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SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-Q

|ý | QUARTERLY REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2002
|- | ---------------------------------------------------------------------------------------------------------------------------

|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from
 to
|- | --------------------------------------------------------------------------------------------------------------------------

Commission file number 000-29335

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WITNESS SYSTEMS, INC.(Exact Name of Registrant as Specified in its Charter)

Delaware(State or Other Jurisdiction of Incorporation or Organization)

23-2518693(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 code770-754-1900

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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 ý    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 May 3, 2002Common Stock, par value $.01 per share

22,704,914


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WITNESS SYSTEMS, INC.    FORM 10-Q    INDEX

|           |         |                                                                                                    |                                                                                       | Page
|---------- | ------- | -------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | ----
|PART I.    |         | FINANCIAL INFORMATION                                                                              |                                                                                       |     
|           | Item 1. |                                                                                                    | Financial Statements:                                                                 |     
|           |         | Condensed Consolidated Balance Sheets at
March 31, 2002 and December 31, 2001                      |                                                                                       | 3   
|           |         | Condensed Consolidated Statements of Operations
for the three months ended March 31, 2002 and 2001 |                                                                                       | 4   
|           |         | Condensed Consolidated Statements of Cash Flows
for the three months ended March 31, 2002 and 2001 |                                                                                       | 5   
|           |         | Notes to the Condensed Consolidated Financial Statements                                           |                                                                                       | 6   
|           | 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 1. |                                                                                                    | Legal Proceedings                                                                     |     
|           | Item 6. |                                                                                                    | Exhibits and Reports on Form 8-K                                                      |     
|SIGNATURES |         | 32                                                                                                

2

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PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements

WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)

|                                                                                                                                                                                  |  | March 31,
2002 |         | December 31,
2001 |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------- | ----------------- | -
|Assets                                                                                                                                                                            |  |                |         |                   |  
|Current assets:                                                                                                                                                                   |  |                |         |                   |  
|Cash and cash equivalents                                                                                                                                                         |  | $              | 25,345  |                   | $
|Restricted cash                                                                                                                                                                   |  |                | 1,105   |                   |  
|Short term investments                                                                                                                                                            |  |                | 31,372  |                   |  
|Accounts receivable, net of allowance for doubtful accounts of
    $1,435 at March 31, 2002 and $1,454 at December 31, 2001                                                       |  |                | 13,166  |                   |  
|Prepaid and other current assets                                                                                                                                                  |  |                | 3,252   |                   |  
|                                                                                                                                                                                  |  |                |         |                   |  
|Total current assets                                                                                                                                                              |  |                | 74,240  |                   |  
|Restricted cash and investments                                                                                                                                                   |  |                | 4,123   |                   |  
|Property and equipment, net                                                                                                                                                       |  |                | 6,033   |                   |  
|Intangible and other assets, net                                                                                                                                                  |  |                | 653     |                   |  
|                                                                                                                                                                                  |  |                |         |                   |  
|                                                                                                                                                                                  |  | $              | 85,049  |                   | $
|                                                                                                                                                                                  |  |                |         |                   |  
|Liabilities and Stockholders' Equity                                                                                                                                              |  |                |         |                   |  
|Current liabilities:                                                                                                                                                              |  |                |         |                   |  
|Accounts payable                                                                                                                                                                  |  | $              | 2,093   |                   | $
|Accrued expenses                                                                                                                                                                  |  |                | 6,708   |                   |  
|Deferred revenue                                                                                                                                                                  |  |                | 8,950   |                   |  
|                                                                                                                                                                                  |  |                |         |                   |  
|Total current liabilities                                                                                                                                                         |  |                | 17,751  |                   |  
|Total liabilities                                                                                                                                                                 |  |                | 17,751  |                   |  
|                                                                                                                                                                                  |  |                |         |                   |  
|Commitments and contingencies                                                                                                                                                     |  |                |         |                   |  
|Stockholders' equity:                                                                                                                                                             |  |                |         |                   |  
|Preferred stock, $.01 par value; 10,000,0000 shares authorized, no
    shares issued or outstanding                                                                               |  |                |        |                   |  
|Common stock, $.01 par value; 50,000,000 shares authorized;
    22,616,091 and 22,479,360 shares issued and outstanding at
    March 31, 2002 and December 31, 2001, respectively |  |                | 226     |                   |  
|Additional paid-in capital                                                                                                                                                        |  |                | 96,125  |                   |  
|Accumulated deficit                                                                                                                                                               |  |                | (27,158 | )                 |  
|Notes receivable for stock                                                                                                                                                        |  |                | (1,470  | )                 |  
|Accumulated other comprehensive loss                                                                                                                                              |  |                | (425    | )                 |  
|                                                                                                                                                                                  |  |                |         |                   |  
|Total stockholders' equity                                                                                                                                                        |  |                | 67,298  |                   |  
|                                                                                                                                                                                  |  |                |         |                   |  
|                                                                                                                                                                                  |  | $              | 85,049  |                   | $
|                                                                                                                                                                                  |  |                |         |                   |  

