one or more large orders or a significant number of small
orders, it would adversely affect the timing of our revenue and
the timing of our corresponding expenditures. This could harm
our ability to meet our financial forecasts for a given quarter.
Our customers decisions regarding their purchase of our
software and services is relatively long due to several factors,
including:



| |   |                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------
| |  | the complex nature of our software;                                                                                                     
| |  | our need to educate potential customers about the uses and
	benefits of our software;                                                   
| |  | competition for a shrinking amount of corporate resources
	because of a slowing economy;                                                
| |  | the investment of money and other resources required by
	customers to purchase and implement our software;                              
| |  | customers budget cycles and operating activities, which
	affect the timing of their purchases;                                         
| |  | the competitive evaluation and internal approval process many of
	our customers undertake before purchasing our software and
	services; 
| |  | delayed purchases due to announcements or planned introductions
	of new software or software enhancements by us or our
	competitors; and
| |  | the length of time some of our larger customers require to make
	a decision to purchase our software and services.                      



| |                                                                                                               
| | --------------------------------------------------------------------------------------------------------------
| | Seasonal trends in sales of business software or customer
	interaction levels may affect our quarterly revenue

The market for business software has experienced seasonal
fluctuations in demand. The second and third quarters of the
year have been typically characterized by lower levels of
revenue. We believe that these fluctuations are caused in part
by customer buying patterns, which are influenced by year-end
budgetary pressures and by sales force commission structures.
Customer interaction centers typically experience much higher
volumes of customer contact during and immediately following the
year-end holiday season. As a result, many customers may elect
to defer installation of our software during this time. This has
caused us to experience, and we expect to continue to
experience, seasonal fluctuations in our revenue. As our revenue
grows, seasonal fluctuations in our revenue may become more
evident.

18



---



##### Table of Contents





| |                                                                                                     
| | ----------------------------------------------------------------------------------------------------
| | We face intense competition that could adversely affect our
	revenue, profitability and market share

The market for products that record and analyze customer
interactions and/or provide electronic learning is intensely
competitive, evolving and experiences rapid changes in
technology. We believe our principal competitors include, but
are not limited to:



| |   |                                                                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | quality monitoring suppliers to the contact center industry;                                                                                                           
| |  | traditional call-logging vendors;                                                                                                                                      
| |  | systems integrators and consulting firms; and                                                                                                                          
| |  | new, larger and more established entities that may acquire,
	invest in or form joint ventures with providers of recording or
	performance enhancing software solutions.

Many of our current and potential competitors have longer
operating histories, more established business relationships,
larger customer bases, a broader range of products and services,
greater name recognition and substantially greater financial,
technical, marketing, personnel, management, service, support
and other resources than we do. This could allow our current and
potential competitors to respond more quickly than we can to new
or emerging technologies and changes in customer requirements,
take better advantage of acquisitions and other opportunities,
devote greater resources to the marketing and sale of their
products and services and adopt more aggressive pricing
policies. These competitors may distinguish themselves from us
on the basis of their longer operating histories and ability to
withstand difficult economic conditions. Our competitors may
also be able to offer products at lower prices or with other
incentives that we cannot match. Additionally, the scope of our
products and services may be viewed as too narrow because some
of our competitors offer a broader range of products and
services.

In addition, many of our competitors market their products
through resellers and companies that integrate their technology
and products with those of the competitor. These resellers and
technology partners of our competitors often have strong
business relationships with our customers and potential
customers. For example, some of our competitors have a better
and more long standing relationship with telephone switch
vendors. Our competitors may use these business relationships to
market and sell their products and compete for customers with
us. We cannot assure you that our competitors will not offer or
develop products and services that are superior to ours. In
addition, it is possible that resellers or technology partners,
such as certain telephone switch vendors, may acquire one or
more of our competitors, which would further solidify their
business relationships.

