**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-K**

| **x******                                            | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**    |
|------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **For the Fiscal year Ended December 31, 2006** |
| **OR**                                               |
| **o******                                            | **TRANSITION REPORT PURSUANT TO SECTION 13 or  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

**Forthe transition period from          to          **

**CommissionFile number 000-51358**

**Kenexa Corporation**

(Exact Name of Registrantas Specified in Its Charter)

| **Pennsylvania**                                                |   | **23-3024013**                           |
|-----------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer Identification  Number) |
| **650 East Swedesford Road, Wayne, PA**                         |   | **19087**                                |
| (Address of  Principal Executive Offices)                       |   | (Zip Code)                               |

 

**Registrant’s Telephone Number,Including Area Code: (610) 971-9171**

**Securities registered pursuant toSection 12(b) of the Act:**

**Common Stock, par value$0.01 per share**

**(Title Class)**

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes o   No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 of Section 15(d) ofthe Act.   Yes o   No x

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

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.   o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

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

 

Indicate by check mark whether the registrant is ashell company (as defined in rule 12b-2 of the Act).   Yes o   No x

The aggregate market value of the voting stock held bynon-affiliates of the registrant on June 30, 2006 was approximately$474,985,293. Such aggregate market value was computed by reference to theclosing price of the common stock as reported on the Nasdaq NationalMarket  on June 30, 2006. Forpurposes of determining this amount only, Registrant has defined affiliates ofthe Registrant to include the executive officers and directors of Registrant onJune 30, 2006.

The number of shares outstanding of the Registrant’sCommon Stock, as of March 8, 2007 was 25,245,694.

**DOCUMENTS INCORPORATED BY REFERENCE**

| **DOCUMENT**                         |   | **FORM 10-K  REFERENCE** |
|--------------------------------------|--------|-------------------------------|
| Portions of Proxy Statement  for     |   | Part III                 |
| 2007 Annual  Meeting of Shareholders |   |                          |

 

 

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**KENEXACORPORATIONFORM 10-KDECEMBER 31, 2006**

**TABLEOF CONTENTS**

|               | ** ** | ** **                                                                                                        | ** ** | **Page** |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       |                                                                                                              |       |     |
| Item 1.       |       | Business                                                                                                          |       | 3        |
| Item 1A.      |       | Risk  Factors                                                                                                     |       | 20       |
| Item 1B.      |       | Unresolved Staff Comments                                                                                         |       | 33       |
| Item  2.      |       | Properties                                                                                                        |       | 33       |
| Item 3.       |       | Legal  Proceedings                                                                                                |       | 33       |
| Item 4.       |       | Submission of Matters to a Vote of Security Holders                                                               |       | 33       |
| PART II  |       |                                                                                                              |       |     |
| Item 5.       |       | Market of Registrant’s Common Equity, Related Stockholder  Matters and Issuer Purchased of Equity Securities |       | 34       |
| Item 6.       |       | Selected Financial Data                                                                                           |       | 37       |
| Item 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                       |       | 39       |
| Item 7A.      |       | Quantitative and Qualitative Disclosures About Market  Risk                                                       |       | 62       |
| Item 8.       |       | Financial Statements and Supplementary Data                                                                       |       | 64       |
| Item 9.       |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                             |       | 101      |
| Item 9A.      |       | Controls and Procedures                                                                                           |       | 101      |
| Item  9B.     |       | Other  Information                                                                                                |       | 103      |
| PART III |       |                                                                                                              |       |     |
| Item 10.      |       | Directors and Executive Officers of the Registrant                                                                |       | 104      |
| Item 11.      |       | Executive Compensation                                                                                            |       | 104      |
| Item 12.      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                   |       | 104      |
| Item 13.      |       | Certain Relationships and Related Transactions                                                                    |       | 104      |
| Item 14.      |       | Principal Accountant Fees and Services                                                                            |       | 104      |
| PART IV  |       |                                                                                                              |       |     |
| Item 15.      |       | Exhibits, Financial Statements Schedules                                                                          |       | 105      |

 

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**PART I**

This Annual Report on Form 10-K and thedocuments incorporated herein contain “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. Those statements aretherefore entitled to the protection of the safe harbor provisions of theselaws. These forward-looking statements, which are usually accompanied by wordssuch as “may,” “might,” “will,” “should,” “could,” “intends,” “estimates,” “predicts,”“potential,” “continue,” “believes,” “anticipates,” “plans,” “expects” andsimilar expressions, involve risks and uncertainties, and relate to, withoutlimitation, statements about our market opportunities, our strategy, ourcompetition, our projected revenue and expense levels and the adequacy of ouravailable cash resources. There are important factors that could cause ouractual results, level of activity, performance or achievements to differmaterially from those expressed or forecasted in, or implied by, suchforward-looking statements, particularly those factors discussed in “Item 1A—RiskFactors” in this Annual Report on Form 10-K.

Although we believe thatthe expectations reflected in these forward-looking statements are based uponreasonable assumptions, no assurance can be given that such expectations willbe attained or that any deviations will not be material. In light of theserisks, uncertainties and assumptions, the forward-looking events andcircumstances discussed in this Annual Report on Form 10-K may notoccur and our actual results could differ materially and adversely from thoseanticipated or implied in the forward-looking statements. We disclaim anyobligation or undertaking to disseminate any updates or revision to any forward-lookingstatement contained herein to reflect any change in our expectations withregard thereto or any change in events, conditions or circumstances on whichany such statement is based.

**ITEM 1. Business**

**Company Overview**

We provide software, services and proprietary contentthat enable organizations to more effectively recruit and retain employees. Oursolutions are built around a suite of easily configurable software applicationsthat automate talent acquisition and employee performance management best practices.We offer the software applications that form the core of our solutions on anon-demand basis, which materially reduces the costs and risks associated withdeploying traditional enterprise applications. We complement our softwareapplications with tailored combinations of outsourcing services, consultingservices and proprietary content based on our 20 years of experienceassisting clients in addressing their human resource, or HR, requirements.Together, our software applications and services form what are commonlyreferred to as solutions. We believe that these solutions enable our clients toimprove the effectiveness of their talent acquisition programs, increaseemployee productivity and retention, measure key HR metrics and make theirtalent acquisition and employee performance management programs more efficient.

We sell our solutions to large- and medium-sizedorganizations through our direct sales force. As of December 31, 2006, wehad a client base of approximately 3,000 companies, including approximately166 companies on the Fortune 500 list published in April 2006. Ourclient base includes companies that we billed for services during the 12 monthsended December 31, 2006 and does not necessarily indicate an ongoingrelationship with each such client. Our top 80 clients contributedapproximately 65.6%, 70.6% and 61.0% of our total revenue for the years ended December 31,2004, 2005 and 2006, respectively. Our clients typically purchase multi-yearsubscriptions which provide us with a recurring revenue stream. During each ofthe years ended December 31, 2005 and 2006, our clients renewed more than 90%of the aggregate contract value up for renewal during the period.

We derive revenue primarily from two sources,subscription fees for our solutions and fees for discrete professionalservices. During the years ended December 31, 2004, 2005 and 2006,subscription revenue comprised approximately 78.5%, 77.7% and 80.7%,respectively, of our total revenue.

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We are a Pennsylvania corporation. We began ouroperations under predecessor companies, Insurance Services, Inc., or ISI,and International Holding Company, Inc., or IHC in 1987. In December 1999,we reorganized our corporate structure by merging ISI and IHC with and intoRaymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and awholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, aPennsylvania corporation. Each of RKA and RKH were newly created to consolidatethe businesses of ISI and IHC. In April 2000, we changed our name toTalentPoint, Inc. and we changed the name of RKA to TalentPointTechnologies, Inc. In November 2000, we changed our name to KenexaCorporation, or Kenexa, and we changed the name of TalentPoint Technologies, Inc.to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexatransacts business primarily through Kenexa Technology and its wholly ownedsubsidiaries.

Our principal executiveoffices are located at 650 East Swedesford Road, 2nd Floor, Wayne, PA 19087. Ourtelephone number is (610) 971-9171. We maintain an Internet website athttp://www.kenexa.com.

**Recent Transactions**

On January 13, 2006, we acquired Webhire, Inc.(“Webhire”), a provider of end-to-end talent acquisition solutions forrecruitment and human resource professionals in middle-market enterprisesacross all industries, for approximately $34.4 million in cash. The total costof the acquisition, including legal, accounting, and other professional fees of$0.6 million, was approximately $35.0 million. The strategicrationale for acquiring Webhire included expanding our market opportunity andproduct suite, broadening our vertical market specialization and increasing ourcustomer base through cross-sales to Webhire’s customers.

On March 8, 2006, we completed a public offeringof 2,425,000 shares of our common stock at a price to the public of $27.00 pershare. We also sold an additional 216,800 shares of our common stock to coverover-allotments of shares. Our net proceeds from the offering, after payment ofall offering expenses and commissions, aggregated approximately $66.3 million. Inaddition, certain of our shareholders sold an aggregate of 3,510,700 shares ofour common stock in the offering, including an over-allotment of 585,700 shares.We received no proceeds from the common stock sold by the selling shareholdersin this offering.

On April 10, 2006, we acquired Knowledge Workers, Inc.,a human capital consulting and technology firm based in Denver Colorado, forapproximately $2.5 million in cash. The total cost of the acquisition,including estimated legal, accounting, and other professional fess, wasapproximately $2.6 million.

On August 14, 2006, we acquired Gantz-WileyResearch Consulting Group, Inc. , an employee and customer survey dataanalysis firm based in Minneapolis, Minnesota, for a purchase price ofapproximately $2.7 million in cash and $3.2 million in stock consideration. Thetotal cost of the acquisition, including estimated legal, accounting, and otherprofessional fees, was approximately $5.9 million. In addition, our agreementwith Gantz-Wiley contained an earnout provision which provided for the paymentof additional consideration by the Company based upon the annual revenues ofGantz-Wiley Research through December 31, 2006. Based upon these results,we paid an additional consideration of $1.3 million in cash and equity duringthe first quarter of 2007 to the former shareholder of Gantz-Wiley. The relatedliability has been reflected in the financial statements at December 31,2006.

On November 13, 2006, we acquired BrassRing Inc.and BrassRing LLC (“BrassRing”) a provider of talent management solutions, forapproximately $114.7 million in cash. The total cost of the acquisition,including legal, accounting, and other professional fees of $2.9 million,was approximately $117.6 million. The strategic rationale for acquiringBrassRing included expansion ofopportunities with large, global customers, expansion of global infrastructureand product capabilities, and creationof cross-marketing opportunities.

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On November 13, 2006, we entered into a newsecured credit facility with PNC Bank, N.A., as administrative agent, inconnection with our acquisition of BrassRing. Our obligations under the newcredit facility are secured by substantially all of our assets and the assetsof our subsidiaries. This credit facility replaced our prior $25 millionrevolving credit facility with PNC Bank. Under the terms of the creditfacility, we borrowed $75 million on November 13, 2006 to fund ouracquisition of BrassRing and repaid the remainder of our borrowings under thecredit facility with the proceeds from the public offering that we completed inJanuary 2007.

On November 20, 2006, we acquired PsychometricServices Limited., or PSL,, a provider of online and paper-based assessmentproducts, training and consultancy based in the United Kingdom, forapproximately $7.5 million in cash and $0.6 million in stock consideration. Thestrategic rationale for acquiring PSL was to add PSL’s library of content andteam of psychologists to extend Kenexa’s value proposition and to furtherdifferentiate Kenexa from a domain expertise perspective. In addition, webelieve that the acquisition of PSL advances Kenexa’s efforts to build  its international infrastructure, whileadding an attractive customer list of commercial and government entities in theUK.

On January 18, 2007,we completed a public offering of 3,750,000 shares of our common stock at aprice to the public of $31.86 per share. We also sold an additional 562,500shares of our common stock to cover over-allotments of shares. Our net proceedsfrom the offering, after payment of all offering expenses and commissions,aggregated approximately $131.0 million.

**Industry Overview**

Talent acquisition is thesourcing, recruiting, screening and assessment of employees. Employeeperformance management is the systematic process by which an organizationtracks, monitors and optimizes employee behavior and productivity, andevaluates performance through employee reviews, appraisals and business metrics.

***Drivers of Demand for Talent Acquisition and EmployeePerformance Management Applications***

According to the Bureau of Economic Analysis, anagency of the U.S. Department of Commerce, the amount spent on U.S. labor in2006 was approximately $7.5 trillion, or approximately 56% of the total U.S.gross domestic product As competition for qualified employees continues tointensify, driven by the retirement of the baby-boomers, the increasing servicecomponent of the U.S. economy and improved economic conditions. According tothe U.S. Bureau of Labor Statistics, the unemployment rate in December 2006of 4.6% was at its lowest level since July 2001.

Over the past two decades, many organizations haveimplemented software systems that systematize best practices and driveefficiency in most departments, including enterprise resource planning systems,customer relationship management systems and supply chain management systems.These software applications provide a wide array of benefits that both increaserevenue growth and eliminate expenses. Based on our experience, however, webelieve that the HR departments of many of these organizations have onlyimplemented HR information systems, which track basic employee information forpayroll and benefits purposes, or rudimentary applicant tracking systems.Although these systems provide some level of automation, they do little toincrease the effectiveness of talent acquisition and employee performancemanagement programs. We believe that few organizations have systemized bestpractices for talent acquisition and employee performance management or haveimplemented software applications to support these processes and provide HRprofessionals with critical analytics and metrics.

Our experience indicates that, presently, manyorganizations’ talent acquisition functions consist of manual, paper-basedprocesses, ad hoc outsourcing and third-party or custom software applicationswith limited functionality. As a result, we believe that they suffer from thefollowing shortcomings:

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·       *Inefficiency*.   Many organizations rely on manual,paper-based processes and  they cannoteffectively manage the massive number of candidates presented by today’s manyrecruiting resources, including unsolicited inquiries, internal referrals,career fairs, campus recruiting, Internet job boards and third-party referrals,among many others. As a result, they fail to identify high potential candidatesor fail to process those candidates in a timely manner.

·       *Redundancy*.   Many organizations donot maintain easily searchable databases of processed candidates and they oftenconduct redundant searches. A candidate who did not meet the criteria for acertain position may meet the criteria for alternative or future positions.Without an easily searchable database, a candidate may be overlooked.

·       *Ineffectiveness*.   Organizations generally do not employsophisticated screening and assessment mechanisms. As a result, most hiringdecisions are at best loosely based on objective indicators of future successand fail to match high-potential candidates with roles or positions thatleverage their unique abilities and experience. This lowers the probabilitythat a new hire will succeed, and negatively impacts employee productivity andsatisfaction.

·       *Inconsistency*.   Many organizations screen applicationsand resumes based on rudimentary criteria, and do not conduct sophisticated andobjective assessments and base hiring decisions primarily on subjective, ad hocinterviews. This process lacks consistency and objectivity. This inconsistencynot only negatively impacts the effectiveness of recruiting programs, but alsomay expose organizations to regulatory liability.

·       *High cost and inflexibility*.   As a result of theirinflexibility and absence of a variable cost structure, organizations musteither maintain larger HR departments or purchase a greater supply ofthird-party services in order to accomplish their recruiting goals,significantly increasing the costs of their talent acquisition programs.

Similarly, webelieve that many organizations have neither automated nor applied bestpractices to employee performance management. In our experience, mostorganizations’ employee performance management processes consist of annualperformance reviews and informal mentoring programs. We believe that effectiveemployee performance management requires a consistent, systematized processthat identifies employee strengths, weaknesses and issues in a timely manner,continually aligns employee goals with the evolving goals of the organization,monitors opportunities for internal advancement and enables management toanalyze employee data over time. We believe the the absence of effectiveemployee performance management systems and processes has the followingnegative implications:

·       *Failure to retain top performers*.   The absence ofsystems and processes to ensure the fulfillment, motivation and internalmobility of key employees negatively impacts an organization’s ability toretain its top performing employees. Management may not have the opportunity torectify problems with valued employees before they depart from the organizationwithout a system to highlight these issues. Reducing employee turnover can havea material impact on an organization’s expenses.

·       *Failure to optimize productivity*.   Maximum productivityis obtained when employees believe their roles match their evolving skill sets,find their jobs challenging and have confidence in their upward mobility. Theabsence of strong employee performance management systems contributes to thefailure to accomplish these goals, and even if organizations succeed inretaining employees, they may not be able to maintain maximum productivity fromtheir employees.

·       *Failure to remove poor performers*.   An employee whodoes not fulfill his or her role effectively may have a recurring negativeimpact on an organization. To the extent that a poor performer has managerialresponsibility, this negative impact on the organization expands materially.Without 

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systems that identify poorperformers, organizations may not be able to address weaknesses within theirhuman capital in a timely manner.    

We believe that thefailure to employ sophisticated systems in their talent acquisition andemployee performance management processes inhibits organizations fromleveraging valuable data generated through these functions. This can negativelyimpact organizations in several ways, including the failure both to identifyoverall trends that could improve the efficiency and effectiveness of itsprocesses and to quickly identify problems that could lead to employeeturnover.

***Emergence of On-Demand Applications***

Based on ourexperience, we believe that organizations have become increasingly dissatisfiedwith traditional enterprise software applications, resulting in the growingadoption of the on-demand model for enterprise software. Historically,  organizations have purchased perpetualsoftware licenses and deployed enterprise software applications on-site withintheir IT environment. This traditional method of purchasing and deployingenterprise software applications has left many organizations questioningwhether the benefits of these technologies outweigh the following burdens:

·       *Expensive and time consuming implementation*.   A traditionalenterprise software application requires an organization to invest in ancillaryIT such as hardware systems, application servers, databases and storagesystems. In addition, the organization must employ consultants or additional ITstaff to integrate the application into increasingly complicated ITenvironments and customize the application for specific needs. The ancillarycosts of a complex deployment can be multiples of the perpetual license fee forthe software application and can take several months or even years to complete.

·       *Expensive maintenance*.   Once the software applicationhas been deployed, the organization must make further investments to maintainthe application. In addition to the maintenance fee paid to the softwarevendor, which is typically approximately 20% of the perpetual license fee, theorganization must retain both an IT staff capable of maintaining and upgradingthe software as well as personnel to train new users to operate theapplications.

·       *Limited incentives to ensure client success*.   A typicalperpetual software license requires the client to pay up-front a materialamount for the license, with a significantly smaller amount, typicallyapproximately 20%, paid annually for basic support and upgrades. This modelleaves little incentive for the software vendor to ensure a successfulimplementation and on-going client satisfaction.

Developments in technology have enabled softwaredevelopers to offer enterprise software applications on an on-demand basis.Leveraging the Internet, multi-tiered architectures, advances in security andopen standards for application integration, software vendors can offer softwareapplications to their clients as a service, hosting the software on serversoperated by the software vendor. Clients, using an Internet browser, access theapplications, which are designed to be easily configured and integrated with aclient’s existing applications.

The on-demand model fundamentally changes both thepurchasing and deployment of enterprise software from a client perspective.Rather than making large, up-front investments in perpetual licenses, clientspurchase limited term subscriptions for on-demand software applications.Further, because only an Internet browser is required to access on-demandsoftware applications, which can be easily configured to meet the buyer’sspecific needs, organizations eliminate the expense of ancillary technology andthird-party services required to implement, configure and maintain theenterprise application on-site. Finally, the finite duration of clientsubscriptions provides a strong incentive to software vendors to ensure thatthe software provides the expected benefits to the client, resulting inconsistent customer service. The on-demand model also reduces research anddevelopment support costs for the software developer. Because 

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only limited versions ofthe software exist at any one time, the on-demand model relieves the burden ofmaintaining and upgrading historical versions of the software.

We believe that talentacquisition and employee performance management applications are particularlywell-suited to the on-demand model. Talent acquisition and employee performancemanagement applications are generally purchased by an organization’s HRdepartment. Because the HR departments of most organizations have littlehistorical experience making capital expenditures for enterprise softwareapplications, we believe that providing these departments the opportunity tolicense software applications on a subscription basis eliminates a majorimpediment to the adoption of talent acquisition and employee performancemanagement applications.

**Our Solution**

We are a leading provider of talent acquisition andemployee performance management solutions. Our solutions enable organizationsto implement systematic talent acquisition practices that ensure the efficient,effective and consistent hiring of qualified individuals. Our solutions alsoprovide employee performance management systems that help to ensure thatorganizations retain and optimize the performance of qualified individuals andidentify employees who fail to perform. Our solutions are built around a suiteof easily configurable software applications that automate talent acquisitionand employee performance management best practices. We believe that byproviding our software applications on an on-demand basis, we materially reducethe costs and risks associated with traditional enterprise software applicationimplementations. We also believe that implementing feature-rich and scalable,or easily configurable on a real-time basis, talent acquisition and employeeperformance management solutions that meet organizations’ specific needsrequires a combination of software, services and domain-specific content.Accordingly, we complement our software applications with consulting services,outsourcing services and proprietary content. Together, these components formsolutions that enable our clients to improve the quality of their hiringprograms, increase employee productivity and retention and make their talentacquisition and employee performance management programs more cost-effective.

·       *More effective and consistent talent acquisitionprograms*.   Our talent acquisition solutions are comprised oftwo major components that enable our clients to increase the consistency andeffectiveness of their recruiting programs. The first component is ourapplicant tracking system, which automates and streamlines the recruitingprocess. The second component is our testing and assessment solutions, whichensures that candidates have the desired knowledge, skills, behavior andexperience necessary to be successful in the desired position. Our talentacquisition solutions enable our clients to:

·        expandthe pool of qualified applicants;

·        identifyhigh-potential candidates more quickly;

·        accuratelymeasure candidate skills, aptitude and experience;

·        createinterviews focused on necessary skills and qualities indicative of success;

·        increaseinterview consistency and objectivity;

·        identifytraining needs immediately;

·        documentcompliance with regulatory requirements; and

·        ensurecultural fit between candidates and the organization.

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·       *Greater employee productivity and retention*.   Ouremployee performance management solutions combine software, proprietary contentand consulting services to automate and systematize employee performancemanagement best practices. Specifically, our solutions enable organizations toautomate career tracking activities, design and administer effective andconsistent employee surveys and implement productive mentoring programs. Oursolutions include tools that facilitate the development of action plans to addressweaknesses and cultivate strengths identified through these processes. Wecomplement the software components of our solutions with consulting servicesthat help to encourage and manage behavioral change within an organization. Asa result, we understand that our clients experience greater employeeproductivity and improved employee retention after implementing our solutions.          

·       *More cost-effective talent acquisition and employeeperformance management programs*.   We believe that our solutionsincrease the cost-effectiveness of talent acquisition and employee performancemanagement programs in three ways. First, our solutions automate theseactivities, enabling organizations to maintain smaller HR departments andeliminate some third-party services. Second, our solutions enable organizationsto more effectively identify high-potential candidates and retain qualifiedemployees. Third, our solutions provide management the opportunity to achieveeconomies of scale by outsourcing non-core functions while also ensuring theapplication of best HR practices and leading technology to these functions.

·       *Application of analytics to talent acquisition andemployee performance management programs*.   Our solutions enableorganizations to use the data generated by their talent acquisition andemployee performance management programs in order to improve these programs.Specifically, our solutions enable management to identify overall trends thatcould improve the efficiency and effectiveness of their processes. For example,we enable our clients to identify their most productive recruiting channels,establish criteria indicative of success in various roles and identify problemsthat could lead to employee turnover.

·       *Ease of integration, configuration and deployment*.   Weprovide the software applications that form the core of our solutions on anon-demand basis, eliminating the material expenses and complexity oftraditionally purchased and deployed software applications. We combine thisdeployment model with an intuitive user interface to facilitate rapid andwidespread adoption within the HR department. Our solutions are designed forease of use by non-technical staffing professionals, managers, candidates andemployees. We believe that these aspects of our solutions enable organizationsto quickly achieve the anticipated benefits.   

**Our Strategy**

Our objective is to be the leading global provider oftalent acquisition and employee performance management solutions. Key elementsof our strategy include:

·       *Focus on talent acquisition and employee performance managementsolutions*.   Unlike some vendors that provide broad suites ofHCM software, we have focused solely on talent acquisition and employeeperformance management, which are the strategic HR elements of our clients. Webelieve that this focus has enabled us to deliver solutions that meet theunique needs of our clients in these areas. We also believe that this focus hashelped us to generate an increasingly recognized brand in these markets, whichare expected to grow at a materially faster rate than the broader HCM marketover the next five years. We intend to continue to focus on talent acquisitionand employee performance management in order to leverage our increasinglyrecognized brand in these markets and these positive market dynamics.

·       *Provide innovative and industry-specific solutions to our clients*.   Duringthe past three years, we have introduced several new solutions, each inresponse to the unique needs of our clients. We intend to 

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continue to work closely withour clients to further develop innovative solutions that increase theeffectiveness of their recruiting programs and contribute to greater employeeretention and productivity. We have also introduced specific solutions for thefollowing vertical industries: financial services and banking; manufacturing;life sciences, biotechnology and pharmaceuticals; retail; healthcare;hospitality; call centers; and education. We intend to develop specificsolutions for additional vertical industries.

·       *Cross-sell additional solutions to and further penetrate currentclients*.   During the year ended December 31, 2006, werenewed more than 90% of the aggregate value of contracts subject to renewal.This renewal rate provides us with a strong base of recurring revenue. Webelieve that our strong client relationships provide us with a meaningfulopportunity to cross-sell additional solutions to our existing clients and toachieve greater penetration within an organization. We expect to continue tocreate innovative programs designed to provide our employees with strongincentives to maximize the value from each of our clients.

·       *Continue to leverage our highly efficient development center in India*.   Weestablished a technology development center in Hyderabad, India in 2003. Wecurrently have approximately 173 developers working in Hyderabad providing uswith low-cost, 24 hours a day, 7 days a week developmentcapabilities. Our cost per developer in India is 70% less than our cost perdeveloper in the United States. We intend to continue to leverage this asset todeliver technologically advanced solutions to our clients.

·       *Expand our global presence and client base*.   We havegrown to $112 million in annual revenue for the year endedDecember 31, 2006 and approximately 3,000 clients as of December 31,2006. Although our primary focus has been on the U.S. market, our solutions arealso well suited to addressing problems faced by organizations outside the UnitedStates. In the future, we intend to expand our distribution efforts in Europe,the Middle East and the Asia/Pacific region. Although we have employed a directsales force in the United States, we intend to expand our internationaldistribution through partnerships. We believe that pursuing a channel strategyenables us to limit the costs associated with international expansion andacknowledges that different geographies present different cultural challengesbest addressed by a local sales force.

·       *Pursue complementary acquisitions*.   We have completed 25acquisitions of businesses since 1994, including our acquisition ofBrassRing, Inc. in November 2006. These acquisitions have helped usto adapt our business to the evolving needs of our clients. We believe that theHCM market is significantly fragmented. Many competing companies have strongtechnology or vertical market expertise but lack the scale to compete with theindustry leaders in the long term. We continue to identify similarly situatedcompanies that we believe could broaden the functionality and strength of ourexisting solutions.

**Our Products andServices**

***Our Talent Acquisition Solution***

*Kenexa Applicant TrackingSystem Products.*   Kenexa has multiple applicanttracking system (ATS) products to meet the recruiting needs of different typesof organizations. The following are the Kenexa ATS products and the marketsthey serve:

·        **Kenexa Recruiter**® serves mid-market andlarge domestic organizations with centralized recruiting processes.

·        **Kenexa Recruiter**®**BrassRing**serves large, domestic customers with more complex and/or decentralizedrecruiting processes and supports multi-national customers with multi-languagerequirements, including the multi-byte languages of Asia Pacific.

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·        **Kenexa StoreFrontTM** serves customers withhourly / retail specific recruiting needs.

The Kenexa Systemsare web-based talent acquisition systems that streamline and automate theentire recruiting process. All include the following features:

·       convertsour client’s corporate website into an interactive, branded career center wherecandidates can search and apply for jobs, update personal information andreceive automatic notifications of available jobs of interest;

·       integrateswith our suite of testing and assessment technologies to identify candidateswith the highest potential for success;

·       enablesclients to post job openings to over 1,100 free and fee-based Internet jobboards;

·       intelligentlysearches Internet job sites, corporate websites, personal web pages and aclient’s database of resumes to automatically capture both passive and activecandidates and pull their resumes directly to the desktop;

·       providesmanagement with both standard and ad hoc reports to facilitate understanding ofthe status of clients’ talent acquisition programs;

·       providesmanagement with individualized HR dashboards that display rich data regardingthe status of clients’ talent acquisition programs and access to the mostfrequently used functions;

·       easilyconfigurable to automate a client’s talent acquisition model and workflowprocesses;

·       integrateseasily with clients’ HR information systems such as Oracle (PeopleSoft), SAP,ADP and Lawson; and

Kenexa StoreFront which is a solution tailored to theretail industry can be presented via an in-store kiosk.

*KenexaPeopleQuest®.*   OurPeopleQuest system enables clients to expand the pool of qualified candidatesfor an open position by automating the phone interview. By combining voicerecognition technology from a third party, software and consulting services,the PeopleQuest solution assists clients in creating friendly and effectivepre-recorded phone interviews tailored to their specific needs. Our softwarealso automates the data gathering, screening and interview scheduling processso that high-potential candidates are processed efficiently.

*KenexaProve It! ®.*   TheKenexa Prove It! tool is an automated, easily configurable skills assessmenttool that enables our clients to accurately identify qualified candidates.Integrating software with proprietary content, Kenexa Prove It! provides ourclients with over 900 skills assessments for clerical, software, call center,industrial, healthcare and technical jobs.

*KenexaSelectorTM.*   TheKenexa Selector tool is an automated, easily configurable candidate assessmenttool that provides accurate performance predictions for hourly, sales andmanagerial positions. Kenexa Selector integrates our software with ourproprietary content to elicit responses that reveal candidate situationaljudgment, cognitive ability, personality, and biodata  and then immediately translate this informationinto profiles of candidate strengths and weaknesses.

*KenexaInsight®.*   TheKenexa Insight solution is a consulting-based solution that provides ourclients with customized, research-based interviews that accurately andconsistently identify talented candidates for hire and promotion. Ourconsultants work directly with our clients to analyze the most talentedperformers in different positions within their organization. We translate thisanalysis into complete structured interviews that identify candidates that havesimilar traits and behaviors to our clients’ most talented employees. We offerclients the option of conducting the interviews themselves or outsourcing thistask to 

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our professionals.Following the interview, we track the results to validate the relationshipbetween the interview and actual performance.

*Kenexa Interview Builder®.*   Our Interview Builder tool isa software tool integrated with a reference library of proprietary content,including more than 1,200 interview questions and competency profiles. Ourclients use Interview Builder to generate efficient, accurate and consistentinterviews that encourage candidates to speak freely about their knowledge,abilities, skills and other crucial job requirements for more than 40 differentcompetencies. We complement this proprietary content with training for creatingand conducting competency-linked, structured interviews.

***Our Employee Performance Management Solution***

*KenexaCareerTracker®.*   TheKenexa CareerTracker system is a complete employee performance managementsystem that streamlines and automates the entire employee performancemanagement process in order to improve employee retention and productivity. TheKenexa CareerTracker system consists of a suite of software applicationscomplemented by proprietary content and consulting services that togethersupport an ongoing performance appraisal process and continuous employeeimprovement.

Kenexa CareerTracker enables managers to:

·       automaticallytrack and categorize employees within the organization;

·       aligneach department’s goal with those of the overall organization;

·       implementsystematic employee performance appraisals;

·       implementsophisticated and automated mentor matching programs;

·       measurepay-for-performance with compensation guidelines, merit matrix and modelingtools;

·       identifyhigh performers by plotting their performance and potential on a 9-boxmap; and

·       preparefor the future with succession planning.            

Kenexa CareerTracker enables employees to:

·       createindividualized step-by-step development plans;

·       alignpersonal goals with organizational objectives;

·       Accessresources for improvement in targeted competencies; and

·       Identifyfuture opportunities within the organization.

*KenexaSurvey Technology.*   We believe that our survey technology enables our clientsto conduct employee surveys that are easy to administer even though theunderlying organizational requirements are extremely complex. Our surveytechnology is comprised of:

·       *Surveys Online*.   A web-based survey system that has beenload-tested to process more than 1 million surveys within a 24-hourperiod.

·       *OrgMapper*.   An automated software system thatsimplifies the process of mapping an organization to ensure appropriaterecording capabilities and options.

·       *Survey Ordering System*.   An automated online systemthat accepts orders, distributes and tracks employee surveys for geographicallydistributed organizations.

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·       *Kenexa Survey Scorecard*.   A software system thatintegrates data derived from our surveys into a secure, web-based online portalthat enables managers to view survey results, identify areas for improvement,automate action-planning to address weaknesses and track progress againstaction-plans. It also integrates proprietary content from our HR best practicesdatabase to guide managers in the action-planning process.

·       *Kenexa Online Dynamic Reporting*.   A flexible, secure,web-based reporting tool for employee surveys which includes a variety ofpre-designed reports as well as facilitates the design of custom reports.   

*Multi-ratersurveys.**  *Thesesurveys combine software, proprietary content and consulting services toprovide our clients with a comprehensive outsourced competency assessmentservice, including design, administration and reporting. The solutionintegrates our competency library, which contains more than 40 competencies anda broad array of assessment items designed to measure the discrete behaviorsthat comprise a competency, with consulting services provided by our staffpsychologists who have significant experience developing, implementing andvalidating competency assessments.

*Employee engagementsurveys.**  *Ourconsultants assist our clients in designing, administering and analyzingemployee engagement surveys. We developed our Employee Engagement model throughstudies of organizational effectiveness and a comprehensive review of theacademic literature related to employee commitment, psychological ownership,organizational pride, loyalty and satisfaction. We conduct analyses which linksurvey results to business metrics. By linking the survey results to clients’performance variables, we can recommend actions for improved performance. Wehave documented the relationship between employee attitudes and businessoutcomes such as customer satisfaction, employee retention and managementeffectiveness. We have used this information to improve customer satisfaction,to increase efficiency and ultimately to increase our clients’ financialperformance.

***Employment Process Outsourcing***

In concert with providing talent acquisition andemployment performance management solutions that enable organizations toimplement best practices in these areas, we provide our clients with the optionof outsourcing to us certain aspects of their staffing operations andrecruiting campaigns, including the sourcing, recruiting, screening, assessmentand on-boarding of employees. Acknowledging that organizations need to retainstrategic control of their HR programs, we offer our clients the ability tooutsource only the tactical components and design solutions that meet eachclient’s specific objectives. These solutions combine our services andtechnology in what we believe is an integrated delivery platform that allowsorganizations to manage fluctuation in hiring needs and leverage sharedinfrastructure to reduce costs. We employ a team of experienced staffingprofessionals who have worked in the internal departments of some of the world’slargest companies and have completed our comprehensive proprietary training andcertification program.

We believe our employment process outsourcing, or EPO,services enable our clients to reduce operating costs, focus on their corebusiness, create a variable cost structure around certain non-strategic HRfunctions, improve the quality of certain HR functions, foster innovation andobtain access to leading technology without the corresponding investment to ownthe technology themselves. Clients contract for our EPO services for apre-determined period. Generally, we enter into service level agreements withour clients to ensure the quality of our services.

Our EPO servicesinclude the following:

·       *Process consulting*.   We perform needs analyses andadvise clients on the implementation of technology and processes to optimizetheir talent acquisition operations.   

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·       *Staffing department management**services*.   Weassume all or discrete parts of the staffing function on an outsourced basis.

·       *On-site staffing professional support*.   We provideon-site support for ongoing staffing operations or during large scale hiringinitiatives.

·       *Multi-channel sourcing strategy development and execution*.   Wedevelop and execute a multi-channel sourcing strategy that allows our clientsto expand their candidate pool and control costs. A multi-channel sourcingstrategy may include leveraging direct recruitment, Internet mining,traditional advertising, Internet job postings, career centers, internalcandidate review and career/job fairs. 

·       *Employee referral program administration*.   We establishand administer our clients’ employee referral program, including promoting theprogram among employees, creating incentive strategies that further ourclients’ goals, recording referrals and administering payments.

·       *Direct sourcing*.   We maintain off-site teams ofrecruiting professionals at our offices in Wayne, Pennsylvania and Hyderabad,India. These professionals support major hiring initiatives for our clients andhandle recruiting projects on an ongoing basis. We believe that our investmentin technology and productivity tools offers our clients efficiency and reducedcosts over other available sourcing options.  

·       *Program Outsourcing*.   We help our clients to developeffective, cost-efficient strategies to conduct large and small scalerecruitment campaigns. These strategies can be executed either by our clients’internal HR department or outsourced to a team of our professionals, or a combinationof both. Program Outsourcing programs can include evaluating the talentacquisition mission and business objectives, mapping recruitment processes andexecution strategies, engaging hiring management and key stakeholders indefining deliverables, creating a detailed definition of a qualified candidatefor each hiring manager, executing candidate sourcing, screening andassessment, managing the candidate interview, selection, hiring andcommunication process, providing comprehensive weekly and monthly reports whichdetail current progress against pre-established performance measures andmetrics and concluding the assignment with a project summary and “lessonslearned” to facilitate knowledge transfer. Executive candidate sourcing is thepractice of identifying, contacting and soliciting individuals for the purposeof screening and selecting for hire.         

Our EPO services areprovided in concert with our talent acquisition and employee performancemanagement solutions and we have developed proprietary technology for largevolume sourcing performed by our sourcing center in Hyderabad, India, enablingus to provide these services in an efficient and scalable manner.

**Customer Support**

We believe that superior customer support is criticalto our clients. Our customer support group assists our clients by answeringquestions and troubleshooting our solutions. Customer support is available24 hours a day, 7 days a week by telephone,  and over the Internet from a member of ourcustomer support team. Members of our customer support team receivecomprehensive training and orientation to ensure that our clients receivehigh-quality support and service. Each of our clients is assigned a singlepoint of contact. When an issue is reported to us, our customer support personnelfollow a clearly defined escalation process to ensure that mission-criticalissues are resolved to the satisfaction of the client. We believe that ourcustomer service model has materially contributed to our client retention rate.During the year ended December 31, 2006, we renewed more than 90% of theaggregate contract value subject to renewal.

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We utilize our talentacquisition and employee performance management solutions to recruit and manageour customer support personnel. We believe that applying these solutions to ourcustomer service department has resulted in a customer support group withsuperior skills, competencies and aptitude for customer service. As of December 31,2006, our customer support group consisted of 636 employees, 160 of whom arelocated in Lincoln, Nebraska, and 51 of whom are located in Hyderabad, India.

**Technology,Development and Operations**

***Technology***

Our integratedsuite of talent acquisition and employee performance management solutions isbuilt on a multi-tier, platform independent Java 2 Platform, EnterpriseEdition, or J2EE, architecture using our Core Application Framework, whichconsists of open source components, commercially available products and our ownproprietary tools. The Core Application Framework consists of the followingcomponents:

·       *User Layer*.   The user layer consists of a commonly usedweb browser. We use Java Server Pages and a Servlet-based server-sideapplication to support the browser-based interface.