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

3

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

|                                                                 |  | Three months ended
March 31, |       
|---------------------------------------------------------------- |  | ---------------------------- | ------
|
|Revenue:                                                         |  |                              |       
|License                                                          |  | $                            | 10,732
|Services                                                         |  |                              | 7,492 
|                                                                 |  |                              |       
|Total revenue                                                    |  |                              | 18,224
|                                                                 |  |                              |       
|Cost of revenue:                                                 |  |                              |       
|License                                                          |  |                              | 154   
|Services                                                         |  |                              | 2,812 
|                                                                 |  |                              |       
|Total cost of revenue                                            |  |                              | 2,966 
|                                                                 |  |                              |       
|Gross profit                                                     |  |                              | 15,258
|Operating expenses:                                              |  |                              |       
|Sales and marketing                                              |  |                              | 8,283 
|Research and development                                         |  |                              | 3,773 
|General and administrative                                       |  |                              | 2,681 
|Acquired in-process research and development and related charges |  |                              |      
|                                                                 |  |                              |       
|Operating income (loss)                                          |  |                              | 521   
|Interest and other income, net                                   |  |                              | 380   
|                                                                 |  |                              |       
|Income (loss) before provision for income taxes                  |  |                              | 901   
|Provision for income taxes                                       |  |                              | 74    
|                                                                 |  |                              |       
|Net income (loss)                                                |  | $                            | 827   
|                                                                 |  |                              |       
|Net income (loss) per share:                                     |  |                              |       
|Basic                                                            |  | $                            | 0.04  
|                                                                 |  |                              |       
|Diluted                                                          |  | $                            | 0.03  
|                                                                 |  |                              |       
|Weighted-average common shares outstanding:                      |  |                              |       
|Basic                                                            |  |                              | 22,572
|                                                                 |  |                              |       
|Diluted                                                          |  |                              | 24,358
|                                                                 |  |                              |       

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

4

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

|                                                                                                        |  | Three months ended
March 31, |        
|------------------------------------------------------------------------------------------------------- |  | ---------------------------- | -------
|
|Cash flows from operating activities:                                                                   |  |                              |        
|Net income (loss)                                                                                       |  | $                            | 827    
|Adjustments to reconcile net income (loss) to net cash provided by
    (used for) operating activities: |  |                              |        
|Depreciation and amortization                                                                           |  |                              | 972    
|Other non-cash items                                                                                    |  |                              | 30     
|Changes in operating assets and liabilities:                                                            |  |                              |        
|Accounts receivable                                                                                     |  |                              | 832    
|Prepaid and other assets                                                                                |  |                              | 306    
|Accounts payable                                                                                        |  |                              | (1,248 
|Accrued expenses                                                                                        |  |                              | (544   
|Deferred revenue                                                                                        |  |                              | 511    
|                                                                                                        |  |                              |        
|Net cash provided by (used for) operating activities                                                    |  |                              | 1,686  
|                                                                                                        |  |                              |        
|Cash flows from investing activities:                                                                   |  |                              |        
|Purchases of property and equipment and other assets, net                                               |  |                              | (1,041 
|Purchases of investments                                                                                |  |                              | (14,563
|Maturities of investments                                                                               |  |                              | 15,350 
|Allocation from restricted cash                                                                         |  |                              | 30     
|                                                                                                        |  |                              |        
|Net cash (used for) provided by investing activities                                                    |  |                              | (224   
|                                                                                                        |  |                              |        
|Cash flows from financing activities:                                                                   |  |                              |        
|Proceeds from exercise of stock options                                                                 |  |                              | 717    
|Other                                                                                                   |  |                              | (43    
|                                                                                                        |  |                              |        
|Net cash provided by financing activities                                                               |  |                              | 674    
|                                                                                                        |  |                              |        
|Net change in cash and cash equivalents                                                                 |  |                              | 2,136  
|Cash and cash equivalents at beginning of period                                                        |  |                              | 23,209 
|                                                                                                        |  |                              |        
|Cash and cash equivalents at end of period                                                              |  | $                            | 25,345 
|                                                                                                        |  |                              |        
|Supplemental disclosure of cash flow information:                                                       |  |                              |        
|Cash paid for income taxes                                                                              |  | $                            | 1      
|                                                                                                        |  |                              |        

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

5

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WITNESS SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2002
(unaudited)

1. General and Basis of Presentation

Witness Systems, Inc. and subsidiaries (the "Company") provides customer interaction recording, performance analysis and electronic learning 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, Brazil, the United Kingdom, the Netherlands, Germany, Japan and Australia. The Company was originally incorporated in 1988 in
Georgia and was reincorporated in Delaware on March 13, 1997.

The
unaudited interim condensed consolidated financial statements include the accounts of Witness Systems, Inc. and its wholly-owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform with the current year presentation.

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 in the United States. 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, 2001, filed with the U.S.
Securities and Exchange Commission.

2. Significant Accounting Policies

Revenue Recognition and Deferred Revenue.The Company recognizes revenue in accordance with Statement of Position ("SOP")
97-2,Software Revenue Recognition, and SOP 98-9,Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions. Revenue is derived from licensing software and providing related services including maintenance. 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.

Revenue
from license fees is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable and collection is
probable. Services revenue includes installation, training, consulting, maintenance and reimbursable out-of-pocket expenses. Revenue from installation, training and consulting
services are recognized upon performance of the related services and are offered and billed as separate elements of contracts. Reimbursable out-of-pocket expenses revenue is
recognized upon incurrence of the related expenses. 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, which is generally billed in advance, is deferred and recognized ratably over the term
of the related contract. Specified upgrades are not typically offered to customers.