In addition, we have developed, and intend to continue to
develop, relationships with companies that resell our software
and companies that provide us with customer referrals or leads,
some of which may become competitors. Revenue from our resellers
accounted for approximately 3% and 8% of our total revenue for
the six months ended June 30, 2001 and for the year ended
December 31, 2000, respectively. We expect revenue from our
resellers, and accordingly our dependence on resellers, to
increase as we establish more relationships with companies to
resell our software worldwide. We engage in joint marketing and
sales efforts with our resellers, and rely on them for
recommendations of our software during the evaluation stage of
the purchase process. When we enter into agreements with these
companies, the agreements are not exclusive and may ordinarily
be terminated by either party. Some of these companies have
similar, and often more established, relationships with our
competitors, and may recommend the products and services of our
competitors to customers instead of our software and services.
In addition, through their relationships with us, these
companies could learn about our software and the market for our
software and services and could develop and sell competing
products and services. As a result, our relationships with these
companies could lead to increased competition for us.

Our software must integrate with software and hardware solutions
provided by a number of our existing and potential competitors.
These competitors or their business partners could alter their
products so that our software no longer integrates well with
them, or they could delay or deny our access to software
releases that allow us to timely adapt our software to integrate
with their products. They could thus effectively prevent us from
modifying our software to keep pace with the changing technology
of their products. If we cannot adapt our software to changes in
our competitors technology, it may significantly impair
our ability to compete

19



---



##### Table of Contents





We expect that competition will increase as other established
and emerging companies enter our market and as new products,
services and technologies are introduced. Increased competition
may result in price reductions, lower gross margins and loss of
our market share. This could materially and adversely affect our
business, financial condition and results of operations.



| |                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we fail to develop new software or improve our existing
	software to meet or adapt to the changing needs and standards of
	our target market, sales of our software and services may
	decline

Our future success depends upon our ability to develop and
introduce new software and software enhancements which meet the
needs of companies seeking to record and analyze their
interactions with customers. To achieve increased market
acceptance of our software and services, we must, among other
things, continue to:



| |   |                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------
| |  | improve our existing software and introduce new software
	solutions;                                                                                
| |  | incorporate new technology into our software and services on a
	timely and cost-effective basis;                                                    
| |  | keep pace with the products and services of our competitors;                                                                                        
| |  | satisfy the changing requirements of our current and potential
	customers;                                                                          
| |  | improve the effectiveness of our software, particularly in
	implementations involving very large databases and large numbers
	of simultaneous users;
| |  | enhance our softwares ease of administration;                                                                                                      
| |  | improve our softwares ability to extract data from
	existing software systems; and                                                                 
| |  | adapt to rapidly changing computer operating system, database
	and software platform standards and Internet technology.                             

In addition, industry standards may not be established, or we
may not be able to conform to new standards in a timely fashion
to remain competitive. Our failure to conform to prevailing
technology standards in our industry could limit our ability to
compete and adversely affect our business.

We may require substantial product development expenditures and
lead-time to keep pace and ensure compatibility with new
technology in our industry. If we fail to develop and introduce
new software and enhancements for our existing software, our
software and services may not achieve market acceptance and we
may be unable to attract new customers. We may also lose
existing customers, to whom we seek to sell additional software
and services. During the year ended December 31, 2000, we
introduced four new eQuality product modules 
eQuality Interactive, Response, Connect, and Now. These new
modules generated less than 5% of our total license revenue
during the six months ended June 30, 2001 and for the year
ended December 31, 2000. The success of these modules is
dependent upon contact centers, adoption of new technologies
that will enable them to interact with their customers via
e-mail and collaborative web-chat sessions and the adoption of
electronic learning applications in the customer contact center.
We cannot predict how quickly, if ever, contact centers will
adopt this new technology. If this does not happen, it could
materially and adversely affect our business, financial
condition, and results of operations.

In March 2001, we acquired technology that relates to the
development of electronic-media interaction capture and
optimization technology. As of June 30, 2001, this
technology had not yet progressed to a stage where it had
reached technological feasibility, and we are currently working
on a project to develop this technology. We cannot assure you
that we will successfully complete this project in a timely
manner. If we are unable to develop this technology in a timely
manner, it may adversely affect our ability to compete and our
ability to attract new customers.



| |                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We believe that our future success also depends upon the
	continued ability of our software to be compatible with the
	products and other technologies offered by other software and
	hardware companies

New products may not be compatible with our software, but may be
compatible with the products of our competitors. For example,
our products must integrate with phone switches made by the
telephone switch

20



---



##### Table of Contents







| |                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------
| | If the market in which we sell our software and services does
	not grow as we anticipate, we will be unable to continue our
	growth