·       *Business Layer*.   Our Business Object Framework supportsthe business logic of our applications as well as providing comprehensiveauditing functionality, security, multi-threading and component pooling.

·       *Integration Layer*.   Our integration tier providesintegration with a wide range of third-party tools, job boards andapplications, such as Oracle (PeopleSoft), SAP, Siebel Systems and Lawson, tosupport the needs of our clients. We are dedicated to the development andpromotion of a standard suite of XML specifications to enable e-business andthe automation of human resources-related data exchanges. The HR-XML consortiumhas recognized and certified Kenexa in this regard.

·       *Data Layer*.   Our Data Access Framework supportscollection pooling, session management and optimization of data retrieval. Weuse Oracle RDBMS as our database engine in the Data Layer. 

Our software is designed to support easy-to-usefeatures such as dynamic workflows, job templates and user configuration thatenable clients to adapt the application for their specific requirements.Dynamic workflows are designs that facilitate business processes whereby onestep in the process cannot be completed until all prior steps have beencompleted.

We provide our clientswith two options to use our solutions. Most of our clients use our solutions onan on-demand basis, with only a limited number of our clients implementing oursolutions on-site.

***Development***

Innovation is an important part of our business. Webelieve that three primary factors drive our innovation: our employees, ourdomain experts and our clients. We have a formalized system to cultivateparticipation from all of our employees in research and development. We also leveragethe experience of our research scholars and domain experts, who produce whitepapers, case studies and thought pieces which form the foundation for ourinnovation. Our research and development team maintains a repository of ideas,and selected ideas are presented to the market validation team. Marketvalidated ideas progress to the prototype stage. The executive team reviewsprototypes and selects those with the highest potential, which then enter theproduct development phase. In addition to our employees and domain experts,some of the key ideas are generated from client feedback gathered during usergroup meetings, client symposiums, and advisory counsels.

We follow a developmentmethodology that we believe allows us to develop projects quickly and thenproceed on a predictable, low risk path for high-quality results. We conductour product development through our global development center, which consistsof four locations: Hyderabad, India, Lincoln, 

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Nebraska,Wayne, Pennsylvania, Waltham, Massachusetts and Cyberjaya, Malaysia. Productdevelopment is primarily conducted at our highly efficient facility in India,which we established in 2003. As of December 31, 2006, we employedapproximately 173 developers in India, 82 in Massachusetts, 33 in Nebraska and20 in Pennsylvania. Our development process is ISO 9001:2000 certified.

***Operations***

Our data center in Wayne, Pennsylvania serves as theprimary hosting facility for our on-demand solutions. We also have  data centers in Massachusetts, Virginia, andNebraska. We adhere to industry standards and best practices in our globaloperations. We have entered into service level agreements with many of ourclients. We have a comprehensive load balanced environment for optimalperformance and server redundancy to avoid single points of applicationfailure. The environment is shared across clients to reduce costs for eachindividual client. Each client’s data is stored in a separate logical partitionin the database, allowing increased security and maintenance efficiency inbacking up data or exporting data to the client when requested.

Our data center Managersare Certified Information Systems Security Professionals, or CISSPs, withtraining in the latest security and availability threats. Our data centers arecontinuously and proactively monitored by a comprehensive set of tools andpersonnel, 24 hours a day, 7 days a week. Our data centers havebuilt-in power redundancy, with two uninterrupted power supplies backed up byindustrial strength generators to provide uninterrupted service to our clients.We have documented our network, server and database management proceduresincluding backup and recovery.

**Clients**

As of December 31,2006, we had a base of approximately 3,000 active clients over a number ofindustries, including financial services and banking, manufacturing, lifesciences, biotechnology and pharmaceuticals, retail, healthcare, hospitality,call centers, and education, including 166 companies on the Fortune 500 listpublished in April 2006.  Our clientbase includes companies that we billed for services during the year ended December 31,2006 and does not necessarily indicate an ongoing relationship with each suchclient. For the year ended December 31, 2006, we provided our talentacquisition and employee performance management solutions on a subscriptionbasis to approximately 522 clients, with an average subscription term oftwo years. Other than a small number of perpetual license sales, the remainderof our clients in 2006 engaged us to provide discrete professional services andmay not engage us for future services once a project is completed. No singleclient accounted for more than 10% of our revenue in the year ended December 31,2006.

**Sales and Marketing**

Our target clients are large- and medium-sizedorganizations with complex talent acquisition and employee performancemanagement needs. We sell our solutions to both new and existing clientsprimarily through our direct sales force, which is comprised of inside sales,telesales and field sales personnel. As of December 31, 2006, we had 152 salesand marketing representatives. Our marketing strategy focuses on generatingqualified sales leads and building our brand. Among various locations wegenerate sales leads through a combination of the marketing efforts describedbelow and a third-party lead generation service. We have sales offices locatedin Wayne, Pennsylvania; Philadelphia, Pennsylvania; Lincoln, Nebraska; Waltham,Massachusetts; Minneapolis, Minnesota; Denver, Colorado; San Francisco,California; London, England; Harrow, England; Toronto, Canada; and Hyderabad,India.

We believe that our client relationships provide uswith a meaningful opportunity to cross-sell additional solutions to ourexisting clients and to achieve greater penetration within the organization. Wehave established a program intended to increase cross-selling into our largestclients, and we expect to 

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continue to createinnovative programs designed to incent our employees and maximize the valuefrom each of our clients.

Our marketinginitiatives are generally targeted toward specific vertical industries orspecific solutions. Our marketing programs primarily consist of:

·       participationin, and sponsorship of, conferences, trade shows and industry events;

·       directmail and email campaigns;

·       advertisingin trade magazines;

·       distributionof  white papers, case studies andthought leadership documents; and

·       usingour website to provide product and company information.

We have focused our publicrelations efforts on building our brand.

**IntellectualProperty**

Our intellectual property rights are important to ourbusiness. We rely on a combination of patents, copyright, trade secret,trademark and other common laws in the United States and other jurisdictions,as well as confidentiality procedures and contractual provisions to protect ourproprietary technology, processes and other intellectual property.

Although we relyprimarily on patents, copyright, trade secret and trademark law, writtenagreements and common law, we believe that the following factors are moreessential to establishing and maintaining a competitive advantage:

·       thetechnological skills of our research and development personnel;

·       thedomain expertise of our consultants and outsourcing service professionals;

·       frequentenhancements to our solutions;

·       continuedexpansion of our proprietary content; and

·       highlevels of customer service.

Others may develop products that are similar to ourtechnology. We generally enter into confidentiality and other writtenagreements with our employees and partners, and through these and other writtenagreements, we attempt to control access to and distribution of our software,documentation and other proprietary technology and other information. Despiteour efforts to protect our proprietary rights, third parties may, in anunauthorized manner, attempt to use, copy or otherwise obtain and market ordistribute our intellectual property rights or technology or otherwise developa product with the same functionality as our software. Policing unauthorizeduse of our software and intellectual property rights is difficult, and nearlyimpossible on a worldwide basis. Therefore, we cannot be certain that the stepswe have taken or will take in the future will prevent misappropriation of ourtechnology or intellectual property rights, particularly in foreign countrieswhere we do business or where our software is sold or used, where the laws maynot protect proprietary rights as fully as do the laws of the United States orwhere enforcement of such laws is not common or effective.

Substantial litigationregarding intellectual property rights exists in the software industry. Fromtime to time, in the ordinary course of our business, we are subject to claimsrelating to our intellectual property rights or those of others, and we expectthat third parties may commence legal proceedings or otherwise assertintellectual property claims against us in the future, particularly as weexpand the complexity and scope of our business, the number of similar productsincreases and the functionality of these products further overlap. We cannot becertain that no third party intellectual property rights that exist couldresult 

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in aclaim against us in the future. These actual and potential claims and anyresulting litigation could subject us to significant liability for damages. Inaddition, even if we prevail, litigation could be time consuming and expensiveto defend and could affect our business materially and adversely. Any claims orlitigation from third parties may also limit our ability to use variousbusiness processes, software and hardware, other systems, technologies orintellectual property subject to these claims or litigation, unless we enterinto license agreements with the third parties. However, these agreements maybe unavailable on commercially reasonable terms, or not available at all.

**Competition**

We have experienced, and expect to continue toexperience, intense competition from a number of companies. We compete withniche point solution vendors, such as Authoria, Inc., Deploy Solutions, Inc.,iCIMS, Inc., Integrated Performance Systems, Inc., InScopeCorporation, PeopleClick, Inc., Kronos, Performix Technologies, Inc.,Pilat HR Solutions, Inc., Previsor, Inc., Vurv Technology Inc., SHLGroup plc, Success Factors, Inc., Taleo Corporation, and WorkstreamSoftware, Inc., that offer products that compete with one or moreapplications in our suite of solutions. In some aspects of our business, wealso compete with established vendors of enterprise resource planning softwarewith much greater resources, such as Oracle Corporation (PeopleSoft), SAP AG,Siebel Systems, Inc. and Lawson, Inc. To a lesser extent, we competewith vendors of employment process outsourcing services and survey servicessuch as Accolo, Inc. The Gallup Organization, Hyrian, LLC and RecruitmentEnhancement Services.

We believe theprincipal competitive factors in our industry include:

·       solutionbreadth and functionality;

·       easeof deployment, integration and configuration;

·       domainexpertise;

·       industry-specificexpertise;

·       servicesupport, including consulting services and outsourcing services;

·       solutionprice;

·       breadthof sales infrastructure; and

·       breadthof customer support

We believe that we generally compete favorably withrespect to these factors.

We may face future competition in the talentacquisition and employee performance management market from large, establishedcompanies, such as Oracle and SAP, as well as from emerging companies. Barriersto entry into our industry are relatively low, new software products arefrequently introduced and existing products are continually enhanced. Inaddition, we expect that there is likely to be consolidation in our industry,which would lead to increased price competition and other forms of competition.Established companies not only may develop their own competitive products, butmay also acquire or establish cooperative relationships with current or futurecompetitors, including cooperative relationships between both larger,established and smaller public and private companies.

In addition, our abilityto sell our solutions will depend, in part, on the compatibility of oursoftware with software provided by our competitors. Our competitors could altertheir products so that they will no longer be compatible with our software orthey could deny or delay access by us to advance software releases, which wouldlimit our ability to adapt our software to these new releases. If ourcompetitors were to bundle their products in this manner or make their productsnon-compatible with ours, our ability to sell our solutions might be harmed andcould reduce our gross margins and operating income.

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**Employees**

As of December 31,2006, we had 1,220 employees, consisting of 152 employees in sales andmarketing, 308 in development, 636 in delivery of our solutions and 124 ingeneral and administrative positions. None of our employees are represented bya union. We consider our relationship with our employees to be good and havenot experienced any interruptions of our operations as a result of labordisagreements.

**Securities andExchange Commission Filings**

Our Securities and Exchange Commission filings areavailable free of charge on our website, www.kenexa.com. Our annual reports onForm 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K and amendments to those reports are posted onour website as soon as practicable after we furnish such materials to the SEC.

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**ITEM 1A. RISKFACTORS**

***We operate in a market environment that involvessignificant risks, many of which are beyond our control. The following riskfactors may adversely impact our results of operations, cash flows and themarket price of our common stock. Although we believe that we have identifiedand discussed below the key risk factors affecting our business, there may beadditional risks and uncertainties that are not presently known or that are notcurrently believed to be significant that may adversely affect our performanceor financial condition.***

***Our business may not continue to grow if the marketsfor our products do not continue to grow.***

Our growth is dependentupon the continued adoption of on-demand software as a key mechanism fordelivering solutions in these markets. The rapidly evolving nature of thismarket reduces our ability to accurately evaluate our future prospects andforecast quarterly or annual performance. The adoption of on-demand talentacquisition and employee performance management solutions, particularly amongorganizations that have relied upon traditional software applications, requiresthe acceptance of a new way of conducting business and exchanging and compilinginformation. Because these markets are new and evolving, it is difficult topredict with any assurance the future growth rate and size of these marketswhich, in comparison with the overall market for enterprise softwareapplications, is relatively small.

***If our on-demand delivery model is not widelyaccepted, our operating results will be harmed.***

The on-demand delivery ofenterprise software is new and, to a large extent, unproven, and it isuncertain whether this model will achieve and sustain high levels of demand andmarket acceptance. The majority of our clients access and use our softwaresolutions on an on-demand basis. If the preferences of our clients change andour clients elect to deploy our software on-site, either upon the initiation ofa new agreement or upon the renewal of an existing agreement, we would potentiallyincur higher costs and encounter greater complexity in providing maintenanceand support for our software. Potential clients may be reluctant or unwillingto purchase enterprise software on-demand for a number of reasons, includingsecurity and data privacy concerns. If such organizations do not adopt theon-demand delivery model, then the market for our solutions may develop moreslowly than we expect. The inability of our on-demand delivery model to achievewidespread market acceptance would harm our business.

***Our business will suffer if our existing clientsterminate or do not renew their software subscriptions.***

We expect to continue to derive a significant portionof our revenue from renewals of subscriptions for our talent acquisition andemployee performance management solutions. During the year ended December 31,2006, our clients renewed more than 90% of the aggregate contract valueeligible to be renewed during the period. If our clients terminate theiragreements, fail to renew their agreements, renew their agreements upon lessfavorable terms to us or fail to purchase new solutions from us, our revenuemay decline or our future revenue growth may be constrained.

Maintaining therenewal rate of our existing subscriptions is critical to our future success.Factors that may affect the renewal rate for our solutions include:

·       theprice, performance and functionality of our solutions;

·       theavailability, price, performance and functionality of competing products andservices;

·       theeffectiveness of our support services; and

·       ourability to develop complementary products and services.

Most of our existing clients have entered intosubscription agreements with us that expire between one and three years fromthe initial contract date. Our clients have the right to terminate theircontracts under certain circumstances and are not obligated to renew theirsubscriptions for our solutions after the 

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expiration of the initialterms of their subscription agreements. In addition, our clients may negotiateterms which are less favorable to us upon renewal, or may request that welicense our software to them on a perpetual basis, which may reduce recurringrevenue from these clients. Our future success also depends in part on ourability to sell new solutions to our existing clients.

***If we fail to develop or acquire new products orenhance our existing solutions to meet the needs of our existing and futureclients, our revenue may decline.***

To remain competitive, we must continually improve andenhance the responsiveness, functionality and features of our existingsolutions and develop new solutions that address the talent acquisition andemployee performance management requirements of organizations. If we are unableto successfully develop or acquire new solutions or enhance our existingsolutions, our revenue may decline and our business and operating results willbe adversely affected. Since our initial public offering, we have introducedenhanced solutions. We intend to continue to introduce enhanced solutions togenerate additional revenue, attract new clients and respond to competition. Wemay not succeed in developing or introducing new or enhanced solutions ordeveloping or introducing them in a timely manner, and new or enhancedsolutions that we develop or introduce may not achieve the market acceptancenecessary to generate significant revenue.

In addition, it ispossible that evolving technology may enable new deployment mechanisms thatmake our on-demand business model obsolete. To the extent that we are notsuccessful in continuing to develop our solutions in correlation with evolvingtechnology, we may not be successful in establishing or maintaining our clientrelationships.

***We may engage in future acquisitions or investmentswhich present many risks, and we may not realize the anticipated financial andstrategic goals for any of these transactions.***

We have focused ondeveloping solutions for the enterprise talent acquisition and employeeperformance management market. Our market is highly fragmented and in thefuture we may acquire or make investments in complementary companies, products,services or technologies. Acquisitions and investments involve a number ofdifficulties that present risks to our business, including the following:

·       wemay be unable to achieve the anticipated benefits from the acquisition orinvestment;

·       wemay have difficulty integrating the operations and personnel of the acquiredbusiness, and may have difficulty retaining the key personnel of the acquiredbusiness;

·       wemay have difficulty incorporating the acquired technologies or products withour existing solutions;

·       ourongoing business and management’s attention may be disrupted or diverted bytransition or integration issues and the complexity of managing geographicallyand culturally diverse locations;

·       wemay lose customers of those companies that we acquire for reasons such as aparticular customer desiring to have multiple service vendors;

·       wemay have difficulty maintaining uniform standards, controls, procedures andpolicies across locations; and

·       wemay experience significant problems or liabilities associated with productquality, technology and legal contingencies        

On November 13, 2006, we acquired BrassRing  for a purchase price of approximately $114.7million. We are in the process of integrating BrassRing’s businesses. Thefactors noted above could have a material adverse effect on our business,results of operations and financial condition or cash flows, particularly inthe case of a larger acquisition or multiple acquisitions in a short period oftime. From time to time, we 

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may enter intonegotiations for acquisitions or investments that are not ultimatelyconsummated. These negotiations could result in significant diversion ofmanagement time, as well as out-of-pocket costs.

The consideration paid foran investment or acquisition may also affect our financial results. If we wereto proceed with one or more significant acquisitions in which the considerationincluded cash, we could be required to use a substantial portion of ouravailable cash or obtain debt or equity financing. To the extent that we issueshares of our capital stock or other rights to purchase shares of our capitalstock as consideration for an acquisition or in connection with the financingof an acquisition, including options or other rights, our existing shareholdersmay be diluted, and our earnings per share may decrease. In addition,acquisitions may result in the incurrence of debt, large one-time write-offs,including write-offs of acquired in-process research and development costs, andrestructuring charges. Acquisitions in the future may require us to incuradditional indebtedness to finance our working capital and may also result ingoodwill and other intangible assets that are subject to impairment tests,which could result in future impairment charges.

***If our efforts to attract new clients or to selladditional solutions to our existing clients are not successful, our revenuegrowth will be adversely affected.***

To grow our revenue, wemust continually add new clients and sell additional solutions to existingclients. If our existing and prospective clients do not perceive our solutionsto be of sufficiently high value and quality, we may not be able to attract newclients or to increase sales to existing clients. Our ability to attract newclients and to sell new solutions to existing clients will depend in large parton the success of our sales and marketing efforts. However, our existing andprospective clients may not be familiar with some of our solutions, or may havetraditionally used other products and services for some of their talentacquisition and employee performance management requirements. Our existing andprospective clients may develop their own solutions to address their talentacquisition and employee performance management requirements, purchasecompetitive product offerings or engage third-party providers of outsourcedtalent acquisition and employee performance management services. Additionally,some clients may require that we license our software to them on a perpetualbasis or that we allow them the contractual right to convert from a termlicense to a perpetual license during the contract term, which may reducerecurring revenue from these clients.

***If we are unable to compete effectively with companiesoffering enterprise talent acquisition and employee performance managementsolutions, our revenue may decline.***

We may not have the resources or expertise to competesuccessfully in the future. If we are unable to successfully compete, we couldlose existing clients, fail to attract new clients and our revenue woulddecline. The talent acquisition and employee performance management solutionsmarkets are rapidly evolving and highly competitive, and we expect competitionin these markets to persist and intensify. Barriers to entry into our industryare low, new software products are frequently introduced and existing productsare continually enhanced. We compete with niche point solution vendors such asAuthoria, Inc., Deploy Solutions, Inc., iCIMS, Inc., IntegratedPerformance Systems, Inc., InScope Corporation, Kronos Incorporated,  PeopleClick, Inc., Pilat HR Solutions, Inc.,Previsor, Inc., SHL Group plc, Success Factors, Inc., TaleoCorporation, Vurv Technology, Inc. and Workstream Inc. that offerproducts that compete with one or more applications contained in our solutions.In some aspects of our business, we also compete with established vendors ofenterprise resource planning, or ERP, software with much greater resources,such as Oracle Corporation (PeopleSoft), SAP AG and Lawson, Inc. To alesser extent, we compete with vendors of employment process outsourcingservices and survey services such as Accolo, Inc., The GallupOrganization, Hyrian, LLC and Recruitment Enhancement Services. In addition,many organizations have developed or may develop internal solutions to addressenterprise talent acquisition and employee performance management requirementsthat may be competitive with our solutions.

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Some of our competitorsand potential competitors, especially vendors of ERP software, havesignificantly greater financial, support, technical, development, marketing,sales, service and other resources, larger installed client bases, longeroperating histories, greater name recognition and more establishedrelationships than we have. In addition, ERP software competitors could bundletheir products with, or incorporate capabilities in addition to, talentacquisition and employee performance management functions, such as automatedpayroll and benefits, in products developed by themselves or others. Productswith such additional functions may be appealing to some clients because theywould reduce the number of different types of software or applications used torun their businesses. Our niche competitors’ products may be more effectivethan our solutions at performing particular talent acquisition and employeeperformance management functions or may be more customized for particularclient needs in a given market. Further, our competitors may be able to respondmore quickly than we can to changes in client requirements or regulatorychanges.

***Mergers or other strategic transactions involving ourcompetitors could weaken our competitive position or reduce our revenue.***

We believe that ourindustry is highly fragmented and that there is likely to be consolidation,which could lead to increased price competition and other forms of competition.Increased competition may cause pricing pressure and loss of market share,either of which could have a material adverse effect on our business, resultsof operations and financial condition. Our competitors may establish orstrengthen cooperative relationships with business process outsourcing vendors,systems integrators, third-party consulting firms or other parties. Establishedcompanies may not only develop their own products but may also merge with oracquire our current competitors. In addition, we may face competition in thefuture from large established companies, as well as from emerging companiesthat have not previously entered the markets for talent acquisition andemployee performance management solutions or that currently do not haveproducts that directly compete with our solutions. It is also possible that newcompetitors or alliances among competitors may emerge and rapidly acquiresignificant market share or sell their products at significantly discountedprices causing pricing pressure. In addition, our competitors may announce newproducts, services or enhancements that better meet the price or performanceneeds of clients or changing industry standards. If any of these events occur,our revenues and profitability could significantly decline.

***If we encounter barriers to the integration of oursoftware with software provided by our competitors or with the software used byour clients, our revenue may decline and our research and development expensesmay increase.***

In some cases our softwaremay need to be integrated with software provided by our competitors. Thesecompetitors could alter their products in ways that inhibit integration withour software, or they could deny or delay access by us to advance softwarereleases, which would restrict our ability to adapt our software to facilitateintegration with these new releases and could result in lost salesopportunities. In addition, our software is designed to be compatible with themost common third-party ERP systems. If the design of these ERP systemschanges, integration of our software with new systems would require significantwork and substantial allocation of our time and resources and increase ourresearch and development expenses.

***Reductions in information technology spending couldlimit our ability to grow our business.***

Our operating results mayvary based on changes in the information technology spending of our clients.The revenue growth and profitability of our business depend on the overalldemand for enterprise application software and services. We sell our solutionsprimarily to large organizations whose businesses fluctuate with generaleconomic and business conditions. As a result, decreased demand for enterpriseapplication software and services, and in particular talent acquisition andemployee performance 

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managementsolutions, caused by a weakening global economy may cause a decline in ourrevenue. Historically, economic downturns have resulted in overall reductionsin corporate information technology spending. In particular, software fortalent acquisition and employee performance management software may be viewed bysome of our existing and potential clients as a lower priority and may be amongthe first expenditures reduced as a result of unfavorable economic conditions.In the future, potential clients may decide to reduce their informationtechnology budgets by deferring or reconsidering product purchases, which wouldnegatively impact our operating results.

***Because we recognize revenue from the sale of oursolutions ratably over the term of the subscription period, a significantdownturn in our business may not be immediately reflected in our operatingresults.***

A decline in new or renewed subscriptions in any onequarter may not impact our financial performance in that quarter, but willnegatively affect our revenue in future quarters. If a number of contracts expireand are not renewed in the same quarter, our revenue could declinesignificantly in that quarter and in subsequent quarters.

We derived approximately 78.5%, 77.7% and 80.7% of ourtotal revenue for the years ended December 31, 2004, 2005 and 2006, respectively,from the sale of subscriptions for our solutions and expect that a significantportion of our revenue for the foreseeable future will be derived from thosesubscriptions. We recognize the associated revenue ratably over the term of thesubscription agreement, which is typically between one and three years. As aresult, a significant portion of the revenue that we report in each quarterreflects the recognition of deferred revenue from subscription agreementsentered into during previous periods. Accordingly, the effect of significantdeclines in sales and market acceptance of our solutions may not be reflectedin our short-term results of operations, making our results less indicative ofour future prospects.

If our revenue does not meet our expectations, we maynot be able to curtail our spending quickly enough and our cost of revenue,compensation and benefits and product development would increase as apercentage of revenue. Our subscription model also makes it difficult for us torapidly increase our revenue through additional sales in any one period, asrevenue from new clients is recognized over the applicable subscription term.

***Our financial performance may be difficult to forecastas a result of our focus on large clients and the long sales cycle associatedwith our solutions.***

Our sales cyclesare generally up to nine months and in some cases even longer. This long salescycle impedes our ability to accurately forecast the timing of sales in a givenperiod which could adversely affect our ability to meet our forecasts for thatperiod. We focus our sales efforts principally on large organizations withcomplex talent acquisition and employee performance management requirements.Accordingly, in any single quarter the majority of our revenue from sales tonew clients may be composed of large sales made to a relatively small number ofclients. Our failure to close a sale in any particular quarter may impederevenue growth until the sale closes, if at all. As a result, substantial timeand cost may be spent attempting to close a sale that may not be successful.The period between an initial sales contact and a contract signing isrelatively long due to several factors, including:

·       theneed to educate potential clients about the uses and benefits of our solutionsand the on-demand delivery model;

·       thediscretionary nature of our clients’ purchase and budget cycles;

·       thecompetitive evaluation of our solutions;

·       fluctuationsin the talent acquisition and employee performance management requirements ofour prospective clients;

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·       potentialeconomic downturns and reductions in corporate IT spending;

·       Announcementsor planned introductions of new products or services by us or our competitors;and

·       the lengthy purchasingapproval processes of our prospective clients       

***Interruptions or delays in service from our Webhosting facilities could impair the delivery of our service and harm ourbusiness.***

We provide our servicethrough computer hardware that is currently located in Web hosting facilitiesthat we operate. Our Web hosting facilities are vulnerable to damage orinterruption from earthquakes, floods, fires, power loss, telecommunicationsfailures and similar events. These facilities are also subject to break-ins,sabotage, intentional acts of terrorism, vandalism and similar misconduct.Despite precautions that we take at these facilities, the occurrence of anatural disaster, act of terrorism or other unanticipated problem at any ofthese facilities could result in lengthy interruptions in our service. Interruptionsin our service may reduce our revenue, cause us to issue credits or paypenalties, cause customers to terminate their subscriptions and adverselyaffect our renewal rates. Our business will be harmed if our customers andpotential customers believe our service is unreliable.

***If our security measures are breached and unauthorizedaccess is obtained to client data, clients may curtail or stop their use of oursolutions, which would harm our business, operating results and financialcondition.***

Our solutions involve thestorage and transmission of confidential information of clients and theirexisting and potential employees, and security breaches could expose us to arisk of loss of, or unauthorized access to, this information, resulting in possiblelitigation and possible liability. Although we have never sustained such abreach, if our security measures were ever breached as a result of third-partyaction, employee error, malfeasance or otherwise, and, as a result, anunauthorized party obtained access to this confidential data, our reputationcould be damaged, our business may suffer and we could incur significantliability. Techniques used to obtain unauthorized access or to sabotage systemschange frequently and generally are not discovered until launched against atarget. As a result, we may be unable to anticipate these techniques or toimplement adequate preventative measures. If an actual or perceived breach ofour security occurs, the market perception of our security measures could be harmedand we could lose sales and clients.

***Because our products collect and analyze applicants’and employees’ stored personal information, concerns that our products do notadequately protect the privacy of applicants and employees could inhibit salesof our products.***

Some of the features ofour talent acquisition and employee performance management applications dependon the ability to develop and maintain profiles of applicants and employees foruse by our clients. These profiles contain personal information, including jobexperience, home address and home telephone number. Typically, our softwareapplications capture this personal information when an applicant creates aprofile to apply for a job and an employee completes a performance review. Oursoftware applications augment these profiles over time by capturing additionaldata and collecting usage data. Although our applications are designed toprotect user privacy, privacy concerns nevertheless may cause employees andapplicants to resist providing the personal data necessary to support ourproducts. Any inability to adequately address privacy concerns could inhibitsales of our products and seriously harm our business, financial condition andoperating results.

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***We may increase our sales and marketing efforts toclients outside the United States, which would expose us to additional risksassociated with international operations, including the risks of managing ageographically diverse operation and foreign currency exchange ratefluctuations.***

As a part of our future business strategy, we intendto increase our international sales efforts in Canada, Europe and Asia. Wecurrently maintain international sales offices in Toronto, Canada; London,England; Harrow, England; Hyderabad, India; Munich, Germany; Hong Kong; KualaLumpur, Malaysia; Amsterdam, The Netherlands; and Taipei, Taiwan. We intend toopen an additional sales office in Vizag, India. We may not be successful inthese efforts. International operations and sales subject us to risks andchallenges that we would otherwise not face if we conducted our business onlyin the United States. For example, we will depend on third parties to marketour solutions through foreign sales channels, and we may be challenged by lawsand business practices favoring local competitors. In addition, our ability tosucceed in foreign markets will depend on the ability of our software toproperly filter foreign languages. We must also adopt our pricing structure toaddress different pricing environments and may face difficulty in enforcingrevenue collection internationally.

In addition, a portion ofour international sales are denominated in foreign currencies, and we incuroperating expenses in Indian rupees, British pounds and Canadian dollars. Weexpect our exposure to foreign exchange gains and losses to increase in thefuture.

***We may be unsuccessful in establishing and maintainingour planned facility in India and newly opened facility in Malaysia.***

We are in the process ofconstructing a facility in Vizag, India that will serve as the center of ourdevelopment activities in India, which are presently located in  facilities that we lease in Hyderabad, India.In addition, we opened an office in Kuala Lumpur, Malaysia in December 2006to house employees who will specialize in the translation of our products intoJapanese, Chinese and Korean. We have no experience with managing theconstruction of new facilities in the United States or abroad. As a result, wemay fail to obtain necessary permits or to comply with relevant governmentalregulations relating to the construction and operation of these facilities. Weintend to move the majority of our developers from our existing offices inHyderabad, India to our new facility in Vizag, India. Some of our existingemployees may not desire to make such a move and as a result may terminatetheir employment with us. If we fail to complete our construction project inVizag, India in a timely and cost-effective fashion, or if a substantial numberof our existing employees do not continue their employment with us upon theopening of that facility, our business may be harmed.

***If the unemployment rate increases materially, ourbusiness may be harmed.***

To the extent that the unemployment rate increasesmaterially, our existing and potential clients may no longer considerimprovement of their talent acquisition and employee performance managementsystems a necessity, which could have a material adverse effect on ourbusiness, results of operations and financial condition. Demand for oursolutions depends in part on our clients’ ability to hire their employees.According to the U.S. Bureau of Labor Statistics, the U.S. unemployment rate inDecember 2006 was 4.5%, which is low by historical standards.

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***Material defects or errors in our software couldaffect our reputation, result in significant costs to us and impair our abilityto sell our solutions, which would harm our business.***

The softwareapplications forming part of our solutions may contain material defects orerrors, which could materially and adversely affect our reputation, result insignificant costs to us and impair our ability to sell our solutions in thefuture. The costs incurred in correcting any material product defects or errorsmay be substantial and would adversely affect our operating results. After therelease of our products, defects or errors may also be identified from time totime by our internal team and by our clients. Such defects or errors may occurin the future. Any defects that cause interruptions to the availability of oursolutions could result in:

·       lostor delayed market acceptance and sales of our solutions;

·       lossof clients;

·       productliability suits against us;

·       diversionof development resources;

·       injuryto our reputation; and

·       increased maintenance andwarranty costs

***If we fail to adequately protect our proprietaryrights, our competitive advantage could be impaired and we may lose valuableassets, experience reduced revenue and incur costly litigation to protect ourrights.***

Our intellectual property rights are important to ourbusiness, and our success is dependent, in part, on protecting our proprietarysoftware and technology and our brand, marks and domain names. We rely on acombination of copyright, trademark, trade secret and other common laws in theUnited States and other jurisdictions as well as confidentiality procedures andcontractual provisions to protect our proprietary technology, processes andother intellectual property. It may be possible for unauthorized third partiesto copy our software and use information that we regard as proprietary tocreate products and services that compete with ours, which could harm ourcompetitive position and cause our revenue to decline.

We have three issued patents, and additionally wehave  four pending patent applications.There is no guarantee that the U.S. Patent and Trademark Office will grantthese patent, or do so in a manner that gives us the protection that we seek. We willnot be able to protect our intellectual property if we are unable to enforceour rights or if we do not detect unauthorized use of our intellectualproperty. Existing intellectual property laws only afford limited protection.

To the extent that we expand our internationalactivities, our exposure to unauthorized copying and use of our software andproprietary information may increase. Some license provisions protectingagainst unauthorized use, copying, transfer and disclosure of our licensedproducts may be unenforceable under the laws of certain jurisdictions andforeign countries in which we operate. Further, the laws of some countries, andin particular India, where we develop much of our intellectual property, do notprotect proprietary rights to the same extent as the laws of the United States.In the event that we are unable to protect our intellectual property rights,especially those rights that we develop in India, our business would bematerially and adversely affected.

Litigation may benecessary in the future to enforce our intellectual property rights and toprotect our trade secrets. Litigation, whether successful or unsuccessful,could result in substantial costs and diversion of management resources, eitherof which could seriously harm our business.

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***Our results of operations may be adversely affected ifwe are subject to a protracted infringement claim or a claim that results in asignificant damage award.***

We expect thatsoftware product developers, such as ourselves, will increasingly be subjectedto infringement claims as the number of products and competitors grows and thefunctionality of products in different industry segments overlaps. Ourcompetitors or other third parties may challenge the validity or scope of ourintellectual property rights. A claim may also be made relating to technologythat we acquire or license from third parties. If we were subject to a claim ofinfringement, regardless of the merit of the claim or our defenses, the claimcould:

·       requirecostly litigation to defend and resolve, and the payment of substantialdamages;

·       requiresignificant management time and attention;

·       causeus to enter into unfavorable royalty or license agreements;

·       requireus to discontinue the sale of our solutions;

·       createnegative publicity that adversely affects the demand for our solutions

·       requireus to indemnify our clients; and/or

·       requireus to expend additional development resources to redesign our software

Litigation could be costlyfor us to defend, have a negative effect on our operating results and financialcondition or require us to devote additional research and development resourcesto change our software.

***Changes in the regulatory environment and generaleconomic condition in India and elsewhere could have a material adverse effecton our business.***

Adverse changes in thebusiness or regulatory climate in India could have a material adverse effect onour business. In addition, wages in India are increasing at a faster rate thanin the United States. In the event that wages continue to rise, the cost benefitof operating in India and elsewhere may diminish. India has also experiencedsignificant inflation in the past and has been subject to civil unrest andterrorism. There can be no assurance that these and other factors will not havea material adverse effect on our business, results of operations and financialcondition.

***We employ technology licensed from third parties foruse in or with our solutions, and the loss or inability to maintain theselicenses on similar terms or errors in the software we license could result inincreased costs, or reduced service levels, which would adversely affect ourbusiness.***

We include in thedistribution of our solutions certain technology obtained under licenses fromother companies. We anticipate that we will continue to license technology anddevelopment tools from third parties in the future. There may not always becommercially reasonable software alternatives to the third-party software thatwe currently license, or any such alternatives may be more difficult or costlyto replace than the third-party software that we currently license. Inaddition, integration of our software with new third-party software may requiresignificant work and substantial allocation of our time and resources. Also, tothe extent we depend upon the successful operation of third-party products inconjunction with our software, any undetected errors in these third-partyproducts could prevent the implementation or impair the functionality of oursoftware, delay new solution introductions and injure our reputation. Our useof additional or alternative third-party software would require us to enterinto license agreements with third parties, which could result in higher costs.

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***Our quarterly operating results may fluctuatesignificantly, and these fluctuations may cause our stock price to fall.***

As a result offluctuations in our revenue and operating expenses, our quarterly operatingresults may vary significantly. We may not be able to curtail our spendingquickly enough if our revenue falls short of our expectations. We expect thatour operating expenses will increase substantially in the future as we expandour selling and marketing activities, increase our new product developmentefforts and hire additional personnel. Our operating results may fluctuate inthe future as a result of the factors described below and elsewhere in thisprospectus:

·       ourability to renew and increase subscriptions sold to existing clients, attractnew clients, cross-sell our solutions and satisfy our clients’ requirements;

·       changesin our pricing policies;

·       theintroduction of new features to our solutions;

·       therate of expansion and effectiveness of our sales force;

·       thelength of the sales cycle for our solutions;

·       newproduct and service introductions by our competitors;

·       concentrationof marketing expenses for activities, such as trade shows and advertisingcampaigns;

·       concentrationof research and development costs; and

·       concentrationof expenses associated with commissions earned on sales of subscriptions forour solutions. 

We believe thatperiod-to-period comparisons of our results of operations are not necessarilymeaningful as our future revenue and results of operations may varysubstantially. It is also possible that in future quarters our results of operationswill be below the expectations of securities market analysts and investors. Ineither case, the price of our common stock could decline, possibly materially.

***If we do not retain our executive officers, ourability to manage our business and continue our growth could be negativelyimpacted.***

We have grownsignificantly in recent years, and our management remains concentrated in asmall number of executive officers , most of whom have been employed with usfor at least five years. Our future success will depend to a significant extenton the continued service of these executive officers, namely Nooruddin S.Karsan, Troy A. Kanter, Donald F. Volk, Sarah M. Teten, , and Archie L. Jones, Jr.as well as our other key employees, software engineers and senior technical andsales personnel. We have not entered into employment agreements with any of ouremployees. The loss of the services of any of these individuals or group ofindividuals could have a material adverse effect on our business, financialcondition and results of operations. Competition for qualified personnel in thesoftware industry is intense, and we compete for these personnel with othersoftware companies that have greater financial and other resources than we do.If we lose the services of one or more of our executive officers or other keypersonnel, or if one or more of them decide to join a competitor or otherwisecompete directly or indirectly with us, our business could be harmed. Searchingfor replacements for key personnel could also divert management’s time andattention and result in increased operating expenses.

***We will not be able to maintain our revenue growth ifwe do not attract, train or retain qualified sales personnel.***

If we fail to successfullymaintain and expand our sales force, our future revenue and profitability willbe adversely affected. We depend on our direct sales force for substantiallyall of our revenue and intend 

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to makesignificant expenditures in upcoming years to expand our sales force. Ourfuture success will depend in part upon the continued expansion and increasedproductivity of our sales force. To the extent that we experience attrition inour direct sales force, we will need to hire replacements. We face intensecompetition for sales personnel in the software industry, and we may not besuccessful in hiring, training or retaining our sales personnel in accordancewith our plans. Even if we hire and train a sufficient number of salespersonnel, we may not generate enough additional revenue to exceed the expenseof hiring and training the new personnel.