6

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3. Net Income (Loss) Per Share

The following table presents the computation of basic and diluted net income (loss) per share for the three months ended March 31, 2002 and 2001:

Three months ended
March 31,2002

2001(in thousands, except per share amounts)Net income (loss)

$
827

$
(3,622
)Average shares of common stock outstanding:Basic


22,572


22,052Effect of stock options


1,786


Diluted common shares outstanding


24,358


22,052Net income (loss) per share:Basic

$
0.04

$
(0.16
)Diluted

$
0.03

$
(0.16
)


For
the three months ended March 31, 2001, the Company has excluded the weighted-average of all outstanding stock options from the calculation of diluted net loss per common share
because all such securities were anti-dilutive. The total number of shares excluded from the calculation of diluted net loss per share for the three months ended March 31, 2001 was
1,768,328.

4. Notes Receivable from Stock Sales

In 1999, the Company issued 879,763 shares of restricted common stock to the CEO of the Company in exchange for a note receivable of $1.5 million. Also in
1999, the CEO was granted and exercised options to acquire 112,230 shares of the Company's common stock in exchange for a note receivable of $334,000. Under the terms of such arrangements, the
underlying restricted stock was fully vested and the maturity dates of the notes were February 2002 as a result of the Company's initial public offering ("IPO") in February 2000. During
the first quarter of 2002, the Company refinanced the $1.8 million notes in part with a full recourse note for approximately $1.5 million and the remaining balance was satisfied by
delivering, at current fair market value, mature shares of common stock to the Company, which were retired immediately. The $1.5 million note receivable has floating monthly interest of 325
basis points over the Federal Funds Rate and is payable in three equal payments of principal and interest due annually through February 2005.

In
1999, the Company issued 269,195 shares of common stock, from treasury shares to certain officers and directors of the Company in exchange for individual notes receivable aggregating
$800,000 which were due in February 2002 as a result of the Company's IPO. Certain officers paid their notes in full prior to maturity totaling $273,000. During the first quarter of 2002, the
remaining notes totaling $527,000 were satisfied by delivering, at current fair market value, mature shares of the Company's common stock to the Company, which were retired immediately.

7

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5. Acquired In-process Research and Development and Related Charges

During 2000, the Company entered into an option agreement to purchase in-process research and development ("IPR&D") technology which had a carrying
value of $650,000. In March 2001, the Company paid $2.0 million to exercise this option to purchase the underlying technology. Also, during the first quarter of 2001, the Company
purchased additional IPR&D technology for $1.1 million relating to similar development projects. At the time of the purchases, the Company estimated that it would take up to a year to complete
these development projects and estimated that it would incur at least an additional $3 million to complete these projects. These projects were successfully completed by the end of 2001.

At
the date of the aforementioned transactions, the acquired IPR&D technologies had not progressed to a stage where they met technological feasibility as defined by SFAS No. 86.
At the time of each transaction, the Company estimated the stage of completion of the project and the time and resources required to complete the project by creating a product design plan and
evaluating the progress of the acquired technology towards this plan. A significant amount of uncertainty existed as to the Company's ability to complete the development projects within a timeframe
acceptable to the market, and failure to do so would have caused the Company's competitive position in the market to erode. Additionally, the amount of development required to enable the acquired
technology to integrate with the Company's primary product was estimated to be significant, which increased the uncertainty surrounding its successful development. The acquired technologies did not
have alternative future uses. As a result of the above, the Company recorded charges totaling $3.7 million as acquired IPR&D in the accompanying 2001 condensed consolidated statement of
operations.

6. Comprehensive Income (Loss)

The following table presents the components of total comprehensive income (loss), net of income tax, and accumulated other comprehensive loss:

Three months ended
March 31,2002

2001(in thousands)Net income (loss)

$
827

$
(3,622
)Other comprehensive (loss) income, net of income tax:Foreign currency translation adjustments


(38
)

(52
)Unrealized net holding (loss) gain on investments


(299
)

82Total comprehensive income (loss), net of income tax

$
490

$
(3,592
)


March 31,

December 31,2002

2001(in thousands)Accumulated other comprehensive loss:Cumulative foreign currency translation adjustments

$
(167
)
$
(129
)Unrealized net holding (loss) gain on investments


(258
)

41Total accumulated other comprehensive loss, net of income tax

$
(425
)
$
(88
)


8

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7. Relocation of Corporate Headquarters and Restricted Cash

During 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 the net costs associated with 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 2001, two of the sublessees were unable to fulfill their
obligations and the subleases were terminated. As a result, the Company recorded an additional obligation of $155,000 in 2001 for the additional estimated loss. As of March 31, 2002, the
remaining accrual balance was $157,000.

The
Company provided three irrevocable standby letters of credit in the aggregate amount of $4.9 million to secure the new corporate headquarters facility and furniture leases.
The Company pledged cash and short-term investments of $5.4 million as collateral on the letters of credit. The letters of credit and related restricted funds have decreasing
schedules that ultimately expire in 2002 and 2007, which correspond with their classification on the accompanying condensed consolidated balance sheets.