The market for customer relationship management software,
including software that records and analyzes customer
interactions, is still emerging. In addition, we are continuing
to expand our product offering with products such as
eQualityNow. If the market for this software does not grow as
quickly or become as large as we anticipate, we may not be able
to continue our growth or may grow more slowly than expected.
Continued growth in demand for this software remains uncertain
because our potential customers may:



| |   |                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | not understand the benefits of using customer relationship
	management software generally or, more specifically, software
	which records and analyzes the interactions between a business
	and its customers;
| |  | not achieve favorable results using this software;                                                                                                                                                           
| |  | experience technical difficulty in implementing this software; or                                                                                                                                            
| |  | use alternative methods such as online self-help to solve the
	same business problems this software is intended to address.                                                                                  

In addition, our software is designed to address the needs of
contact centers. If the number of contact centers does not
increase as we expect, or if it grows more slowly than we
anticipate, we may not be able to continue our growth or may
grow more slowly than expected.



| |                                                                                   
| | ----------------------------------------------------------------------------------
| | We rely heavily on sales of our eQuality Balance and eQuality
	Evaluation software

Our financial performance has depended, and will continue to
depend, on our ability to develop and maintain market acceptance
of our eQuality Balance software and new and enhanced versions
of it. Historically, nearly all of our license revenue has been
derived from the sale of our eQuality Balance and eQuality
Evaluation software, and we expect revenue from these two
products to continue to account for most of our revenue for the
foreseeable future. Through June 30, 2001, we have
recognized less than 5% of our revenue from products other than
eQuality Balance and eQuality Evaluation. As a result, factors
which adversely affect the pricing or demand for our eQuality
Balance and eQuality Evaluation software, such as competitive
pressures, technological change or evolution in customer
preferences, could materially and adversely affect our business,
financial condition and results of operations. Many of these
factors are beyond our control and difficult to predict.



| |                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our internal professional services employees do not
	provide installation services effectively and according to
	schedule, our customers may not use our implementation services
	or may stop using our software

Customers that license our products ordinarily purchase
installation, training and maintenance services, which they
typically obtain from our internal professional services
organization. Because our software must be installed to work
with a number of computer and telephone network systems,
installation of our software can be difficult. These systems
vary greatly from one customer site to another, and the versions
and integration requirements of these third-party systems change
frequently. We believe that the speed and quality of
installation services are competitive factors in our industry.
If our installation services are not satisfactory to our
customers, the customers may choose to not use our
implementation services to install software they license from
us. In addition, these customers may determine that they will
not license our software and instead will use the products and
services of one of our competitors. If this happens, we would
lose licensing and services revenue from these customers, and it
would likely harm our reputation in the industry in which we
compete. This could materially and adversely affect our
business, financial condition and results of operations.

21



---



##### Table of Contents





| |                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------
| | If we need additional financing to maintain or expand our
	business, it may not be available on favorable terms, or at
	all

Although we believe our current cash and borrowing capacity will
be sufficient to meet our anticipated cash needs for working
capital and capital expenditures for at least the next
12 months, we may need additional funds to expand or meet
all of our operating needs. If we need additional financing, we
cannot be certain that it will be available to us on favorable
terms, or at all. If we raise additional funds by issuing equity
securities, the ownership interest of our stockholders would be
significantly diluted, and any additional equity securities we
issue may have rights, preferences or privileges senior to the
rights of our stockholders.Also, the terms of any
additional financing we obtain may significantly limit our
future financing and operating activities. If we need funds and
cannot raise them on acceptable terms, we may be forced to sell
assets or seek to refinance our outstanding obligations. We may
also be unable to:



| |   |                                                                         
| | - | ------------------------------------------------------------------------
| |  | develop and enhance our software to remain competitive;                 
| |  | take advantage of future opportunities, such as acquisitions;           
| |  | respond to changing customer needs and our competitors
	innovations; or
| |  | attract and retain qualified key personnel.                             