***Failure to implement the appropriate controls andprocedures to manage our growth could harm our growth, business, operatingresults and financial condition.***

We are currentlyexperiencing a period of rapid growth in our operations, which has placed, andwill continue to place, a significant strain on our management, administrative,operational, technical and financial infrastructure. In particular, continuedrapid growth will require us to invest significant resources in additionalinfrastructure and to hire additional personnel. We decreased our employee basefrom 403 employees on December 31, 2002 to 393 on December 31,2003, but then increased our employee base to 522 employees on December 31,2004, 693 employees on December 31, 2005 and 1,220 employees on December 31,2006, including 44 and 254 employees that we acquired as a part of ouracquisitions including  Webhire in January 2006and BrassRing in November 2006, respectively. To manage our growth, wewill need to continue to improve our operational, financial and managementprocesses and controls and reporting systems and procedures. This effort mayrequire us to make significant capital expenditures or to incur significantexpenses, and may divert the attention of our personnel from our core businessoperations, any of which may adversely affect our financial performance. If wefail to successfully manage our growth, our business, operating results andfinancial condition will be adversely affected.

***Evolving European Union regulations related toconfidentiality of personal data may adversely affect our business.***

In order to provide oursolutions to our clients, we rely in part on our ability to access our clients’employee data. The European Union and other jurisdictions has adopted variousdata protection regulations related to the confidentiality of personal data. Todate, these regulations have not restricted our business as we have qualifiedfor a safe harbor available for U.S. companies that collect personal data fromareas under the jurisdiction of the European Union. To the extent that theseregulations are modified in such a manner that our safe harbor no longerapplies, our ability to conduct business in the European Union may be adverselyaffected.

***Any impairment in the value of our goodwill willresult in an accounting charge against our earnings, which could negativelyimpact our stock price.***

As of December 31,2006, we had $161 million of goodwill, representing approximately 60% ofour total assets as of such date. We will likely record a significant portionof the consideration that we paid in our acquisition of BrassRing as goodwill.As a result of acquisitions that we may complete in the future, we may berequired to record additional goodwill. In accordance with U.S. generallyaccepted accounting principles, we conduct an impairment analysis of ourgoodwill annually and at such other times when an event or change incircumstances occurs which would indicate potential impairment. If we determinesignificant impairment of our goodwill as a result of any of those tests, wewould be required to record a corresponding non-cash impairment charge againstour earnings that could negatively affect our stock price.

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***Evolving regulation of the Internet may increase ourexpenditures related to compliance efforts, which may adversely affect ourfinancial condition.***

As Internet commercecontinues to evolve, increasing regulation by federal, state and / or foreignagencies becomes more likely. We are particularly sensitive to these risksbecause the Internet is a critical component of our business model. Forexample, we believe that increased regulation is likely in the area of dataprivacy, and laws and regulations applying to the solicitation, collection,processing or use of personal or consumer information could affect our clients’ability to use and share data, potentially reducing demand for solutionsaccessed via the Internet and restricting our ability to store, process andshare data with our clients via the Internet. In addition, taxation of servicesprovided over the Internet or other charges imposed by government agencies orby private organizations for accessing the Internet may also be imposed. Anyregulation imposing greater fees for Internet use or restricting informationexchange over the Internet could result in a decline in the use of the Internetand the viability of Internet-based services, which could harm our business.

***The failure of our solutions to comply with employmentlaws may require us to indemnify our clients, which may harm our business.***

Some of our clientcontracts contain indemnification provisions that require us to indemnify ourclients against claims of non-compliance with employment laws related tohiring. To the extent these claims are successful and exceed our insurancecoverages, these obligations would have a negative impact on our cash flow,results of operation and financial condition.

***Our reported financial results may be adverselyaffected by changes in generally accepted accounting principles.***

Generally acceptedaccounting principles in the United States are subject to interpretation by theFinancial Accounting Standards Board, or FASB, the American Institute ofCertified Public Accountants, the SEC, and various bodies formed to promulgateand interpret appropriate accounting principles. A change in theseprinciples or interpretations could have a significant effect on our historicalor future financial results. For example, prior to January 1, 2006, wewere not required to record share-based compensation charges if the employee’sstock option exercise price is equal to or exceeds the deemed fair value of theunderlying security at the date of grant. However, effective January 1,2006 we are required to record the fair value of stock options as an expense inaccordance with new accounting pronouncements.

***Anti-takeover provisions of Pennsylvania law and ourarticles of incorporation and bylaws could delay and discourage takeoverattempts that shareholders may consider to be favorable.***

Certain provisionsof our articles of incorporation and and applicable provisions of thePennsylvania Business Corporation Law may make it more difficult for a thirdparty to, or prevent a third party from, acquiring control of us or effecting achange in our board of directors and management. These provisions include:

·       theclassification of our board of directors into three classes, with one classelected each year;

·       prohibitingcumulative voting in the election of directors;

·       theability of our board of directors to issue preferred stock without shareholderapproval;

·       ourshareholders may only take action at a meeting of our shareholders and not bywritten consent;

·       prohibitingshareholders from calling a special meeting of our shareholders;

·       ourshareholders must comply with advance notice procedures in order to nominatecandidates for election to our board of directors or to place shareholdersproposals on the agenda for consideration at any meeting of our shareholders;and

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·       prohibitingus from engaging in some types of business combinations with holders of 20% ormore of our voting securities without prior approval of our board of directors,unless a majority of our disinterested shareholders approve the transaction

The Pennsylvania Business Corporation Law furtherprovides that because our articles of incorporation provide for a classifiedboard of directors, shareholders may remove directors only for cause. These andother provisions of the Pennsylvania Business Corporation Law and our articlesof incorporation and bylaws could delay, defer or prevent us from experiencinga change of control or changes in our board of directors and management and mayadversely affect our shareholders’ voting and other rights. Any delay orprevention of a change of control transaction or changes in our board ofdirectors and management could deter potential acquirors or prevent thecompletion of a transaction in which our shareholders could receive asubstantial premium over the then current market price for their shares of ourcommon stock.

***The market price of our common stock may beparticularly volatile, and our shareholders may be unable to resell theirshares at a profit.***

The market price ofour common stock has been subject to significant fluctuations and may continueto fluctuate or decline. Since our initial public offering in June 2005,the closing prices of our common stock have ranged from a low of $11.80 to ahigh of $38.40. In the past several years, technology stocks have experiencedhigh levels of volatility and significant declines in value from their historichighs. Factors that could cause fluctuations in the trading price of our commonstock include the following:

·       priceand volume fluctuations in the overall stock market from time to time;

·       significantvolatility in the market price and trading volume of software companies ingeneral, and HR software companies in particular;

·       actualor anticipated changes in our earnings or fluctuations in our operatingresults;

·       generaleconomic conditions and trends;

·       majorcatastrophic events;

·       salesof large blocks of our stock; or

·       departuresof key personnel.

In the past, followingperiods of volatility in the market price of a company’s securities, securitiesclass action litigation has often been brought against that company. If ourstock price is volatile, we may become the target of securities litigation.Securities litigation could result in substantial costs and divert ourmanagement’s attention and resources from our business.

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**ITEM 1B. UnresolvedStaff Comments.**

Not Applicable.

**ITEM 2.     Properties**

Welease our headquarters in Wayne, Pennsylvania, which consists of approximately 41,808square feet. The table below provides additional information concerning our principalleased facilities, including the approximate square footage of each facilityand the lease expiration date. We believe that our facilities are in goodoperating condition and will adequately serve our needs for at least the next12 months. We also anticipate that, if required, suitable additional oralternative space will be available on commercially reasonable terms, in officebuildings we currently occupy or in space nearby, to accommodate expansion ofour operations.

| **Location**             | ** ** | ** ** | ** ** | **Approximate  Square Footage** | ** ** | **Monthly Rent** | ** ** | **Lease Expiration** | ** ** | ** ** | ** **                                        |
|--------------------------|------------|------------|------------|--------------------------------------|------------|-----------------------|------------|---------------------------|------------|------------|---------------------------------------------------|
| Hyderabad,  India        |       |       | 31,837     |                                 |       |                  | $          | 21,597                    |       |       | April 9,  2007 – February 14, 2011 |   |
| Lexington, Massachusetts |       |       | 29,241     |                                 |       |                  | $          | 61,829                    |       |       | September 30,  2007                          |   |
| Lincoln, Nebraska        |       |       | 41,374     |                                 |       |                  | $          | 70,053                    |       |       | October 31,  2009                            |   |
| Minneapolis, Minnesota   |       |       | 2,877      |                                 |       |                  | $          | 27,091                    |       |       | February 29,  2012                           |   |
| Waltham, Massachusetts   |       |       | 65,546     |                                 |       |                  | $          | 92,311                    |       |       | April 29,  2011                              |   |
| Wayne, Pennsylvania      |       |       | 41,808     |                                 |       |                  | $          | 92,769                    |       |       | May 13, 2013                                 |   |

 

**ITEM 3.     Legal Proceedings**

We are involved in claimsfrom time to time which arise in the ordinary course of business. In the opinionof management, we have made adequate provision for potential liabilities, ifany, arising from any such matters. However, litigation is inherentlyunpredictable, and the costs and other effects of pending or future litigation,governmental investigations, legal and administrative cases and proceedings(whether civil or criminal), settlements, judgments and investigations, claimsand changes in any such matters, and developments or assertions by or againstus relating to intellectual property rights and intellectual property licenses,could have a material adverse effect on our business, financial condition andoperating results.

**ITEM 4.     Submission of Matters to a Vote of SecurityHolders**

Not applicable

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**PART II**

**ITEM 5.    Market For TheRegistrant’s Common Equity, Related Stockholder Matters And Issuer Purchases ofEquity Securities**

***Market Information and Dividends***

Ourcommon stock has been quoted on The Nasdaq Stock Market, LLC under the symbol “KNXA”since June 24, 2005. Prior to that date, there was no public market forour common stock. The following table sets forth, for the periods indicated,the high and low sales prices of our common stock reported by The Nasdaq StockMarket, LLC.

| ** **                               | ** ** | **Common  Stock Price** | ** ** |
|------------------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **High**                     | ** ** | **Low** | ** ** |
| **Year  Ended December 31, 2005:**  | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Second Quarter (from June 24, 2005) |       | $                            | 13.38      |   | $ | 11.99 |   |
| Third Quarter                            |       | $                            | 16.20      |   | $ | 11.71 |   |
| Fourth Quarter                           |       | $                            | 21.61      |   | $ | 13.00 |   |
| **Year  Ended December 31, 2006:**  |       |                         |       |   |   |
| First Quarter                            |       | $                            | 31.30      |   | $ | 20.40 |   |
| Second Quarter                           |       | $                            | 38.40      |   | $ | 25.93 |   |
| Third Quarter                            |       | $                            | 33.38      |   | $ | 21.06 |   |
| Fourth Quarter                           |       | $                            | 34.96      |   | $ | 24.80 |   |

 

On March 8, 2007, the last reported sale price ofour common stock on The Nasdaq Stock Market, LLC was $32.50 per share. As of March 8,2007, there were approximately 99 holders of record of our common stock.

We have not declared or paid any cash dividends on ourcommon stock since our inception. We intend to retain future earnings, if any,to finance the operation and expansion of our business and do not anticipatepaying any cash dividends in the foreseeable future. Consequently, shareholderswill need to sell shares of our common stock to realize a return on theirinvestment, if any.

EquityCompensation Plan Information (as of December 31, 2006)

| ** **                                               | **Plan Category** | ** ** | ** ** | **Number of  Securities to be  issued  upon exercise** | ** ** | **Weighted-average  exercise price** | ** ** | **Securities  available for  future issuance  under equity  compensation  plan** | ** ** |
|----------------------------------------------------------|------------------------|------------|------------|----------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| Equity  Compensation Plans approved by shareholders      |                   |       | 896,400    |                                                                       |       |                                      | $          | 17.00                                                                                           |       |   |   | 3,138,046 |   |   |
| Equity Compensation  Plans not approved  by shareholders |                   |       | 405,608    |                                                                       |       |                                      | $          | 9.39                                                                                            |       |   |   |   |   |   |

 

All of the equitycompensation plans pursuant to which we are currently granting equity awardshave been approved by our shareholders.

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**STOCK PERFORMANCEGRAPH AND CUMULATIVE TOTAL RETURN**

The following graph shall not be deemed incorporatedby reference into any of our filings under the Securities Act of 1933 or theSecurities Exchange Act of 1934, except to the extent we specificallyincorporate it by reference therein.

Prior to June 28,2005, we were not publicly traded and there was no public market for oursecurities. The graph below compares the cumulative total return of our commonstock with that of the NASDAQ Composite Index, the NASDAQ Computer &Data Processing Index and the S&P Smallcap 600 Index from June 28, 2005(the date shares of our common stock began to trade publicly) through December 29,2006. The graph assumes that you invested $100 at the close of market on June 28,2005 in shares of our common stock and invested $100 at that same time in eachof these indexes, and in each case assumes the reinvestment of dividends. Thecomparisons in this graph are provided in accordance with Securities andExchange Commission disclosure requirements and are not intended to forecast orbe indicative of the future performance of shares of our common stock.

| ** **                                      | ** ** | **6/05**   | ** ** | **6/05**   | ** ** | **9/05**   | ** ** | **12/05**  | ** ** | **3/06**   | ** ** | **6/06**   | ** ** | **9/06**   | ** ** | **12/06**  | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Kenexa Corporation**                     | ** ** | **100.00** | ** ** | **104.10** | ** ** | **98.74**  | ** ** | **166.40** | ** ** | **242.51** | ** ** | **251.18** | ** ** | **198.90** | ** ** | **262.30** | ** ** |
| **NASDAQ  Composite**                           | ** ** | **100.00** | ** ** | **100.14** | ** ** | **105.77** | ** ** | **105.43** | ** ** | **113.36** | ** ** | **105.90** | ** ** | **109.91** | ** ** | **114.40** | ** ** |
| **S &  P Smallcap 600**                | ** ** | **100.00** | ** ** | **103.25** | ** ** | **108.80** | ** ** | **109.22** | ** ** | **123.24** | ** ** | **117.63** | ** ** | **116.59** | ** ** | **125.73** | ** ** |
| **NASDAQ Computer & Data  Processing** | ** ** | **100.00** | ** ** | **98.34**  | ** ** | **102.57** | ** ** | **107.05** | ** ** | **110.97** | ** ** | **102.95** | ** ** | **112.90** | ** ** | **121.01** | ** ** |

 

35

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** **

** **

***Sales of Unregistered Securities***

On November 20, 2006, as partial considerationfor the Company’s acquisition of all of the outstanding stock of PsychometricsLtd., the Company issued 19,611 shares of the Company’s common stock. Theseshares were issued without registration under the Securities Act of 1933, asamended, or the securities laws of certain states, in reliance on theexemptions provided by Section 4(2) of the Securities Act and similarexemptions under applicable state laws.

During the year ended December 31, 2006, warrantsto purchase 761,622 shares of our common stock were exercised by “cashlessexercise” resulting in the issuance of an aggregate of 250,499 shares of ourcommon stock. We did not receive any proceeds from the exercise of thesewarrants.

The term “cashlessexercise” refers to the surrender of a portion of a warrant as payment for theexercise price of the portion of the warrant exercised. No underwriters wereinvolved in the foregoing sales of securities. The sale of these securities wasexempt from registration under the Securities Act in reliance onSection 4(2) thereof or Regulation D promulgated thereunderrelating to sales not involving a public offering.

** **

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**ITEM 6. SelectedConsolidated Financial Data**

**SELECTEDCONSOLIDATED FINANCIAL DATA**

The selected consolidatedfinancial data set forth below are derived from our consolidated financialstatements and should be read in conjunction with our consolidated financialstatements and related notes appearing elsewhere in this Annual Report on Form 10-Kand “Management’s Discussion and Analysis of Financial Condition and Results ofOperations” section of this Annual Report on Form 10-K. Theconsolidated statement of operations data for each of the years ended December 31,2004, 2005 and 2006 and the consolidated balance sheet data as of December 31,2005 and 2006 are derived from, and qualified by reference to, our auditedconsolidated financial statements and related notes appearing elsewhere in thisfiling. The consolidated statement of operations data for each of the yearsended December 31, 2002 and 2003 and the consolidated balance sheet dataas of December 31, 2002, 2003 and 2004 are derived from our audited consolidatedfinancial statements not included in this filing. All of the historicalconsolidated financial data set forth below gives retroactive effect to a 0.8-for-1reverse stock split of our common stock on June 27, 2005. Our historicalresults are not necessarily indicative of results for any future period.

| ** **                                                                                            | ** ** | **For the Year Ended December 31,**                           | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2002**                                                                               | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                                            | ** ** | **(in thousands, except share and per share data)** | ** ** |
| **Consolidated Statement of Operations Data:**                                                        | ** ** | ** **                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                                                              |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Subscription revenue                                                                                  |       | $                                                                                      | 22,749     |   | $ | 25,511 |   | $ | 36,348 |   | $ | 50,974 |   | $ | 90,470 |   |
| Other revenue                                                                                         |       | 9,685                                                                                  |       | 8,480 |   | 9,952 |   | 14,667 |   | 21,637 |   |
| Total revenue                                                                                         |       | 32,434                                                                                 |       | 33,991 |   | 46,300 |   | 65,641 |   | 112,107 |   |
| Cost of revenue                                                                                       |       | 8,388                                                                                  |       | 8,768 |   | 12,230 |   | 18,782 |   | 31,712 |   |
| Gross profit                                                                                          |       | 24,046                                                                                 |       | 25,223 |   | 34,070 |   | 46,859 |   | 80,395 |   |
| **Operating expenses:**                                                                               | ** ** | ** **                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sales and marketing                                                                                   |       | 11,088                                                                                 |       | 10,470 |   | 13,350 |   | 16,133 |   | 25,134 |   |
| General and  administrative                                                                           |       | 8,684                                                                                  |       | 7,482 |   | 10,243 |   | 15,116 |   | 24,520 |   |
| Research and development                                                                              |       | 2,982                                                                                  |       | 3,463 |   | 4,271 |   | 3,986 |   | 8,618 |   |
| Depreciation and  amortization                                                                        |       | 2,640                                                                                  |       | 2,720 |   | 2,476 |   | 2,112 |   | 3,487 |   |
| Total operating expenses (3)                                                                          |       | 25,394                                                                                 |       | 24,135 |   | 30,340 |   | 37,347 |   | 61,759 |   |
| (Loss) income from  continuing operations before income tax and interest expense                      |       | (1,348                                                                                 | )          | 1,088 |   | 3,730 |   | 9,512 |   | 18,636 |   |
| Interest expense (income)                                                                             |       | 423                                                                                    |       | 352 |   | 160 |   | (566 | ) | (1,560 | ) |
| Interest on mandatory  redeemable preferred shares (1)                                                |       | —                                                                                 |       | 1,667 |   | 8,386 |   | 3,396 |   | — |   |
| (Loss) income from  continuing operations before income tax                                           |       | (1,771                                                                                 | )          | (931 | ) | (4,816 | ) | 6,682 |   | 20,196 |   |
| Income tax (benefit)  expense on continuing operations                                                |       | (84                                                                                    | )          | 33 |   | (723 | ) | 591 |   | 4,303 |   |
| (Loss) income from  continuing operations                                                             |       | (1,687                                                                                 | )          | (964 | ) | (4,093 | ) | 6,091 |   | 15,893 |   |
| Income from discontinued  operations, net of tax (2)                                                  |       | 283                                                                                    |       | 15 |   | — |   | — |   | — |   |
| Net (loss) income before  cumulative effect of change in accounting principle                         |       | (1,404                                                                                 | )          | (949 | ) | (4,093 | ) | 6,091 |   | 15,893 |   |
| Cumulative effect of  change in accounting principle (1)                                              |       | —                                                                                 |       | (11,233 | ) | — |   | — |   | — |   |
| Net (loss) income                                                                                     |       | $                                                                                      | (1,404     | ) | $ | (12,182 | ) | $ | (4,093 | ) | $ | 6,091 |   | $ | 15,893 |   |
| Accretion of redeemable  class B common shares and class C common shares                              |       | $                                                                                      | (3,609     | ) | $ | (3,443 | ) | $ | 1,019 |   | $ | 41,488 |   | $ | — |   |
| Accrued dividends on  series A preferred shares and series B preferred shares                         |       | 3,043                                                                                  |       | 1,586 |   | — |   | — |   | — |   |
| Accretion on series A preferred  shares and series B preferred shares                                 |       | 133                                                                                    |       | 872 |   | — |   | — |   | — |   |
| Net (loss) income  available to common shareholders                                                   |       | $                                                                                      | (971       | ) | $ | (11,197 | ) | $ | (5,112 | ) | $ | (35,397 | ) | $ | 15,893 |   |
| Basic (loss) income per share:                                                                        |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Net (loss) income from  continuing operations                                                         |       | $                                                                                      | (0.21      | ) | $ | (0.16 | ) | $ | (0.85 | ) | $ | (3.06 | ) | $ | 0.80 |   |
| Net income from  discontinued operations                                                              |       | 0.05                                                                                   |       | 0.00 |   | — |   | — |   | — |   |
| Net loss from cumulative  effect of change in accounting principle                                    |       | —                                                                                 |       | (1.86 | ) | — |   | — |   | — |   |
| Net (loss) income per  share available to common shareholders - basic                                 |       | $                                                                                      | (0.16      | ) | $ | (1.86 | ) | $ | (0.85 | ) | $ | (3.06 | ) | $ | 0.80 |   |
| Weighted average shares  used to compute net (loss) income available to common shareholders - basic   |       | 6,054,383                                                                              |       | 6,033,834 |   | 5,995,389 |   | 11,578,885 |   | 19,911,775 |   |
| Net (loss) income per  share available to common shareholders - diluted                               |       | $                                                                                      | (0.16      | ) | $ | (1.86 | ) | $ | (0.85 | ) | $ | (3.06 | ) | $ | 0.78 |   |
| Weighted average shares used to compute net (loss)  income available to common shareholders - diluted |       | 6,054,383                                                                              |       | 6,033,834 |   | 5,995,389 |   | 11,578,885 |   | 20,425,794 |   |

 

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| ** **                                    | ** ** | **As of December 31**, | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2002**                              | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                    | ** ** | **(in thousands)**               | ** ** |
| **Consolidated Balance Sheet  Data:**         | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                    |       | $                                     | 410        |   | $ | 3,078 |   | $ | 9,494 |   | $ | 43,499 |   | $ | 42,502 |   |
| Total assets                                  |       | 26,149                                |       | 25,309 |   | 33,288 |   | 73,899 |   | 267,459 |   |
| Short term debt,  net                         |       | 3,817                                 |       | 1,558 |   | — |   | — |   | 20,000 |   |
| Capital leases,  short term                   |       | 351                                   |       | 292 |   | 199 |   | 219 |   | 229 |   |
| Deferred revenue                              |       | 2,577                                 |       | 3,260 |   | 6,650 |   | 12,588 |   | 31,251 |   |
| Long term debt:                               |       |                                  |       |   |   |   |   |   |   |   |   |
| Series A preferred stock                 |       | 23,420                                |       | 35,471 |   | 41,727 |   | — |   | — |   |
| Series B preferred stock                 |       | 11,741                                |       | 15,048 |   | 17,178 |   | — |   | — |   |
| Capital leases, long term                     |       | 156                                   |       | 147 |   | 277 |   | 185 |   | 145 |   |
| Term Loan, long term                          |       | —                                |       | — |   | — |   | — |   | 45,000 |   |
| Other long term debt, net                     |       | 3                                     |       | — |   | 101 |   | 163 |   | 225 |   |
| Redeemable class B  common stock              |       | 5,201                                 |       | 3,747 |   | 5,291 |   | — |   | — |   |
| Redeemable class C  common stock              |       | 7,085                                 |       | 5,096 |   | 4,571 |   | — |   | — |   |
| Class A  common stock                    |       | 80                                    |       | 80 |   | 80 |   | 174 |   | 209 |   |
| Treasury stock                                |       | (8,195                                | )          | (8,199 | ) | (8,772 | ) | — |   | — |   |
| Total shareholders’  (deficiency) equity |       | (33,050                               | )          | (44,221 | ) | (49,576 | ) | 50,742 |   | 147,161 |   |
|                                               |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)             We adopted SFAS 150 effective July 1, 2003, whichrequired us to record the mandatory redeemable preferred stock at fair value atthe date of adoption and reflect the difference between carrying value and fairvalue as a cumulative effect of a change in accounting principle. Changes infair value after the initial adoption date are treated as interest expense.Dividends on mandatory redeemable preferred stock are also treated as interestexpense. The interest and change in accounting principle charges to net incomewere discontinued with the redemption of our series A preferred stock andseries B preferred stock in connection with the completion of our initialpublic offering in June 2005.

(2)             Discontinued operations related to ourpharmaceutical training and technology solutions group division for the yearsended December 31,  2002 and 2003are as follows (dollars in thousands): 

| ** **                                                      | ** ** | **For the year Ended  December 31,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2002**                                                 | ** ** | **2003** | ** ** |
| Revenue:                                                        |       |                                                     |       |   |   |
| Subscription revenue                                            |       | $                                                        | —     |   | $ | — |   |
| Other revenue                                                   |       | 14,239                                                   |       | 6,046 |   |
| Total revenue                                                   |       | 14,239                                                   |       | 6,046 |   |
| Cost of revenue                                                 |       | 7,565                                                    |       | 2,714 |   |
| Gross profit                                                    |       | 6,674                                                    |       | 3,332 |   |
| Total operating  expenses                                       |       | 6,179                                                    |       | 4,153 |   |
| Interest expense                                                |       | 24                                                       |       | 23 |   |
| Income (loss) from  discontinued operations before income taxes |       | 471                                                      |       | (844 | ) |
| Gain on sale of  discontinued operations                        |       | —                                                   |       | 869 |   |
| Income tax expense                                              |       | 188                                                      |       | 10 |   |
| Net income from  discontinued operations                        |       | $                                                        | 283        |   | $ | 15 |   |

 

(3)             In 2006 the company adopted Statement 123(R), whichrequires that the cost resulting from all share-based payment transactions berecognized in the financials statements.  As such, comparability between2004, 2005 and 2006 are affected.   See footnote No. 12, Stock Plans,to the Consolidated Financial Statements for the period ended December 31, 2006for further discussion.

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**ITEM 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

*Youshould read the following discussion and analysis of our financial conditionand results of operations in conjunction with the “Selected ConsolidatedFinancial Data” section and our consolidated financial statements and relatednotes appearing elsewhere in this Annual Report on Form 10-K. Inaddition to historical information, this discussion and analysis containsforward-looking statements based on current expectations that involve risks,uncertainties and assumptions, such as our plans, objectives, expectations andintentions. Our actual results and the timing of events may differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors, including those set forth in the “Item 1A—Risk Factors”section and elsewhere in this Annual Report on Form 10-K.*

**Overview**

We provide software,services and proprietary content that enable organizations to more effectivelyrecruit and retain employees. Our solutions are built around a suite of easilyconfigurable software applications that automate talent acquisition andemployee performance management best practices. We offer the softwareapplications that form the core of our solutions on an on-demand basis, whichmaterially reduces the costs and risks associated with deploying traditionalenterprise applications. We complement our software applications with tailoredcombinations of outsourcing services, consulting services and proprietarycontent based on our 18 years of experience assisting clients in addressingtheir human resource requirements. Together, our software applications andservices form solutions that we believe enable our clients to improve theeffectiveness of their talent acquisition programs, increase employeeproductivity and retention, measure key HR metrics and make their talentacquisition and employee performance management programs more efficient.

Since 1999, we havefocused on providing talent acquisition and employee performance managementsolutions on a subscription basis and currently generate a significant portionof our revenue from these subscriptions. For the years ended December 31,2005 and 2006, revenue from these subscriptions comprised approximately 77.7%and 80.7%, respectively, of our total revenue. We generate the remainder of ourrevenue from discrete professional services that are not provided as part of anintegrated solution on a subscription basis. These subscription-based solutionsprovide us with a recurring revenue stream and we believe represent a morecompelling opportunity in terms of growth and profitability than discreteprofessional services. As a result, since 1999 discrete professional serviceshave represented a consistently decreasing percentage of our revenue. We expectthat trend to continue.

We sell our solutions tolarge and medium-sized organizations through our direct sales force. As of December 31,2005, we had a client base of approximately 2,200 companies, including approximately119 companies on the Fortune 500 list published in April 2005. As a resultof the acquisitions of Webhire, Inc., Knowledge Workers, Gantz WileyResearch, Psychometric Services Ltd. and BrassRing in 2006, we increased ourclient base to approximately 3,000 companies, including approximately 166companies on the Fortune 500 list published in April 2006. Our client baseincludes companies that we billed for services during the year ended December 31,2006 and does not necessarily indicate an ongoing relationship with each suchclient. Our top 80 clients contributed approximately $68.4 million, or 61.0%,of our total revenue for the year ended December 31, 2006.

Our revenue has increasedat a compound annual growth rate of approximately 49% since 2003, from$34.0 million for the year ended December 31, 2003 to$46.3 million for the year ended December 31, 2004 to$65.6 million for the year ended December 31, 2005 and$112.1 million for the year ended December 31, 2006.

Historically, asubstantial portion of our clients have renewed their subscriptions each year.During the years ended December 31, 2004, 2005 and 2006, our clientsrenewed approximately  90% or higher  respectively, of the aggregate contract valueup for renewal during each of those periods.

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**Background**

We commenced operations in1987 as a provider of recruiting services to a wide variety of industries. In1993, we offered our first automated talent acquisition system and by 1997 wehad expanded our business to provide employee research, employee performancemanagement technology and consulting services. In late 1997, responding to agrowing demand from our customers, we embarked on a strategy to providecomprehensive human capital management services integrated with on-demandsoftware. Between 1994 and 1998, we acquired 15 businesses that collectivelyenabled us to offer comprehensive HCM services integrated with on-demandtechnology.

In1999, we commenced a strategy designed to focus our business on talentacquisition and employee performance management solutions and reduce ourstrategic focus on discrete professional services that generated lesspredictable revenue streams and lower margins. To that end:

·       in1999, we exited our temporary staffing business;

·       in2000 and 2001, we acquired four businesses which enhanced our screening andbehavioral assessment solutions and skills testing technologies;

·       since2002, we have reduced our strategic focus on position-specific recruitingservices;

·       in2003, we discontinued our Oracle implementation business and discontinued andsold our pharmaceutical training division; and

·       in2006, we enhanced our talent acquisition solutions and client base through ouracquisitions of Webhire, Inc., Knowledge Workers Inc.,  Gantz Wiley Research, Psychometric ServicesLtd., and BrassRing Inc.

As a result of our shiftin strategic focus in 2000, an increasing proportion of our revenue has beenderived from talent acquisition and employee performance management solutionswhile a decreasing portion of our revenue has been derived from discreteprofessional services. In 2000, revenue derived from subscriptions for thesesolutions comprised approximately 54.4% of our total revenue; in 2006 thispercentage increased to 80.7% of total revenue.  This shift to subscription based services hasbeen driven by our customer’s adoption of the on-demand model for softwaredelivery and need for solutions that improve employee recruiting and retention.

From our inception through1999, our operations were funded primarily through internally generated cashflows and our line of credit. In December 1999, we issued common stock andwarrants to purchase common stock to several investors, including ParthenonInvestors, L.P. and PCIP Investors, for approximately $22.0 million. Inconnection with this investment, we repurchased common stock held by aco-founder and former president of our predecessor for consideration ofapproximately $6.9 million and restructured our outstanding debt. On June 16,2000, we entered into a bridge financing in which we issued promissory notes inan aggregate principal amount of $10.0 million to Parthenon and PCIP foraggregate cash proceeds of $8.1 million, representing an original initialissue discount of $1.9 million. In connection with the bridge financing,Parthenon and PCIP also exercised warrants to purchase shares of common stockthat were acquired in the 1999 financing for an aggregate exercise price of$1.9 million.

In February 2001, we issued common and preferredstock to Wafra Acquisition Fund 14, L.P. for approximately $15.5 millionand to Parthenon and PCIP in exchange for the cancellation and discharge of thebridge notes issued in 2000. In March 2001, we issued common and preferredstock to Westbury Equity Partners SBIC, L.P. for approximately $6.0 millionin cash. In the same transaction, we redeemed a portion of the shares of commonand preferred stock held by Parthenon and PCIP for an aggregate price ofapproximately $2.4 million.

***Our Initial PublicOffering***

On June 29, 2005, wecompleted our initial public offering in which we sold an aggregate of5,750,000 shares of our common stock, including 750,000 shares sold pursuant tothe underwriters’ exercise of their 

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over-allotmentoption on July 3, 2005, at a price of $12.00 per share. Our net proceedsfrom our initial public offering aggregated approximately $61.5 millionafter deducting underwriting commissions and offering expenses.

Pursuant to the terms ofan agreement that we entered into prior to our initial public offering with theholders of all of our class B common stock, class C common stock,series A preferred stock and series B preferred stock and as providedfor in our articles of incorporation in effect prior to our initial publicoffering, all of our outstanding shares of class B common stock andclass C common stock automatically converted into 2,179,152 and 2,100,060shares of our common stock, respectively, at the closing of our initial publicoffering. Under the terms of this agreement, we also redeemed all of theoutstanding shares of our series A preferred stock and series Bpreferred stock for a combination of an aggregate of approximately$28.6 million and $11.4 million, respectively, in cash, and theissuance of 1,134,126 and 724,250 shares of our common stock, respectively. Inaddition, pursuant to this agreement, we issued 396,195 shares of our commonstock upon the exercise of warrants held by certain of our principal shareholdersin connection with our initial public offering.

In connection with theredemption and conversion transactions described above, we incurred charges of$32.6 million due to the accretion on our class B common stock,class C common stock, series A preferred stock and series Bpreferred stock and $0.9 million due to accrued dividends on ourseries A preferred stock and series B preferred stock.

***Recent Transactions***

On January 13, 2006,we acquired Webhire, Inc., a provider of end-to-end talent acquisitionsolutions for recruitment and human resource professionals in middle-marketenterprises across all industries, for approximately $34.4 million in cash. Thetotal cost of the acquisition, including legal, accounting, and otherprofessional fees of $0.6 million, was approximately $35.0 million. Thestrategic rationale for acquiring Webhire included expanding our marketopportunity and product suite, broadening our vertical market specializationand increasing our customer base through cross-sales to Webhire’s customers.

On March 8, 2006, wecompleted a public offering of 2,425,000 shares of our common stock at a priceto the public of $27.00 per share. We also sold an additional 216,800 shares ofour common stock to cover over-allotments of shares. Our net proceeds from theoffering, after payment of all offering expenses and commissions, aggregatedapproximately $66.3 million. In addition, certain of our shareholders sold anaggregate of 3,510,700 shares of our common stock in the offering, including anover-allotment of 585,700 shares. We received no proceeds from the common stocksold by the selling shareholders in this offering.

On April 10, 2006, weacquired Knowledge Workers Inc., a human capital consulting and technology firmbased in Denver Colorado, for approximately $2.5 million in cash. The totalcost of the acquisition, including estimated legal, accounting, and otherprofessional fess, was approximately $2.6 million.

On August 14, 2006,we acquired Gantz Wiley Research, an employee and customer survey data analysisfirm based in Minneapolis, Minnesota, for a purchase price of approximately$2.7 million in cash and $3.2 million in stock consideration. The total cost ofthe acquisition, including estimated legal, accounting, and other professionalfees, was approximately $5.9 million. In addition, our agreement with GantzWiley contained an earnout provision which provided for the payment ofadditional consideration by the Company based upon the annual revenues of GantzWiley Research through December 31, 2006. Based upon these results, wepaid an additional consideration of $1.3 million in cash and equity during thefirst quarter of 2007 to the former shareholder of Gantz Wiley. The relatedliability has been reflected in the financial statements at December 31,2006.

On November 13, 2006,we acquired BrassRing Inc. and BrassRing LLC a provider of talent managementsolutions, for approximately $114.7 million in cash. The total cost of theacquisition, including legal, accounting, and other professional fees of$2.9 million, was approximately $117.6 million. The strategicrationale for acquiring BrassRing included expansion of opportunities with large, global 

41

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customers, expansion of global infrastructure andproduct capabilities, and creationof cross-marketing opportunities.

On November 13, 2006,we entered into a new secured credit facility with PNC Bank, N.A., asadministrative agent, in connection with our acquisition of BrassRing. Ourobligations under the new credit facility are secured by substantially all ofour assets and the assets of our subsidiaries. This credit facility replacedour prior $25 million revolving credit facility with PNC Bank. Under the termsof the credit facility, we borrowed $75 million on November 13, 2006 tofund our acquisition of BrassRing and repaid the remainder of our borrowingsunder the credit facility with the proceeds from the public offering that wecompleted in January 2007.

On November 20, 2006,we acquired Psychometric Services Ltd., or PSL, a provider of online andpaper-based assessment products, training and consultancy based in the UnitedKingdom for approximately $7.5 million in cash and $0.6 million in stockconsideration. The strategic rationale for acquiring PSL was to add PSL’slibrary of content and team of psychologists to extend Kenexa’s valueproposition and to further differentiate Kenexa from a domain expertiseperspective. In addition, we believe that the acquisition of PSL advancesKenexa’s efforts to build out its international infrastructure, while adding anattractive customer list of commercial and government entities in the UK.

On January 18, 2007,we completed a public offering of 3,750,000 shares of our common stock at aprice to the public of $31.86 per share. We also sold an additional 562,500shares of our common stock to cover over-allotments of shares. Our net proceedsfrom the offering, after payment of all offering expenses and commissions,aggregated approximately $131.0 million.

***Sources of Revenue***

We derive revenueprimarily from two sources: (1) subscription revenue for our solutions,which is comprised of subscription fees from clients accessing our on-demandsoftware, consulting services, outsourcing services and proprietary content,and from clients purchasing additional support that is not included in thebasic subscription fee; and (2) fees for discrete professional services.

Our clients primarilypurchase renewable subscriptions for our solutions. The typical term is one tothree years, with some terms extending up to five years. The majority of oursubscription agreements are not cancelable for convenience although our clientshave the right to terminate their contracts for cause if we fail to provide theagreed upon services or otherwise breach the agreement. A client does not generallyhave a right to a refund of any advance payments if the contract is cancelled.We expect that we will maintain our renewal rate of approximately 90.0% of theaggregate contract value up for renewal for 2007, 2008 and 2009. The revenuederived from subscription fees is recognized ratably over the term of thesubscription agreement. We generally invoice our clients in advance in monthlyor quarterly installments and typical payment terms provide that our clientspay us within 30 days of invoice. Amounts that have been invoiced are recordedin accounts receivable prior to the receipt of payment and in deferred revenueto the extent revenue recognition criteria have not been met. As thesubscription component of our revenue has grown and clients’ willingness to payus in advance for their subscriptions has increased, the amount of deferredrevenue on our balance sheet has grown at a higher rate than our revenue. As ofDecember 31, 2006, deferred revenue increased to $31.3 million from $12.6million at December 31. 2005. We generally price our solutions based onthe number of software applications and services included and the number ofclient employees. Accordingly, subscription fees are generally greater forlarger organizations and for those that subscribe for a broader array ofsoftware applications and services.