8. Geographic Information

The Company's revenue derived from customers outside North America, which includes the United States and Canada, was $2.4 million and $1.2 million
in the first quarter of 2002 and 2001, respectively. International revenue was derived from customers in Europe, Latin America and Asia Pacific.

9. Recent Accounting Pronouncements

In November 2001, the Financial Accounting Standards Board ("FASB") issued Topic D-103,Income Statement
Characterization of Reimbursements Received for Out of Pocket Expenses Incurred. Topic D-103 requires companies to characterize reimbursements received for
out-of-pocket expenses incurred as revenue in the statement of operations. The Company has historically recorded reimbursements as a reduction of services cost of revenue.
Effective January 1, 2002, the Company adopted the policies outlined in Topic D-103 and reclassified $126,000 of reimbursed out-of-pocket expenses to
services revenue and cost of services revenue leaving gross profit unchanged for the three months ended March 31, 2001. Gross profit margin decreased to 81% from 82% for the three months ended
March 31, 2001 after the effect of Topic D-103.

In
October 2001, the FASB issued SFAS No. 144,Accounting for the Impairment or Disposal of Long-lived Assets,
which supersedes SFAS No. 121,Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of,and APB Opinion No. 30,Reporting the Results of Operations  Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 amends accounting and reporting standards for the disposal of segments of a
business and addresses various issues related to the accounting for impairments or disposals of long-lived assets. This SFAS is effective for fiscal years beginning after
December 15, 2001. The adoption of this SFAS did not have a material impact on the Company's results of operations or financial position.

9

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In
August 2001, the FASB issued SFAS No. 143,Accounting for Asset Retirement Obligations, which addresses financial
accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This SFAS is effective for fiscal years
beginning after June 15, 2002. The Company does not anticipate that the adoption of this SFAS will have a material impact on its results of operations or financial position.

In
July 2001, the FASB issued 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 intangible assets acquired
after June 30, 2001 are subject to the new rules. The adoption of this SFAS did not have a material impact on the Company's results of operations or financial position.

10. Subsequent Event

In April 2002, the Company secured a $7.5 million revolving line of credit from a bank which matures on April 2, 2003. All borrowings under
the line of credit bear interest at the bank's prime rate, which was 4.75% on April 3, 2002. The revolving line of credit is secured by all assets of the Company and requires compliance with
various covenants, including liquidity ratios and tangible net worth requirements, among others. Borrowings under the revolving line of credit are limited to 80% of eligible accounts receivable, as
defined by the agreement. To date, the Company has not borrowed any funds under the line of credit.

10

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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, and 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 customer interaction recording, performance analysis and electronic learning management software that enables companies to
optimize their customer relationships. By using our browser-based architecture to capture samples of customer interactions taking place in the contact center, and then sharing them with other
departments via e-mail and Web links, organizations can enhance the quality of customer interactions across multiple communications media  including the telephone,
e-mail and the Internet. 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 applications, 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.

During
the first quarter of 2002, many of our prospects and customers extended their software purchasing processes, making it more difficult to predict when a particular sale will occur.
As a result of this decreased visibility into the length of our sales cycle, we expect that our second quarter 2002 revenue will be less than our revenue for the first quarter of 2002. We cannot
predict how long any economy related trends will continue or the extent to which this economic uncertainty will continue to impact our prospects and customers. A deterioration in the economy, a
reduction in the level of corporate spending for information technology or other matters may cause us to experience a material adverse effect on our business, financial condition and results of
operations.

Sources of Revenue and Revenue Recognition Policy

We derive our revenue from licensing our software and providing related services. We primarily utilize a direct sales organization, select resellers and a variety
of strategic marketing alliances to reach our target customer base. Although, historically, more than 90% of our license revenue has been derived from our direct sales force, we expect a greater
proportion of future license revenue will be derived from resellers in 2002.

11

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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 collection is probable. Services revenue
includes installation, training, consulting, maintenance and reimbursable out-of-pocket expenses revenue. Revenue from installation, training and consulting services are
recognized upon performance of the related services. Reimbursable out-of-pocket expenses revenue is recognized upon incurrence of the related expenses.

Services
are traditionally offered and billed as separate elements of contracts on either a time-and-material basis or a fixed service fee plus
out-of-pocket expense reimbursement basis. The functionality of the software is not dependent on these services. Maintenance is offered as a separate element and includes the
right to unspecified upgrades on an if-and-when available basis. Maintenance revenue, which is generally billed annually in advance, is deferred and recognized ratably over the
term of the related contract. Specified upgrades are not typically offered to customers. Historically, all customers have purchased an initial maintenance contract for each newly licensed site. During
the first quarter of 2002, 99% of active customer installation sites renewed their annual maintenance contracts.

During
the first quarter of 2002 and 2001, approximately 88% and 92%, respectively, of revenue was derived from customers within North America, including the U.S. and Canada. We expect
that a
greater proportion of future 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 product is licensed, the number of software products licensed, the number of installation sites 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 for installation, training, consulting
and maintenance services includes personnel costs and related expenses and allocations of facilities, communications and depreciation expense. Personnel costs include salaries, benefits, stock-based
compensation and out-of-pocket expenses. We classify all charges to the operating expense categories based on the nature of the expenditures. We allocate the costs for
facilities, communications and depreciation to each of the functional areas based on use. These allocated charges include rent for corporate offices and furniture, communication charges and
depreciation and amortization expenses for office equipment and leasehold improvements.