Any of these events could significantly harm our business and
financial condition and limit our growth.



| |                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we do not continue to expand the distribution of our
	products through direct and indirect sales channels, we may be
	unable to expand our market share or increase our revenue

To expand our market share and revenue, attract new customers
and increase sales to existing customers, we will need to expand
our direct and indirect channels of distribution. Although we
have historically received approximately 92% of our revenue from
direct sales through December 31, 2000, we will require an
increase in our direct sales to achieve our growth plans. To
accomplish this, we will need to expand our direct sales force
by hiring additional sales personnel and management, and
increase the number of relationships we have with companies that
provide us with customer referrals or leads for new business.
Historically, it has taken us up to six months to train new
sales personnel before they reach an acceptable level of
productivity. We have also experienced difficulty in finding new
sales personnel with experience in computer and telephone
integration technologies. We cannot assure you that we will be
able to continue to find an adequate number of new sales
personnel meeting our specific needs. If the personnel we hire
are less qualified, it may take us more time to train them and
they may take a longer time to reach an acceptable level of
productivity. We cannot assure you that we will be able to hire
the necessary sales personnel and management on reasonable
terms, or at all. Moreover, we will be required to train any new
personnel, and the new personnel may not reach full productivity
for a long period of time.

We also intend to derive revenue from our indirect sales channel
through relationships with companies that resell our software.
In particular, we intend to use resellers to increase our sales
internationally and to market our software to small and medium
contact centers.

Through December 31, 2000, we have entered into agreements
with only a small number of companies that resell our software
and companies that provide us with customer referrals. For the
six months ended June 30, 2001 and for the year ended
December 31, 2000, approximately 2% and 8%, respectively,
of our revenue was generated through these resellers. When we
enter into agreements with these companies, they are not
exclusive and may ordinarily be terminated by either party. Some
of these companies have similar, and often more established,
relationships with our competitors, and may recommend the
products and services of our competitors to customers instead of
our software and services. Maintaining reseller relationships in
todays rapidly evolving marketplace has proven to be
difficult. For example, during the year ended December 31,
1998, we incurred a $900,000 charge to terminate a distributor
agreement that we believed had become counterproductive. We
cannot assure you that we will be able to maintain productive
relationships or that we will be able to establish similar
relationships with additional companies on a timely basis, or at
all. In addition, we cannot be certain that these distribution
partners will devote adequate resources to selling our software
and services. If we are unable to maintain and expand our direct
sales force and indirect distribution channels, we will not be
able to increase our revenue and our business will suffer.

22



---



##### Table of Contents





| |                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------
| | We expect to face difficulty in attracting and retaining key
	personnel, which are necessary to effectively manage and expand
	our business

Our future success will depend in large part on our ability to
hire, train, retain and motivate a sufficient number of
qualified personnel, particularly in sales, marketing, research
and development, service and support. In particular, competition
for research and development personnel with computer and
telephone integration skills is intense, and turnover of
technical personnel is particularly high in our industry. We
expect to face additional difficulties retaining personnel who
have stock options with exercise prices above the fair market
value of our stock. In order to retain some of our personnel, we
will need to grant additional options to purchase common stock
to these employees with exercise prices equal to the fair market
value of our stock, which will cause dilution to our
stockholders. If we are unable to attract and retain qualified
personnel or if we experience high personnel turnover, it would
increase our costs of operations and could prevent us from
effectively managing and expanding our business.

Our future success also depends upon the continued service of
our executive officers, particularly our Chairman and Chief
Executive Officer, David Gould. We have an employment agreement
with Mr. Gould and non-compete agreements with all of our
executive officers. However, any of our executive officers and
other employees could terminate his or her relationship with us
at any time. The loss of the services of our executive officers
or other key personnel could materially and adversely affect our
business. In addition, if one or more of our executive officers
or key employees were to join one of our competitors or
otherwise compete with us, it could harm our business.



| |                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------
| | Our failure to properly manage our rapid growth could strain
	our resources and make it difficult to support our future
	operations

Our business could suffer if we fail to effectively manage our
growth. Our revenue increased approximately 64% and 91% during
the six months ended June 30, 2001 and the year ended
December 31, 2000, respectively, from the previous year.
Although we expect revenue to grow on an annual basis, we do not
expect to maintain this same rate of revenue growth year over
year. From December 31, 2000 to June 30, 2001, the
number of our employees increased from approximately 275 to 297.
This growth in our revenue and number of employees has placed,
and will continue to place, a significant strain on our
management, personnel, systems, controls and other resources. If
we are unable to effectively manage our growth, it may be
difficult to support our future operations. To manage growth
effectively, we must:



| |   |                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------
| |  | accurately predict the growth in demand for our software and
	expand our capacity and implementation services to meet that
	demand;
| |  | expand and improve our operating and financial systems,
	procedures and controls;                                                  
| |  | attract, train, motivate, manage and retain key personnel;                                                                         
| |  | expand our facilities;                                                                                                             
| |  | successfully integrate the operations and personnel of any
	businesses we acquire; and                                             
| |  | respond quickly and effectively to unanticipated changes in our
	industry.                                                         