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We derive other revenue from the sale of discreteprofessional services, and translation services as well as from out-of-pocketexpenses. The majority of our other revenue is derived from discreteprofessional services, which primarily consist of consulting and trainingservices. This revenue is recognized differently depending on the type ofservice provided as described in greater detail below under “CriticalAccounting Policies and Estimates.”

We generate substantiallyall of our revenue from within the United States. For the year ended December 31,2006, approximately 90% of our total revenue was derived from sales in theUnited States. Other than the revenue that we generated from clients in theNetherlands and the United Kingdom, which in the aggregate amounted to 5.3% ofour total revenue for the year ended December 31, 2006, and revenue thatwas generated from clients in Canada which amounted to 2.4% for the year ended December 31,2006, we did not have revenue from any other country in excess of 0.5% of ourtotal revenue for the year ended December 31, 2006.

***Cost of Revenue***

Our cost of revenueprimarily consists of compensation, employee benefits and out-of-pockettravel-related expenses for our employees and independent contractors whoprovide consulting or other professional services to our clients. Additionally,our application hosting costs, amortization of third-party license royaltycosts, technical support personnel costs, overhead allocated based on headcountand reimbursed expenses are also recorded as cost of revenue. Many factorsaffect our cost of revenue, including changes in the mix of products andservices, pricing trends, changes in the amount of reimbursed expenses andfluctuations in our client base. Because cost as a percentage of revenue ishigher for professional services than for software products, an increase in theservices component of our solutions or an increase in discrete professionalservices as a percentage of our total revenue would reduce gross profit as apercentage of total revenue. As our business expands, we expect thatthird-party license royalty costs and personnel costs associated with thedelivery of our solutions will continue to increase.

***Operating Expenses***

We classify our operating expenses as follows:

*Sales and Marketing.*   Sales and marketing expenses primarily consist ofpersonnel and related costs for employees engaged in sales and marketing,including salaries, commissions, and other variable compensation, travelexpenses and costs associated with trade shows, advertising and other marketingefforts and allocated overhead. We expense our sales commissions at the timethe related revenue is recognized, and we recognize revenue from oursubscription agreements ratably over the terms of the agreements. Investment insales and marketing commencing in 2003 resulted in significant revenue growthduring 2004, 2005 and 2006. We intend to continue to invest in sales andmarketing to pursue new clients and expand relationships with existing clients.Our sales and marketing expense has increased in absolute terms although it hasdecreased as a percentage of total revenue. We expect this trend to continue.

*Researchand Development.**  *Researchand development expenses primarily consist of personnel and related costs,including salaries, and employee benefits, for software engineers, qualityassurance engineers, product managers, technical sales engineers and managementinformation systems personnel. Our research and development efforts have beendevoted primarily to enhancements and upgrades to our existing products.Historically, we have capitalized a small percentage of our research anddevelopment expenses as internally developed software. Capitalized expensestotaled $0.3 million, $0.3 million, and $0.6 million for theyears ended December 31, 2004, 2005 and 2006, respectively. The remainingresearch and development expenses have been expensed as incurred. We expectresearch and development expenses to increase in the future as we employ morepersonnel to support enhancements of our solutions 

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and new solutionsofferings. However, we expect research and development expenses to increase asa percentage of total revenue primarily due to the expansion of our researchand development efforts.

*General and Administrative.**  *General and administrative expensesprimarily consist of personnel and related costs for our executive, finance,human resources and administrative personnel, professional fees and othercorporate expenses and allocated overhead. As we expand our business and incuradditional expenses associated with being a public company, we believe thatgeneral and administrative expenses will increase in dollar amount and maydecrease as a percentage of total revenue in 2007 and future periods.

**Key PerformanceIndicators**

Thefollowing tables summarize the key performance indicators that we consider tobe material in managing our business:

| ** **                                                     | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2004**                                                     | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                     | ** ** | **(in thousands, except for  percentages)**   | ** ** |
| Total Revenue                                                  |       | $                                                            | 46,301     |   | $ | 65,641 |   | $ | 112,107 |   |
| Subscription  revenue as a percentage of total revenue         |       | 78.5                                                         | %          | 77.7 | % | 80.7 | % |
| Income from  operations before income tax and interest expense |       | $                                                            | 3,730      |   | $ | 9,512 |   | 18,636 |   |
| Net cash provided by  operating activities                     |       | $                                                            | 10,056     |   | $ | 16,941 |   | $ | 18,610 |   |

 

| ** **       | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------|------------|--------------------------------------------------------------|------------|
| ** **       | ** ** | **2004**                                                     | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **       | ** ** | **(in thousands)**                                      | ** ** |
| Deferred revenue |       | $                                                            | 6,650      |   | $ | 12,588 |   | $ | 32,251 |   |
|                  |            |                                                              |            |  |  |  |  |  |  |  |

 

The following is a discussion of some of the termsused in the tables above.

***Subscription revenue as a percentageof total revenue.***   Subscription revenue as apercentage of total revenue can be derived from our consolidated statement ofoperations. This performance indicator illustrates the evolution of ourbusiness towards subscription-based solutions, which provide us with arecurring revenue stream and which we believe to be a more compelling revenuegrowth and profitability opportunity. We expect that the percentage ofsubscription revenue will be in the range of 78-82% of our total revenuesthrough at least 2008.

***Net cash provided by operatingactivities.***   Net cash provided by operatingactivities is taken from our consolidated statement of cash flows andrepresents the amount of cash generated by our operations that is available forinvesting and financing activities. Historically, our net cash provided byoperating activities has exceeded our net income primarily due to the positiveimpact of deferred revenue. We expect this trend to continue because of theadvance payment structure of our subscription agreements and because as oursales increase, we expect incremental costs to decline.

***Deferred revenue.***   Wegenerate revenue primarily from multi-year subscriptions for our on-demandtalent acquisition and employee performance management solutions. We recognizerevenue from these subscription agreements ratably over the term of thecontract, which are typically one to three years. We generally invoice ourclients in quarterly or monthly installments in advance. Deferred revenue,which is included in our consolidated balance sheets, is the amount of invoicedsubscriptions in excess of the amount recognized as revenue. Deferred revenuerepresents, in part, the amount that we will record as revenue in ourconsolidated statements of operations in future periods. As the subscriptioncomponent of our revenue has grown and customer willingness to pay us inadvance for their subscriptions has increased, the amount of deferred revenueon our balance sheet has grown at a higher rate than our revenue growth rate.We expect this trend to continue.

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Thefollowing table reconciles beginning and ending deferred revenue for each ofthe periods shown:

| ** **                                       | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                                     | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                                      | ** ** |
| Deferred revenue  at the beginning of the period |       | $                                                            | 3,260      |   | $ | 6,650 |   | $ | 12,588 |   |
| Total invoiced  subscriptions during period      |       | 39,738                                                       |       | 56,882 |   | 95,087 |   |
| Deferred revenue  from acquisition               |       | —                                                       |       |   |   | 14,046 |   |
| Subscription  revenue recognized during period   |       | (36,348                                                      | )          | (50,974 | ) | (90,470 | ) |
| Deferred revenue at end  of period               |       | $                                                            | 6,650      |   | $ | 12,588 |   | $ | 31,251 |   |

 

**Critical AccountingPolicies and Estimates**

Our discussion and analysis of our financial conditionand consolidated results of operations are based upon our consolidatedfinancial statements, which have been prepared in accordance with generallyaccepted accounting principles in the United States. The preparation of our consolidatedfinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenue and expenses and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to uncollectable accountsreceivable and accrued expenses. We base these estimates on historicalexperience and various other assumptions that we believe to be reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. Our actual results may differ from theseestimates.

We believe that thefollowing critical accounting policies affect our more significant estimatesand judgments used in the preparation of our consolidated financial statements:

***Revenue Recognition***

We derive ourrevenue from two sources: (1) subscription revenues for solutions, whichare comprised of subscription fees from clients accessing our on-demandsoftware, consulting services, outsourcing services and proprietary content,and from clients purchasing additional support beyond the standard support thatis included in the basic subscription fee; and (2) other fees for professionalservices, translation services and reimbursed out-of-pocket expenses. Becausewe provide our solutions as a service, we follow the provisions of StaffAccounting Bulletin No. 101, Revenue Recognition in Financial Statements,as amended by Staff Accounting Bulletin No. 104, Revenue Recognition. On August 1,2003, we adopted Emerging Issues Task Force Issue No. 00-21, RevenueArrangements with Multiple Deliverables. We recognize revenue when all of thefollowing conditions are met:

·       Thereis persuasive evidence of an arrangement;

·       Theservice has been provided to the client;

·       Thecollection of the fees is probable; and

·       Theamount of fees to be paid by the customer is fixed or determinable.

*SubscriptionFees and Support Revenues.**  *Subscription fees and support revenues are recognizedon a monthly basis over the lives of the contracts. Amounts that have beeninvoiced are recorded in accounts receivable and in deferred revenue orrevenue, depending on whether the revenue recognition criteria have been met.We recorded subscription fees and support revenues of approximately$36.3 million, $51.0 million and $90.5 million for the yearsended December 31, 2004, 2005 and 2006, respectively.

*OtherRevenue.**  *Otherrevenue consists of discrete professional services, translation services andreimbursable out-of-pocket expenses. Discrete professional services, when soldwith subscription and 

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support offerings, areaccounted for separately since these services have value to the customer on astand-alone basis and there is objective and reliable evidence of fair value ofthe delivered elements. Our arrangements do not contain general rights ofreturn. Additionally, when professional services are sold with other elements,the consideration from the revenue arrangement is allocated among the separateelements based upon the relative fair value. Revenues from professionalservices are recognized as the services are rendered.

In determining whether revenues from professionalservices can be accounted for separately from subscription revenue, we considerthe following factors for each agreement: availability of professional servicesfrom other vendors, whether objective and reliable evidence of the fair valueexists of the undelivered elements, the nature and the timing of when theagreement was signed in comparison to the subscription agreement start date andthe contractual dependence of the subscription service on the customer’ssatisfaction with the other services. If the professional service does not qualifyfor separate accounting, we recognize the revenue ratably over the remainingterm of the subscription contract. In these situations we defer the direct andincremental costs of the professional service over the same period as therevenue is recognized.

We record reimbursableout-of-pocket expenses incurred in accordance with EITF issue 01-14,Income Statement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred, which requires that reimbursements received for out-of-pocketexpenses be classified as revenue and not as cost reductions. Before the December 15,2001 effective date of EITF Issue 01-14, out-of-pocket reimbursementsfrom clients were netted with the applicable costs. These items primarilyinclude travel, meals and certain telecommunication costs. For the years ended December 31,2004, 2005, and 2006, reimbursed expenses totaled $1.3 million,$1.4 million, and $1.9 million, respectively.

***Allowance for Doubtful Accounts***

We maintain an allowancefor doubtful accounts for estimated losses resulting from clients’ inability topay us. The provision is based on our historical experience and for specificclients that, in our opinion, are likely to default on our receivables fromthem. In order to identify these clients, we perform ongoing reviews of allclients that have breached their payment terms, as well as those that havefiled for bankruptcy or for whom information has become available indicating asignificant risk of non-recoverability. In addition, we have experiencedsignificant growth in number of clients, and we have less payment history torely upon with these clients. We rely on historical trends of bad debt as apercentage of total revenue and apply these percentages to the accountsreceivable associated with new clients and evaluate these clients over time. Tothe extent that our future collections differ from our assumptions based onhistorical experience, the amount of our bad debt and allowance recorded may bedifferent.

***Capitalized Software Research and Development Costs***

In accordance with EITFIssue 00-3, “Application of AICPA Statement of Position 97-2 toArrangements That Include the Right to Use Software Stored on Another Entity’sHardware,” we apply AICPA Statement of Position No. 98-1, Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use. Thecosts incurred in the preliminary stages of development are expensed asincurred. Once an application has reached the development stage, internal andexternal costs, if direct and incremental, will be capitalized until thesoftware is substantially complete and ready for its intended use.Capitalization ceases upon completion of all substantial testing. We alsocapitalize costs related to specific upgrades and enhancements when it is probablethe expenditures will result in additional functionality. Maintenance andtraining cost are expensed as incurred. Internal use software is amortized on astraight-line basis over its estimated useful life, generally three years.Management evaluates the useful lives of these assets on an annual basis andtests for impairments whenever events or changes in circumstances 

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occurthat could impact the recoverability of these assets. There were no impairmentsto internal software in any of the periods covered in this audit report.

***Goodwill and Other Identified Intangible AssetImpairment***

On January 1, 2002,we adopted SFAS No. 142, Goodwill and Other Intangible Assets whichsuperseded Accounting Board Opinion No. 17, Intangible Assets. Uponadoption of SFAS No. 142, we ceased amortization of existing goodwill andare required to review the carrying value of goodwill for impairment. Ifgoodwill becomes impaired, some or all of the goodwill could be written off asa charge to operations. This comparison is performed annually or morefrequently if circumstances change that would more likely than not reduce thefair value of the reporting unit below its carry amount. We have reviewed thecarrying values of goodwill of each business unit by comparing the carryingvalues to the estimated fair values of the business components. The fair valueis based on management’s estimate of the future discounted cash flows to begenerated by the respective business components and comparable companymultiples. Such cash flows consider factors such as future operating income,historical trends, as well as demand and competition. Comparable companymultiples are based upon public companies in sectors relevant to our businessbased on our knowledge of the industry. Changes in the underlying businesscould affect these estimates, which in turn could affect the recoverability ofgoodwill. We determined that the carrying values of our goodwill did not exceedthe fair values and as a result we do not believe that impairment of goodwill existedat December 31, 2006.

***Accounting for Share-Based Compensation***

We use aBlack-Scholes option-pricing model to calculate the fair value of our stockawards. The calculation of the fair value of the awards using the Black-Scholesoption-pricing model is affected by our stock price on the date of grant aswell as assumptions regarding the following:

·       Volatilityis a measure of the amount by which the stock price is expected to fluctuateeach year during the expected life of the award and is based on a weightedaverage of peer companies, comparable indices and our stock volatility. Anincrease in the volatility would result in an increase in our expense.

·       Theexpected term represents the period of time that awards granted are expected tobe outstanding and is currently based upon an average of the contractual lifeand the vesting period of the options. With the passage of time actualbehavioral patterns surrounding the expected term will replace the currentmethodology. Changes in the future exercise behavior of employees or in thevesting period of the award could result in a change in the expected term. Anincrease in the expected term would result in an increase to our expense.

·       Therisk-free interest rate is based on the U.S. Treasury yield curve in effect attime of grant. An increase in the risk-free interest rate would result in anincrease in our expense.

·       Theestimated forfeiture rate is the rate by which awards are expected to expirebefore they become fully vested and exercisable. An increase in the forfeiturerate would result in a decrease to our expense.

Share-based compensationexpense recognized during the period is based on the value of the number ofawards that are expected to vest. In determining the share-based compensationexpense to be recognized, a forfeiture rate is applied to the fair value of theaward. This rate represents the number of awards that are expected to beforfeited prior to vesting and is based on Kenexa’s employee historicalbehavior. Changes in the future behavior of employees could impact this rate. Adecrease in this rate would result in an increase in our expense.

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***Accounting for Income Taxes***

We account for income taxes in accordance with FASBStatement No. 109, “Accounting for Income Taxes,” or SFAS No. 109,which requires that deferred tax assets and liabilities be recognized usingenacted tax rates for the effect of temporary differences between the book andtax basis of recorded assets and liabilities. SFAS No. 109 alsorequires that deferred tax assets be reduced by a valuation allowance if it ismore likely than not that some portion of all of the deferred tax asset willnot be realized.

The realization of the deferred tax assets isevaluated quarterly by assessing the valuation allowance and by adjusting theamount of the allowance, if necessary. The factors used to assess thelikelihood of realization are the forecast of future taxable income andavailable tax planning strategies that could be implemented to realize the netdeferred tax assets. We have used tax-planning strategies to realize or renewnet deferred tax assets in order to avoid the potential loss of future taxbenefits.

In addition, we operate within multiple taxingjurisdictions and are subject to audit in each jurisdiction. These audits caninvolve complex issues that may require an extended period of time to resolve.In our opinion, adequate provisions for income taxes have been made for allperiods.

***Self-Insurance***

We are self-insured for the majority of our healthinsurance costs, including claims filed and claims incurred but not reportedsubject to certain stop loss provisions. We estimate our liability based uponmanagement’s judgment and historical experience. We also rely on the advice ofconsulting administrators in determining an adequate liability forself-insurance claims. As of December 31, 2004, 2005 and 2006,self-insurance accruals totaled approximately $0.2 million,$0.2 million and $0.3 million, respectively. We continuously reviewthe adequacy of our insurance coverage. Material differences may result in theamount and timing of insurance expense if actual experience differssignificantly from management’s estimates.

**ConsolidatedResults of Operations and Geographic Information**

***Consolidated Historical Results of Operations***

The following table setsforth certain consolidated historical results of operations data expressed as apercentage of total revenue for the periods indicated. Period-to-periodcomparisons of our financial results are not necessarily meaningful and youshould not rely on them as an indication of future performance.

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**KenexaCorporation Consolidated Statement of Operations(In thousands)**

| ** **                                                          | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                                                     | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                          | ** ** | **Amount**                                                   | ** ** | **Percent of  Revenues** | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** |
| Revenue:                                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Subscription  revenue                                               |       | $                                                            | 36,349     |   |   | 78.5 | % |   | $ | 50,974 |   |   | 77.7 | % |   | $ | 90,470 |   |   | 80.7 | % |   |
| Other revenue                                                       |       | 9,952                                                        |       |   | 21.5 | % |   | 14,667 |   |   | 22.3 | % |   | 21,637 |   |   | 19.3 | % |   |
| Total revenue                                                       |       | 46,301                                                       |       |   | 100.0 | % |   | 65,641 |   |   | 100.0 | % |   | 112,107 |   |   | 100.0 | % |   |
| Cost of revenue                                                     |       | 12,230                                                       |       |   | 26.4 | % |   | 18,782 |   |   | 28.6 | % |   | 31,712 |   |   | 28.3 | % |   |
| Gross profit                                                        |       | 34,071                                                       |       |   | 73.6 | % |   | 46,859 |   |   | 71.4 | % |   | 80,395 |   |   | 71.7 | % |   |
| Operating expenses:                                                 |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and  marketing                                                |       | 13,351                                                       |       |   | 29.0 | % |   | 16,133 |   |   | 24.6 | % |   | 25,134 |   |   | 22.4 | % |   |
| General and  administrative                                         |       | 10,243                                                       |       |   | 22.0 | % |   | 15,116 |   |   | 23.0 | % |   | 24,520 |   |   | 21.9 | % |   |
| Research and  development                                           |       | 4,271                                                        |       |   | 9.2 | % |   | 3,986 |   |   | 6.1 | % |   | 8,618 |   |   | 7.7 | % |   |
| Depreciation and  amortization                                      |       | 2,476                                                        |       |   | 5.3 | % |   | 2,112 |   |   | 3.2 | % |   | 3,487 |   |   | 3.1 | % |   |
| Total operating  expenses                                           |       | 30,341                                                       |       |   | 65.5 | % |   | 37,347 |   |   | 59.6 | % |   | 61,759 |   |   | 55.1 | % |   |
| Income from operations  before income tax and interest expense      |       | 3,730                                                        |       |   | 8.1 | % |   | 9,512 |   |   | 14.5 | % |   | 18,636 |   |   | 16.6 | % |   |
| Interest (income) expense                                           |       | 160                                                          |       |   | 0.3 | % |   | (566 | ) |   | (0.9 | )% |   | (1,560 | ) |   | (1.4 | )% |   |
| Interest (income) expense  on mandatory redeemable preferred shares |       | 8,386                                                        |       |   | 18.1 | % |   | 3,396 |   |   | 5.2 | % |   | — |   |   | 0.0 | % |   |
| Income (loss) from  operations before income tax                    |       | (4,816                                                       | )          |   | (10.3 | )% |   | 6,682 |   |   | 10.2 | % |   | 20,196 |   |   | 18.0 | % |   |
| Income tax expense  (benefit) from continuing operations            |       | (723                                                         | )          |   | (1.6 | )% |   | 591 |   |   | 0.9 | % |   | 4,303 |   |   | 3.8 | % |   |
| Net income (loss)                                                   |       | $                                                            | (4,093     | ) |   | (8.7 | )% |   | $ | 6,091 |   |   | 9.3 | % |   | $ | 15,893 |   |   | 14.2 | % |   |
| Accretion of redeemable  class B common shares and C common shares  |       | 1,020                                                        |       |   | 2.2 | % |   | 41,488 |   |   | 63.2 | % |   | — |   |   | 0.0 | % |   |
| Net income (loss) available to common shareholders                  |       | $                                                            | (5,113     | ) |   | (11.0 | )% |   | $ | (35,397 | ) |   | (53.9 | )% |   | $ | 15,893 |   |   | 14.2 | % |   |

 

***Geographic Information***

Thefollowing table summarizes the distribution of revenue by geographic region asdetermined by billing addresses for each of the periods shown:

| ** **                      | ** ** | **For the Year  Ended December 31,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                                 | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States                   |       | 91.2                                                     | %          | 90.1 | % | 90.2 | % |
| Europe, Middle  East and Africa |       | 7.6                                                      | %          | 6.0 | % | 6.2 | % |
| Canada                          |       | 0.5                                                      | %          | 3.2 | % | 2.4 | % |
| Asia-Pacific and  other         |       | 0.7                                                      | %          | 0.7 | % | 1.2 | % |
| Total revenue                   |       | 100.0                                                    | %          | 100.0 | % | 100.0 | % |

 

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**Comparison of YearsEnded December 31, 2005 and 2006**

***Revenue***

Total revenue increased by$46.5 million or 70.8% to $112.1 million for the year ended December 31,2006 from $65.6 million for the year ended December 31, 2005. Whileacquisitions completed during 2006 contributed approximately $23.5 millionor 51% of the increase in our revenue for the year ended December 31, 2006from the prior year, our existing customers added approximately $23.1 millionto our revenue increase from the prior year. Our subscription revenue increasedby 77.5% to $90.5 million for the year ended December 31, 2006 from$51.0 million for the year ended December 31, 2005. Subscriptionrevenue represented approximately 80.7% of our total revenue for the year endedDecember 31, 2006 compared to 77.7% of our total revenue for the yearended December 31, 2005. This increase is attributable to increasing salesof our talent acquisition and employee performance management solutionsprimarily due to the increasing adoption of our on-demand model for software.Additionally, our average revenue per customer from our top 80 customers byrevenue increased from approximately $0.6 million per customer for theyear ended December 31, 2005 to approximately $0.8 million percustomer for the year ended December 31, 2006. Our other revenue increasedby 47.5% to $21.6 million for the year ended December 31, 2006 from$14.7 million for the year ended December 31, 2005. This increase wasdue to an increase in demand for our consulting services which resulted from anincrease in our subscription based revenues. We expect subscription-based andother revenues to increase in 2007 over the prior year primarily due to customeracquisitions and additional sales to existing customers.

***Cost of Revenue***

Cost of revenue increasedby $12.9 million or 68.8% to $31.7 million for the year ended December 31,2006 from $18.8 million for the year ended December 31, 2005. As apercentage of revenue, cost of revenue remained approximately the same at 28.3%for the year ended December 31, 2006 compared to 28.6% for the year ended December 31,2005. The increase in the cost of revenue was primarily due to increased salaries,overhead, direct costs and other expense of $8.6 million, $1.4 million,$2.0 million and $0.9 million, respectively, associated with ourincreased revenue. Our increased salaries were due to the addition of 226employees from our acquisitions in 2006.

***Sales and Marketing (“S&M”)***

S&M expense increased$9.0 million or 55.8% to $25.1 million for the year ended December 31,2006 compared to $16.1 million for the year ended December 31, 2005.Increased salary, commission, performance bonus and tax and benefits expense of$4.1 million, $1.0 million, $0.5 million and $1.4 million,respectively, contributed to the increase in S&M expense for the year endedDecember 31, 2006 from the prior year. Additionally,  non-cash stock option expense from ouradoption of SFAS 123R, increased travel and other expenses of $1.1 million,$0.7 million and $0.2 million, respectively, contributed to theincrease in S&M expense for the year ended December 31, 2006 from theprior year. The increase in salaries was due to the addition of74 employees in 2006, of which 36 employees were related to our acquisitionsand 38 employees were from internal growth in 2006.   As a percentage of total revenue, S&Mexpense decreased to 22.4% for the year ended December 31, 2006 from 24.6%for the year ended December 31, 2005 due to increased revenues.

***General and Administrative (“G&A”)***

G&A expense increasedby $9.4 million or 62.2% to $24.5 million for the year ended December 31,2006 compared to $15.1 million for the year ended December 31, 2005.The $9.4 million increase was due primarily to an increase in salary andtax and benefits expenses of $2.0 million and $0.9 million,respectively primarily due to the addition of 38 employees from ouracquisitions in 2006.  In addition, rent 

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expense,associated with our recent acquisitions, professional fees, and non-cash stockoption expense from our adoption of SFAS 123R in 2006 contributed $1.8 million,$1.5 million and $1.3 million, respectively, to the increase inG&A expense for the year ended December 31, 2006 compared to the prioryear. The remainder of the $1.9 million increase was attributable toincreases in travel expense of $0.5 million and additional infrastructureexpenses of $1.4 million which included expenses such as phone, supplies,utilities, insurance and other expenses. As a percentage of total revenue,G&A expense decreased to 21.9% for the year ended December 31, 2006compared to 23.0% for the prior year due to increased revenues.

***Research and Development (“R&D”)***

R&D expense increased$4.6 million or 116.2% to $8.6 million for the year ended December 31,2006 from $4.0 million for the year ended December 31, 2005. The $4.6 millionincrease in R&D expense was due to the addition of 146 employees in2006; of which 82 employees were related to our acquisitions and 64employees were from internal growth in 2006.  As a percentage of total revenue, research anddevelopment expense increased from 6.1% to 7.7% for the year ended December 31,2006 compared to the year ended December 31, 2005 due to increaseddevelopment effort on our products.

***Depreciation and Amortization***

Depreciation andamortization expense increased $1.4 million or 65.2% to $3.5 millionfor the year ended December 31, 2006 compared to $2.1 million for theyear ended December 31, 2005 due to increased capital purchases andadditional intangibles acquired in connection with our recent acquisitions. Inthe future, we expect depreciation and amortization expense to increase due torecent capital purchases.

***Interest Income***

Interest income increased$1.0 million or 175.6% for the year ended December 31, 2006 to $1.6 millionfor the year ended December 31, 2006 from $0.6 million for the yearended December 31, 2005. The $1.0 million increase is due primarilyto interest earned on the net proceeds of our March 2006 public offeringin which we raised $66.3 million.

***Interest on Mandatory Redeemable Preferred Shares***

Interest expense onmandatory redeemable shares of $3.4 million for the year ended December 31,2005 was related to the redemption of class A and class B preferredshares upon the closing of our initial public offering in June 2005. Becausewe redeemed all of our class A and class B preferred shares in ourinitial public offering, we no longer record any interest expense on mandatoryredeemable shares.

***Income Tax Expense***

Income tax expense on operations increased $3.7 millionto $4.3 million expense for the year ended December 31, 2006 from$0.6 million for the year ended December 31, 2005. The $3.7 millionincrease in income tax expense was primarily attributable to an increase inincome before taxes offset by a reduction of our valuation allowance ofapproximately $0.9 million.  Thesechanges were due to management’s evaluation of our positive and negative evidencebearing upon the realizability of its deferred tax assets and has determinedthat it is more likely than not that we will realize a portion of the benefitsof federal and state tax assets. In 2006 we acquired net operating losscarryforwards from various acquisitions totaling $41.1 million. Based uponthe uncertainty to fully utilize these net operating loss carryforwards due toInternal Revenue Code section 382 the Company recorded a valuationallowance of $36.1 million.

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**Comparison of YearsEnded December 31, 2004 and 2005**

***Revenue***

Total revenue increased by41.7% to $65.6 million for the year ended December 31, 2005 from$46.3 million for the year ended December 31, 2004. Our subscriptionrevenue increased by 40.2% to $51.0 million for the year ended December 31,2005 from $36.3 million for the year ended December 31, 2004. Subscriptionrevenue represented approximately 77.7% of our total revenue for the year endedDecember 31, 2005. This increase is attributable to increasing sales ofour talent acquisition and employee performance management solutions primarilydue to the increasing adoption of our on-demand model for software generallyand talent acquisition and employee performance management solutions inparticular. Additionally, our average revenue per customer from our top80 customers by revenue increased from approximately $0.4 million percustomer for the year ended December 31, 2004 to approximately $0.6 millionper customer for the year ended December 31, 2005. Our other revenueincreased by 47.4% to $14.7 million for the year ended December 31,2005 from $10.0 million for the year ended December 31, 2004. Thisincrease was due to an increase in demand for our consulting services whichresulted from an increase in our subscription based revenues.

***Cost of Revenue***

Cost of revenue increasedby 54.1% to $18.8 million for the year ended December 31, 2005 from$12.2 million for the year ended December 31, 2004. As a percentageof revenue, cost of revenue increased by 2.2% to 28.6% for the year ended December 31,2005 compared to 26.4% for the year ended December 31, 2004. The increasein the cost of revenue was primarily due to our increased revenue. The increasein the cost of revenue as a percentage of revenue was caused by a change in themix of our sales, specifically an increase in consulting revenues, which havemore costs as a percentage of revenues than our subscription-based revenues.

***Sales and Marketing (“S&M”)***

S&M expense increasedby 20.1% to $16.1 million for the year ended December 31, 2005compared to $13.4 million for the year ended December 31, 2004.Increased salary, performance bonus and commissions of $0.9 million, $0.7 millionand $0.4 million, respectively, contributed to the increase in S&Mexpense for the year ended December 31, 2005 from the prior year.Additionally, increased travel, bad debt expense and marketing expense of $0.3 million,$0.2 million and $0.2 million, respectively, contributed to theincrease in S&M expense for the year ended December 31, 2005 from theprior year. As a percentage of total revenue, S&M expense decreased to24.6% for the year ended December 31, 2005 from 29.0% the year ended December 31,2004 due to increased revenues.

***General and Administrative (G&A”)***

G&A expense increasedby 47.6% to $15.1 million for the year ended December 31, 2005compared to $10.2 million for the year ended December 31, 2004. The$4.9 million increase was primarily due to an increase in staff relatedexpense of $1.0 million, the addition of 17 employees, an increase inperformance bonuses for our executives and management of $1.6 million, anincrease in professional fees of $0.5 million, an increase in rent expenseof $0.2 million, and other G&A infrastructure expenses totaling $1.6 million.As a percentage of total revenue, G&A expense increased to 23.0% for theyear ended December 31, 2005 compared to 22.1% for the prior year due toincreased expense.

***Research and Development (“R&D”)***

R&D expense decreasedby 6.7% to $4.0 million for the year ended December 31, 2005 comparedto $4.3 million for the year ended December 31, 2004. The $0.3 milliondecrease in R&D expense was due to 

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thetransition of our development efforts to India. As a percentage of totalrevenue, R&D expense decreased from 9.2% to 6.1% for the year ended December 31,2005 compared to the year ended December 31, 2004 due to increasedrevenues. As a result of the continuing transition of our R&D efforts toIndia, we expect to expand the features and functionality of our solutionswithout increasing R&D expenses as a percentage of revenue.

***Depreciation and Amortization***

Depreciation andamortization expense decreased 14.7% to $2.1 million for the year ended December 31,2005 compared to $2.5 million for the year ended December 31, 2004due to an early version of our applicant tracking system becoming fullydepreciated. In the future, we expect depreciation and amortization expense toincrease due to recent capital purchases.

***Interest Expense (Income)***

Interest expense (income)decreased to income of $0.6 million for the year ended December 31,2005 from an expense of $0.2 million for the year ended December 31,2004. The $0.8 million increase is due primarily to interest earned on thenet proceeds of our initial public offering which was completed in June 2005.

***Interest on Mandatory Redeemable Preferred Shares***

Interest on mandatoryredeemable preferred shares decreased by 59.5% to $3.4 million for theyear ended December 31, 2005 from $8.4 million for the year ended December 31,2004. As a result of our adoption of SFAS No. 150 in 2003, dividends onand changes in fair value in the mandatory redeemable preferred shares wererecorded as a cumulative change in accounting principle through July 1,2003 and as an interest expense in subsequent periods. Because we redeemed allof our class A and class B preferred shares in our initial public offering, weno longer record any interest expense on mandatory redeemable shares.

***Income Tax (Benefit) Expense***

Income tax expense oncontinuing operations increased to a $0.6 million expense for the yearended December 31, 2005 from a $0.7 million benefit for the yearended December 31, 2004. The $1.3 million increase in income taxexpense was primarily attributable to the increase in income offset by theutilization of its net operating loss carryforward and reduction of valuationallowance of approximately $5.0 million. The benefit realized in 2004resulted from a decrease in our valuation allowance of $0.4 million and anincrease in our deferred tax asset of $0.6 million. These changes were dueto management’s evaluation of our positive and negative evidence bearing uponthe realizability of its deferred tax assets and has determined that it is morelikely than not that we will realize a portion of the benefits of federal andstate tax assets.

**Liquidity andCapital Resources**

Since we were formed in 1987, we have financed ouroperations primarily through internally generated cash flows, our revolvingcredit facilities and the issuance of equity. As of December 31, 2006, wehad cash and cash equivalents of $42.5 million and accounts receivable of$31.5 million. In addition, we had $65.0 million of debt and lessthan $0.4 million in capital equipment leases.

Our cash provided from operations was $10.1 million,$16.9 million and $18.6 million for the years ended December 31,2004, 2005 and 2006, respectively. Cash used in investing activities was $1.2 million,$3.9 million and 156.1 million for the years ended December 31,2004, 2005 and 2006, respectively. Cash used in financing activities was2.5 million for the year ended December 31, 2004. Cash provided by 

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financing activities was $21.1 millionand $136.4 million for the years ended December 31, 2005 and 2006,respectively. These changes in 2006 resulted in a decrease in our cash and cashequivalents of $1.0 million for the year ended December 31, 2006.  Our net increase in cash and cash equivalentsof $34.0 million for the year ended December 31, 2005 resultedprimarily from our net proceeds of $21.5 million from our initial publicoffering.  We expect positive cash flowto continue in future periods.

On January 13, 2006, we acquired Webhire, Inc.,a provider of end-to-end talent acquisition solutions for recruitment and humanresource professionals for a purchase price of approximately $34.4 millionin cash. The total cost of the acquisition, including legal, accounting, andother professional fees of 0.7 million, was approximately $35.1 million.Additionally, on that date, we borrowed $25.0 million under our revolvingcredit facility and repaid all outstanding borrowings with a portion of the netproceeds from our public offering which we completed in March 2006.

On March 8, 2006, we completed a public offeringof 2,425,000 shares of our common stock at a price to the public of $27.00per share.  We also sold an additional 216,800 shares of our commonstock to cover over-allotments of shares. Our net proceeds from the offering,after payment of all offering expenses and commissions, aggregatedapproximately $66.3 million. In addition, certain of our shareholders soldan aggregate of 3,510,700 shares of our common stock in the offering,including an over-allotment of 585,700 shares. We received no proceedsfrom the common stock sold by the selling shareholders in this offering.

On April 10, 2006 we acquired all of theoutstanding stock of Knowledge Workers Inc., a human capital consulting andtechnology firm based in Denver Colorado, for a purchase price of approximately$2.5 million in cash. The total cost of the acquisition, includingestimated legal, accounting, and other professional fees, was approximately$2.6 million.

On August 14, 2006 we acquired all of theoutstanding stock of Gantz Wiley Research Consulting Group, Inc., anemployee and customer survey data analysis firm based in Minneapolis,Minnesota, for a purchase price of approximately $5.8 million in cash andequity. The total cost of the acquisition, including estimated legal,accounting, and other professional fees, was approximately $5.9 million. Inaddition, the acquisition agreement contained an earnout provision whichprovided for the payment of additional consideration by the Company based uponthe annual revenues of Gantz Wiley Research through December 31,2006. Based upon these results we paid, additional consideration of $1.3 millioncash and equity during the first quarter of 2007 to the former shareholder ofGantz Wiley.

On November 13, 2006, we acquired BrassRing Inc.and BrassRing LLC a leading provider of talent management solutions, forapproximately $114.7 million in cash. The total cost of the acquisition,including legal, accounting, and other professional fees of $2.9 million,was approximately $117.6 million.

On November 13, 2006, we entered into a newsecured credit facility with PNC Bank, N.A., as administrative agent, inconnection with our acquisition of BrassRing. Our obligations under the newcredit facility are secured by substantially all of our assets and the assetsof our subsidiaries.Under the terms of the credit facility, we may borrow up to$75 million, consisting of (i) a $25 million revolving creditfacility, including a sublimit of up to $2 million for letters of credit,and (ii) a $50 million term loan. Borrowings of $50 millionunder the term loan facility and $15 million under the revolving creditfacility, together with other sources of funds, were used to pay theconsideration in the BrassRing acquisition. We used a portion of the netproceeds of the public offering that we completed in January 2007 to repayall of our outstanding term loan obligations.

Our revolving credit facility will terminate on November 12,2011, at which time all outstanding borrowings must be repaid, and alloutstanding letters of credit, if any, must be cash collateralized.

Borrowings under our revolving credit facility bearinterest at tiered rates based upon the ratio of the Total Net Debt to ModifiedEBITDA Ratio of us and our consolidated subsidiaries. We may also elect 

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interest rates on itsborrowings calculated by reference to either (i) the higher of PNC’s primerate or the current Federal Funds rate plus 1¤2% (Base Rate),or (ii) the Eurodollar Rate, in either case plus a margin based upon theratio of the Company and its consolidated subsidiaries Net Funded Debt toEBITDA ratio.  Interest is payablequarterly for Base Rate loans and at the end of the applicable interest periodfor Eurodollar Rate loans.  EurodollarRate advances will be available for periods of 1, 2, 3, 6 or, if available toall lenders under the Credit Agreement, 9 or 12 months.  Eurodollar Rate pricing will be adjusted forany statutory reserves.

Our revolving credit facility provides for financialand operating covenants. Financial covenants include minimum EBITDA, minimumfixed charge coverage ratio, maximum leverage ratio and other financial tests. Operatingcovenants include limitations on the ability of us and our subsidiaries toincur additional indebtedness, grant liens on assets, enter into affiliatetransactions, pay dividends and make acquisitions and investments.

On November 20, 2006, we acquired PsychometricServices Ltd. (“PSL”), a provider of online and paper-based assessmentproducts, training and consultancy that help organizations achieve tangiblebusiness results for approximately $7.5 million in cash and $0.6 million instock consideration.

On January 18, 2007,we completed a public offering of 3,750,000 shares of our common stock at aprice to the public of $31.86 per share. We also sold an additional 562,500shares of our common stock to cover over-allotments of shares. Our net proceedsfrom the offering, after payment of all offering expenses and commissions,aggregated approximately $131.0 million.