Operating
expenses are classified into three general categories: sales and marketing, research and development and general and administrative. Sales and marketing expenses consist
primarily of personnel costs, sales commissions, promotional expenses, public relations, and tradeshows, as well as allocations of facilities, communications and depreciation expense. Research and
development expenses consist primarily of personnel costs to support product development, as well as allocations of facilities, communications and depreciation expense. 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. General and administrative expense consists primarily of personnel costs for accounting, information technology,
human resources, legal and facilities, as well as provisions for allowance for doubtful accounts and allocations of facilities, communications and depreciation expense.

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We
had 358 full-time employees at March 31, 2002, up from 327 at December 31, 2001 and 305 at March 31, 2001. We anticipate that operating expenses will
increase over time 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.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect our
reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those
related to revenue recognition, allowance for doubtful accounts, property and equipment, intangible assets, research and development and software development costs and provision for income taxes. We
base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of
assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Factors
that could affect our future operating results and cause actual results to vary materially from expectations include, but are not limited to, lower than anticipated growth from
existing customers, an inability to attract new customers and grow internationally, an inability to grow through acquisitions or successfully integrate acquisitions, technology changes, or a decline
in the financial stability of our customers. Negative developments in these or other risk factors could have a material adverse effect on our financial position and results of operations. A summary of
our critical accounting policies follows.

Revenue Recognition.Our revenue recognition policy is significant because our revenues are a key component of our results of
operations. We follow very specific and detailed guidelines, discussed above, in measuring revenues; however, certain judgments affect the application of our revenue policy. Further, assessment of
collectibility is particularly critical in determining whether or not revenues should be recognized in the current market environment. We also record provisions for estimated sales allowances on
product and service related revenues in the same period as the related revenues are recorded. These estimates are based on historical sales allowances, analysis of credit memo data and other known
factors. If the historical data we use to calculate these estimates does not properly reflect future credits, revenues could be overstated.

Allowance for Doubtful Accounts.We perform ongoing evaluations of our customers and continuously monitor collections and
payments and maintain a provision for allowance for doubtful accounts for estimated losses based on a percentage of our accounts receivable, our historical experience and any specific customer
collection issues that we have identified. While such credit losses have historically been within our expectations and appropriate reserves have been established, we cannot guarantee that we will
continue to experience the same credit loss rates that we have experienced in the past. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to
make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination was made.

Impairment of Long-lived Assets and Intangible Assets.We evaluate the recoverability of property and equipment
and intangible assets by comparing the carrying amount of the asset against the estimated undiscounted cash flows associated with it. Should the sum of the expected future cash flows be less than the
carrying value of the asset being evaluated, we use the fair value in determining the amount of impairment loss that should be recorded. The determination of undiscounted net operating cash flows
requires management to make estimates.

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Research and Development and Software Development Costs.We evaluate the establishment of technological feasibility of our
products in accordance with Statement of Financial Accounting Standards ("SFAS") No. 86,Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise
Marketed. We sell products in a market that is subject to rapid technological change, new product development and changing customer needs; accordingly, we have concluded that
technological feasibility is not established until the completion of a working model. To date, software development costs incurred after technological feasibility has been established have not been
material. Therefore, we have charged all such costs to research and development in the period incurred.

Allowance for Deferred Tax Assets.We record a valuation allowance to reduce our deferred tax assets to an amount that is
more likely than not to be realized. While we have considered future taxable income in assessing the need for the valuation allowance, in the event we were to determine that we would be able to
realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would be made, increasing income in the period in which such determination
was made.

Results of Operations

The following table sets forth the results of operations for the three months ended March 31, 2002 and 2001 expressed as a percentage of total revenue.

Three months ended
March 31,2002

2001Revenue:License

59
%
71
%Services

41

29Total revenue

100

100Cost of revenue:License

1

1Services

15

18Total cost of revenue

16

19Gross profit

84

81Operating expenses:Sales and marketing

45

47Research and development

21

24General and administrative

15

16Acquired in-process research and development and related
    charges



24Operating income (loss)

3

(30
)Interest and other income, net

2

7Income (loss) before provision for income taxes

5

(23
)Provision for income taxes



1Net income (loss)

5
%
(24
)%


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Revenue

Total revenue increased 20% to $18.2 million in the first quarter of 2002 from $15.2 million in the first quarter of 2001. This increase was
primarily attributable to the growth in maintenance services revenue as a result of the number of customer sites, which grew to 970 sites at the end of the first quarter of 2002 from 641 sites at the
end of the first quarter of 2001 and, to a lesser extent, the growth in installation and training services.

License
revenue remained relatively constant at $10.7 million in the first quarter of 2002 from $10.8 million in the first quarter of 2001, representing 59% and 71% of
total revenue. The decrease of license revenue as a percentage of total revenue was a result of increased services revenue, as discussed below. During the first quarter of 2002 and 2001, 43% and 74%
of license revenue was attributable to new customers, respectively. The percentage decrease in revenue attributable to new customers was partially due to a longer sales cycle for new customers in the
first quarter of 2002 compared to the first quarter of 2001 and also demonstrates the strength of repeat orders we consistently receive from our existing customers.