If we fail to expand and manage our
international operations, we may be unable to reach or maintain
our desired levels of revenue or profitability

Revenue from customers located outside of North America
accounted for approximately 9% and 6% of our total revenue for
the six months ended June 30, 2001 and for the year ended
December 31, 2000, respectively. We intend to continue to
expand our international operations through internal business
expansion and strategic business relationships. Our operations
outside of North America at June 30, 2001 consisted of
33 dedicated employees located in the United Kingdom, the
Netherlands, Mexico, Australia and Japan. Most of our
international revenue through June 30, 2001 has come from
international branches of our customers based in North America.
We have established relationships with a small number of
international resellers but, through June 30, 2001, we have
not recognized a material amount of revenue from these
relationships. In addition to general risks associated with
international expansion, such as foreign currency fluctuations
and

23



---



##### Table of Contents







| |   |                                                                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | limited development of an international market for our software
	and services;                                                                         
| |  | the challenges we face in expanding and training our
	international sales force and support operations;                                                
| |  | expenses associated with customizing products for multiple
	countries;                                                                                 
| |  | longer payment cycles, different accounting procedures and
	difficulties in collecting accounts receivable; and                                        
| |  | multiple, conflicting and changing governmental laws and
	regulations governing intellectual property, call monitoring and
	the recording of employees.

As we further expand our operations outside the United States,
we will face new competitors and competitive environments. In
addition to the risks associated with our domestic competitors,
foreign competitors may pose an even greater risk, as they may
possess a better understanding of their local markets and better
working relationships with local infrastructure providers and
others. In particular, because telephone protocols and standards
are unique to each country, local competitors will have more
experience with, and may have a competitive advantage in, these
markets. We may not be able to obtain similar levels of local
knowledge or similar relationships in foreign markets, which
could place us at a significant competitive disadvantage.



| |                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our failure to protect our intellectual property may lead to
	third parties using our technology for their own benefit and our
	failure to access third-party technology could delay the
	development or sale of our software

Our success depends to a significant degree upon the legal
protection of our software and other proprietary technology
rights. We rely on a combination of patent, trade secret,
copyright and trademark laws and confidentiality and
non-disclosure agreements with employees and third parties to
establish and protect our proprietary rights. These measures may
not be sufficient to protect our proprietary rights, and we
cannot be certain that third parties will not misappropriate our
technology and use it for their own benefit. Also, most of these
protections do not preclude our competitors from independently
developing products with functionality or features substantially
equivalent or superior to our software. Any failure to protect
our intellectual property could have a material adverse effect
on our business.

As of June 30, 2001, we have four U.S. registered
trademarks, one patent generally relating to our voice and data
synchronization technology and data capture technique and seven
pending copyright registrations protecting our software source
code. We cannot assure you that we will file further patent,
trademark or copyright applications, that any future
applications will be approved, that any existing or future
patents, trademarks or copyrights will adequately protect our
intellectual property or that any existing or future patents,
trademarks or copyrights will not be challenged by third
parties. Furthermore, one or more of our existing or future
patents, trademarks or copyrights may be found to be invalid or
unenforceable.

We are aware of certain uses, U.S. trademark registrations, and
U.S. trademark applications for the trademark
eQuality and its variations that predate our use of,
and U.S. trademark application for, our trademark eQuality. It
is possible that the U.S. Patent and Trademark Office will deny
our U.S. trademark application. In addition, it is possible that
the owner of legal rights resulting from one or more of these
prior uses, U.S. trademark registrations, or U.S. trademark
applications will bring legal action to prevent us from
registering and/or using the trademark eQuality, and may also
seek compensation for damages resulting from our use of this
trademark. As a result, we cannot assure you that our efforts to
use and register this trademark will ultimately be successful,
or that this use will not result in liability for trademark
infringement, trademark dilution, and/or unfair competition.