***Operating Activities***

Net cash provided by operating activities was $10.1million, $16.9 million and $18.6 for the years ended December 31, 2004, 2005and 2006, respectively.  

Net cash provided by operating activities for the yearended December 31, 2004 resulted primarily from a net loss of approximately$4.1 million, non-cash charges to net income of $11.7 million, including $8.4 millionof accrued interest expense on the redeemable preferred stock, deferred revenueof $3.4 million, and other changes in working capital of $0.6 partiallyoffset by an increase in accounts and unbilled receivables of $1.5 million.

Net cash provided by operating activities for the yearended December  31, 2005 resulted primarily from net income ofapproximately $6.1 million, non-cash charges to net income of $6.4 million,including $3.4 million of accrued interest expense on the redeemablepreferred stock, deferred revenue of $5.9 million, and other changes inworking capital of $0.8 partially offset by an increase in accounts andunbilled receivables of $2.3 million.

Net cash provided byoperating activities for the year ended December 31, 2006 resulted primarilyfrom net income of approximately $15.9 million, non-cash charges to net incomeof $6.6 million, deferred revenue of $4.6 million and other changes in workingcapital of $5.3 million offset by a $2.8 million reduction in taxes payableresulting from our adoption of FAS 123R in 2006 and an increase in accounts andunbilled receivables of $11.0 million.  

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***Investing Activities***

Netcash used in investing activities was $1.2 million, $3.9 million and $156.1 millionfor the years ended December 31, 2004, 2005 and 2006, respectively.  Cashflows used in investing activities consisted primarily of acquisitions andadditional capital equipment as follows:

| ** **                                               | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Scottworks  acquisition                                  |       | $                                           | —     |   | $ | 0.2 |   | $ | — |   |
| Webhire  acquisition                                     |       | —                                      |       | — |   | 32.2 |   |
| Knowledge Workers  acquisition                           |       | —                                      |       | — |   | 2.2 |   |
| Gantz Wiley  Research acquisition                        |       | —                                      |       | — |   | 2.7 |   |
| BrassRing  acquisition                                   |       | —                                      |       | — |   | 107.0 |   |
| Psychometrics  acquisition                               |       | —                                      |       | — |   | 7.5 |   |
| Intangible asset  purchase                               |       | —                                      |       | — |   | 0.3 |   |
| Capitalized  software and purchases of computer hardware |       | $                                           | 1.2        |   | 3.7 |   | 4.2 |   |
| Total Cash flows from  investing activities              |       | $                                           | 1.2        |   | $ | 3.9 |   | $ | 156.1 |   |

 

***Financing Activities***

Net cash used in financing activities was $2.5 millionfor the year ended December 31, 2004. Net cash provided by financing activities was $21.1 million and$136.4 million for the years ended December 31, 2005 and 2006,respectively.  

For the year ended December 31, 2004, net cash used infinancing activity resulted primarily from repayments of borrowings under ourrevolving credit facility of $1.6 million, the repurchase of shares of ourcommon stock owned by certain of our former employees of $0.6 million andrepayments of capital lease obligations of $0.3 million.

For the year ended December 31, 2005, net cashprovided by financing activity resulted primarily from net proceeds from ourinitial public offering of $61.5 million, the collection of notes receivable of$0.2 million and net proceeds from stock option exercises of $0.1 millionpartially offset by the redemption of our series A and B preferred sharesof $40.0 million, the repurchase of shares of our common stock owned by certainof our former employees of $0.5 million and repayments of capital leaseobligations of $0.2 million.

For the year ended December 31, 2006, net cashprovided by financing activity resulted primarily from net proceeds from ourpublic offering of $66.3 million, borrowings under our line of credit of $65.0million, net proceeds from stock option exercises of $4.4 million, excess taxbenefits from share-based payment arrangements of $2.8 million, partiallyoffset by deferred financing costs of $1.4 million, repayments of capital leaseobligations of $0.4 million, and net repayments of notes payable of $0.3million.  In January 2007 the Companyused a portion of the net proceeds of the public offering to repay alloutstanding borrowings.  Refer tofootnote No. 14. Subsequent events for details on the public offering in 2007.

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We believe that our cash and cash equivalent balancesand cash flows from operations will be sufficient to satisfy our workingcapital and capital expenditure requirements for at least the next 12 months.We intend to continue to invest our cash in excess of current operatingrequirements in interest-bearing, investment-grade securities. Changes in ouroperating plans, lower than anticipated revenue, increased expenses or otherevents, may cause us to seek additional debt or equity financing. Financing maynot be available on acceptable terms, or at all, and our failure to raisecapital when needed could negatively impact our growth plans and our financialcondition and consolidated results of operations. Additional equity financingwould be dilutive to the holders of our common stock, and debt financing, ifavailable, may involve significant cash payment obligations and covenants orfinancial ratios that restrict our ability to operate our business.

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***Unaudited Quarterly Statements of Operations***

The following tablespresent our unaudited quarterly results of operations for each of the eightquarters in the period ended December 31, 2006 and our unaudited quarterlyresults of operations expressed as a percentage of our subscription and otherrevenues for the same periods. You should read the following tables inconjunction with our audited consolidated financial statements and relatednotes appearing at the end of this prospectus. We have prepared the unauditedinformation on a basis consistent with our audited consolidated financialstatements and have included all adjustments, which, in the opinion ofmanagement, are necessary to fairly present our operating results for thequarters presented. Our historical unaudited quarterly results of operationsare not necessarily indicative of results for any future quarter or for a fullyear.

**ConsolidatedStatement of Operations**

| ** **   | ** ** | **For the Three Months Ended**                                         | ** ** |
|--------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **   | ** ** | **March 31,  2005**                                                                   | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** |
| ** **   | ** ** | **(unaudited and in thousands, except per share data)** | ** ** |
| **Revenue:** |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|              |            |                                                                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Subscription  revenue                                                  |   |   | $      | 10,871 |   |   | $       | 12,122 |   |   | $      | 13,377 |   |   |   | $      | 14,603 |   |   |   | $      | 17,593 |   |   | $      | 19,947 |   |   | $      | 23,185 |   |   |   | $     | 29,745 |   |   |
|------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|-------|--------|--------|--------|
| Other revenue                                                          |   |   | 3,461  |   |   | 3,883  |    |   | 3,857  |   |   |   | 3,467  |   |   |   | 5,422  |   |   | 4,760  |   |   | 4,827  |   |   |   | 6,627  |   |   |
| Total revenue                                                          |   |   | 14,332 |   |   | 16,005 |    |   | 17,234 |   |   |   | 18,070 |   |   |   | 23,015 |   |   | 24,707 |   |   | 28,012 |   |   |   | 36,372 |   |   |
| Cost of revenue  (exclusive of depreciation, shown separately below)   |   |   | 4,060  |   |   | 4,597  |    |   | 4,935  |   |   |   | 5,190  |   |   |   | 6,354  |   |   | 6,672  |   |   | 8,392  |   |   |   | 10,293 |   |   |
| Gross profit                                                           |   |   | 10,272 |   |   | 11,408 |    |   | 12,299 |   |   |   | 12,880 |   |   |   | 16,661 |   |   | 18,035 |   |   | 19,620 |   |   |   | 26,079 |   |   |
| **Operating expenses:**                                                |   |   |   |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                                    |   |   | 3,603  |   |   | 3,927  |    |   | 4,218  |   |   |   | 4,385  |   |   |   | 5,728  |   |   | 5,717  |   |   | 5,991  |   |   |   | 7,698  |   |   |
| General and  administrative                                            |   |   | 3,313  |   |   | 3,563  |    |   | 4,036  |   |   |   | 4,205  |   |   |   | 5,287  |   |   | 5,914  |   |   | 5,771  |   |   |   | 7,548  |   |   |
| Research and  development                                              |   |   | 1,120  |   |   | 957    |    |   | 961    |   |   |   | 948    |   |   |   | 1,536  |   |   | 1,815  |   |   | 2,218  |   |   |   | 3,048  |   |   |
| Depreciation and  amortization                                         |   |   | 552    |   |   | 505    |    |   | 498    |   |   |   | 556    |   |   |   | 722    |   |   | 768    |   |   | 872    |   |   |   | 1,126  |   |   |
| Total operating  expenses                                              |   |   | 8,588  |   |   | 8,952  |    |   | 9,713  |   |   |   | 10,094 |   |   |   | 13,273 |   |   | 14,214 |   |   | 14,852 |   |   |   | 19,420 |   |   |
| Income from  operations before income tax and interest expense         |   |   | 1,684  |   |   | 2,456  |    |   | 2,586  |   |   |   | 2,786  |   |   |   | 3,388  |   |   | 3,821  |   |   | 4,768  |   |   |   | 6,659  |   |   |
| Interest (income)  expense                                             |   |   | 12     |   |   | (1.5   | )       |   | (220   | )      |   |   | (344   | )      |   |   | (120   | )      |   | (682   | )      |   | (764   | )      |   |   | 6      |   |   |
| Interest expense (income)  on mandatory redeemable preferred shares    |   |   | 8,534  |   |   | (5,138 | )       |   | — |   |   |   | — |   |   |   | — |   |   | — |   |   | — |   |   |   | — |   |   |
| (Loss) income from  operations before income tax                       |   |   | (6,862 | )      |   | 7,609  |    |   | 2,806  |   |   |   | 3,130  |   |   |   | 3,508  |   |   | 4,503  |   |   | 5,532  |   |   |   | 6,653  |   |   |
| Income tax expense  on   operations                                    |   |   | 40     |   |   | 219    |    |   | 219    |   |   |   | 113    |   |   |   | 229    |   |   | 1,223  |   |   | 1,373  |   |   |   | 1,478  |   |   |
| Net (loss) income                                                      |   |   | (6,902 | )      |   | $      | 7,390   |   |   | $      | 2,587  |   |   |   | $      | 3,017  |   |   |   | $      | 3,279  |   |   | $      | 3,280  |   |   | $      | 4,159  |   |   |   | $      | 5,175 |   |   |
| Net (loss) income available  to common shareholders                    |   |   | (9,699 | )      |   | $      | (31,302 | )      |   | $      | 2,587  |   |   |   | $      | 3,017  |   |   |   | $      | 3,279  |   |   | $      | 3,280  |   |   | $      | 4,159  |   |   |   | $      | 5,175 |   |   |
| Net (loss) income per  share available to common shareholder - basic   |   |   | $      | (1.88  | )      |   | (5.29   | )      |   | $      | 0.15   |   |   |   | $      | 0.17   |   |   |   | $      | 0.18   |   |   | $      | 0.16   |   |   | $      | 0.20   |   |   |   | $      | 0.25  |   |   |
| Net (loss) income per share available to common shareholder  - diluted |   |   | $      | (1.88  | )      |   | (5.29   | )      |   | $      | 0.15   |   |   |   | $      | 0.17   |   |   |   | $      | 0.17   |   |   | $      | 0.16   |   |   | $      | 0.20   |   |   |   | $      | 0.24  |   |   |

 

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**ConsolidatedStatement of Operations**

| ** **                                                          | ** ** | **For the Three Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                          | ** ** | **March 31,  2005**                           | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** |
| Revenue:                                                            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Subscription revenue                                                |       |                                               | 75.9       | % |   |   | 75.7 | % |   |   | 77.6 | % |   |   | 80.8 | % |   |   | 76.4 | % |   |   | 80.7 | % |   |   | 82.8 | % |   |   | 81.8 | % |   |
| Other revenue                                                       |       |                                               | 24.1       | % |   |   | 24.3 | % |   |   | 22.4 | % |   |   | 19.2 | % |   |   | 23.6 | % |   |   | 19.3 | % |   |   | 17.2 | % |   |   | 18.2 | % |   |
| Total revenue                                                       |       |                                               | 100.0      | % |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |
| Cost of revenue                                                     |       |                                               | 28.3       | % |   |   | 28.7 | % |   |   | 28.6 | % |   |   | 28.7 | % |   |   | 27.6 | % |   |   | 27.0 | % |   |   | 30.0 | % |   |   | 28.6 | % |   |
| Gross profit                                                        |       |                                               | 71.7       | % |   |   | 71.3 | % |   |   | 71.4 | % |   |   | 71.3 | % |   |   | 72.4 | % |   |   | 73.0 | % |   |   | 70.0 | % |   |   | 71.7 | % |   |
| Operating  expenses:                                                |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                                 |       |                                               | 25.2       | % |   |   | 24.5 | % |   |   | 24.5 | % |   |   | 24.3 | % |   |   | 24.9 | % |   |   | 23.1 | % |   |   | 21.4 | % |   |   | 21.2 | % |   |
| General and administrative                                          |       |                                               | 23.1       | % |   |   | 22.3 | % |   |   | 23.4 | % |   |   | 23.3 | % |   |   | 23.0 | % |   |   | 23.9 | % |   |   | 20.6 | % |   |   | 20.8 | % |   |
| Research and development                                            |       |                                               | 7.8        | % |   |   | 6.0 | % |   |   | 5.6 | % |   |   | 5.2 | % |   |   | 6.7 | % |   |   | 7.3 | % |   |   | 7.9 | % |   |   | 8.4 | % |   |
| Depreciation and amortization                                       |       |                                               | 3.9        | % |   |   | 3.2 | % |   |   | 2.9 | % |   |   | 3.1 | % |   |   | 3.1 | % |   |   | 3.1 | % |   |   | 3.1 | % |   |   | 3.1 | % |   |
| Total operating expenses                                            |       |                                               | 60.0       | % |   |   | 56.0 | % |   |   | 56.4 | % |   |   | 55.9 | % |   |   | 57.7 | % |   |   | 57.5 | % |   |   | 53.0 | % |   |   | 53.4 | % |   |
| Income from operations before income tax and interest  expense      |       |                                               | 11.7       | % |   |   | 15.3 | % |   |   | 15.0 | % |   |   | 15.4 | % |   |   | 14.7 | % |   |   | 15.5 | % |   |   | 17.0 | % |   |   | 18.3 | % |   |
| Interest expense (income)                                           |       |                                               | 0.1        | % |   |   | (0.1 | )% |   |   | (1.3 | )% |   |   | (1.9 | )% |   |   | (0.5 | )% |   |   | (2.8 | )% |   |   | (2.7 | )% |   |   | 0.0 | % |   |
| Interest expense (income) on mandatory redeemable  preferred shares |       |                                               | 59.5       | % |   |   | (32.1 | )% |   |   | 0.0 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |
| (Loss) income from operations before income tax                     |       |                                               | (47.9      | )% |   |   | 47.5 | % |   |   | 16.3 | % |   |   | 17.3 | % |   |   | 15.2 | % |   |   | 18.2 | % |   |   | 19.7 | % |   |   | 18.3 | % |   |
| Income tax expense from continuing operations                       |       |                                               | 0.3        | % |   |   | 1.4 | % |   |   | 1.3 | % |   |   | 0.6 | % |   |   | 1.0 | % |   |   | 5.0 | % |   |   | 4.9 | % |   |   | 4.1 | % |   |
| Net (loss) income                                                   |       |                                               | (48.2      | )% |   |   | 46.1 | % |   |   | 15.0 | % |   |   | 16.7 | % |   |   | 14.2 | % |   |   | 13.3 | % |   |   | 14.8 | % |   |   | 14.2 | % |   |

 

**Comparison ofUnaudited Quarterly Results**

In 2006 the company adopted Statement 123(R), whichrequires that the cost resulting from all share-based payment transactions berecognized in the financials statements.  As such, comparability between2004, 2005 and 2006 are affected. See footnote No. 12, Stock Plans, to theConsolidated Financial Statements for the period ended December 31, 2006for further discussion.

***Revenue***

Total revenue hasincreased each of our last eight quarters primarily due to purchases of oursolutions by new clients, purchases of additional solutions by existing clientsand contract renewals. Our subscription revenue increased in every quarterpresented from $10.9 million for the three months ended March 31,2005 to $29.7 million for the three months ended December 31, 2006.Our other revenue increased from $3.5 million for the three months ended March 31,2005 to $6.6 million for the three months ended December 31, 2006. Webelieve that subscription revenue increased more quickly than other revenue dueto our continuing shift in focus toward subscription-based solutions and awayfrom discrete professional services.

***Cost of Revenue***

Cost of revenue for thequarters presented has fluctuated based on the mix of sales betweensubscription revenue and other revenue. Cost of revenue was highest as apercentage of total revenue for the three months ended September 30, 2006.This was caused by the mix of sales included in other revenue in that quarter. Includedin other revenue are reimbursed expenses which have no margin and 

60

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subcontractorpass through expenses which has minimal mark up. An increase or decrease inthese components as a percentage of sales can have an impact on the cost ofrevenue.

***Sales and Marketing***

Sales and marketingexpenses have decreased as a percentage of total revenue for each of the threemonth periods ended March 31, 2005 through December 31, 2006. Salesand marketing expenses have increased in terms of absolute dollars through thesame period as a result of increased marketing programs and variablecompensation programs. The decrease as a percentage of sales is a result of theeffectiveness of the marketing program and the effectiveness of an experiencedsales force.

***General and Administration***

General and administrativeexpenses for the quarters presented have decreased in the last two quarters dueto the company’s ability to leverage these costs as a percentage of revenueserviced. We expect that the general and administrative expenses will continueto decrease as a percentage of revenue.

***Research and Development***

Research and developmentexpenses for the quarters presented have generally increased each quarter dueto an increase in product development expenses and enhancements and upgrades toour existing products. We have a substantial portion of our research anddevelopment expenses in India to reduce costs while maintaining sufficientresearch and development to enhance our products. During the last quarter weacquired BrassRing which contributed partially to the increase in research anddevelopment expenses.

***Contractual Obligations and Commitments***

Thefollowing table summarizes our contractual obligations at December 31,2006:

| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** |
| ** **                       | ** ** | **(in thousands)**                   | ** ** |
| Capital lease  obligations       |       | $                                         | 229        |   | 104 |   | 36 |   | — |   | — |   |
| Operating lease  obligations     |       | 6,257                                     |       | 4,382 |   | 4,005 |   | 2,977 |   | 1,981 |   |
| Line of Credit                   |       | 65,000                                    |       |   |   |   |   |   |   |   |   |
| Total                            |       | $                                         | 71,486     |   | 4,486 |   | 4,041 |   | 2,977 |   | 1,981 |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

The amounts listed abovefor capital lease obligations represent payments that we are required to makefor equipment. If we fail to remain current with our obligations for any ofthese capital leases, we would be in default, and our continued failure to curesuch a default would cause our remaining obligations under the defaultedcapital lease to become immediately due.

The amounts listed abovefor operating leases represent our leases for office space, copiers and otheroperating. If we fail to make rent payments on any of these operating leaseswhen due, we will be required to pay all remaining rent payments on the leases.

See footnote 6 to thefinancial statements for discussion on the amount listed above for line ofcredit.

We had no off-balancesheet arrangements for the periods presented in this Annual Report on Form 10-K.

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**Recent Accounting Pronouncements**

In December 2004, theFASB issued Statement of Financial Accounting Standards No. 123 (revised2004), “Share-Based Payment” (SFAS 123R). SFAS 123R requires that the costresulting from all share-based payment transactions be recognized in thefinancial statements. SFAS 123R also establishes fair value as the measurementmethod in accounting for share-based payments. The FASB required the provisionsof SFAS 123R be adopted for interim or annual periods beginning after June 15,2005. In April 2005, the SEC adopted a new rule amending thecompliance dates for SFAS 123R for public companies. In accordance with thisrule, we adopted SFAS 123R effective January 1, 2006 using the modifiedprospective transition method. We did not modify the terms of any previouslygranted options in anticipation of the adoption of SFAS 123R.

The application of the provisionsof SFAS 123R resulted in a pretax compensation expense of approximately $3,075in 2006. Based on the same assumptions used to value our 2006 compensation expense,we estimate our pretax expense associated with our share-based compensationplans will be approximately $2, 283 in 2007 and $1,713 in 2008.

In November 2005, theFASB issued FSP FAS 123(R)-3, Transition Election Related to Accountingfor the Tax Effects of Share-Based Payment Awards, to provide an alternativeapproach of accounting for the tax effects of employee share-based awards. Wehave elected to adopt the alternative transition method provided in FSP FAS123(R)-3 for calculating the tax effects of share-based compensationpursuant to SFAS 123(R). The alternative transition method includes simplifiedmethods to establish the beginning balance of the additional paid-in capitalpool (APIC pool) related to the tax effects of employee share-basedcompensation, and to determine the subsequent impact on the APIC pool andconsolidated statements of cash flows of the tax effects of employeestock-based compensation awards that are outstanding upon the adoption of SFAS123(R).

In July 2006, theFinancial Accounting Standards Board (FASB) issued FASB InterpretationNo. 48, Accounting for Uncertainty in Income Taxes—an interpretation ofFASB Statement No. 109 (FIN 48), which clarifies the accounting foruncertainty in tax positions. This Interpretation requires that we recognize inour financial statements, the impact of a tax position, if that position ismore likely than not of being sustained on audit, based on the technical meritsof the position. The provisions of FIN 48 are effective as of the beginning ofour 2007 fiscal year, with the cumulative effect of the change in accountingprinciple recorded as an adjustment to opening retained earnings. We arecurrently evaluating the impact of adopting FIN 48 on our financial statements.

In September 2006, theFASB issued SFAS No. 157, “Fair Value Measurements.”  SFAS No. 157clarifies the principle that fair value should be based on the assumptionsmarket participants would use when pricing an asset or liability andestablishes a fair-value hierarchy that prioritizes the information used todevelop those assumptions. Under SFAS No. 157, fair-value measurementswould be separately disclosed by level within the fair-value hierarchy. SFASNo. 157 is effective for fiscal years beginning after November  15,2007. We do not believe the adoption of SFAS No. 157 will have a materialimpact on our consolidated financial position, results of operations or cashflows.

**ITEM 7A. Quantitativeand Qualitative Disclosures About Market Risk**

Market risk represents therisk of loss that may impact our financial position due to adverse changes infinancial market prices and rates. Our market risk exposure is primarily aresult of fluctuations in interest rates and foreign currency exchange rates.We do not hold or issue financial instruments for trading purposes.

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***Foreign Currency Exchange Risk***

In 2006, approximately 90.4% of our total revenue wascomprised of sales to clients in the United States. A key component of ourbusiness strategy is to expand our international sales efforts, which willexpose us to foreign currency exchange rate fluctuations. A 10% change in thevalue of the U.S. dollar relative to each of the currencies of our non-U.S.-generatedsales would not have resulted in a material change to our results for the yearended December 31, 2006.

The financial position andoperating results of our foreign operations are consolidated using the localcurrency as the functional currency. Local currency assets and liabilities aretranslated at the rate of exchange to the U.S. dollar on the balance sheetdate, and the local currency revenue and expenses are translated at averagerates of exchange to the U.S. dollar during the period. The related translationadjustments was ($0.1) million and $0.1 million at December 31,2005 and 2006, respectively, and are included in other comprehensive income.The foreign currency translation adjustment is not adjusted for income taxes asit relates to an indefinite investment in a non-U.S. subsidiary.

***Interest Rate Risk***

The primary objective ofour investment activities is to preserve principal while maximizing incomewithout significantly increasing risk. Some of the securities in which weinvest may be subject to market risk. This means that a change in prevailinginterest rates may cause the principal amount of the investment to fluctuate.To minimize this risk in the future, we intend to maintain our portfolio ofcash equivalents and short-term investments in a variety of securities,including commercial paper, money market funds, government and non-governmentdebt securities and certificates of deposit. Our cash equivalents, whichconsist solely of money market funds, are not subject to market risk becausethe interest paid on these funds fluctuates with the prevailing interest rate.We do not believe that a 10% change in interest rates would have a significanteffect on our interest income for the year ended December 31, 2006.

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**ITEM8. Financial Statement and Supplementary Data**

| **Report of Independent Registered  Public Accounting Firm.**                                                       |   | 65     |
|---------------------------------------------------------------------------------------------------------------------|--------|--------|
| **Consolidated Financial  Statements:**                                                                             |   |   |
| Consolidated  Balance sheets as of December 31, 2005 and 2006                                                  |   | 66     |
| Consolidated Statements of operations for the years  ended December 31, 2004, 2005 and 2006                    |   | 68     |
| Consolidated Statements of shareholders’ deficiency  for the years ended December 31, 2004, 2005 and 2006 |   | 69     |
| Consolidated Statements of cash flows for the years  ended December 31, 2004, 2005 and 2006                    |   | 70     |
| **Notes to Consolidated Financial Statements.**                                                                     |   | 72     |

 

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**Report ofIndependent Registered Public Accounting Firm**

Board of Directors and Stockholders of KenexaCorporation

Wayne, Pennsylvania

We have audited the accompanying consolidated balancesheets of Kenexa Corporation and subsidiaries (the “Company”) as of December 31,2005 and 2006, and the related consolidated statements of operations,shareholders’ equity, and cash flows for each of the three years then ended.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Kenexa Corporation and subsidiaries as of December 31, 2005and 2006, and the results of its operations and its cash flows for each of thethree years then ended in conformity with accounting principles generallyaccepted in the United States of America.

As discussed in Note 12 to the financial statements,the Company adopted SFAS No, 123(revised 2004), “Share-based payment,” in 2006.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of Kenexa Corporation’s internal control over financial reportingas of December 31, 2006, based on criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (the COSOcriteria) and our report dated March 16, 2007 expressed an unqualifiedopinion thereon.

BDO Seidman, LLP

Philadelphia, PA

March 16, 2007

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**Kenexa Corporationand Subsidiaries**

**ConsolidatedBalance Sheets**

**(in thousands,except share data)**
|                                                                               | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                    | ** ** | **2005**              | ** ** | **2006** | ** ** |
| **Assets**                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets                                                                |       |                  |       |   |   |
| Cash and cash  equivalents                                                    |       | $                     | 43,499     |   | $ | 42,502 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $447 and $975 |       | 10,306                |       | 31,493 |   |
| Unbilled  receivables                                                         |       | 312                   |       | 1,005 |   |
| Deferred income  taxes                                                        |       | 2,519                 |       | 8,093 |   |
| Prepaid expenses  and other current assets                                    |       | 2,134                 |       | 3,578 |   |
| **Total  current assets**                                                     |       | 58,770                |       | 86,671 |   |
| Property and equipment, net of accumulated  depreciation                      |       | 4,737                 |       | 8,469 |   |
| Software, net of  accumulated depreciation                                    |       | 850                   |       | 2,122 |   |
| Goodwill                                                                      |       | 8,815                 |       | 161,329 |   |
| Intangible  assets, net of accumulated amortization                           |       | 125                   |       | 4,570 |   |
| Deferred income  taxes non current                                            |       | —                |       | 1,430 |   |
| Deferred  financing costs, net of accumulated amortization                    |       | 50                    |       | 1,295 |   |
| Other assets                                                                  |       | 552                   |       | 1,573 |   |
| **Total  assets**                                                             |       | $                     | 73,899     |   | $ | 267,459 |   |

 

*See accompanying report of independent registeredpublic accounting firm and notes to consolidated financial statements.*

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**Kenexa Corporationand Subsidiaries**

**ConsolidatedBalance Sheets (Continued)**

**(in thousands,except share data)**
|                                                                                                                                    | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                         | ** ** | **2005**              | ** ** | **2006** | ** ** |
| **Liabilities and Shareholders’  Equity**                                                                                     |       |                  |       |   |   |
| Current liabilities                                                                                                                |       |                  |       |   |   |
| Accounts payable                                                                                                                   |       | $                     | 2,306      |   | $ | 5,672 |   |
| Line of credit                                                                                                                     |       | —                |       | 20,000 |   |
| Notes payable, current                                                                                                             |       | 95                    |       | 138 |   |
| Commissions payable                                                                                                                |       | 834                   |       | 1,674 |   |
| Accrued compensation and benefits                                                                                                  |       | 4,590                 |       | 9,878 |   |
| Other accrued liabilities                                                                                                          |       | 2,177                 |       | 6,086 |   |
| Deferred revenue                                                                                                                   |       | 12,588                |       | 31,251 |   |
| Capital lease obligations                                                                                                          |       | 219                   |       | 229 |   |
| **Total  current liabilities**                                                                                                     |       | 22,809                |       | 74,928 |   |
| Term Loan                                                                                                                          |       | —                |       | 45,000 |   |
| Capital lease  obligations, less current portion                                                                                   |       | 185                   |       | 145 |   |
| Notes payable,  less current portion                                                                                               |       | 108                   |       | 111 |   |
| Other liabilities                                                                                                                  |       | 55                    |       | 114 |   |
| **Total  liabilities**                                                                                                             |       | 23,157                |       | 120,298 |   |
| **Shareholders’  equity**                                                                                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Preferred stock, par value $0.01; 100,000 shares  authorized; no shares issued or outstanding                                 |       | —                |       | — |   |
| Class A common stock, $0.01 par value;  100,000,000 shares authorized; 17,459,044 and 20,897,777 shares issued,  respectively |       | 174                   |       | 209 |   |
| Additional paid-in capital                                                                                                         |       | 97,140                |       | 176,345 |   |
| Deferred Compensation                                                                                                              |       | (1,040                | )          | — |   |
| Notes receivable for class A common stock                                                                                          |       | (120                  | )          | — |   |
| Treasury stock, shares class A common stock, none  and none, respectively, at cost                                                 |       | —                |       | — |   |
| Accumulated other comprehensive (loss) income                                                                                      |       | (30                   | )          | 96 |   |
| Accumulated deficit                                                                                                                |       | (45,382               | )          | (29,489 | ) |
| **Total  shareholders’ equity**                                                                                               |       | 50,742                |       | 147,161 |   |
| **Total liabilities and  shareholders’ equity**                                                                               |       | $                     | 73,899     |   | $ | 267,459 |   |

 

*Seeaccompanying report of independent registered public accounting firm and notesto consolidated financial statements.*

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**Kenexa Corporation and SubsidiariesConsolidated Statements of Operations**(in thousands, except share and per sharedata)

| ** **                                                                                                              | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenue                                                                                                                 |       |                                       |       |   |   |   |   |
| Subscription revenue                                                                                                    |       | $                                          | 36,349     |   | $ | 50,974 |   | $ | 90,470 |   |
| Other revenue                                                                                                           |       | 9,952                                      |       | 14,667 |   | 21,637 |   |
| Total revenue                                                                                                           |       | 46,301                                     |       | 65,641 |   | 112,107 |   |
| Cost of revenue                                                                                                         |       | 12,230                                     |       | 18,782 |   | 31,712 |   |
| Gross profit                                                                                                            |       | 34,071                                     |       | 46,859 |   | 80,395 |   |
| Operating expenses:                                                                                                     |       |                                       |       |   |   |   |   |
| Sales and marketing                                                                                                     |       | 13,351                                     |       | 16,133 |   | 25,134 |   |
| General and administrative                                                                                              |       | 10,243                                     |       | 15,116 |   | 24,520 |   |
| Research and development                                                                                                |       | 4,271                                      |       | 3,986 |   | 8,618 |   |
| Depreciation and amortization                                                                                           |       | 2,476                                      |       | 2,112 |   | 3,487 |   |
| Total operating  expenses                                                                                               |       | 30,341                                     |       | 37,347 |   | 61,759 |   |
| Income from operations before income taxes and  interest expense                                                        |       | 3,730                                      |       | 9,512 |   | 18,636 |   |
| Interest expense  (income)                                                                                              |       | 160                                        |       | (566 | ) | (1,560 | ) |
| Interest on  mandatory redeemable shares                                                                                |       | 8,386                                      |       | 3,396 |   | — |   |
| (Loss) income  from operations before income tax                                                                   |       | (4,816                                     | )          | 6,682 |   | 20,196 |   |
| Income tax  (benefit) expense on operations                                                                             |       | (723                                       | )          | 591 |   | 4,303 |   |
| Net (loss) income                                                                                                       |       | $                                          | (4,093     | ) | $ | 6,091 |   | $ | 15,893 |   |
| Accretion of  redeemable class B common shares and class C common shares                                                |       | 1,020                                      |       | 41,488 |   | — |   |
| Net (loss) income available to common shareholders                                                                      |       | $                                          | (5,113     | ) | $ | (35,397 | ) | $ | 15,893 |   |
| Basic and diluted  (loss) income per share:                                                                             |       |                                       |       |   |   |   |   |
| Basic net (loss)  income per weighted average common share outstanding:                                                 |       | $                                          | (0.85      | ) | $ | (3.06 | ) | $ | 0.80 |   |
| Weighted average  shares used to compute net (loss) income available to common shareholders per  common share - basic   |       | 5,995,389                                  |       | 11,578,885 |   | 19,911,775 |   |
| Diluted net  (loss) income per weighted average common share outstanding:                                               |       | $                                          | (0.85      | ) | $ | (3.06 | ) | $ | 0.78 |   |
| Weighted average shares  used to compute net (loss) income available to common shareholders per common  share - diluted |       | 5,995,389                                  |       | 11,578,885 |   | 20,425,794 |   |

*See accompanying report ofindependent registered public accounting firm and notes to consolidatedfinancial statements.*

 

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**KenexaCorporation and SubsidiariesConsolidated Statements of Shareholders’ Equity (Deficiency)(in thousands)**

|                                                                                                    | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** | **Redeemable**                                                | ** ** | **Stockholders’ (Deficit) Equity**                       | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                         | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** | **Participating**                                             | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** | ** ** | ** ** | **Note** | ** ** | **Total** | ** ** | ** ** | ** ** |
| ** **                                                                                         | ** ** | **Common Stock**                                         | ** ** | **Preferred**                                                 | ** ** | **Class A**                                              | ** ** | **Additional**                                                | ** ** | ** ** | ** ** | **Other** | ** ** | ** ** | ** ** | ** ** | ** ** | **Receivable** | ** ** | **Stockholder’** | ** ** | ** ** | ** ** |
| ** **                                                                                         | ** ** | **Redeemable**                                                | ** ** | **Stock Class A**                                   | ** ** | **Common**                                                    | ** ** | **Paid-In**                                                   | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Treasury** | ** ** | **Deferred** | ** ** | **Common** | ** ** | **(Deficiency)** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                         | ** ** | **Class B**                                              | ** ** | **Class C**                                              | ** ** | **Series A**                                             | ** ** | **Series B**                                             | ** ** | **Stock** | ** ** | **Capital** | ** ** | **(Deficit)** | ** ** | **(Loss) Income** | ** ** | **Stock** | ** ** | **Compensation** | ** ** | **Stock** | ** ** | **Equity** | ** ** | **(Loss) Income** | ** ** |
| Balance, December 31, 2003                                                                    |       | $  3,747                                            |       | $  5,096                                            |       | $ 35,471                                                 |       | $ 15,048                                                 |       |   | $ 80 |   |   |   | $  4,701 |   |   |   | $ (40,275 | ) |   |   | $ (1 | ) |   |   | $ (8,195 | ) |   |   | $      — |   |   |   | $ (531 | ) |   |   | $ (44,221 | ) |   |   | $ (12,159 | ) |   |
| Stock repurchase                                                                                   |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (577 | ) |   |   | — |   |   |   | — |   |   |   | (577 | ) |   |   | — |   |   |
| Payments received on notes receivable  for class A common stock                               |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 12 |   |   |   | 12 |   |   |   | — |   |   |
| Accretion of  common stock to redemption values                                                    |       | 1,544                                                         |       | (525                                                          | )          | —                                                        |       | —                                                        |       |   | — |   |   |   | (1,019 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (1,019 | ) |   |   | — |   |   |
| Interest on preferred shares                                                                       |       | —                                                        |       | —                                                        |       | 6,256                                                         |       | 2,130                                                         |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Gain on currency  exchange                                                                         |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 95 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 95 |   |   |   | 95 |   |   |
| Deferred stock compensation related to  stock options                                              |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | 681 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (681 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Amortization of  deferred stock compensation                                                       |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 227 |   |   |   | — |   |   |   | 227 |   |   |   | — |   |   |
| Net loss                                                                                           |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | (4,093 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (4,093 | ) |   |   | (4,093 | ) |   |
| Balance,  December 31, 2004                                                                   |       | $    5,291                                |       | $    4,571                                |       | $  41,727                                           |       | $  17,178                                           |       |   | $  80 |   |   |   | $     4,363 |   |   |   | $ (44,368 | ) |   |   | $ 94 |   |   |   | $ (8,772 | ) |   |   | $   (454 | ) |   |   | $ (519 | ) |   |   | $ (49,576 | ) |   |   | $   (3,998 | ) |   |
| Stock repurchase                                                                                   |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (515 | ) |   |   | — |   |   |   | — |   |   |   | (515 | ) |   |   | — |   |   |
| Retire Treasury  Stock                                                                             |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | (28 | ) |   |   | (2,154 | ) |   |   | (7,105 | ) |   |   | — |   |   |   | 9,287 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Payments received on notes receivable  for class A common stock                               |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 399 |   |   |   | 399 |   |   |   | — |   |   |
| Accretion of  common stock to redemption values                                                    |       | 20,859                                                        |       | 20,630                                                        |       | (664                                                          | )          | 2,243                                                         |       |   | — |   |   |   | (41,488 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (41,488 | ) |   |   | — |   |   |
| Accrued dividends                                                                                  |       | —                                                        |       | —                                                        |       | 1,147                                                         |       | 670                                                           |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Interest on  preferred shares                                                                      |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Loss on currency exchange                                                                          |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (124 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (124 | ) |   |   | (124 | ) |   |
| Deferred stock  compensation related to stock options                                              |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | 1,220 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (1,220 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Amortization of deferred stock  compensation                                                       |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 634 |   |   |   | — |   |   |   | 634 |   |   |   |   |   |   |
| Option exercises                                                                                   |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | 147 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 147 |   |   |   | — |   |   |
| Conversion of class C warrants                                                                     |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | 4 |   |   |   | (4 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Initial public  stock offering, net                                                                |       | —                                                        |       | —                                                        |       | (28,600                                                       | )          | (11,400                                                       | )          |   | 57 |   |   |   | 61,466 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 61,523 |   |   |   | — |   |   |
| Conversion of preferred stock to common  stock upon public offering                                |       | —                                                        |       | —                                                        |       | (13,610                                                       | )          | (8,691                                                        | )          |   | 18 |   |   |   | 22,282 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 22,300 |   |   |   | — |   |   |
| Conversion of  class B and class C redeemable common stock to class A common upon public  offering |       | (26,150                                                       | )          | (25,201                                                       | )          | —                                                        |       | —                                                        |       |   | 43 |   |   |   | 51,308 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 51,351 |   |   |   | — |   |   |
| Net income                                                                                         |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | 6,091 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 6,091 |   |   |   | 6,091 |   |   |
| Balance,  December 31, 2005                                                                   |       | $         — |       | $         — |       | $         — |       | $         — |       |   | $ 174 |   |   |   | $   97,140 |   |   |   | $ (45,382 | ) |   |   | $ (30 | ) |   |   | $       — |   |   |   | $ (1,040 | ) |   |   | $ (120 | ) |   |   | $   50,742 |   |   |   | $    5,967 |   |   |
| Payments received on notes receivable  for class A common stock                               |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 120 |   |   |   | 120 |   |   |   | — |   |   |
| Gain on currency  exchange                                                                         |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 126 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 126 |   |   |   | 126 |   |   |
| Reclassification of deferred  compensation balance to additional paid-in capital                   |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | (1,040 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,040 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Share based  compensation                                                                          |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | 3,076 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,076 |   |   |   | — |   |   |
| Income tax benefits realized from  activity in employee stock plans                                |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | 2,762 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,762 |   |   |   | — |   |   |
| Option exercises                                                                                   |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | 4 |   |   |   | 4,360 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 4,364 |   |   |   | — |   |   |
| Conversion of class B, D & E  warrants                                                    |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | 3 |   |   |   | (3 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Public stock  offering, net                                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | 26 |   |   |   | 66,255 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 66,281 |   |   |   | — |   |   |
| Common Stock Issuance for Gantz Wiley  Research Acquisition                                        |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | 2 |   |   |   | 3,168 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,170 |   |   |   | — |   |   |
| Common Stock  Issuance for Psychometrics Services Ltd. Acquisition                            |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   | — |   |   |   | 627 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 627 |   |   |   | — |   |   |
| Net Income                                                                                         |       | —                                                        |       | —                                                        |       | —                                                        |       | —                                                        |       |   |   |   |   |   |   |   |   |   | 15,893 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 15,893 |   |   |   | 15,893 |   |   |
| Balance,  December 31, 2006                                                                   |       | $         — |       | $         — |       | $         — |       | $         — |       |   | $ 209 |   |   |   | $ 176,345 |   |   |   | $ (29,489 | ) |   |   | $ 96 |   |   |   | $       — |   |   |   | $       — |   |   |   | $    — |   |   |   | $ 147,161 |   |   |   | $  16,019 |   |   |
|                                                                                               |       |                                                          |       |                                                          |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