Services
revenue, consisting of installation, training, consulting and maintenance services revenue, as well as reimbursable out-of-pocket expense revenue,
increased 68% to $7.5 million in the first quarter of 2002 from $4.5 million in the first quarter of 2001, representing 41% and 29% of total revenue, respectively. Maintenance revenue
increased due to new customer sites and renewals of annual maintenance contracts from existing customer sites. Installation and training revenue increased due to a related increase in the number of
customer sites installed during the first quarter of 2002 compared to the first quarter of 2001.

Cost of Revenue

Total cost of revenue increased 5% to $3.0 million in the first quarter of 2002 from $2.8 million in the first quarter of 2001. Gross profit margins
increased to 84% in the first quarter of 2002 from 81% in the first quarter of 2001 due primarily to an increased proportion of maintenance revenue and an increase in installation and training
productivity.

Cost
of license revenue decreased 16% to $154,000 in the first quarter of 2002 from $184,000 in the first quarter of 2001, representing 1% of total revenue, respectively. Although cost
of license decreased in the first quarter of 2002, we expect cost of license revenue to increase over time as a greater proportion of revenue is derived from products containing third-party software
components.

Cost
of services revenue increased 6% to $2.8 million in the first quarter of 2002 from $2.7 million in the first quarter of 2001. This increase was primarily a result of
an increase in the number of employees engaged in customer maintenance services. Cost of services revenue as a percentage of services revenue decreased to 38% in the first quarter of 2002 from 60% in
the first quarter of 2001. This improvement was due primarily to the increased productivity in the installation and training groups in the first quarter of 2002. We expect to continue growing our
customer service organization over time and, therefore, we anticipate that the absolute dollars will increase as we grow our customer base, however, we do not anticipate cost of services revenue as a
percentage of services revenue to change significantly during 2002.

Operating Expenses

Sales and Marketing.Sales and marketing expense increased 17% to $8.3 million in the first quarter of 2002 from
$7.1 million in the first quarter of 2001. This increase was due primarily to increases in sales personnel and increased marketing activities in Europe and Asia Pacific. As a percentage of
total revenue, sales and marketing expenses decreased to 45% in the first quarter of 2002 from 47% in the first quarter of 2001. We expect sales and marketing expense to increase in absolute dollars
as we continue to promote our products and services on a world-wide basis. We expect sales and marketing expenses to decrease as a percentage of total revenue for the year ended
December 31, 2002.

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Research and Development.Research and development expense increased 4% to $3.8 million in the
first quarter of 2002
from $3.6 million in the first quarter of 2001, representing 21% and 24% of total revenue, respectively. We expect research and development expense to increase in absolute dollars as we
continue to commit substantial resources to enhancing existing product functionality and to developing new products. As a percentage of total revenue, we expect research and development expense to
remain fairly constant throughout 2002.

General and Administrative.General and administrative expense increased 7% to $2.7 million in the first quarter of
2002 from $2.5 million in the first quarter of 2001 primarily due to an increase in the number of employees and related expenses in the finance and administrative functions to manage our
international expansion. As a percentage of total revenue, general and administrative expense decreased to 15% in the first quarter of 2002 from 16% in the first quarter of 2001. We expect general and
administrative expense to increase in absolute dollars as we continue to add infrastructure to support a growing organization and continue to invest in our international expansion. As a percentage of
total revenue, we expect general and administrative expense to remain fairly constant throughout 2002.

In-Process Research and Development and Related Charges.During 2000, we entered into an option agreement to
purchase in-process research and development ("IPR&D") technology which had a carrying value of $650,000. In March 2001, we paid $2.0 million to exercise this option to
purchase the underlying technology. Also, during the first quarter of 2001, we purchased additional IPR&D technology for $1.1 million relating to similar development projects. At the time of
the purchases, we estimated that it would take up to a year to complete these development projects and we estimated that we would incur at least an additional $3 million to complete these
projects. These projects were successfully completed by the end of 2001.

At
the date of the aforementioned transactions, the acquired IPR&D technologies had not progressed to a stage where they met technological feasibility as defined by SFAS No. 86.
At the time of each transaction, we estimated the stage of completion of the project and the time and resources required to complete the project by creating a product design plan and evaluating the
progress of the acquired technology towards this plan. A significant amount of uncertainty existed as to our ability to complete the development projects within a timeframe acceptable to the market,
and failure to do so would have caused our competitive position in the market to erode. Additionally, the amount of development required to enable the acquired technology to integrate with our primary
product was estimated to be significant, which increased the uncertainty surrounding its successful development. The acquired technologies did not have alternative future uses. As a result of the
above, we recorded charges totaling $3.7 million as acquired IPR&D in the accompanying 2001 condensed consolidated statement of operations.

Interest and Other Income, Net

Net interest and other income decreased to $380,000 in the first quarter of 2002 from $1.0 million in the first quarter of 2001 due to lower yields on
investments.

Provision for Income Taxes

We recorded a provision for state income tax and federal alternative minimum tax, and foreign income tax expense of $74,000 in the first quarter of 2002. During
the first quarter of 2001, we recorded a provision for state income tax and federal alternative minimum tax of $84,000. We have recorded a full valuation allowance against the deferred tax asset
generated as a result of net operating loss carryforwards aggregating $6.3 million for U.S. tax purposes and $6.1 million for foreign tax purposes at December 31, 2001, as the
future realization of the tax benefit is not currently considered more likely than not.