We are also currently evaluating whether to revise one aspect of
the patent for our synchronization techniques. If we are
unsuccessful, we may not be able to enforce any aspect of that
patent against third parties who infringe it. We also have two
patent applications pending in the U.S. Patent and Trademark
Office. There is no guarantee that our pending applications will
result in issued patents or, if issued, that they will provide
us with any competitive advantages.

24



---



##### Table of Contents



Moreover, the laws of other countries in which we market our
products may afford little or no effective protection of our
proprietary technology. If we resort to litigation to enforce
our intellectual property rights, the proceedings could be
burdensome and expensive, would likely divert valuable
management and product development resources and could involve a
high degree of risk, regardless of whether we win or lose the
litigation.

We rely on technology licensed from third parties, including
databases, application programming interfaces, developmental
tools and software necessary to integrate our software with
third-party technology and products. In addition, third-party
products are bundled with our software. If we lose access to
this technology, or if it is not available to us on reasonable
terms, it could cause delays in our development and introduction
of new and enhanced software until we can obtain equivalent or
replacement technology, if available, or develop this technology
internally, if feasible. If we lost access to technology that is
bundled with our software, this would require us to modify or
redesign our software and could cause a delay in our ability to
market and sell our current software, or a delay in our ability
to develop, market and sell new or enhanced software. This delay
or a failure to obtain replacement technology could have a
material adverse effect on our business, financial condition and
results of operations.



| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Claims by other companies that our software infringes their
	intellectual property could require us to incur substantial
	expenses or prevent us from selling our software or services

If any of our software violates the intellectual property rights
of others, we may be required to reengineer or redevelop our
software, seek to obtain licenses from third parties to continue
offering our software without substantial reengineering, or
conduct studies of such intellectual property rights so as to
evaluate whether such intellectual property rights are valid or
enforceable. Any efforts to reengineer our software or obtain
licenses from third parties may not be successful, could be
extremely costly and would likely divert valuable management and
product development resources. Any efforts to study the
intellectual property rights of third parties may not be
successful and could reveal that such intellectual property
rights are valid and enforceable, could be extremely costly and
would likely divert valuable management and product development
resources.

In addition, in the rapidly developing technological environment
in which we operate, third parties may have filed a number of
patent applications, many of which are confidential when filed.
If our software is found to violate these patents when they are
issued or any other intellectual property of others, we may
become subject to claims for infringement. An infringement claim
against us could result in the loss of our proprietary rights
and, whether meritorious or not, could be time-consuming, result
in costly litigation or require us to pay damages or enter into
royalty or licensing agreements on terms that are unfavorable to
us. Royalty or licensing agreements might not be available to us
on reasonable terms or at all. In addition, our customers may
become subject to claims if the software they license from us
infringes the intellectual property of others. Our license
agreements with our customers generally provide that we will
indemnify the customers for liability they incur as a result of
these infringement claims. As a result, any infringement claim
could materially and adversely affect our business, financial
condition and results of operations.

Approximately three years prior to December 31, 2000, we
were accused of infringing a patent owned by a third-party. We
undertook to study the matter, concluded that the asserted
patent was not infringed, and informed the third-party of our
belief that the patent was not infringed. Following an exchange
of correspondence between September 1996 and January 1998,
nothing further was heard from the patent owner.

Although we have not exchanged correspondence with this
third-party since January 1998, we cannot assure you that a
renewed claim of infringement by this third-party, either in
connection with the patent referred to above or another patent
or other intellectual property, or a claim of infringement by a
different patent or other intellectual property owner, will not
be asserted against us in the future. Furthermore, we expect
that we and other participants in our industry and related
industries will be increasingly subject to infringement claims
as the number of competitors with patent and other intellectual
property portfolios in these industries grows. Although patent
and intellectual property disputes may be settled through
licensing or similar arrangements, costs associated with these
arrangements may be substantial and we cannot assure you that
necessary licenses or similar arrangements will be made
available to us on a reasonable basis or at all.