 

*Seeaccompanying report of independent registered public accounting firm and notesto consolidated financial statements.*

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**Kenexa Corporation and SubsidiariesConsolidated Statements of Cash Flows**(in thousands)
|                                                                                          | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                               | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Cash flows from operating  activities**                                                |       |                                       |       |   |   |   |   |
| Net loss (income) from continuing operations                                             |       | $                                          | (4,093     | ) | $ | 6,091 |   | $ | 15,893 |   |
| Adjustments to reconcile  net loss (income) to net cash provided by operating activities |       |                                       |       |   |   |   |   |
| Depreciation and amortization                                                            |       | 2,545                                      |       | 2,123 |   | 3,487 |   |
| Non-cash interest expense                                                                |       | —                                     |       | — |   | 72 |   |
| Non-cash compensation                                                                    |       | 227                                        |       | 634 |   | 3,076 |   |
| Excess tax benefits from share-based payment  arrangements                               |       | —                                     |       | — |   | (2,762 | ) |
| Amortization of deferred financing fees                                                  |       | 82                                         |       | 93 |   | 115 |   |
| Bad debt expense (recovery)                                                              |       | 432                                        |       | 154 |   | (182 | ) |
| Accrued interest on mandatory redeemable preferred stock                                 |       | 8,386                                      |       | 3,396 |   | — |   |
| Deferred taxes                                                                           |       | (1,023                                     | )          | (1,497 | ) | (829 | ) |
| **Changes in assets and  liabilities**                                                   |       |                                       |       |   |   |   |   |
| Accounts and unbilled receivables                                                        |       | (1,509                                     | )          | (2,282 | ) | (11,010 | ) |
| Prepaid expenses and other current assets                                                |       | (386                                       | )          | (785 | ) | 967 |   |
| Other assets                                                                             |       | 19                                         |       | 2 |   | (233 | ) |
| Accounts payable                                                                         |       | 323                                        |       | 633 |   | (1,446 | ) |
| Accrued compensation and other accrued liabilities                                       |       | 1,658                                      |       | 2,272 |   | 6,107 |   |
| Commissions payable                                                                      |       | 83                                         |       | 264 |   | 787 |   |
| Deferred revenue                                                                         |       | 3,390                                      |       | 5,889 |   | 4,616 |   |
| Other liabilities                                                                        |       | (78                                        | )          | (46 | ) | (48 | ) |
| **Net cash provided by operating activities**                                            |       | 10,056                                     |       | 16,941 |   | 18,610 |   |
| **Cash flows from investing  activities**                                                |       |                                       |       |   |   |   |   |
| Purchases of property and equipment                                                      |       | $                                          | (1,150     | ) | $ | (3,763 | ) | $ | (4,182 | ) |
| Cash paid for intangible assets                                                          |       | (18                                        | )          | (8 | ) | (300 | ) |
| Cash paid for acquisition(s)                                                             |       | —                                     |       | (164 | ) | (151,636 | ) |
| **Net cash used in by investing activities**                                             |       | (1,168                                     | )          | (3,935 | ) | (156,118 | ) |
| **Cash flows from financing  activities**                                                |       |                                       |       |   |   |   |   |
| Net (repayments) borrowings under line of credit  agreement                              |       | $                                          | (1,558     | ) | $ | — |   | $ | 65,000 |   |
| Repayments of notes payable                                                              |       | —                                     |       | (39 | ) | (422 | ) |
| Repurchase of common shares                                                              |       | (577                                       | )          | (515 | ) |   |   |
| Collections of notes receivable                                                          |       | 12                                         |       | 249 |   | 120 |   |
| Excess tax benefits from share-based payment  arrangements                               |       | —                                     |       | — |   | 2,762 |   |
| Net proceeds from initial public offering                                                |       | —                                     |       | 61,532 |   | — |   |
| Redemption of series A and B preferred stock                                             |       | —                                     |       | (40,000 | ) | — |   |
| Net proceeds from public offering                                                        |       | —                                     |       | — |   | 66,281 |   |
| Deferred financing costs                                                                 |       | (5                                         | )          | (16 | ) | (1,360 | ) |
| Net proceeds from option exercises                                                       |       | —                                     |       | 147 |   | 4,364 |   |
| Repayments of capital lease obligations                                                  |       | (344                                       | )          | (235 | ) | (360 | ) |
| **Net cash (used in) provided by financing  activities**                                 |       | (2,472                                     | )          | 21,123 |   | 136,385 |   |
| Effect of exchange rate changes on cash and cash  equivalents                            |       | —                                     |       | (124 | ) | 126 |   |
| Net increase (decrease) in cash and cash equivalents                                     |       | 6,416                                      |       | 34,005 |   | (997 | ) |
| Cash and cash equivalents at beginning of year                                           |       | 3,078                                      |       | 9,494 |   | 43,499 |   |
| Cash and cash  equivalents at end of year                                                |       | $                                          | 9,494      |   | $ | 43,499 |   | $ | 42,502 |   |

*See accompanying report ofindependent registered public accounting firm and notes to consolidatedfinancial statements.*

 

70

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**Kenexa Corporationand SubsidiariesConsolidated Statements of Cash Flows (Continued)**(in thousands)

| ** **                                                                       | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Supplemental disclosures of  cash flow information**                           |       |                                       |       |   |   |   |   |
| Cash paid during the  year for:                                                  |       |                                       |       |   |   |   |   |
| Interest expense                                                                 |       | $                                          | 98         |   | $ | 225 |   | $ | 1,050 |   |
| Income taxes                                                                     |       | 203                                        |       | 1,336 |   | 2,442 |   |
| **Non-cash  investing and financing activities**                                 |       |                                       |       |   |   |   |   |
| Capital lease  obligations                                                       |       | $                                          | 383        |   | $ | 167 |   | $ | 325 |   |
| Notes receivable  applied to accrued bonus                                       |       | —                                     |       | 151 |   | — |   |
| Accretion of  class B common stock and class C common stock to redemption value  |       | 1,020                                      |       | 41,448 |   | — |   |
| Redemption and  conversion of class B and class C common to class A common stock |       | —                                     |       | 51,351 |   | — |   |
| Stock consideration for  acquisitions                                            |       | —                                     |       | — |   | 3,797 |   |

*See accompanying report of independentregistered public accounting firm and notes to consolidated financialstatements.*

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements**(All amounts in thousands, except share and per share data, unless noted otherwise)

**1.   Organization**

Kenexa Corporation, and its subsidiaries (collectivelythe “Company”), commenced operations in 1987 as a provider of recruitingservices to a wide variety of industries. In 1993, the Company offered itsfirst automated talent management system. Between 1994 and 2006, the Companyacquired 25 businesses that enabled it to offer comprehensive human capitalmanagement, or HCM, services integrated with web-based technology.

The Company began itsoperations in 1987 under its predecessor companies, Insurance Services, Inc.,or ISI, and International Holding Company, Inc., or IHC in 1987. In December 1999,the Company reorganized its corporate structure by merging ISI and IHC with andinto Raymond Karsan Associates, Inc., or RKA, a Pennsylvania corporationand a wholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, aPennsylvania corporation. Each of RKA and RKH were newly created to consolidatethe businesses of ISI and IHC. In April 2000, the Company changed its nameto TalentPoint, Inc. and changed the name of RKA to TalentPointTechnologies, Inc. In November 2000, the Company changed its name toKenexa Corporation, and changed the name of TalentPoint Technologies, Inc.to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexatransacts business primarily through Kenexa Technology. The Company operates inone segment.

**2.**   Summaryof Significant Accounting Policies

**Principles ofConsolidation**

The consolidated financialstatements of the Company include the accounts of Kenexa and its subsidiaries. Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.

**Cash and CashEquivalents**

Cash and cash equivalentsconsist of highly liquid investments with remaining maturities of three monthsor less at the time of purchase. Cash which is restricted for lease deposits isincluded in other assets.

**Prepaid Expensesand Other Assets**

Prepaid expenses and othercurrent assets consist primarily of prepaid software maintenance agreements,deferred implementation costs, insurance and other current assets. Deferredimplementation costs represent internal payroll and other costs incurred inconnection with the customization of the sites associated with the internethosting arrangements. These costs are deferred over the implementation period,typically three to four months, and are expensed ratably over the subscriptionperiod, typically one to three years. These amounts aggregated $1,089 and $985at December 31, 2005 and 2006, respectively. The current portion of thesedeferred costs of $979 and $636 at December 31, 2005 and 2006,respectively, is included in other current assets and the non-current portionof $110 and $349 at December 31, 2005 and 2006, respectively, is includedin other assets in the accompanying consolidated balance sheets.

**Property andEquipment**

Property and equipment arestated at cost. Equipment under capital lease is stated at the lower of thefair market value at the date of acquisition or net present value of theminimum lease payments at 

72

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summary of Significant Accounting Policies (Continued)

inceptionof the lease. Depreciation and amortization are provided on the straight-linebasis over the assets’ estimated useful lives or, if shorter, the lease termsfor leasehold improvements. Estimated useful lives are generally 7 yearsfor office furniture, 3 to 5 years for computer equipment and 3 to5 years for software. Costs of maintenance and repairs are charged toexpense as incurred. When property and equipment or leasehold improvements aresold or otherwise disposed of, the fixed asset account and related accumulateddepreciation account are relieved and any gain or loss is included inoperations. Costs of software not yet placed into service are accumulated assoftware in development. Upon placement into service, the costs of the assetsare transferred to software. Costs of building construction not yet placed intoservice are accumulated as building construction in progress. Upon placementinto service, the costs of the assets are transferred to building.

**Allowance forDoubtful Accounts**

TheCompany records an allowance for doubtful accounts based on specificallyidentified amounts that management believes to be uncollectible. The Companyalso records an additional allowance based on certain percentages of agedreceivables, which are determined based on historical experience and management’sassessment of the general financial conditions affecting the Company’s customerbase. If actual collections experience changes, revisions to the allowance maybe required. Activity in the allowance for doubtful accounts is as follows:
| **Year** | ** ** | ** ** | ** ** | **Balance at  January 1,** | ** ** | **Charged  (Recovered)  Costs** | ** ** | **Acquired  reserves** | ** ** | **(Recovery)  Write Offs** | ** ** | **Balance at  December 31,** | ** ** |
|----------|------------|------------|------------|--------------------------------------|------------|---------------------------------|------------|------------------------|------------|---------------------------------|------------|----------------------------------------|------------|
| 2006     |       |       | $ 448 |                                 |       |                            | $ 405 |                   |       |                            | $ 304 |                                   |       |   | $ (182 | ) |   |   | $ 975 |   |   |
| 2005     |       |       | 288        |                                 |       |                            | 314        |                   |       |                            | —     |                                   |       |   | 154 |   |   |   | 448 |   |   |
| 2004     |       |       | 813        |                                 |       |                            | (93        | )                      |       |                            | —     |                                   |       |   | 432 |   |   |   | 288 |   |   |

 

**Software Developedfor Internal Use**

In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements That Include the Rightto Use Software Stored on Another Entity’s Hardware”, the Company applies AICPAStatement of Position No. 98-1, *Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use*.The costs incurred in the preliminary stages of development are expensed asincurred. Once an application has reached the development stage, internal andexternal costs, if direct and incremental, will be capitalized until thesoftware is substantially complete and ready for its intended use.Capitalization ceases upon completion of all substantial testing. The Companyalso capitalizes costs related to specific upgrades and enhancements when it isprobable the expenditures will result in additional functionality. Maintenanceand training cost are expensed as incurred. Internal use software is amortizedon a straight-line basis over its estimated useful life, generally three years.Management evaluates the useful lives of these assets on an annual basis andtests for impairments whenever events or changes in circumstances occur thatcould impact the recoverability of these assets. There were no impairments tointernal software in any of the periods covered in this audit report.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summary of Significant Accounting Policies (Continued)

The Company capitalizedinternal-use software costs for the years ended December 31, 2004, 2005,and 2006 of $386, $994 and $1,954, respectively. Amortization of capitalizedinternal-use software costs for the years ended December 31, 2004, 2005and 2006 were $1,054, $675 and $1,291, respectively.

**Goodwill**

On January 1, 2002, the Company adopted Statementof Financial Accounting Standards No. 142, *Goodwill and Other Intangible Assets* (“SFAS 142”), whichsuperseded Accounting Board Opinion No. 17, *Intangible Assets*. Upon adoption of SFAS 142, theCompany ceased amortization of existing goodwill and is required to review thecarrying value of goodwill for impairment. If goodwill becomes impaired, someor all of the goodwill could be written off as a charge to operations. Thiscomparison is performed annually or more frequently if circumstances changethat would more likely than not reduce the fair value of the reporting unitbelow its carrying amount. The Company has reviewed the carrying values ofgoodwill of each business component by comparing the carrying values to theestimated fair values of the business components. The fair value is based onmanagement’s estimate of the future discounted cash flows to be generated bythe respective business components and comparable company multiples. These cashflows consider factors such as future operating income, historical trends, aswell as demand and competition. Comparable company multiples are based upon publiccompanies in sectors relevant to the Company’s business based on its knowledgeof the industry. Changes in the underlying business could affect theseestimates, which in turn could affect the recoverability of goodwill.Management determined that the carrying values of its goodwill did not exceedthe fair values and as a result believes that no impairment of goodwill existedat December 31, 2006.

Thechanges in the carrying amount of goodwill for the years ended December 31,2004, and 2005 and 2006 are as follows:
| Balance as of  December 31, 2003 |   | $   8,534 |   |
|---------------------------------------|--------|--------------------------|--------|
| Goodwill                              |   | —                   |   |
| Balance as of December 31, 2004  |   | $   8,534 |   |
| ScottWorks  Acquisition               |   | 281                      |   |
| Balance as of December 31, 2005  |   | $   8,815 |   |
| Acquisitions:                         |   |                     |   |
| ScottWorks                            |   | 30                       |   |
| Webhire                               |   | 31,564                   |   |
| Knowledge Workers                     |   | 2,574                    |   |
| Gantz Wiley Research                  |   | 6,173                    |   |
| BrassRing                             |   | 104,604                  |   |
| Psychometrics Services Ltd.           |   | 7,569                    |   |
| Balance as of  December 31, 2006 |   | $ 161,329           |   |

 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summary of Significant Accounting Policies (Continued)

**Intangible Assets**

Intellectual property andnon-compete agreements (“intangible assets”) are amortized on a straight-linebasis over their estimated useful lives or contract periods, generally rangingfrom 3 to 20 years. The increase in customer lists during the year ended December 31,2006 was due to acquisitions completed in 2006 (see Footnote 3—Acquisitions). Theamounts were based, in part, on an analysis of the incremental cash flowsexpected to be derived from the customer lists using historic retention ratesand an appropriate discount rate.  Accumulated amortization of intangible assetswas $1,275 and $1,688 as of December 31, 2005 and 2006, respectively.Amortization expense related to these intangible assets was $38 and $175 as of December 31,2005 and 2006, respectively.

IntangibleAssets that are subject to amortization at December 31, 2005 and 2006,consist of the following:
| ** **                   | ** ** | **Gross Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Weighted  Average   Amortization  Period (in years)** | ** ** |
|------------------------------|------------|--------------------------------|------------|-------------------------------|------------|-------------------------------------------------------------------|------------|
| **Description**              | ** ** | **2005**                       | ** ** | **2006**                      | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2006** | ** ** |
| Customer Lists               |       | $  102               |       | $ 4,940                  |       | $    33                                       |       | $  441 |   |   | 9.7 | ** ** |   |
| Trademarks                   |       | 67                             |       | 87                            |       | 11                                                                |       | 16 |   |   | 15.4 | ** ** |   |
| Fully Amortized  Intangibles |       | 1,231                          |       | 1,231                         |       | 1,231                                                             |       | 1,231 |   |   |   | ** ** |   |
| Total                        |       | $ 1,400                   |       | $ 6,258                  |       | $ 1,275                                                      |       | $ 1,688 |   |   | 9.8 | ** ** |   |

 

Estimatedamortization expense for each of the next five years is as follows:
| **Year Ending December 31,** | ** ** | ** ** | ** ** | **Amortization  Expense** | ** ** |
|---------------------------------------------|------------|------------|------------|---------------------------|------------|
| 2007                                        |       |       | $ 691 |                      |       |
| 2008                                        |       |       | 646        |                      |       |
| 2009                                        |       |       | 490        |                      |       |
| 2010                                        |       |       | 489        |                      |       |
| 2011                                        |       |       | 478        |                      |       |

 

**Impairment of LongLived Assets**

The Company evaluates itslong-lived assets, including certain identifiable intangible assets, forimpairment whenever events or changes in circumstances indicate that thecarrying amount of such assets may not be recoverable. Recoverability of assetsto be held and used is measured by a comparison of the carrying amount of anyasset to future net cash flows expected to be generated by the asset. If suchassets are considered to be impaired, the impairment is measured by the amountby which the carrying amount of the assets exceeds the fair value of the assets.

75

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summary ofSignificant Accounting Policies (Continued)

**Revenue Recognition**

TheCompany derives its revenue from two sources: (1) subscription revenue forsolutions, which is comprised of subscription fees from clients accessing ouron-demand software, consulting services, outsourcing services and proprietarycontent, and from clients purchasing additional support beyond the standardsupport that is included in the basic subscription fee; and (2) other feesfor discrete professional services. Because the Company provides its solutionas a service, the Company follows the provisions of Securities and ExchangeCommission Staff Accounting Bulletin No. 101, *Revenue Recognition in Financial Statements,* as amended byStaff Accounting Bulletin No. 104, *RevenueRecognition.* On August 1, 2003, the Company adopted EmergingIssues Task Force Issue No. 00-21, *RevenueArrangements with Multiple Deliverables.* The Company recognizesrevenue when all of the following conditions are met:

·       Thereis persuasive evidence of an arrangement;

·       Theservice has been provided to the client;

·       Thecollection of the fees is probable; and

·       Theamount of fees to be paid by the client is fixed or determinable.        

Subscription fees andsupport revenues are recognized on a monthly basis over the lives of thecontracts. Amounts that have been invoiced are recorded in accounts receivableand in deferred revenue or revenue, depending on whether the revenuerecognition criteria have been met.

Discrete professionalservices and other revenues, when sold with subscription and support offerings,are accounted for separately since these services have value to the customer ona stand-alone basis and there is objective and reliable evidence of fair valueof the delivered elements. The Company’s arrangements do not contain generalrights of return. Additionally, when professional services are sold with otherelements, the consideration from the revenue arrangement is allocated among theseparate elements based upon the relative fair value. Professional services andother revenues are recorded as follows: Consulting revenues are recognized uponcompletion of the contracts that are of short duration (generally less than60 days) and as the services are rendered for contracts of longerduration.

In determining whetherrevenues from professional services can be accounted for separately fromsubscription revenue, the Company considers the following factors for eachagreement: availability from other vendors, whether objective and reliableevidence of fair value exists of the undelivered elements, the nature and thetiming of when the agreement was signed in comparison to the subscriptionagreement start date and the contractual dependence of the subscription serviceon the client’s satisfaction with the other services. If the professionalservice does not qualify for separate accounting, the Company recognizes therevenue ratably over the remaining term of the subscription contract. In thesesituations the Company defers the direct and incremental costs of the professionalservice over the same period as the revenue is recognized.

Deferred revenuerepresents payments received or accounts receivable from the Company’s clientsfor amounts billed in advance of subscription services being provided.

The Company records “*Out-of-Pocket” Expenses Incurred* (“EITF 01-14”),which requires that reimbursements received for out-of-pocket expenses beclassified as revenues and not as cost reductions. 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summary ofSignificant Accounting Policies (Continued)

Beforethe effective date of EITF 01-14, out-of-pocket reimbursements fromclients were netted with the applicable costs. These items primarily includetravel, meals and certain telecommunication costs. For the year ended December 31,2004, 2005 and 2006, reimbursed expenses totaled $1,331, $1,436 and $1,915,respectively

**Income Taxes**

Kenexa files aconsolidated tax return with its subsidiaries for federal tax purposes and on aseparate company basis for state tax purposes. Deferred income taxes areprovided using the asset and liability method for temporary differences betweenthe financial statement and tax bases of assets and liabilities using enactedtax rates in effect for the year in which the differences are expected toreverse. Valuation allowances are established when necessary to reduce deferredtax assets to the amounts expected to be realized.

**Other Taxes**

***Non-income taxes such as sales and value-added tax arepresented on a net basis.***

**Advertising**

Advertising costs areexpensed when incurred. Advertising for the years ended December 31, 2004,2005, and 2006 were $117, $178 and $220, respectively.

**Self-Insurance**

The Company isself-insured for the majority of its health insurance costs, including claimsfiled and claims incurred but not reported subject to certain stop lossprovisions. The Company estimated the liability based upon management’sjudgment and historical experience. At December 31, 2005 and 2006,self-insurance accruals totaled $190 and $340, respectively. Managementcontinuously reviews the adequacy of the Company’s stop loss insurancecoverage. Material differences may result in the amount and timing of insuranceexpense if actual experience differs significantly from management’s estimates.

**Concentration of Credit Risk**

Financial instrumentswhich potentially expose the Company to concentration of credit risk consistprimarily of accounts receivable. Credit risk arising from receivables ismitigated due to the large number of clients comprising the Company’s clientbase and their dispersion across various industries. The clients areconcentrated primarily in the Company’s U.S. market area. At December 31,2006, there were no clients that represented more than 10% of the net accountsreceivable balance. There were no clients that individually exceeded 10% of theCompany’s revenues.

Cash balances aremaintained at several banks. Accounts located in the United States are insuredby the Federal Deposit Insurance Corporation (“FDIC”) up to $100,000. Certainoperating cash accounts may exceed the FDIC limits.

**401(k) Plan**

The Company sponsors a 401(k) definedcontribution plan which is available for participation to all eligibleemployees. Company contributions to the plan are subject to the board ofdirector’s election to make a contribution each year. Company contributions, ifelected by the board of directors, are allocated to the participants’ accountsbased upon the percentage of each participant’s contributions to the planduring the given year to the total of all participant contributions. For theyears ended December 31, 2004, 2005 and 2006, the Company’s board ofdirectors elected to make a matching contribution of 50%, 25% and 50% ofemployee contributions, respectively.

 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summaryof Significant Accounting Policies (Continued)

**Earnings (Loss) PerShare**

TheCompany follows SFAS 128, “Earnings Per Share.” Under SFAS 128,companies that are publicly held or have complex capital structures arerequired to present basic and diluted earnings per share on the face of thestatement of operations. Earnings (loss) per share are based on the weightedaverage number of shares and common stock equivalents outstanding during theperiod. In the calculation of diluted earnings per share, shares outstandingare adjusted to assume conversion of the Company’s non-interest bearingconvertible stock and the exercise of options and warrants if they are dilutive.In the calculation of basic earnings per share, weighted average numbers ofshares outstanding are used as the denominator. The Company had a net lossavailable to common shareholders for the periods ended December 31, 2004and 2005. As a result, the common stock equivalents of stock options, warrantsand convertible securities issued and outstanding at December 31, 2004 and2005 were not included in the computation of diluted earnings per share for theperiod then ended as they were antidilutive. The Company had a net incomeavailable to common shareholders for the period ended December 31, 2006. Income(loss) per share is computed as follows:

| ** **                                                                                                                  | ** ** | **Twelve Months Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2004**                                                 | ** ** | **2005** | ** ** | **2006** | ** ** |
| Numerator:                                                                                                                  |       |                                                     |       |   |   |   |   |
| Net (loss) income                                                                                                           |       | $                                                        | (4,093     | ) | $ | 6,091 |   | $ | 15,893 |   |
| Accretion of redeemable  class B common stock and redeemable class C common stock                                           |       | 1,020                                                    |       | 41,488 |   | — |   |
| Net (loss) income available  to common shareholders                                                                         |       | $                                                        | (5,113     | ) | $ | (35,397 | ) | $ | 15,893 |   |
| Denominator:                                                                                                                |       |                                                     |       |   |   |   |   |
| Weighted average shares  used to compute net (loss) income available to common shareholders per common  share—basic    |       | 5,995,389                                                |       | 11,578,885 |   | 19,911,775 |   |
| Effect of dilutive stock  options and warrants                                                                              |       | —                                                   |       | — |   | 514,019 |   |
| Weighted average shares  used to compute net (loss) income available to common shareholders per common  share—dilutive |       | 5,995,389                                                |       | 11,578,885 |   | 20,425,794 |   |
| Basic net (loss) income per  share to common shareholder                                                                    |       | $                                                        | (0.85      | ) | $ | (3.06 | ) | $ | 0.80 |   |
| Diluted net (loss) income per share to common  shareholder                                                                  |       | $                                                        | (0.85      | ) | $ | (3.06 | ) | $ | 0.78 |   |

 

The Company has restatedall shares to reflect a 0.8-for-1 reverse stock split effected on June 27,2005.

**Share-Based Compensation**

On January 1, 2006,we adopted SFAS No. 123R using the Modified Prospective Approach (“MPA”).The MPA requires that compensation expense be recorded for restricted stock andall unvested stock options as of January 1, 2006. Upon adoption we willcontinue to recognize the cost of previously granted share-based awards underthe straight-line basis and anticipate that we will recognize the cost for newshare-based awards on a straight-line basis over the requisite service period. Thepool of excess tax benefits 

78

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summary of Significant Accounting Policies (Continued)

availableto absorb tax deficiencies was determined using the alternative transitionmethod described in FSP FAS 123(R)-3. Using this method an opening poolbalance of $22 was calculated.

**Use of Estimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities,disclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

**Fair Value ofFinancial Instruments**

The carrying amounts ofthe Company’s financial assets and liabilities, including cash, accountsreceivable and accounts payable at December 31, 2005 and 2006 approximatefair value of these instruments. Redeemable preferred stock is carried at fairvalue, based upon redemption requirements. See footnote 9 for furtherdiscussion.

**Foreign Currency**

The financial position andoperating results of our foreign operations are consolidated using the localcurrency as the functional currency. Local currency assets and liabilities aretranslated at the rate of exchange to the U.S. dollar on the balance sheetdate, and the local currency revenues and expenses are translated at averagerates of exchange to the U.S. dollar during the period. The related translationadjustments were $(124) and $126 for the years ended December 31, 2005 and2006, respectively, and are reported in the equity section of the balancesheet. The foreign currency translation adjustment is not adjusted for incometaxes as it relates to an indefinite investment in a non-U.S. subsidiary.

**ComprehensiveIncome (Loss)**

Comprehensive income(loss) consists of net loss or gain on foreign currency translations and netincome or loss from operations and is presented in the consolidated statementof shareholders deficiency.

**New AccountingPronouncements**

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R). SFAS 123R requires that the cost resulting from all share-basedpayment transactions be recognized in the financial statements. SFAS 123R alsoestablishes fair value as the measurement method in accounting for share-basedpayments. The FASB required the provisions of SFAS 123R be adopted for interimor annual periods beginning after June 15, 2005. In April 2005, theSEC adopted a new rule amending the compliance dates for SFAS 123R forpublic companies. In accordance with this rule, we adopted SFAS 123R effective January 1,2006 using the modified prospective transition method. We did not modify theterms of any previously granted options in anticipation of the adoption of SFAS123R.

The application of the provisions of SFAS 123Rresulted in a pretax expense of approximately $3,076 in 2006. Based on the sameassumptions used to value our 2006 compensation expense, we estimate our 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**2.**   Summary of Significant Accounting Policies (Continued)

pretax expense associatedwith our share-based compensation plans will approximate $2,283 in 2007 and$1,713 in 2008.

In November 2005, the FASB issued FSP FAS 123(R)-3,Transition Election Related to Accounting for the Tax Effects of Share-BasedPayment Awards, to provide an alternative approach of accounting for the taxeffects of employee share-based awards. We have elected to adopt thealternative transition method provided in FSP FAS 123(R)-3 forcalculating the tax effects of share-based compensation pursuant to SFAS123(R). The alternative transition method includes simplified methods toestablish the beginning balance of the additional paid-in capital pool (APICpool) related to the tax effects of employee share-based compensation, and todetermine the subsequent impact on the APIC pool and consolidated statements ofcash flows of the tax effects of employee share-based compensation awards thatare outstanding upon the adoption of SFAS 123(R).

In July 2006, theFinancial Accounting Standards Board (FASB) issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109(FIN 48), which clarifies the accounting for uncertainty in tax positions.This Interpretation requires that we recognize in our financial statements, theimpact of a tax position, if that position is more likely than not of beingsustained on audit, based on the technical merits of the position. The provisionsof FIN 48 are effective as of the beginning of our 2007 fiscal year, with thecumulative effect of the change in accounting principle recorded as anadjustment to opening retained earnings. We are currently evaluating the impactof adopting FIN 48 on our financial statements.

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.” SFAS No. 157 clarifies the principle that fair valueshould be based on the assumptions market participants would use when pricingan asset or liability and establishes a fair-value hierarchy that prioritizesthe information used to develop those assumptions. Under SFAS No. 157,fair-value measurements would be separately disclosed by level within thefair-value hierarchy. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. We do not believe the adoption of SFAS No. 157will have a material impact on our consolidated financial position, results ofoperations or cash flows.

**3.**   Acquisitions

**PsychometricServices**

On November 20, 2006,the Company acquired all of the outstanding stock of Psychometric Services,Ltd., a provider of user friendly psychometric tests, based in Harrow, UnitedKingdom, for a purchase price of approximately $7,459 in cash and $627 in stockconsideration. The total cost of the acquisition was approximately $8,087. Inconnection with the acquisition $758 of the cash portion of the purchase pricewas deposited into an escrow account to cover any claims for indemnificationmade by the Company against Psychometrics Services under the acquisitionagreement.  The escrow agreement willremain in place for one year from the acquisition date, and any funds remainingin the escrow account at the end of the one year period will be distributed tothe stockholders of Psychometric Services Ltd. The purchase price has beenallocated on a preliminary basis to the assets acquired and liabilities assumedbased upon management’s best estimate of fair value with any excess over thenet tangible and intangible assets acquired allocated to goodwill. Inaccordance with Statement of Financial Accounting Standard No. 141 

80

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**3.**   Acquisitions (Continued)

thepurchase price and related purchase price allocation may be update to reflectchanges such as any additional transaction fees or the valuation of certainassets acquired or liabilities assumed.

**BrassRing**

On November 13, 2006,the Company acquired BrassRing, LLC, a provider of talent management solutions,combining innovative technology, consulting, and outsourcing with recruitmentexpertise to build successful workforces to meet the specific needs of clients,for approximately $114,708 in cash. On the date of close, approximately$11,500 or 10% of the aggregate purchase price was deposited into anescrow account to cover any claims for indemnification made by the Companyagainst BrassRing under the acquisition agreement. Assuming there are noindemnification claims, this amount will be released to BrassRing on or aboutMay 13, 2008. The totalcost of the acquisition, including legal, accounting, and other professionalfees of $2,910, was approximately $117,618.

BrassRing’s results ofoperations were included in the Company’s consolidated financial statementsbeginning on November 13, 2006.

Thepurchase price was allocated as follows:
| Description                                | ** ** | ** ** | ** ** | **Amount** | ** **     | **Amortization period** | ** ** |
|--------------------------------------------|------------|------------|------------|------------|----------------|------------------------------|------------|
| Assets acquired                            |       |       |       |       |           |                         |       |
| Cash and short-term investments            |       | $          | 10,567     |       |           |                         |       |   |
| Accounts receivable                        |       | 6,363      |       |       |           |                         |       |
| Prepaid expenses and  other current assets |       | 1,514      |       |       |           |                         |       |
| Property & equipment              |       | 1,776      |       |       |           |                         |       |
| Other long-term assets                     |       | 520        |       |       |           |                         |       |
| Technology-related  assets                 |       | 368        |       |       | 1.5 years      |                         |       |
| Contract-related assets                    |       | 416        |       |       | 5 years        |                         |       |
| Goodwill                                   |       | 104,604    |       |       | Indeterminable |                         |       |
| Other intangibles, net                     |       | 24         |       |       |           |                         |       |
| Deferred income taxes                      |       | 3,279      |       |       | 5 years        |                         |       |
| Less: Liabilities assumed                  |       |       |       |       |           |                         |       |
| Accounts payable                           |       | 3,875      |       |       |           |                         |       |
| Deferred federal income  taxes             |       | 21         |       |       |           |                         |       |
| Deferred revenue                           |       | 7,418      |       |       |           |                         |       |
| Deferred rent                              |       | 499        |       |       |           |                         |       |
| Total Cash Purchase Price                  |       | $          | 117,618    |       |           |                         |       |   |

 

The purchase price has been allocated on a preliminarybasis to the assets acquired and liabilities assumed based upon management’sbest estimate of fair value with any excess over the net tangible andintangible assets acquired allocated to goodwill. In accordance with Statementof Financial Accounting Standard No. 141 the purchase price and relatedpurchase price allocation may be update to reflect changes such as anyadditional transaction fees or the valuation of certain assets acquired or liabilitiesassumed. The estimated fair values of the intangibles assets are furtherdescribed below. Contract-related assets, technology-related assets, and netoperating loss tax attributes are being amortized over their estimated usefullives.  Goodwill is not amortized but isperiodically evaluated for impairment.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**3.**   Acquisitions (Continued)

The valuation ofcontract-related assets in the amount of $416, which relates to BrassRing’scurrent customer portfolio, was determined based upon estimated discountedincremental future cash flow to be received as a result of these relationships.

Goodwill from theacquisition resulted from our belief that the recruiter products developed byBrassRing will be complementary to our Kenexa Recruiter product offerings andwill help us remain competitive in the talent acquisition market. The goodwillfrom the BrassRing acquisition will not be deductible for tax purposes.

If the BrassRing andWebhire acquisitions had occurred on January 1, 2005, the unaudited proforma results of operations for the year ended December 31, 2005 wouldhave been as noted below. If BrassRing acquisition had occurred onJanuary 1, 2006, the unaudited pro forma results of operations for theyear ended December 31, 2006 would have been:

| ** **                                                                 | ** ** | **Year ended  December 31, 2005** | ** ** | **Year ended  December 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Revenue                                                                    |       |                                             | $          | 115,063                                          |       |   |   | $ | 145,269 |   |   |
| Net (loss) income available  to common shareholders                        |       |                                             | (36,087    | )                                                |       |   | 14,295 |   |   |
| Net (loss) income per  share available to common shareholders—basic   |       |                                             | $          | (3.12                                            | )          |   |   | $ | 0.72 |   |   |
| Net (loss) income per share available to common  shareholders—diluted |       |                                             | $          | (3.12                                            | )          |   |   | $ | 0.70 |   |   |

 

**Gantz WileyResearch**

On August 14, 2006,the Company, through its wholly-owned subsidiary, Kenexa Technology, Inc.,acquired all of the outstanding stock of Gantz Wiley Research, an employee andcustomer research firm based in Minneapolis, Minnesota, for a purchase price ofapproximately $2,652 in cash and $3,170 in stock consideration. The total costof the acquisition, including estimated legal, accounting, and other professionalfees, was approximately $5,864. In connection with the acquisition $600 of thecash portion of the purchase price was deposited into an escrow account tocover any claims for indemnification made by the Company against Gantz WileyResearch under the acquisition agreement.  The escrow agreement will remain in place forone year from the acquisition date, and any funds remaining in the escrowaccount at the end of the one year period will be distributed to thestockholder of Gantz Wiley Research.  Inaddition, the acquisition agreement with Gantz Wiley Research contains anearnout provision which provides for the payment of additional consideration bythe Company based upon the annual revenues of Gantz Wiley Research through December 31,2006. Based  upon the results, contingentconsideration  of  $1,300 was paid in cash and equity during thefirst quarter of 2007 to the former shareholder of Gantz Wiley Research. Therelated liability has been reflected in the financial statements atDecember 31, 2006. The purchase price has been allocated on a preliminarybasis to the assets acquired and liabilities assumed based upon management’sbest estimate of fair value with any excess over the net tangible andintangible assets acquired allocated to goodwill. In accordance with Statementof Financial Accounting Standard No. 141 the purchase price and relatedpurchase price allocation may be update to reflect changes such as anyadditional transaction fees or the valuation of certain assets acquired orliabilities assumed.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**3.**   Acquisitions (Continued)

**Knowledge Workers**

On April 10,2006, the Company, through its wholly-owned subsidiary, Kenexa Technology, Inc.,and Kenexa Acquisition Corp., a wholly-owned subsidiary of Kenexa Technology,acquired all of the outstanding stock of Knowledge Workers, Inc., a humancapital consulting and technology firm based in Denver, Colorado, for apurchase price of approximately $2,476 in cash. The total cost of theacquisition, including estimated legal, accounting, and other professionalfees, was approximately $2,580. In connection with the acquisition the Companydeposited $100 into an escrow account to cover any claims for indemnificationmade by the Company against Knowledge Workers, Inc. under the acquisitionagreement.  The escrow agreement willremain in place for two years from the acquisition date. The purchase price hasbeen allocated on a preliminary basis to the assets acquired and liabilitiesassumed based upon management’s best estimate of fair value with any excess overthe net tangible and intangible assets acquired allocated to goodwill. Inaccordance with Statement of Financial Accounting Standard No. 141 thepurchase price and related purchase price allocation may be update to reflectchanges such as any additional transaction fees or the valuation of certainassets acquired or liabilities assumed.