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Liquidity and Capital Resources

We generated $1.7 million in cash flows from operating activities during the first quarter of 2002 compared to cash used in operating activities of ($6.3)
million during the first quarter of 2001. This increase in cash flow from operations was due primarily to the $2.8 million cash paid for IPR&D in the first quarter of 2001 and the timing of
collections of accounts receivable in the first quarter of 2002. Net cash used in investing activities was $224,000 in the first quarter of 2002 as compared to net cash provided by investing
activities of $22.9 million in the first quarter of 2001. This decrease was due to the movement of investments of $24.0 million into cash and cash equivalents during the first quarter of
2001. Investing activities consisted of capital expenditures totaling $1.0 million and $1.1 million for the first quarter of 2002 and 2001, respectively, which was used primarily to
acquire computer equipment and leasehold improvements. Net cash provided by financing activities for the first quarter of 2002 and 2001 was $674,000 and $513,000, respectively.

At
March 31, 2002, we had $61.9 million in cash and cash equivalents, short-term investments, and restricted investments and $56.5 million in working
capital. We have three irrevocable standby letters of credit in the aggregate amount of $4.8 million as of March 31, 2001 to secure our headquarters facility and furniture leases. As of
March 31, 2002, we had restricted cash of $5.2 million which served as collateral on the letters of credit. The letters of credit and related restricted funds have decreasing schedules
that ultimately expire in 2002 and 2007, which correspond with their classification on the accompanying condensed consolidated balance sheets.

In
April 2002, we secured a $7.5 million revolving line of credit from a bank, which matures on April 2, 2003. All borrowings under the line of credit bear interest
at the bank's prime rate, which was 4.75% on April 3, 2002. The revolving line of credit is secured by all of our assets and requires compliance with various covenants, including liquidity
ratios and tangible net worth requirements, among others. Borrowings under the revolving line of credit are limited to 80% of eligible accounts receivable, as defined by the agreement. To date, we
have not borrowed any funds under the line of credit. The line of credit will serve as replacement collateral upon the reissuance of our existing letters of credit by the same bank during the second
quarter of 2002; which will relieve our $5.2 million restricted cash.

We
expect to have total capital expenditures of approximately $5 million in 2002. We anticipate that our capital expenditures will increase over the next several years as we
expand our facilities and acquire equipment to support the expansion of our research and development activities and internal management information systems.

We
expect to continue to experience growth in our operating expenses. We anticipate that operating expenses and planned capital expenditures will continue to be a material use of our
cash resources. We believe that our existing cash and cash equivalents and short-term investments will be more than sufficient to meet our anticipated cash needs for working capital and
capital expenditures for the next 12 months and the foreseeable future. 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.

Our
accounts receivable days sales outstanding decreased to 65 days at March 31, 2002 from 72 days at March 31, 2001, primarily due to better than expected
collection efforts during the first quarter of 2002 as well as payments received in advance of their scheduled terms. We expect our days sales outstanding to increase as we derive a greater proportion
of our revenue from international operations where payment is typically slower than in the United States.

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Our
interest income is sensitive to changes in interest rates of investment grade securities. We expect that interest income in 2002 will be materially less than in 2001 due to lower
yields on the underlying investments. To reduce our balance sheet exposure to variations in asset values, our investment policy guidelines specify that we invest in the highest investment grade
securities and maintain a weighted average maturity of nine months for our entire portfolio. Our investment portfolio may contain securities with maturities of up to three years. While this minimizes
our interest rate risk to asset values, our results are exposed to fluctuations in interest income due to changes in market rates.

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 offices in
Canada, Mexico, Brazil, the United Kingdom, the Netherlands, Germany, Japan and Australia and conduct transactions in either the local currency of the location or in U.S. dollars. To date, the impact
of fluctuations in the relative value of other currencies has not been material.



During the first quarter of 2002, notes receivable due from certain officers totaling $455,000 were satisfied by delivering, at current fair market value, mature
shares of our common stock, which were retired immediately. Notes receivable from our CEO totaling $1.8 million were refinanced in part with a full recourse note for approximately
$1.5 million with floating monthly interest of 325 basis points over the Federal Funds Rate. The note is payable in three equal payments of principal and interest due annually through
February 2005. The remaining balance was satisfied by delivering, at current fair market value, mature shares of our common stock, which were retired immediately. See Note 4 of the
accompanying notes to the condensed consolidated financial statements for further information.

Factors That May Affect Our Future Results and Market Price of Our 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:



Our quarterly revenue, expenses and operating results could vary significantly from period to period. With respect to the current fiscal year, this is discussed
above under the heading "Overview." 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 could 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

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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:



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 a 5% decline to as high as a
58% growth 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.



We may acquire or make investments in companies, products, services and technologies which we believe complement our software and services. Because of the
increasing use 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:



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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.



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. This was the case in the quarter ended March 31, 2002, and may be the case in future quarters. 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:





We have only recently achieved a quarterly operating profit. 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 $27.2 million as of March 31, 2002. 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. If we do not continue to achieve profitability from operations, or if we do not remain profitable on a net basis, we may 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.

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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 March 31, 2002, we have recognized less than 10% of our license 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.