25



---



##### Table of Contents





In addition, if we decide to, or are forced to, litigate any of
these claims, the litigation could be expensive and
time-consuming, could divert our managements attention
from other matters, and could otherwise materially and adversely
affect our business, financial condition and results of
operations, regardless of the outcome of the litigation.
Litigation and intellectual property claims against us could
also disrupt our sale of software. Additionally, it could lead
to claims by third parties against our customers and others
using our software. Our customers and these other users of our
software would likely hold us responsible for these claims and
any resulting harm they suffer.



| |                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Government regulation of telephone and Internet monitoring
	could cause a decline in the use of our software, result in
	increased expenses for us or subject us and our customers to
	liability

As the telecommunications industry continues to evolve, state,
federal and foreign governments may increasingly regulate the
monitoring of telecommunications and telephone and Internet
monitoring and recording products, such as our software. We
believe that increases in regulation could come in the form of a
number of different kinds of laws, including privacy and
employment regulations. The adoption of new laws governing the
use of our software or changes made to existing laws could cause
a decline in the use of our software and could result in
increased expenses for us, particularly if we are required to
modify our software to accommodate these new or changing laws.
Moreover, new laws or changes to existing laws could subject us
and our customers to liability. In addition, whether or not
these laws are adopted, if we do not adequately address the
privacy concerns of consumers, companies may be hesitant to use
our software. If any of these events occur, it could materially
and adversely affect our business.



| |                                                                                                          
| | ---------------------------------------------------------------------------------------------------------
| | Our products may fail to perform properly, which may cause us
	to incur additional expenses or lose sales

Our software is used in a complex operating environment that
requires its integration with computer and telephone networks
and other business software applications. Furthermore, the
hardware, software and network systems generally used in
conjunction with our software, particularly telephone standards
and protocols, change rapidly. The evolution of these standards
may cause our products to function slowly or improperly. Poor
product performance may necessitate redevelopment of our product
or other costly reengineering measures which may divert our
management and product development resources and funds. Due to
the large number of, and variations in, computer and telephone
network systems and applications, as well as the rapid changes
in these products, our testing process may be unable to
duplicate all possible environments in which our software is
expected to perform. Any errors or defects that are discovered
after we release new or enhanced software could cause us to lose
revenue, cause a delay in the market acceptance of our software,
damage our customer relationships and reputation and increase
our service and warranty costs.



| |                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our management and affiliates control a large percentage of
	our voting stock and could exert significant influence over
	matters requiring stockholder approval

At March 1, 2001, our executive officers and directors and
their affiliates together control approximately 41% of our
outstanding common stock on that date. As a result, these
stockholders, if they act together, will be able to exert
significant control over all matters requiring stockholder
approval, including the election of our directors and the
approval of significant corporate transactions. This control may
have the effect of delaying, preventing or deterring a change in
control of Witness Systems and could deprive our stockholders of
an opportunity to receive a premium for their common stock as
part of any sale or acquisition.



| |                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Future sales of common stock and the rights of some of our
	stockholders to register sales of their stock could adversely
	affect the market price of our stock

Sales of a substantial number of shares of our common stock can
cause the market price of our common stock to decline or can
make it more difficult for us to raise funds through the sale of
equity in the future. The

26



---



##### Table of Contents





Some of our existing stockholders have the right to require us
to register under the Securities Act shares of their common
stock at any time. Once we register these shares, they can be
freely sold in the public market, subject to these lock-up
agreements.

Our stock price has been volatile

The market price of our common stock could be subject to
significant fluctuations in response to variations in quarterly
operating results and other factors. In addition, the securities
markets have experienced significant price and volume
fluctuations from time to time that have often been unrelated or
disproportionate to the operating performance of particular
companies. Any announcement with respect to any adverse variance
in revenue or earnings from levels generally expected by
securities analysts or investors for a given period could have
an immediate and significant adverse effect on the trading price
of our common stock. In addition, factors such as announcements
of technological innovations or new products by us, our
competitors or third parties, changing conditions in the market
for products that record and analyze customer interactions,
changes in estimates by securities analysts, announcements of
extraordinary events, such as acquisitions or litigation, or
general economic conditions may have an adverse effect on the
market price of the common stock.



| |                                                                                                              
| | -------------------------------------------------------------------------------------------------------------
| | Our certificate of incorporation and bylaws, as well as
	Delaware law, may prevent or delay a future takeover

Our amended and restated certificate of incorporation and bylaws
contain provisions which could make it harder for a third-party
to acquire us without consent of our board of directors. For
example, if a potential acquirer were to make a hostile bid for
us, the acquirer would not be able to call a special meeting of
stockholders to remove our board of directors or act by written
consent without a meeting. In addition, our board of directors
has staggered terms which makes it difficult to remove all our
directors at once. The acquirer would also be required to
provide advance notice of its proposal to remove directors at an
annual meeting.