**Webhire**

On January 13, 2006, the Company, through itswholly-owned subsidiary, Kenexa Technology, Inc., and Kenexa AcquisitionCorp., a wholly-owned subsidiary of Kenexa Technology, completed itsacquisition of Webhire, Inc. (“Webhire”) for approximately $34,395 incash. The total cost of the acquisition, including legal, accounting, and otherprofessional fees of $666, was approximately $35,061.

Approximately $5,000, or 14.3% of the aggregatepurchase price, remains deposited in an escrow account to cover any claims forindemnification made by the Company against Webhire under the acquisitionagreement. Assuming there are no indemnification claims, this amount will bereleased to the former stockholders of Webhire on or about June 13, 2007.

Webhire’s results of operations were included in theCompany’s consolidated financial statements beginning on January 1, 2006.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**3.**   Acquisitions (Continued)

The purchase price wasallocated as follows:
| Description                                                | ** ** | ** ** | ** ** | **Amount**     | ** ** | **Amortization  period** | ** ** |
|------------------------------------------------------------|------------|------------|------------|----------------|------------|--------------------------|------------|
| Assets acquired                                            |       |       |       |           |       |
| Cash and  short-term investments                           |       | $          | 2,849      |           |       |                     |
| Accounts receivable, net  of allowance of $187             |       | 2,015      |       |           |       |
| Prepaid expenses and  other current assets                 |       | 461        |       |           |       |
| Property &  equipment                             |       | 623        |       |           |       |
| Other assets                                               |       | 209        |       |           |       |
| Trademark/tradename,  service marks & domain name |       | 20         |       | Indeterminable |       |
| Customer Lists                                             |       | 1,031      |       | 22 years       |       |
| Internally developed  software                             |       | 877        |       | 3 years        |       |
| Goodwill                                                   |       | 31,564     |       | Indeterminable |       |
| Deferred income taxes                                      |       | 3,631      |       | 15 years       |       |
| Less: Liabilities assumed                                  |       |       |       |           |       |
| Notes payable                                              |       | 26         |       |           |       |
| Capital lease  obligations                                 |       | 102        |       |           |       |
| Accounts payable                                           |       | 294        |       |           |       |
| Accrued expenses                                           |       | 1,549      |       |           |       |
| Other liabilities                                          |       | 1,006      |       |           |       |
| Deferred revenue                                           |       | 5,313      |       |           |       |
| Total Cash Purchase Price                                  |       | $          | 34,990     |           |       |                     |

 

The purchase price has been allocated on a preliminarybasis to the assets acquired and liabilities assumed based upon management’sbest estimate of fair value with any excess over the net tangible andintangible assets acquired allocated to goodwill. In accordance with Statementof Financial Accounting Standard No. 141 the purchase price and relatedpurchase price allocation may be update to reflect changes such as anyadditional transaction fees or the valuation of certain assets acquired orliabilities assumed. The estimated fair values of the intangibles assets arefurther described below. Customer lists, internally developed software, and netoperating loss tax attributes are being amortized over their estimated usefullives.  Goodwill is not amortized but isperiodically evaluated for impairment.

In accordance with Statement of Financial AccountingStandard No. 141 the purchase price allocation for Webhire has beenupdated to reflect additional transaction fees and additional informationconcerning our deferred income tax analysis since the acquisition. The deferredincome tax and corresponding valuation allowance have been increased to reflectcurrent estimates relating to the utilization of the acquired NOL as well asany NOL limitations from the acquisition. These adjustments and any futureadjustments to the deferred tax asset or corresponding NOL will be adjustedthrough the goodwill and recorded as part of the transaction. The valuation ofthe net operating loss tax attributes of $3,631 was based upon the anticipateduse of the present value of cash flows from Webhire’s net operating losses.

The valuation of customer lists in the amount of$1,031, which relates to Webhire’s current customer portfolio, was determined basedupon estimated discounted incremental future cash flow to be received as aresult of these relationships.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**3.**   Acquisitions (Continued)

Goodwill from theacquisition resulted from our belief that the recruiter products developed byWebhire will be complementary to our Kenexa Recruiter product offerings andwill help us remain competitive in the talent acquisition market. The goodwillfrom the Webhire acquisition will not be deductible for tax purposes.

If theWebhire acquisition had occurred on January 1, 2005, the unaudited proforma results of operations for the year ended December 31, 2005 wouldhave been:

| ** **                                                                           | ** ** | **Year ended  December 31,   2005** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| Revenue                                                                              |       |                                               | $          | 77,698 |   |   |
| Net (loss) income  available to common shareholders                                  |       |                                               | (34,697    | ) |   |
| Net (loss) income per share available to common  shareholders—basic and diluted |       |                                               | $          | (3.00 | ) |   |

 

**4.**   Property,Equipment and Software

Asummary of property, equipment and software and related accumulateddepreciation as of December 31, 2005 and 2006 is as follows:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Equipment                          |       | $                     | 7,338      |   | $ | 8,914 |   |
| Software                           |       | 6,583                 |       | 9,934 |   |
| Office furniture and  fixtures     |       | 1,175                 |       | 1,225 |   |
| Leasehold improvements             |       | 645                   |       | 1,282 |   |
| Land                               |       | 578                   |       | 708 |   |
| Building construction in  progress |       | —                |       | 430 |   |
| Software in development            |       | 846                   |       | 237 |   |
|                               |       | 17,165                |       | 22,730 |   |
| Less accumulated  depreciation     |       | 11,578                |       | 12,139 |   |
|                               |       | $                     | 5,587      |   | $ | 10,591 |   |

 

Equipment, office furniture and fixtures includedcapital leases totaling $2,241 and $2,499 at December 31, 2005 and 2006,respectively. Depreciation and amortization expense, including amortization ofassets under capital leases, was $2,074 and $3,312 for the years endedDecember 31, 2005 and 2006, respectively.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**5.**   OtherAccrued Liabilities

Other accrued liabilities consist of the following:

| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Accrued  professional fees            |       | 260                   |       | 361 |   |
| Straight line  rent accrual           |       | 199                   |       | 1,405 |   |
| Other taxes  payable (non-income tax) |       | 220                   |       | 666 |   |
| Income taxes  payable                 |       | 1,084                 |       | 740 |   |
| Other liabilities                     |       | 414                   |       | 1,614 |   |
| Contingent  purchase price            |       |                  |       | 1,300 |   |
| Total other accrued  liabilities      |       | $                     | 2,177      |   | $ | 6,086 |   |
|                                       |            |                       |            |  |  |  |  |

 

**6.**   Lineof Credit

On November 13, 2006, the Company entered into anew secured credit agreement with PNC Bank, N.A., as administrative agent, inconnection with its acquisition of BrassRing.  The new secured credit agreement increased themaximum amount available under the credit facility from $25,000 to $75,000, consistingof (i) a $25,000 revolving credit facility, including a sublimit of up to$2,000 for letters of credit, and (ii) a $50,000 term loan. Borrowingsunder the new credit facility are secured by substantially all of the Company’sassets and the assets of its subsidiaries.  This credit facility replaced the prior$25,000 revolving credit facility with PNC Bank. As of December 31, 2006the Company had borrowings of $65,000 from the credit facility with aweighted average interest rate of 7.9% per annum. In January 2007 theCompany used a portion of the net proceeds of the public offering to repay alloutstanding borrowings. See footnote 14 for discussion of 2007 publicoffering.

Our revolving credit facility will terminate onNovember 12, 2011, at which time all outstanding borrowings must berepaid, and all outstanding letters of credit, if any, must be cashcollateralized.

On December 29, 2005, the Company entered into aThird Amendment and Modification to the Revolving Credit and Security Agreementwith PNC Bank, N.A., originally dated July 15, 2003, and as amended on October 10,2003 and March 22, 2005. The Third Amendment increased the maximum amountavailable under the credit facility from $10,000 to $25,000, including asublimit of up to $2,000 for letters of credit. No amounts wereoutstanding on the line on December 31, 2005. On January 13, 2006,the Company borrowed $25,000 from the credit facility for working capitalpurposes.

The Company’s borrowings under the credit facilitybear interest at tiered rates based upon the ratio of Net Funded Debt to EBITDAas defined in the Third Amendment. The Company may also elect interest rates onits borrowings calculated by reference to LIBOR plus a margin based upon theratio of its Net Funded Debt to EBITDA ratio. Interest on LIBOR borrowings iscalculated on an actual/360 day basis and is paid on the last day of eachinterest period. LIBOR advances are available for periods of 1,2,3 or6 months. LIBOR pricing is adjusted for any statutory reserves. The creditfacility will terminate on December 31, 2008, at which time alloutstanding borrowings must be repaid, and all outstanding letters of credit,if any, must be cash collateralized.

On July 15, 2003, the Company refinanced its lineof credit agreement by entering into a revolving credit and security agreement(“the Revolver”) with a new lender. Maximum available borrowings under theRevolver represent the lesser of $10,000,000 or the Borrowing Base, which isdefined as 85% of the amount of Eligible Receivables and 75% of the amount of UnbilledReceivables. Based upon these 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**6.**   Line of Credit (Continued)

criteria, maximumavailable borrowings on December 31, 2004 were $3,726,901. No amounts wereoutstanding on the line of credit on December 31, 2004.

Borrowings under the Revolver are collateralized bygenerally all the Company’s assets, including a pledge of the capital stock ofits subsidiaries. Repayment of amounts outstanding under certain notes payableand all issued or issuable shares of common and preferred stock aresubordinated to the rights of the lender under terms of the Revolver. TheRevolver contains various terms and covenants that provide for restrictions oncapital expenditures, payment of dividends, dispositions of assets, investmentsand acquisitions and require the Company, among other things, to maintain minimumlevels of tangible net worth, net income and fixed charge coverage. The Companywas compliant with covenants at December 31, 2006.

**7.**   IncomeTaxes

The income tax (benefit)expense for the years ended December 31, 2004, 2005 and 2006 consisted ofthe following:

| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2004**              | ** ** | **2005** | ** ** | **2006** | ** ** |
| Current                              |       |                  |       |   |   |   |   |
| Federal                              |       | $                     | 75         |   | $ | 1,401 |   | $ | 4,646 |   |
| Foreign                              |       | 85                    |       | 15 |   | 177 |   |
| State and local                      |       | 141                   |       | 672 |   | 664 |   |
| Total Current                        |       | $                     | 301        |   | 2,088 |   | 5,487 |   |
| Deferred                             |       |                  |       |   |   |   |   |
| Federal                              |       | (869                  | )          | (1,119 | ) | (427 | ) |
| Foreign                              |       | —                |       | (270 | ) | (574 | ) |
| State and local                      |       | (154                  | )          | (108 | ) | (183 | ) |
| Total Deferred                       |       | (1,023                | )          | (1,497 | ) | (1,184 | ) |
| Total Income tax provision (benefit) |       | $                     | (722       | ) | $ | 591 |   | $ | 4,303 |   |

 

 

 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**7.**   Income Taxes (Continued)

A reconciliation of the Company’s effective income taxrate to the statutory federal income tax rate of 34% for the years endedDecember 31, 2004 and 2005 and income tax rate of 35% for the year endedDecember 31, 2006 is as follows:

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2004**              | ** ** | **2005** | ** ** | **2006** | ** ** |
| Statutory federal tax  rate      |       | (34.0                 | )%         | 34.0 | % | 35 | % |
| Foreign tax differential         |       | 2.0                   | %          | 5.2 | % | (2.8 | )% |
| Section 162 Credit          |       | 0.0                   | %          | (2.5 | )% | 0.0 |   |
| Marking to market charge         |       | 36.3                  | %          | 17.3 | % | 0.0 | % |
| State income taxes               |       | 3.1                   | %          | 10.1 | % | 2.4 | % |
| Officer’s life insurance    |       | 1.0                   | %          | 0.4 | % | 0.2 | % |
| Other nondeductible  expenses    |       | 1.4                   | %          | 0.6 | % | 0.5 | % |
| AMT tax                          |       | 1.6                   | %          | 0.0 | % | 0.0 | % |
| Change in valuation  allowance   |       | 3.0                   | %          | (25.7 | )% | (4.7 | )% |
| Use of NOL                       |       | (30.1                 | )%         | (30.5 | )% | — | % |
| Research and development  credit |       | —                |       | — |   | (3.4 | )% |
| Non-taxable interest             |       | —                |       | — |   | (1.8 | )% |
| Provision to return  true-up     |       | —                |       | — |   | (1.2 | )% |
| HRI trust                        |       | —                |       | — |   | (2.9 | )% |
| Income tax expense               |       | (15.7                 | )%         | (8.8 | )% | 21.3 | % |

 

 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

 

**7.**   Income Taxes (Continued)

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amount of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. Significant components of the Company’snet deferred tax assets and liabilities as of December 31, 2004, 2005 and2006 were as follows:

| ** **                               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2006** | ** ** |
| Deferred tax assets                      |       |                  |       |   |   |   |   |
| Foreign net operating  loss carryforward |       | $                     | 1,185      |   | $ | 1,216 |   | $ | 922 |   |
| Accrued expenses                         |       | 2,669                 |       | 769 |   | 1,160 |   |
| Federal and state net  operating losses  |       | 4,394                 |       | 1,672 |   | 136 |   |
| Acquired net operating  losses           |       | —                |       | — |   | 14,394 |   |
| AMT tax carryforward                     |       | 139                   |       | — |   | 1,314 |   |
| Deferred revenue  adjustment             |       | 1,031                 |       | 1,706 |   | 5,633 |   |
| Accounts receivable  allowance           |       | 185                   |       | 369 |   | 588 |   |
| Stock Options                            |       | —                |       | — |   | 960 |   |
| Depreciation                             |       | —                |       | — |   | 714 |   |
| Capitalized R&D                      |       | —                |       | — |   | 1,541 |   |
| Other                                    |       | 4                     |       | — |   | — |   |
| Total deferred tax  assets               |       | 9,607                 |       | 5,732 |   | 27,362 |   |
| Deferred tax liabilities                 |       |                  |       |   |   |   |   |
| Depreciation and amortization            |       | (801                  | )          | (127 | ) | — |   |
| Amortization of  intangibles             |       | (1,793                | )          | (2,140 | ) | (5,205 | ) |
| Total deferred tax  liabilities          |       | (2,594                | )          | (2,267 | ) | (5,205 | ) |
| Net deferred tax asset                   |       | $                     | 7,013      |   | $ | 3,465 |   | $ | 22,157 |   |
| Valuation allowance                      |       | (5,991                | )          | (946 | ) | (12,634 | ) |
| Net deferred tax asset                   |       | $                     | 1,022      |   | $ | 2,519 |   | $ | 9,523 |   |

 

At December 2006 the Company has remaining netoperating loss carryforwards from acquisitions of $41,126. Based upon theuncertainty to fully utilize these net operating loss carryforwards the Companyrecorded a valuation allowance of $36,098. Additionally, the Company is subjectto Internal Revenue Code section 382 loss limitations for these acquired netoperating loss carryforwards. In the future, if the valuation allowance isreduced a reduction to goodwill will be recorded, otherwise if the valuationallowance is increased the adjustment will be charged to expense. The Companyalso has net operating loss carryforwards available from foreign operations of$3,073. In 2006 the Company released $945 of its foreign valuation allowanceresulting in no corresponding valuation allowance against these foreign netoperating loss carryforwards as the Company believes they will be fullyutilized in the future.  In 2005 theCompany was granted a tax holiday from the government of India for itsdevelopment center located in Hyderabad, India. This tax holiday was granted for a five year period and expires in2010.  The income tax benefit on thisholiday is $404 in 2006.

A valuation allowance of$5,991and $946 has been recorded at December 31, 2004, and 2005,respectively. In 2004 based upon historical taxable income in 2003 andprojected taxable income for 2004 and 2005 the Company reduced its valuationallowance on its net deferred tax assets. At December 31, 2005, theCompany had available net operating loss carryforwards from U.S. operations ofapproximately $4.4 million for federal purposes which expire in the year2022 and approximately $2.9 million for state 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**7.**   Income Taxes (Continued)

purposeswhich expire in 2006 through 2022 for state purposes. At December 31,2005, the Company also had available net operating loss carryforwards fromforeign operations of approximately $4.9 million with no expiration date. In2005, the Company reduced its valuation allowance by approximately$5.0 million due to the utilzation of net operating loss carryforwards tooffset the increase in income resulting in income tax expense on continuingoperations of $0.6 million for the year ended December 31, 2005. In2004, the Company reduced its valuation allowance by approximately$0.4 million and increased deferred tax assets by approximately$0.6 million as a result of management’s determination that it is morelikely than not that the Company will realize a portion of the benefits of thefederal and state tax assets resulting in an income tax benefit of$0.7 million for the year ended December 31, 2004.

The Company does notprovide for federal income taxes or tax benefits on the undistributed earningsor losses of its international subsidiaries because earnings are permanently reinvestedand, in the opinion of management, will continue to be reinvested indefinitely.At December 31, 2006, the Company had not provided for federal income tax expensefor cumulative income of individual international subsidiaries of $1,395 at December 31,2006. Should these earnings be distributed in the form of dividends orotherwise, the Company would be subject to both U.S. income taxes andwithholding taxes in various international jurisdictions. Determination of therelated amount of unrecognized deferred U.S. income tax liability is notpracticable because of the com plexities associated with its hypotheticalcalculation. As noted above, the Company has significant net operating losscarryforwards for U.S. federal income taxes purposes, which are available tooffset the potential tax liability if the earnings were to be distributed.

Non-income taxes such assales and value-added tax are presented on a net basis.

**8.**   Commitmentsand Contingencies

**Leasing Arrangements**

TheCompany leases certain of its facilities and equipment under various operatingand capital leases. Equipment under capital leases consists primarily ofcomputer equipment and furniture and fixtures. These leases generally haveterms of three to five years, bear interest of 0.0% to 13.0% per annum and arecollateralized by the underlying equipment. Operating leases primarily consistof leases for office space and equipment. Future minimum lease payments foreach of the following five years are:

| ** **                                              | ** ** | **Year ended  December 31,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                              | ** ** | **Capital  Leases**                    | ** ** | **Operating  Leases** | ** ** |
| 2007                                                    |       | $                                      | 229        |   |   | $ | 6,257 |   |   |
| 2008                                                    |       | 104                                    |       |   | 4,382 |   |   |
| 2009                                                    |       | 36                                     |       |   | 4,005 |   |   |
| 2010                                                    |       | —                                 |       |   | 2,977 |   |   |
| 2011                                                    |       | —                                 |       |   | 1,981 |   |   |
| Total minimum lease  payments                           |       | $                                      | 369        |   |   | $ | 19,602 |   |   |
| Less amount representing  interest                      |       | 6                                      |       |   |   |   |   |
| Present value of minimum  payments under capital leases |       | 363                                    |       |   |   |   |   |
| Less current portion                                    |       | 224                                    |       |   |   |   |   |
|                                                    |       | $                                      | 139        |   |   |   |   |   |

 

Rent expense was $1,844, $2,111 and $3,678 for theyears ended December 31, 2004, 2005 and 2006, respectively.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**8.**   Commitmentsand Contingencies (Continued)

**Severancearrangement**

On November 26, 2006, the Company entered into aseparation agreement and general release with its former Chief OperatingOfficer who resigned from his positions as an officer and a director of theCompany and each of its subsidiaries, effective on the close of business on November 30,2006.  The separation agreement providedthat the Company continue to pay the former officer his base salary of $250 peryear through November 29, 2008. In addition, until May 29, 2010, theCompany will provide the former officer with continued participation in themedical insurance coverage plans of the Company, or the economic equivalent ofthe employer portion of the premium for such plans. Pursuant to the separationagreement, the former officer received $397 under the Company’s 2006 bonus plan. In addition, previously unvested optionsto purchase 28,333 shares of the Company’s common stock held by the formerofficer became immediately exercisable, and all other unvested stock optionsgranted to the former officer by the Company were forfeited on the separationdate.

Also, pursuant to theseparation agreement, the former officer provided the Company and itssubsidiaries and affiliates with a general release, and the former officeragreed to certain restrictive covenants, including confidentiality andnon-disparagement, and non-competition and non-solicitation for a period of twoyears after the separation date, as such the company will recognize theseverance expense over the non-compete term.

**DeferredCompensation**

The Company has an unfunded deferred compensationcontract with a former employee shareholder of the Company. Under the terms ofthe agreement, the former employee shareholder is receiving monthly retirementbenefit payments through June 2008. Amounts paid under this plan arepayable to the former employee’s beneficiaries in the event of his death.

At December 31, 2005and 2006, the liability under the deferred compensation plan was $99 and $96,respectively. The present value of the estimated liability, which is includedin other liabilities, as determined by calculating the net present value of theretirement benefits expected to be earned by the former employee shareholderfrom the effective date of the agreement through retirement date using adiscount rate of 8.0%. The interest expense associated with this plan was $9and $6 for the years ended December 31, 2005 and 2006, respectively.

**Litigation**

On October 31, 2000,Gallup, Inc., which conducts its business under the name The GallupOrganization, filed suit against us in U.S. District Court for the EasternDistrict of Pennsylvania seeking unspecified damages and injunctive relief,alleging that we unlawfully raided Gallup’s employees and tortuously interferedwith Gallup’s relationships with former employees and customers, infringed onGallup’s copyrighted survey language and falsely advertised aspects of ouremployee survey services. In November 2001, the District Court granted ourmotion to dismiss Gallup’s claim that we conducted an unlawful raid of Gallup’semployees. In December 2002, the District Court granted our motion forsummary judgment on the false advertising claim. In January 2003, theDistrict Court granted our motion 

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**8.**   Commitments and Contingencies (Continued)

forsummary judgment on the claims regarding our alleged tortuous interference withGallup’s relationships with its former employees and its customers. Gallup didnot appeal any of these rulings.

In November 2004, the District Court granted ourmotion for summary judgment on the copyright claim. Gallup appealed that rulingto the U.S. Court of Appeals for the Third Circuit, and the U.S. Court ofAppeals reversed the judge’s grant of summary judgment in our favor.

On January 27, 2006 the Company and Gallupsettled the outstanding claim and entered into a confidential settlementagreement. On January 30, 2006, the Court entered a consent order relatingto the settlement. The terms of the settlement will not have a material adverseeffect on our results of operations or financial position.

We are involved in claims,including those identified above, which arise in the ordinary course ofbusiness. In the opinion of management, we have made adequate provision forpotential liabilities, if any, arising from any such matters. However,litigation is inherently unpredictable, and the costs and other effects ofpending or future litigation, governmental investigations, legal andadministrative cases and proceedings (whether civil or criminal), settlements,judgments and investigations, claims and changes in any such matters, anddevelopments or assertions by or against us relating to intellectual propertyrights and intellectual property licenses, could have a material adverse effecton our business, financial condition and operating results.

**9.**   SharesSubject to Mandatory Redemption

**MandatoryRedeemable Preferred Stock Rollforward of Shares**

TheCompany’s mandatory redeemable preferred shares issued remained the same duringthe years ended December 31, 2005 and were converted to the Company’sclass A common stock during the Company’s initial public offering asfollows:

| ** **                               | ** ** | **Mandatory  Redeemable** | ** ** |
|------------------------------------------|------------|---------------------------|------------|
| ** **                               | ** ** | **Preferred Stock**  | ** ** |
| ** **                               | ** ** | **Series A**         | ** ** | **Series B** | ** ** |
| Balance,  December 31, 2004         |       | $                         | 29,953     |   | $ | 12,042 |   |
| Conversion to  Class A common stock |       | (29,953                   | )          | (12,042 | ) |
| Balance,  December 31, 2005         |       | —                    |       | — |   |
|                                          |            |                           |            |  |  |  |  |

 

No shares were repurchased during this period.Effective with the Company’s initial public offering on June 29, 2005these shares were converted into 1,858,376 shares of common stock.

Upon the adoption of SFAS No. 150,effective July 1, 2003 as discussed in Note 2, the Companytransferred its preferred stock previously presented in the equity section ofthe balance sheet to the long term liability section of the ConsolidatedBalance Sheet. Also, effective July 1, 2003, dividends accrued onmandatory redeemable preferred stock and any accretion of mandatory redeemablepreferred stock to redemption value have been classified as interest expense onthe Consolidated Statement of Operations. In 2004 and 2005 the interest expenserelated to accrued dividends on preferred stock was $3,491, and $1,817 

91

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**9.**   Shares Subject to Mandatory Redemption (Continued)

respectively.In 2004 and 2005 interest expense related to the accretion of preferred stockwas $4,895 and $1,579, respectively.

At December 31, 2004, the Company had 30,000 and12,042 authorized shares of Series A and B preferred stock, respectively.The Series A and B preferred stock both had a stated value of $1,000 pershare and accrued dividends at 6% and 8% per annum, respectively, compoundedquarterly. The Series A and B preferred stock are on a pari pasu basiswith each other and senior to all classes of common stock with respect topayment of dividends. The Series A preferred stock had preferential rightsin the event of liquidation over all other classes of preferred or commonstock. The Series A and B preferred stock was mandatory redeemable uponthe earlier of August 12, 2006 or occurrence of a Realization Event. ARealization Event is defined as (a) the consummation of a qualified publicoffering of the Company’s common stock or; (b) the consummation of a saletransaction involving the Company. Each Series A and B preferredshareholder is entitled, except for the election of directors, to a number ofvotes equal to the preferred share participation factor multiplied by thenumber of preferred shares owned. The participation factors for the Series Aand B preferred are 9.3336 and 20.1072, respectively, and are subject toadjustment for anti-dilution events.

The redemption price ofeach share of Series A and B preferred was based upon the fair marketvalue of a share of Class A common on the redemption notice datemultiplied by the participation factor, plus the stated value of $1,000 pershare and all accrued and unpaid dividends. The aggregate redemption price on June 29,2005 for the Series A preferred stock was approximately $42,200 whichincluded 1,134,126 shares of common stock. The aggregate redemption priceon June 29, 2005 for the Series B preferred stock was approximately$20,091 which included 724,250 shares of common stock. The Company  accreted to the estimated redemption value ofthe Series A and B preferred stock through the redemption date,June 29, 2005. The Company recorded $4,040 of accretion and $(664) of negativeaccretion for the Series A preferred stock at December 31, 2004 and 2005,respectively. The Company recorded $1,275 and $2,243 of accretion for the Series Bpreferred stock at December 31, 2004 and 2005, respectively.

**10.**   RedeemableCommon Stock Rollforward of Shares

TheCompany’s redeemable common shares issued and outstanding at December 31, 2004were converted to the Company’s class A common stock during the Company’sinitial public offering as follows:

| ** **                               | ** ** | **Common Shares** | ** ** |
|------------------------------------------|------------|------------------------|------------|
| ** **                               | ** ** | **Redeemable**         | ** ** |
| ** **                               | ** ** | **Class B**       | ** ** | **Class C** | ** ** |
| Balance, December 31,  2004         |       | $                      | 54,579     |   | $ | 1,526,813 |   |
| Conversion to  Class A common stock |       | (54,579                | )          | (1,526,813 | ) |
| Balance,  December 31, 2005         |       | —                 |       | — |   |
|                                          |            |                        |            |  |  |  |  |

 

No shares were repurchasedduring this period. Effective with the Company’s initial public offering on June 29,2005 these shares were converted into 9,439,942 shares of common stock.

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**10.**   Redeemable Common Stock Rollforward of Shares(Continued)

***Class B Redeemable Common Stock***

At December 31, 2004, the Company had 200,000authorized shares of Class B redeemable common with 54,479 shares issuedand outstanding at December 31, 2004. Class B redeemable commonshares are mandatorily convertible upon occurrence of a Realization Event priorto August 12, 2006. Each Class B redeemable common shareholder is entitledto a number of votes equal to the number of shares of Class A common intowhich the Class B redeemable shares are convertible, except for theelection of directors. Two of the Class B redeemable common shareholdershave the right to designate two of the Company’s directors.

The actual redemptionprice, on the date of conversion to Class A common, based upon the actualfair value of the Company’s initial offering price was $26,150. The Companyrecorded $1,545 and 20,859 of accretion for the Class B redeemable commonat December 31, 2004 and 2005, respectively.

***Class C Redeemable Common Stock***

At December 31, 2004, the Company had 2,000,000authorized shares of Class C redeemable common with 1,526,813 sharesissued and outstanding. At December 31, 2004, the Class C redeemablecommon shares were convertible into Class A common shares upon election bythe holder by dividing $14.08 by the Class C conversion factor of 14.08,subject to adjustment for anti-dilution events. The Class C redeemablecommon redemption price is equivalent to the fair market value of one share of Class Acommon multiplied by the number of shares of Class A common into which theClass C shares are convertible. The Company’s Board of Directors hasdiscretion over whether this redemption is in cash or through issuance of atwo-year interest bearing promissory note. Each Class C redeemable commonshareholder is entitled to a number of votes equal to the number of shares of Class Acommon into which the Class C shares are convertible, except for theelection of directors.

The 2001 Private Placementincluded a contingency requiring the Company to issue up to 218,683 additionalshares of Class C redeemable common to certain investors if the Companydid not repurchase at least an aggregate of $5,900 shares of Series Apreferred and Class C redeemable common from the Bridge Note investors by June 16,2001. The Company did not meet this requirement since only $2,400 of Series Apreferred and Class C redeemable common shares were repurchased by thisdate. In October 2002, the Company issued 129,006 shares of Class Credeemable common to the 2001 Private Placement investors to satisfy this obligation.

The actual redemptionprice, on the date of conversion to Class A common, based upon the actualfair value of the Company’s initial offering price was $25,201. At December 31,2004 and 2005, the Company recorded negative accretion of $525 and positiveaccretion of $20,630, respectively.

93

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**11.   Equity**

**Rollforward ofShares**

TheCompany’s common shares issued and repurchased during the years ended December 31,2005 and 2006 are as follows:

| ** **                                                  | ** ** | **Common Shares** | ** ** |
|-------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                  | ** ** | **Class A**       | ** ** | **Class A Treasury** | ** ** |
| Balance, December 31, 2004                             |       | 7,982,628              |       |   | (2,410,138 | ) |   |
| Repurchase of shares                                        |       | —                 |       |   | (411,760 | ) |   |
| Shares from initial public offering                         |       | 5,750,000              |       |   | — |   |   |
| Shares from Class B, C and preferred stock  conversion |       | 6,137,249              |       |   | — |   |   |
| Class C warrant exercises                              |       | 396,195                |       |   | — |   |   |
| Stock option exercises                                      |       | 14,870                 |       |   | — |   |   |
| Retirement of treasury shares to authorized but  unissued   |       | (2,821,898             | )          |   | 2,821,898 |   |   |
| Balance, December 31, 2005                             |       | 17,459,044             |       |   | — |   |   |
| Shares from public offering                                 |       | 2,641,800              |       |   | — |   |   |
| Warrant exercises                                           |       | 250,499                |       |   | — |   |   |
| Stock option exercises                                      |       | 387,986                |       |   | — |   |   |
| Shares issued for acquisition                               |       | 158,448                |       |   | — |   |   |
| Balance,  December 31, 2006                            |       | 20,897,777             |       |   | — |   |   |

 

Refer to the accompanying consolidated statements ofshareholders’ equity and this note for further discussion.

94

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**11.**   Equity (Continued)

**Stock and VotingRights**

***Undesignated Preferred Stock***

The Company has 100,000shares of $0.01 par value undesignated preferred stock authorized, with noshares issued or outstanding at December 31, 2005 or 2006. These shareshave preferential rights in the event of liquidation and payment of dividends.

***Common Stock***

At December 31, 2005and 2006, the Company had 100,000,000 authorized shares of  common stock. At December 31, 2005 and2006, 17,459,044 and 20,897,777 shares of common stock respectively, wereoutstanding, net of treasury stock discussed below. Each share of common stockhas one-for-one voting rights.

***Treasury Stock***

Pursuant to ratificationfrom our Board of Directors, 2,821,898 of our treasury shares with a cost of$9,286,664 were restored to authorized but unissued common stock. During theyear ended December 31, 2005 the board of directors granted management theauthority to repurchase up to 873,114 shares of common stock at $1.25 per share. Through the date our treasury shareswere restored to authorized but unissued, the Company repurchased 873,104shares of  common stock from formeremployees under this repurchase plan.

***Shareholder Agreements***

Certain shareholders have entered into shareholderagreements that define and provide for, among other things, the purchase, saleand transfer of shares in accordance with the agreements. Certain employeeshave purchased shares of common stock using notes. These employees elected topurchase shares in accordance with provisions under the stock purchaseagreement that permitted an initial 25% cash payment at the time of purchasewith the remainder due in equal annual installments each anniversary dateduring the next three years. The subscriptions bear no interest to the employee.The unpaid portion of subscriptions receivable has been classified ascontra-equity, notes receivable for Class A common stock in theaccompanying consolidated balance sheets. All outstanding notes were settled in2006.

**12.**   Stock Plans

**Stock Option Plan**

The Company’s 2005 Equity Incentive Plan (the “2005Option Plan”), which was adopted by the Company’s Board of Directors (the“Board”) in March 2005 and was approved by the Company’s shareholders inJune 2005, provides for the granting of stock options to employees anddirectors at the discretion of the Board or a committee of the Board. The 2005Option Plan replaced the Company’s 2000 Stock Option Plan (the “2000 OptionPlan”). As of December 31, 2006, there were options to purchase 1,302,008shares of common stock outstanding under the 2005 Option Plan. The Company isauthorized to issue up to an aggregate of 4,842,910 shares of its common stockpursuant to stock options granted under 

95

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**12.**   Stock Plans (Continued)

the 2005 Option Plan. Asof December 31, 2006, there were a total of 3,138,046 shares of commonstock not subject to outstanding options and available for issuance under the2005 Option Plan. The purpose of stock options is to recognize past servicesrendered and to provide additional incentive in furthering the continuedsuccess of the Company. Stock options granted under both the 2005 Option Planand the 2000 Stock Option Plan expire between the fifth and tenth anniversaryof the date of grant and generally vest on the third anniversary of the date ofgrant. Unexercised stock options may expire up to 90 days after anemployee’s termination.

SFAS 123R requirescompanies to estimate the fair value of share-based payment awards on the dateof grant using an option-pricing model. In 2005 and 2006, the fair value ofeach grant was estimated using the Black-Scholes valuation model. Expectedvolatility was based upon a weighted average of peer companies, comparableindices, and the Company’s stock volatility. The expected life was determinedbased upon an average of the contractual life and vesting period of the options.The estimated forfeiture rate was based upon an analysis of historical data.  The risk-free rate was based on U.S. Treasuryzero coupon bond yields at the time of grant. The following table provides theassumptions used in determining the fair value of the share-based awards forthe year ended December 31, 2004, 2005 and 2006, respectively.

| ** **               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------|------------|---------------------------------------------|------------|
| ** **               | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Expected volatility      |       | 51.3                                        | %          | 51.3 | % | 39.5 – 41.98 | % |
| Expected dividends       |       | 0                                           |       | 0 |   | 0 |   |
| Expected term (in years) |       | 4 – 6.5                                |       | 4 – 6.5 |   | 4 – 5 |   |
| Risk-free rate           |       | 4.5                                         | %          | 4.5 | % | 4.6 – 5.1 | % |

 

A summary of the status ofthe Company’s stock options as of December 31, 2005 and 2006 and changesduring the period then ended is as follows:

| ** **                         | ** ** | **Options Outstanding**          | ** ** | **Options Exercisable** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **Shares  available for  Grant** | ** ** | **Shares**                   | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Shares** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** |
| Balance at  December 31, 2003 |       |                                  | 1,319,188  |                         |       | 830,522 |   |   | $ | 11.95 |   |   | 570,659 |   |   | $ | 10.96 |   |   |
| Granted at market                  |       |                                  | (64,800    | )                            |       | 64,800 |   |   | 4.49 |   |   |   |   |   |   |   |   |
| Forfeited                          |       |                                  | 190,069    |                         |       | (190,069 | ) |   | 11.85 |   |   |   |   |   |   |   |   |
| Balance at  December 31, 2004 |       |                                  | 1,444,387  |                         |       | 705,253 |   |   | $ | 11.29 |   |   | 554,013 |   |   | $ | 11.63 |   |   |
| Additional shares  authorized      |       |                                  | 2,963,270  |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Granted at market                  |       |                                  | (796,400   | )                            |       | 796,400 |   |   | 13.18 |   |   |   |   |   |   |   |   |
| Granted below market               |       |                                  | (117,600   | )                            |       | 117,600 |   |   | 4.63 |   |   |   |   |   |   |   |   |
| Exercised                          |       |                                  |       |                         |       | (14,870 | ) |   | 9.92 |   |   |   |   |   |   |   |   |
| Forfeited                          |       |                                  | 42,202     |                         |       | (42,202 | ) |   | 11.90 |   |   |   |   |   |   |   |   |
| Balance at  December 31, 2005 |       |                                  | 3,265,859  |                         |       | 1,562,181 |   |   | $ | 11.74 |   |   | 638,781 |   |   | $ | 12.08 |   |   |
| Granted                            |       |                                  | (316,333   | )                            |       | 316,333 |   |   | $ | 25.24 |   |   | — |   |   | — |   |   |
| Exercised                          |       |                                  | —     |                         |       | (387,986 | ) |   | $ | 11.25 |   |   | — |   |   | — |   |   |
| Forfeited or expired               |       |                                  | 188,520    |                         |       | (188,520 | ) |   | $ | 15.47 |   |   | — |   |   | — |   |   |
| Balance at December 31, 2006  |       |                                  | 3,138,046  |                         |       | 1,302,008 |   |   | $ | 14.63 |   |   | 321,208 |   |   | $ | 14.26 |   |   |

 

96

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**12.**   Stock Plans (Continued)

The total intrinsic value of options outstanding, exercisableand exercised for the period ended December 31, 2006 was $24,259, $6,103and $7,487, respectively.  The weightedaverage fair value for options granted during the period ended December 31,2005 and 2006 was $7.66 and $11.05, respectively.