Revenue from customers located outside of North America accounted for approximately 12% and 8% of our total revenue for quarters ended March 31, 2002 and
2001, 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
March 31, 2002 consisted of 41 dedicated employees located in Australia, Canada, Germany, Japan, Mexico, the Netherlands and the United Kingdom. Most of our international revenue through
March 31, 2002 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
March 31, 2002, 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 political and economic instability, our plans to expand internationally may be adversely affected by a number of risks, including:



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.



Even if we are successful in expanding our operations internationally, conducting business outside North America poses many risks that could adversely affect our
operating results. In particular, we may experience gains and losses resulting from fluctuations in currency exchange rates, for which hedging activities may not adequately protect us. Moreover,
exchange rate risks can have an adverse effect on our ability to sell our products in foreign markets. Where we sell our products in U.S. dollars, our sales could

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be adversely affected by declines in foreign currencies relative to the dollar, thereby making our products more expensive in local currencies. Where we sell our products in local currencies, we
could be competitively unable to change our prices to reflect fluctuations in the exchange rate. In recent periods, for example, our revenues in Europe have been adversely affected by the decline in
the value of the Euro and its component currencies relative to the U.S. dollar. Additional risks we face in conducting business internationally include the following: longer payment cycles;
difficulties in staffing and managing international operations; problems in collecting accounts receivable; and the adverse effects of tariffs, duties, price controls or other restrictions that impair
trade. In addition, we have limited experience in developing local language versions of our products or in marketing our products to international customers. We may not be able to successfully
translate, market, sell, and deliver our products internationally.



The market for products that record customer interactions, analyze performance 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:



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. License revenue from our resellers accounted for approximately 15% and 3% of our license revenue for the quarters ended March 31, 2002 and 2001,
respectively. We expect revenue from our resellers, and accordingly our dependence on resellers, to continue to increase as we establish more

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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.

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.



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 and/or deliver electronic learning to their employees. To achieve increased market acceptance of our software and services, we must, among other things, continue to:



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 2001 and 2000, we introduced five new eQuality product modules  eQuality Discover, Interactive, Response,
Connect, and Now. These new modules generated less than 10% of our total license revenue during the quarters ended March 31, 2002 and 2001. 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.

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We
released for general availability version six of our eQuality Balance product in July 2001. As with any new version of a product there are significant factors that may
adversely affect anticipated future revenues, including:



Because
of these and additional risks, both known and unknown, we cannot be certain that future revenues generated by this product will meet expectations. Failure of these revenues to
develop could have a material adverse effect on our business, results of operations and financial condition.



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.
All of these problems could be exacerbated as we move our product to the latest software technologies and platforms.



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 March 15, 2002, we have four U.S. registered trademarks, one patent generally relating to our voice/data synchronization technology and data capture technique and six patent
applications pending. 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. 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,

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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.

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.



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. Our 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 is alleged to infringe the intellectual property of others.

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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.

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. Consequently, if we become
subject to an adverse determination in a judicial or administrative proceeding or we fail to obtain necessary licenses it could prevent us from producing and selling some or potentially all of the
components of our software. This would have a material adverse effect on our business, financial condition and results of operations.



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 effectively, particularly if our software must integrate with the software and hardware solutions
of our competitors.

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 vendors, and computer telephony software applications offered by other software providers. If our products are not compatible with the new technologies offered by other software and
hardware companies, it would have a material adverse effect on our business and results of operations.



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 eQuality Discover. 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:



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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.



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 received approximately 85% of our license revenue from direct sales for the quarter ended March 31, 2002, 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
March 31, 2002, 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 quarters ended March 31, 2002 and 2001, approximately 15% and 3%, respectively, of our license 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. 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.



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

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the industry in which we compete. This could materially and adversely affect our business, financial condition and results of operations.



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 and the foreseeable future, 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:



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



The market for business software has experienced seasonal fluctuations in demand. The first and third quarters of the year have been typically characterized by
slightly longer sales cycles related to holiday and vacation schedules. 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.



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 limited 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.

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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 business could suffer if we fail to effectively manage our growth. Our revenue increased approximately 20% during the quarter ended March 31, 2002 from
the quarter ended March 31, 2001. 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,
2001 to March 31, 2002, the number of our employees increased from approximately 327 to 358. 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:



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.



At March 15, 2002, our executive officers and directors and their affiliates together controlled approximately 27% of our outstanding common stock. As a
result, these stockholders, if they act together, will be able to exert significant influence 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.

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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 shares of common stock sold in our initial public offering generally are freely tradable without restriction. At March 15, 2002,
6,676,530 shares of common stock outstanding are restricted securities as defined in Rule 144 under the Securities Act. The holders of these shares of common stock may sell them in the future
without registration under the Securities Act if they comply with Rule 144, Rule 701 or any other applicable exemption under the Securities Act.

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.



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 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

None.

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PART II.  OTHER INFORMATION

Item 1. Legal Proceedings

From time to time we may be involved in legal proceedings and/or litigation arising in the ordinary course of business. As of the date hereof, we are not party to
any litigation or other legal proceedings that we believe could have a material adverse effect on our business, operating results or financial condition.

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 first quarter of 2002.

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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: May 13, 2002 |  | WITNESS SYSTEMS, INC.
|------------------- |  | ---------------------
|                    |  | By:                  
|                    |  | By:                  

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