Our board of directors has the ability to issue preferred stock
which would significantly dilute the ownership of a hostile
acquirer. In addition, Delaware law limits business combination
transactions with 15% stockholders that have not been approved
by the board of directors. These provisions and other similar
provisions make it more difficult for a third-party to acquire
us without negotiation.




Item  3.     Quantitative and
Qualitative Disclosures About Market Risk

Our interest income is sensitive to changes in the general level
of U.S. interest rates, particularly since the majority of our
investments are in short-term instruments. Due to the nature of
our short-term instruments, we do not have material market risk
exposure.

The majority of our operations are based in the United States
and, accordingly, the majority of our transactions are
denominated in U.S. dollars. However, we do have foreign-based
operations where transactions are denominated in foreign
currencies and are subject to market risk with respect to
fluctuations in the relative value of currencies. Currently, we
have operations in Canada, the United Kingdom, the Netherlands,
Australia, Mexico and Japan and conduct transactions in the
local currency of each location. To date, the impact of
fluctuations in the relative value of other currencies has not
been material.

27



---



##### Table of Contents






PART II

OTHER INFORMATION





Item  4.     Submission of
Matters to a Vote of Security Holders

The Companys Annual Meeting of Stockholders (the
Annual Meeting) was held on May 29, 2001. The
matters voted on at the Annual Meeting were as follows:



| |                                                                                                      
| | -----------------------------------------------------------------------------------------------------
| | (1)  The Election of Director 
	 The nomination of Peter Sinisgalli was approved as indicated
	below:

|         |  |  |            | 
|-------- |  |  | ---------- | 
|        
|        
|        
|        
|For      |  |  | 17,507,845 | 
|        
|        
|        
|        
|Withhold |  |  | 491,529    | 



| |                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------
| | (2)  The approval of the amendment and restatement of the
	Companys Certificate of Incorporation as indicated below:

|        |  |  |            | 
|------- |  |  | ---------- | 
|       
|       
|       
|       
|For     |  |  | 14,554,552 | 
|       
|       
|       
|       
|Against |  |  | 1,004,149  | 
|       
|       
|       
|       
|Abstain |  |  | 88,280     | 



| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | (3)  The approval of an amendment to the Companys
	Amended and Restated Stock Incentive Plan as indicated below:

|        |  |  |            | 
|------- |  |  | ---------- | 
|       
|       
|       
|       
|For     |  |  | 12,668,043 | 
|       
|       
|       
|       
|Against |  |  | 2,889,477  | 
|       
|       
|       
|       
|Abstain |  |  | 89,461     | 



| |                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------
| | (4)  Ratification of the appointment of KPMG LLP as
	independent public accountants for year ending December 31,
	2001 as follows:

|        |  |  |            | 
|------- |  |  | ---------- | 
|       
|       
|       
|       
|For     |  |  | 17,908,193 | 
|       
|       
|       
|       
|Against |  |  | 3,140      | 
|       
|       
|       
|       
|Abstain |  |  | 88,041     | 




Item  6.     Exhibits and
Reports on Form 8-K

(a)  Exhibits

(b)  Reports on Form 8-K

There were no reports on Form 8-K filed during the second
quarter of 2001.

28



---



##### Table of Contents






SIGNATURES

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

|                       |  |                                                                                                     
|---------------------- |  | ----------------------------------------------------------------------------------------------------
|Dated: August 10, 2001 |  | WITNESS SYSTEMS, INC.                                                                               
|                      
|                       |  | By: /s/ DAVID B. GOULD DAVID B. GOULD
	CHAIRMAN OF THE BOARD,
	PRESIDENT AND CHIEF EXECUTIVE OFFICER
|                      
|                       |  | By: /s/ JON W. EZRINE JON W. EZRINE
	CHIEF FINANCIAL OFFICER AND
	ASSISTANT SECRETARY               

29