The following tablesummarizes information about stock options outstanding at December 31,2006:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted  Average  Remaining  Contract Life  (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Remaining  Contract Life  (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $3.63 – $7.27                          |       |                         | 205,817    |                         |       |   | 6.79 |   |   |   | $ | 4.62 |   |   |   | 43,417 |   |   |   |   |   |   |   | $ | 4.62 |   |   |
| $7.28 – $14.53                         |       |                         | 724,191    |                         |       |   | 7.33 |   |   |   | $ | 12.75 |   |   |   | 239,791 |   |   |   |   |   |   |   | $ | 13.92 |   |   |
| $14.54 – $18.17                        |       |                         | 152,000    |                         |       |   | 4.26 |   |   |   | $ | 17.58 |   |   |   | 10,000 |   |   |   |   |   |   |   | $ | 15.60 |   |   |
| $18.18 – $21.80                        |       |                         | 25,000     |                         |       |   | 4.01 |   |   |   | $ | 21.10 |   |   |   | 0 |   |   |   |   |   |   |   | $ | 0.00 |   |   |
| $21.81 – $25.43                        |       |                         | 40,000     |                         |       |   | 4.05 |   |   |   | $ | 22.07 |   |   |   | 0 |   |   |   |   |   |   |   | $ | 0.00 |   |   |
| $25.44 – $29.06                        |       |                         | 46,000     |                         |       |   | 4.45 |   |   |   | $ | 27.25 |   |   |   | 0 |   |   |   |   |   |   |   | $ | 0.00 |   |   |
| $29.07 – $32.70                        |       |                         | 109,000    |                         |       |   | 6.03 |   |   |   | $ | 32.37 |   |   |   | 28,000 |   |   |   |   |   |   |   | $ | 31.63 |   |   |
| $3.63 – $32.70                         |       |                         | 1,302,008  |                         |       |   | 6.51 |   |   |   | $ | 14.63 |   |   |   | 321,208 |   |   |   | 5.26 |   |   |   | $ | 14.26 |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

As ofDecember 31, 2006, there was $5,155 of total unrecognized compensationcost related to nonvested share-based compensation arrangements granted underthe 2005 Option Plan and the 2000 Option Plan. That cost is expected to berecognized over a weighted-average period of 3.5 years.

A summary of the status ofthe Company’s nonvested share options as of December 31, 2005 and 2006 ispresented below:

| **Nonvested Shares**            | ** ** | ** ** | ** ** | **Shares** | ** ** | **Wtd. Avg.  Grant Date  Fair Value** | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|------------------------------------------------------|------------|
| Nonvested at  December 31, 2005 |       | 923,400    |       |       | $          | 8.10                                                 |       |   |
| Granted                              |       | 316,333    |       |       | $          | 11.05                                                |       |   |
| Vested                               |       | (76,333    | )          |       | $          | 15.31                                                |       |   |
| Forfeited or  expired                |       | (182,600   | )          |       | $          | 7.23                                                 |       |   |
| Nonvested at  December 31, 2006 |       | 980,800    |       |       | $          | 8.65                                                 |       |   |

 

SFAS No. 123R also requires us to change theclassification of any tax benefits realized upon exercise of stock options inexcess of that which is associated with the expense recognized for financialreporting purposes. These amounts are presented as a financing cash inflowrather than as a reduction of income taxes paid in our consolidated statementof cash flows.

The pool of excesstax benefits available to absorb tax deficiencies was determined using thealternative transition method described in FSP FAS 123(R)-3. Using thismethod an opening pool balance of $22 was calculated.

97

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**12.**   Stock Plans (Continued)

In accordance with Staff Accounting BulletinNo. 107, we classified share-based compensation within cost of goods sold,selling, general and administrative expenses and research and developmentcorresponding to the same line as the cash compensation paid to respectiveemployees, officers and non-employee directors.

Thefollowing table shows total share-based compensation expense included in theConsolidated Statement of Operations:

| ** **                             | ** ** | **Year ended  December 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2006**                               | ** ** |
| Cost of Revenue                        |       |                                   | $          | 513 |   |   |
| Sales and  marketing                   |       |                                   | 1,109      |   |   |
| General and  administrative            |       |                                   | 1,292      |   |   |
| Research and  development              |       |                                   | $          | 162 |   |   |
| Pre-tax share-based  compensation      |       |                                   | 3,076      |   |   |
| Income tax  benefit                    |       |                                   | 936        |   |   |
| Share-based compensation  expense, net |       |                                   | $          | 2,140 |   |   |

 

As a result of adopting Statement 123(R) on January 1,2006, the company’s income before income taxes and net income for the yearended December 31, 2006 are $2,442 and $1,709 lower, respectively, than ifit had continued to account for share-based compensation under Opinion No. 25.Basic and diluted earnings per share for the year ended December 31, 2006would have been $0.96 and $0.93, respectively, if the company had not adoptedStatement 123(R), compared to reported basic and diluted earnings per share of$0.80 and $0.78, respectively.

Prior to January 1,2006 the Company accounted for stock options under Accounting Principles Board(“APB”) Opinion 25.  Had compensationexpense for stock options granted been determined based on the fair value atthe grant dates under the provisions of SFAS 123, the Company’s pro formanet income for the period ended December 31, 2004 and 2005 would have beenas follows:

| ** **                                                                                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net (loss) income  as reported                                                                                              |       | $        | (4,093     | )        | $          | 6,091 |   |
| Add: share based  employee compensation expense included in reported net income, net of tax                            |       | 214      |       | 596      |       |
| Deduct: total  share-based compensation expense determined under fair value based method for  all awards, net of tax   |       | 176      |       | 1,544    |       |
| Pro forma net  (loss) income                                                                                                |       | $        | (4,055     | )        | $          | 5,143 |   |
| Accretion of  redeemable class B common stock, class C common stock, series A preferred  stock and series B preferred stock |       | 1,020    |       | 41,488   |       |
| Net (loss)  available to common shareholders                                                                                |       | $        | (5,075     | )        | $          | (36,345 | ) |
| Basic and diluted  (loss) per share as reported:                                                                            |       | $        | (0.85      | )        | $          | (3.06 | ) |
| Pro forma                                                                                                                   |       | $        | (0.85      | )        | $          | (3.14 | ) |
| Weighted average fair  value of outstanding options                                                                         |       | $        | 3.67       |     | $          | 7.95 |   |

** **

98

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**12.**   Stock Plans (Continued)

On January 14, 2005,the Company granted options to certain employees to purchase an aggregate of117,600 shares of the Company’s  commonstock at an exercise price of $4.63 per share. On January 14, 2005 theCompany valued the Class A common stock at $15 per share and the excess ofthe underlying  common stock fair valueover the options exercise price was $1,220. The Company recognized $407 of thisexcess value as compensation expense in the year ended December 31, 2005.Total compensation expense recognized was $227 and $634 for the year ended December 31,2004 and 2005, respectively in connection with options granted in January 2004and January 2005.

Between June 23, 2005and December 31, 2005, the Company granted options to certain employees topurchase an aggregate of 796,400 shares of the Company’s common stock at a weightedexercise price of $13.18 per share. The Company granted the options atprevailing market prices ranging from $12.05 to $17.72 per share.

Between January 1,2006 and December 31, 2006, the Company granted options to certainemployees to purchase an aggregate of 316,333 shares of the Company’s commonstock at a weighted exercise price of $25.24 per share. The Company granted theoptions at prevailing market prices ranging from $21.10 to $32.69 per share.

**Employee Stock Purchase Plan**

The Employee StockPurchase Plan which was approved May 2006, enables substantially all U.S.and Foreign employees to purchase shares of our common stock at a discountedoffering price. The offering price is 5% of the closing market price of ourcommon stock on the NASDAQ National Market, LLC on the offering date. We havegranted rights to purchase up to 500,000 common shares to our employees underthe Plan. The Plan is not considered a compensatory plan in accordance withSFAS 123(R) and requires no compensation expense to be recognized. Noshares of our common stock were purchased under the employee stock purchaseplan during the year ended December 31, 2006.

**Warrants**

Asummary of the Company’s warrant activity and balances as of December 31,2005 and 2006, respectively, is as follows:

| **Warrant Class** | ** ** | ** ** | ** ** | **Exercise  Price** | ** ** | **Balance at  December 31,  2005** | ** ** | **Exercised** | ** ** | **Forfeited** | ** ** | **Balance at  December 31,  2006** | ** ** |
|------------------------|------------|------------|------------|---------------------|------------|----------------------------------------------|------------|---------------|------------|---------------|------------|----------------------------------------------|------------|
| Class B           |       | $          | 20.88      |                |       | 622,542                                      |       |          | (590,022   | )             |       | (32,520                                      | )          |   |   | — |   |   |
| Class D           |       | $          | 4.18       |                |       | 158,480                                      |       |          | (158,480   | )             |       | —                                       |       |   |   | — |   |   |
| Class E           |       | $          | 20.88      |                |       | 13,120                                       |       |          | (13,120    | )             |       | —                                       |       |   |   |   |   |   |
| Total                  |       |       |       |                | 794,142    |                                         |       | (761,622      | )          |          | (32,520    | )                                            |       |   | — |   |   |

 

Class B, D and E warrants were exercisable until December 16,2006, after which they expired. The holders of the Class D warrants hadthe ability to require the Company to repurchase these warrants at the PutPrice, as defined by the warrant agreements, on or after August 12, 2006if a Realization Event has not occurred. In connection with the 2001 PrivatePlacement, the Class D warrant agreements were amended to only permitredemption of these warrants if all outstanding Series A preferred shareshave been redeemed.

99

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**Kenexa Corporation and Subsidiaries Notes to Consolidated Financial Statements (Continued)**(All amounts in thousands, except share and per share data, unless noted otherwise)

**12.**   Stock Plans (Continued)

Pursuant to the initial public offering all of the Class Cwarrants to purchase 396,195 shares of common stock were converted into common shares and 396,195 Class A warrants were terminated.Additionally, the Class D warrant put feature expired.  Following theconversion and termination of warrants, the Company had 794,142 warrantsoutstanding with an average exercise price of $17.54 as of December 31,2005.

All outstanding warrants are subject to anti-dilutionprovisions and correspondingly their exercise and conversion prices will beadjusted for occurrence of certain events, as defined, including changes inshares, options and warrants issued and currently outstanding. In connectionwith the 2001 Private Placement, all outstanding warrant agreements wereamended to permit the issuance of shares in connection with this transactionwithout triggering the anti-dilution provisions of these agreements.

The fair value of thewarrants are immaterial for all years presented.

**13.**   RelatedParty

The Company’s CEO served on the Board of Directors ofa software development consulting company that provided services to the Companyduring the years ended December 31, 2003 and 2004 in connection withsoftware being developed for sale. In 2004, the Company’s CEO resigned from theBoard of Directors for this company. Payment for these services aggregated$1,632, $1,154 and $84 for the years ended December 31, 2002, 2003 and2004, respectively, and is included in software or construction in progress inproperty and equipment and in prepaid expense in the accompanying consolidatedbalance sheets. In 2003, the Company terminated its agreement with the softwaredevelopment consulting company. The Company paid $215 for perpetual licenses inaccordance with the termination agreement. This amount is being amortized overthree years. The Company’s CEO did not receive any cash compensation during2003, 2004 or 2005 for his participation on the Board of Directors of thesoftware development consulting company. In 2006 the Company purchased certainintangibles and property, plant and equipment for $300 from the softwaredevelopment consulting company.

One of the Company’sdirectors, Barry M. Abelson, is a partner in the law firm of Pepper HamiltonLLP. This firm has represented the Company since 1997. For the years ended December 31,2004, 2005 and 2006, the Company paid Pepper Hamilton LLP net of insurancecoverage $39, $1,058 and $2,326, respectively, for general legal matters. Theincrease in payments to Pepper Hamilton LLP resulted from services performed inconjunction with our public offerings, various acquisitions in 2005 and 2006,credit facility arrangements and other corporate matters. The amount payable toPepper Hamilton as of December 31, 2005 and 2006 was $64 and $931,respectively.

**14.**   SubsequentEvents

On January 18, 2007,the Company completed a public offering of 3,750,000 shares of its common stockat a price to the public of $31.86 per share. Net proceeds to the Companyaggregated approximately $114,000 after payment of all offering fees andunderwriters’ commission and offering expenses of $5,475. On January 24,2007, the underwriters exercised their over-allotment option under the terms ofthe underwriting agreement to purchase 562,500 additional shares of commonstock. Net proceeds to the Company following the sale of the overallotmentshares were $17,100.

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**ITEM9. Changes in and Disagreements With Accountants on Accounting and FinancialDiscloure**

Not Applicable

**ITEM9A. Disclosure Controls and Procedures**

Under the supervision andwith the participation of our management, including our principal executive officerand principal financial officer, we conducted an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934 as of the end of the period covered by thisreport, or the Evaluation Date. Based upon the evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures were effective as of the Evaluation Date. Disclosurecontrols and procedures are controls and procedures designed to reasonablyensure that information required to be disclosed in our reports filed under theExchange Act, such as this report, is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms.Disclosure controls and procedures include controls and procedures designed toreasonably ensure that such information is accumulated and communicated to ourmanagement, including our chief executive officer and chief financial officer,as appropriate to allow timely decisions regarding required disclosure.

Internal Control overFinancial Reporting

(a)  Management’s Annual Report on Internal Control over FinancialReporting

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting to provide reasonable assurance regarding the reliabilityof our financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles.Internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that inreasonable detail accurately and fairly reflect the transactions and dispositionsof our assets, (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that our receiptsand expenditures are being made only in accordance with authorizations of ourmanagement and directors, and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof our assets that could have a material effect on the financial statements.

Management assessed ourinternal control over financial reporting as of December 31, 2006, the endof the Company’s fiscal year. Management based its assessment on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission. Management’s assessmentincluded evaluation of such elements as the design and operating effectivenessof key financial reporting controls, process documentation, accountingpolicies, and our overall control environment.

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Weexcluded from the scope of our assessment of internal control over financialreporting the operations and related assets of the following acquisitionscompleted in 2006, as permitted by the rules and regulations of the Securitiesand Exchange Commission. Expressed as a percentage of our total revenues,income before taxes and our total assets as of and for the year ended December 31,2006 these exclusions included the following entities:

| **Acquisition**       | ** ** | ** **        | ** ** | **Date of Acquisition** | ** ** | **As a %  of total  revenue** | ** ** | **As a %  of  net income** | ** ** | **As a %  of  assets** | ** ** | **As a %  of total  assets** | ** ** |
|-----------------------|------------|-------------------|------------|-----------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| Webhire               |       | January 13, 2006  |       |                              | 11.6       |                                         |       |                                                | 19.1       |                                       |       |                                        | (5.5       | ) |   |   | 15.0 |   |   |
| Knowledge Workers     |       | April 10, 2006    |       |                              | 1.9        |                                         |       |                                                | 3.3        |                                       |       |                                        | 0.3        |   |   |   | 1.4 |   |   |
| Gantz-Wiley Research  |       | August 24, 2006   |       |                              | 2.5        |                                         |       |                                                | 0.0        |                                       |       |                                        | 0.0        |   |   |   | 3.6 |   |   |
| BrassRing             |       | November 13, 2006 |       |                              | 4.3        |                                         |       |                                                | 1.8        |                                       |       |                                        | 0.2        |   |   |   | 46.8 |   |   |
| Psychometric Services |       | November 20, 2006 |       |                              | 0.6        |                                         |       |                                                | 0.8        |                                       |       |                                        | 0.1        |   |   |   | 4.1 |   |   |

 

Based on its assessment, management has concluded thatour internal control over financial reporting was effective as of the end ofthe fiscal year to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalreporting purposes in accordance with generally accepted accounting principles.The results of management’s assessment were reviewed with the Audit Committeeof the Board of Directors.

BDO Seidman, LLP audited management’s assessment andindependently assessed the effectiveness of our internal control over financialreporting. BDO Seidman, LLP has issued an attestation report concurring withmanagement’s assessment, which is included below.

(b)  Report ofIndependent Registered Public Accounting Firm

**Report ofIndependent Registered Public Accounting FirmOn Internal Control over Financial Reporting**

Board of Directors and ShareholdersKenexa CorporationWayne, PA

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control over FinancialReporting, that Kenexa Corporation maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria establishedin *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(the COSO criteria). Kenexa Corporation’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal 

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control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company aremade only in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

As indicated in the accompanying “Item 9A,Management’s Report on Internal Control over Financial Reporting”, management’sassessment of and conclusion on the effectiveness of internal control overfinancial reporting did not include the internal controls of Webhire, acquiredon  January 13, 2006, Knowledge Workers,acquired on April 10, 2006, Gantz Wiley, acquired on  August 4, 2006, BrassRing, acquired on  November 13, 2006, and Psychometric ServicesLimited, acquired on November 20, 2006, which are included in the consolidatedbalance sheets of Kenexa Corporation as of December 31, 2006, and the relatedconsolidated statements of income, stockholders’ equity, and cash flows for theyear then ended. 

Webhire constituted 15.0% and -5.5% of total and netassets, respectively, as of December 31, 2006, and 11.6% and 19.1% of revenuesand net income, respectively, for the year then ended.  Knowledge Workers constituted 1.4% and 0.3%of total assets and net assets, respectively, as of December 31, 2006, and 1.9%and 3.3% of revenues and net income, respectively, for the year thenended.  Gantz Wiley constituted 3.6% and0.0% of total assets and net assets, respectively, as of December 31, 2006, and2.5% and 0.0% of revenues and net income, respectively, for the year thenended.  BrassRing constituted 46.8% and0.2% of total assets and net assets, respectively, as of December 31, 2006, and4.3% and 1.8% of revenues and net income, respectively, for the year thenended.  Psychometric Services Limitedconstituted 4.1% and 0.1% of total and net assets, respectively, as of December31, 2006, and 0.6% and 0.8% of revenues and net income, respectively, for theyear then ended.  Management did notassess the effectiveness of internal control over financial reporting of GantzWiley, Webhire, Knowledge Workers, BrassRing, and Psychometric Services Limitedbecause of the timing of the acquisition. Our audit of internal control over financial reporting of Kenexa Corporationalso did not include an evaluation of the internal control over financialreporting of Gantz Wiley, Webhire, Knowledge Workers, BrassRing, orPsychometric Services Limited.

In our opinion, management’s assessment that KenexaCorporation maintained effective internal control over financial reporting asof December 31, 2006, is fairly stated, in all material respects, based onthe COSO criteria. Also in our opinion, Kenexa Corporation maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2006, based on the COSO criteria.

We have also audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheets of Kenexa Corporation as of December 31, 2006and 2005, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the three years in the period ended December 31,2006 and our report dated March 16, 2007 expressed an unqualified opinionthereon.

/s/ BDO Seidman, LLPPhiladelphia, PAMarch 16, 2007

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(c)  Change in Internal Control over FinancialReporting

There have been no changesin internal control over financial reporting identified in connection withmanagement’s evaluation that occurred during the last fiscal quarter ended December 31,2006, that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

**ITEM 9B.**       OtherInformation

**Not Applicable**

**PART III**

**ITEM 10.**         Directorsand Executive Officers and Corporate Governance

We incorporate by reference the information containedunder the captions “Board of Directors”, “Structure and Practices of the Boardof Directors”, “Section 16(a) Beneficial Ownership ReportingCompliance”, “Executive Officers and Executive Compensation”  in our Definitive Proxy Statement for our2007 annual meeting of stockholders, to be filed within 120 days after theend of the year covered by this Report pursuant to Regulation 14A underthe Securities Exchange Act of 1934, as amended (the “2007 Proxy Statement”).

We have adopted a writtencode of business conduct and ethics, known as our Corporate Code of Conduct,which applies to all of our directors, officers and employees, including ourprincipal executive officer and our principal financial and accounting officer.Our code of conduct is available on our Internet website, www.Kenexat.com. Anyamendments to our Corporate Code of Conduct or waivers from the provisions ofthe Corporate Code of Conduct for our principal executive officer and our principalfinancial and accounting officer will be disclosed on our Internet websitewithin five business days following the date of such amendment or waiver.

**ITEM 11.**         ExecutiveCompensation

We incorporate byreference the information contained under the captions “Executive Officers andExecutive Compensation” and “Other Forms of Compensation” in our 2007 ProxyStatement.

**ITEM 12.    Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters**

We incorporate byreference the information contained under the caption “Security Ownership ofCertain Beneficial Owners and Directors and Officers” in our 2007 ProxyStatements.

**ITEM 13.**         CertainRelationships and Related Transactions, and Director Independence

We incorporate byreference the information contained under the caption “Certain Relationshipsand Related Party Transactions” in our 2007 Proxy Statement.

**ITEM 14.**         PrincipalAccountant Fees and Services

We incorporate byreference the information contained under the caption Proposal No. 3—“Ratificationof Appointment of Independent Registered Public Accounting Firm” in our 2007Proxy Statement.

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**PART IV**

**ITEM15.**         Index to ConsolidatedFinancial Statements

(a)   Documents filed as part of this report:

1.**     **Financial Statements. Thefinancial statements as set forth under Item 8 of this Annual Report on Form10-K are incorporated herein.

2.**     **Financial Statement Schedules.All financial statement schedules have been omitted because they are notapplicable, not required, or the information is shown in the financialstatements or related notes.

3.**     **Exhibits. See (b) below.

(b)**  **Exhibits:

| Exhibit   Number | ** ** | **Description of Document**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1              |       | Agreement and Plan of Merger, dated as of  December 21, 2005, among Kenexa Corporation, Kenexa  Technology, Inc., Kenexa Acquisition Corp., Webhire, Inc., and  Gazaway L. Crittenden, solely as the representative of the Equityholders  (incorporated by reference to Exhibit 2.1 filed with the Company’s  Current Report on Form 8-K dated December 22, 2005)                                                                                                                                                                                                                                                                                                                                                                     |
| 2.2              |       | Equity Purchase  Agreement and Agreement and Plan of Merger, dated as of October 5, 2006,  among Kenexa Corporation, Kenexa Technology, Inc., Birmingham  Acquisition Corp., BrassRing LLC, BrassRing Inc., Gannett Satellite  Information Network, Inc., BRLLC Holdings Inc., Tribune National  Marketing Company, Accel VI L.P., Accel Internet Fund II, L.P., Accel  Keiretsu VI L.P., Accel Investors ‘98 L.P., Accel VI-S L.P., Accel Investors  ‘98-S L.P., James W. Breyer, and Gerald M. Rosberg solely as the  representative of the stockholders of BRINC and the selling members of BRLLC  (incorporated by reference to Exhibit 2.1 filed with the Company’s  Current Report on Form 8-K dated October 6, 2006) |
| 3.1              |       | Amended and Restated  Articles of Incorporation of Kenexa Corporation (incorporated by reference to  Exhibit 3.3 filed with Amendment No. 2 to the Company’s  Registration Statement on Form S-1 dated June 6, 2005,  Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.2              |       | Amended and Restated  Bylaws of Kenexa Corporation (incorporated by reference to Exhibit 3.2  filed with the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.1              |       | Form of Specimen  Common Stock Certificate of Kenexa Corporation (incorporated by reference to  Exhibit 4.1 filed with Amendment No. 4 to the Company’s  Registration Statement on Form S-1 dated June 20, 2005,  Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2              |       | Form of Amended and  Restated Class B Common Stock Purchase Warrant to purchase common stock  of Kenexa Corporation (incorporated by reference to Exhibit 4.4 filed  with Amendment No. 1 to the Company’s Registration Statement on  Form S-1 dated May 17, 2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.3              |       | Form of Amended and  Restated Class D Common Stock Purchase Warrant to purchase common stock  of Kenexa Corporation (incorporated by reference to Exhibit 4.5 filed  with Amendment No. 1 to the Company’s Registration Statement on  Form S-1 dated May 17, 2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.4              |       | Form of Amended and  Restated Class E Common Stock Purchase Warrant to purchase common stock  of Kenexa Corporation (incorporated by reference to Exhibit 4.6 filed  with Amendment No. 1 to the Company’s Registration Statement on  Form S-1 dated May 17, 2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                  |

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| 10.1* |   | Kenexa Corporation 2000  Stock Option Plan (incorporated by reference to Exhibit 10.1 filed with  the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                                                                                |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2* |   | Form of  Non-Qualified Stock Option Agreement under the Kenexa Corporation 2000 Stock  Option Plan (incorporated by reference to Exhibit 10.2 filed with the  Company’s Registration Statement on Form S-1 dated April 12,  2005, Registration No. 333-124028)                                   |
| 10.3* |   | Kenexa Corporation 2005  Equity Incentive Plan (incorporated by reference to Exhibit 10.3 filed  with the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                                                                            |
| 10.4* |   | Form of  Non-Qualified Stock Option Award Agreement under the 2005 Equity Incentive  Plan (Director) (incorporated by reference to Exhibit 10.4 filed with  the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                 |
| 10.5* |   | Form of  Non-Qualified Stock Option Award Agreement under the 2005 Equity Incentive  Plan (Employee) (incorporated by reference to Exhibit 10.5 filed with  the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                 |
| 10.6* |   | Kenexa Corporation  Amended and Restated 2006 Employee Stock Purchase Plan (incorporated by  reference to Exhibit 2.1 filed with the Company’s Current Report on  Form 8-K dated October 20, 2006)                                                                                                         |
| 10.7  |   | Investor Agreement dated  April 8, 2005 among Kenexa Corporation and certain shareholders  (incorporated by reference to Exhibit 10.7 filed with the Company’s  Registration Statement on Form S-1 dated April 12, 2005,  Registration No. 333-124028) of Kenexa Corporation                     |
| 10.8  |   | Agreement Among Certain  Management Shareholders dated April 8, 2005 among Kenexa Corporation and  the investors named therein (incorporated by reference to Exhibit 10.8  filed with the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)       |
| 10.9  |   | Second Amended and  Restated Registration Rights Agreement, dated March 29, 2001  (incorporated by reference to Exhibit 10.9 filed with the Company’s  Registration Statement on Form S-1 dated April 12, 2005,  Registration No. 333-124028)                                                    |
| 10.10 |   | Agreement of Lease  between Liberty Property Limited Partnership and Raymond Karsan Associates  dated July 1, 1996 (incorporated by reference to Exhibit 10.10  filed with the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                  |
| 10.11 |   | First Amendment to  Agreement of Lease dated August 14, 2002 between Liberty Property  Limited Partnership and Kenexa Corporation (incorporated by reference to  Exhibit 10.11 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)   |
| 10.12 |   | Second Amendment to  Agreement of Lease dated November 8, 2002 between Liberty Property  Limited Partnership and Kenexa Corporation (incorporated by reference to  Exhibit 10.12 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028) |

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| 10.13  |   | Credit Agreement dated  November 13, 2006 by and among Kenexa Technology, Inc., the several  banks and other financial institutions from time to time parties hereto, and  PNC Bank, National Association, as administrative agent (incorporated by  reference to Exhibit 10.24 filed with the Company’s Current Report on  Form 8-K dated November 17, 2006) |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14  |   | Revolving Credit and  Security Agreement dated July 15, 2003 between PNC Bank, National  Association and Kenexa Technology, Inc. (incorporated by reference to  Exhibit 10.13 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                            |
| 10.15  |   | First Amendment and  Waiver to Revolving Credit and Security Agreement dated October 10, 2003  between PNC Bank, National Association and Kenexa Technology, Inc.  (incorporated by reference to Exhibit 10.14 filed with the Company’s  Registration Statement on Form S-1 dated April 12, 2005,  Registration No. 333-124028)                          |
| 10.16  |   | Second Amendment and  Modification to Loan and Security Agreement dated March 22, 2005 between  PNC Bank, National Association and Kenexa Technology, Inc. (incorporated  by reference to Exhibit 10.15 filed with the Company’s Registration  Statement on Form S-1 dated April 12, 2005, Registration  No. 333-124028)                                 |
| 10.17  |   | Third Amendment and  Modification to the Revolving Credit and Security Agreement dated  December 29, 2005 between Kenexa Technology, Inc. and PNC Bank,  National Association (incorporated by reference to Exhibit 10.24 filed  with the Company’s Current Report on Form 8-K dated  December 30, 2005)                                                      |
| 10.18  |   | Guaranty dated  July 15, 2003 by Kenexa Corporation in favor of PNC Bank, National  Association 1996 (incorporated by reference to Exhibit 10.6 filed with  the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                                                                              |
| 10.19  |   | Form of  Indemnification Agreements between Kenexa Corporation and each of its  directors and certain officers 1996 (incorporated by reference to  Exhibit 10.23 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                                              |
| 10.20* |   | Separation Agreement by  and among Kenexa Technology, Inc., and Eliot Chack (a/k/a Elliot H.  Clark), dated November 26, 2006 (incorporated by reference to  Exhibit 10.1 filed with the Company’s Current Report on Form 8-K  dated November 29, 2006)                                                                                                       |
| 21.1   |   | Subsidiaries of Kenexa  Corporation                                                                                                                                                                                                                                                                                                                                                         |
| 23.1   |   | Consent of BDO Seidman,  LLP                                                                                                                                                                                                                                                                                                                                                                |
| 31.1   |   | Certification by Chief  Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                                                         |
| 31.2   |   | Certification by Chief  Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                                                         |
| 32.1   |   | Certification Furnished  Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                 |

 

*                    Managementcontracts and compensatory plans and arrangements required to be filed asexhibits pursuant to Item 15(c) of this Annual Report on Form 10-K.

(c)           FinancialStatement Schedules. None

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized, on March 16, 2007.

|        | Kenexa Corporation                                                               |
|--------|----------------------------------------------------------------------------------|
|   | /s/  NOORUDDIN S. KARSAN                                               |
|   | Nooruddin S.  Karsan                                                             |
|   | Chairman of the  Board and Chief Executive Officer (Principal Executive Officer) |
|   | /s/  DONALD F. VOLK                                                    |
|   | Donald F. Volk                                                                   |
|   | Chief Financial  Officer (Principal Financial and Accounting Officer)            |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, thisreport has been signed by the following persons on March 16, 2007 in thecapacities indicated:

| Signature               | ** ** | **Title**                                          | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
|                    |       |                                               |       |
| /s/ NOORUDDIN S. KARSAN |       | Chairman of the  Board and Chief Executive         |       |
| Nooruddin S.  Karsan    |       | Officer and Director (Principal Executive Officer) |       |
| /s/ DONALD F. VOLK      |       | Chief Financial  Officer (Principal Financial and  |       |
| Donald F. Volk          |       | Accounting Officer)                                |       |
| /s/  TROY A. KANTER     |       | President, Chief Operating Officer and Director    |       |
| Troy A. Kanter          |       |                                               |       |
| /s/  BARRY M. ABELSON   |       | Director                                           |       |
| Barry M. Abelson        |       |                                               |       |
| /s/  RENEE B. BOOTH     |       | Director                                           |       |
| Renee B. Booth          |       |                                               |       |
| /s/  JOSEPH A. KONEN    |       | Director                                           |       |
| Joseph A. Konen         |       |                                               |       |
| /s/  JOHN A. NIES       |       | Director                                           |       |
| John A. Nies            |       |                                               |       |
| /s/  RICHARD J. PINOLA  |       | Director                                           |       |
| Richard J. Pinola       |       |                                               |       |
| /s/ REBECCA MADDOX      |       | Director                                           |       |
| Rebecca Maddox          |       |                                               |       |

 

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**EXHIBIT INDEX**

Exhibit Numberand Description

| Exhibit   Number | ** ** | ** ** | ** ** | **Description   of Document**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             | 2.1        |       |       | Agreement and  Plan of Merger, dated as of December 21, 2005, among Kenexa Corporation,  Kenexa Technology, Inc., Kenexa Acquisition Corp., Webhire, Inc.,  and Gazaway L. Crittenden, solely as the representative of the Equityholders  (incorporated by reference to Exhibit 2.1 filed with the Company’s  Current Report on Form 8-K dated December 22, 2005)                                                                                                                                                                                                                                                                                                                                                                     |
|             | 2.2        |       |       | Equity Purchase  Agreement and Agreement and Plan of Merger, dated as of October 5, 2006,  among Kenexa Corporation, Kenexa Technology, Inc., Birmingham  Acquisition Corp., BrassRing LLC, BrassRing Inc., Gannett Satellite  Information Network, Inc., BRLLC Holdings Inc., Tribune National Marketing  Company, Accel VI L.P., Accel Internet Fund II, L.P., Accel Keiretsu VI L.P.,  Accel Investors ‘98 L.P., Accel VI-S L.P., Accel Investors ‘98-S L.P.,  James W. Breyer, and Gerald M. Rosberg solely as the representative of the  stockholders of BRINC and the selling members of BRLLC (incorporated by  reference to Exhibit 2.1 filed with the Company’s Current Report on  Form 8-K dated October 6, 2006) |
|             | 3.1        |       |       | Amended and  Restated Articles of Incorporation of Kenexa Corporation (incorporated by  reference to Exhibit 3.3 filed with Amendment No. 2 to the  Company’s Registration Statement on Form S-1 dated June 6,  2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|             | 3.2        |       |       | Amended and  Restated Bylaws of Kenexa Corporation (incorporated by reference to  Exhibit 3.2 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|             | 4.1        |       |       | Form of  Specimen Common Stock Certificate of Kenexa Corporation (incorporated by  reference to Exhibit 4.1 filed with Amendment No. 4 to the  Company’s Registration Statement on Form S-1 dated June 20,  2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|             | 4.2        |       |       | Form of  Amended and Restated Class B Common Stock Purchase Warrant to purchase  common stock of Kenexa Corporation (incorporated by reference to  Exhibit 4.4 filed with Amendment No. 1 to the Company’s  Registration Statement on Form S-1 dated May 17, 2005,  Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|             | 4.3        |       |       | Form of  Amended and Restated Class D Common Stock Purchase Warrant to purchase  common stock of Kenexa Corporation (incorporated by reference to  Exhibit 4.5 filed with Amendment No. 1 to the Company’s  Registration Statement on Form S-1 dated May 17, 2005,  Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|             | 4.4        |       |       | Form of  Amended and Restated Class E Common Stock Purchase Warrant to purchase  common stock of Kenexa Corporation (incorporated by reference to  Exhibit 4.6 filed with Amendment No. 1 to the Company’s  Registration Statement on Form S-1 dated May 17, 2005,  Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|             | 10.1*      |       |       | Kenexa  Corporation 2000 Stock Option Plan (incorporated by reference to  Exhibit 10.1 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|             | 10.2*      |       |       | Form of  Non-Qualified Stock Option Agreement under the Kenexa Corporation 2000 Stock  Option Plan (incorporated by reference to Exhibit 10.2 filed with the  Company’s Registration Statement on Form S-1 dated April 12,  2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|             | 10.3*      |       |       | Kenexa  Corporation 2005 Equity Incentive Plan (incorporated by reference to  Exhibit 10.3 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|                  |            |            |            |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |  |

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|        | 10.4* |   |   | Form of  Non-Qualified Stock Option Award Agreement under the 2005 Equity Incentive  Plan (Director) (incorporated by reference to Exhibit 10.4 filed with the  Company’s Registration Statement on Form S-1 dated April 12,  2005, Registration No. 333-124028)                                                                                              |
|--------|-------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 10.5* |   |   | Form of  Non-Qualified Stock Option Award Agreement under the 2005 Equity Incentive  Plan (Employee) (incorporated by reference to Exhibit 10.5 filed with  the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                                                                              |
|   | 10.6* |   |   | Kenexa  Corporation Amended and Restated 2006 Employee Stock Purchase Plan  (incorporated by reference to Exhibit 2.1 filed with the Company’s  Current Report on Form 8-K dated October 20, 2006)                                                                                                                                                                      |
|   | 10.7  |   |   | Investor  Agreement dated April 8, 2005 among Kenexa Corporation and certain  shareholders (incorporated by reference to Exhibit 10.7 filed with the  Company’s Registration Statement on Form S-1 dated April 12,  2005, Registration No. 333-124028) of Kenexa Corporation                                                                                  |
|   | 10.8  |   |   | Agreement Among  Certain Management Shareholders dated April 8, 2005 among Kenexa  Corporation and the investors named therein (incorporated by reference to  Exhibit 10.8 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                                    |
|   | 10.9  |   |   | Second Amended  and Restated Registration Rights Agreement, dated March 29, 2001  (incorporated by reference to Exhibit 10.9 filed with the Company’s  Registration Statement on Form S-1 dated April 12, 2005,  Registration No. 333-124028)                                                                                                                 |
|   | 10.10 |   |   | Agreement of  Lease between Liberty Property Limited Partnership and Raymond Karsan  Associates dated July 1, 1996 (incorporated by reference to  Exhibit 10.10 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                                               |
|   | 10.11 |   |   | First Amendment  to Agreement of Lease dated August 14, 2002 between Liberty Property  Limited Partnership and Kenexa Corporation (incorporated by reference to  Exhibit 10.11 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                                |
|   | 10.12 |   |   | Second Amendment  to Agreement of Lease dated November 8, 2002 between Liberty Property  Limited Partnership and Kenexa Corporation (incorporated by reference to  Exhibit 10.12 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                              |
|   | 10.13 |   |   | Credit Agreement  dated November 13, 2006 by and among Kenexa Technology, Inc., the  several banks and other financial institutions from time to time parties  hereto, and PNC Bank, National Association, as administrative agent  (incorporated by reference to Exhibit 10.24 filed with the Company’s  Current Report on Form 8-K dated November 17, 2006) |
|   | 10.14 |   |   | Revolving Credit  and Security Agreement dated July 15, 2003 between PNC Bank, National  Association and Kenexa Technology, Inc. (incorporated by reference to  Exhibit 10.13 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                                            |
|   | 10.15 |   |   | First Amendment  and Waiver to Revolving Credit and Security Agreement dated October 10,  2003 between PNC Bank, National Association and Kenexa Technology, Inc.  (incorporated by reference to Exhibit 10.14 filed with the Company’s  Registration Statement on Form S-1 dated April 12, 2005,  Registration No. 333-124028)                          |

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|        | 10.16  |   |   | Second Amendment  and Modification to Loan and Security Agreement dated March 22, 2005  between PNC Bank, National Association and Kenexa Technology, Inc.  (incorporated by reference to Exhibit 10.15 filed with the Company’s  Registration Statement on Form S-1 dated April 12, 2005,  Registration No. 333-124028) |
|--------|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 10.17  |   |   | Third Amendment  and Modification to the Revolving Credit and Security Agreement dated  December 29, 2005 between Kenexa Technology, Inc. and PNC Bank,  National Association (incorporated by reference to Exhibit 10.24 filed  with the Company’s Current Report on Form 8-K dated  December 30, 2005)                      |
|   | 10.18  |   |   | Guaranty dated  July 15, 2003 by Kenexa Corporation in favor of PNC Bank, National  Association 1996 (incorporated by reference to Exhibit 10.6 filed with  the Company’s Registration Statement on Form S-1 dated  April 12, 2005, Registration No. 333-124028)                                                              |
|   | 10.19  |   |   | Form of  Indemnification Agreements between Kenexa Corporation and each of its  directors and certain officers 1996 (incorporated by reference to  Exhibit 10.23 filed with the Company’s Registration Statement on  Form S-1 dated April 12, 2005, Registration No. 333-124028)                                              |
|   | 10.20* |   |   | Separation  Agreement by and among Kenexa Technology, Inc., and Eliot Chack (a/k/a  Elliot H. Clark), dated November 26, 2006 (incorporated by  reference to Exhibit 10.1 filed with the Company’s Current Report on  Form 8-K dated November 29, 2006)                                                                  |
|   | 21.1   |   |   | Subsidiaries of  Kenexa Corporation                                                                                                                                                                                                                                                                                                                         |
|   | 23.1   |   |   | Consent of BDO  Seidman, LLP                                                                                                                                                                                                                                                                                                                                |
|   | 31.1   |   |   | Certification by  Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                         |
|   | 31.2   |   |   | Certification by  Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                         |
|   | 32.1   |   |   | Certification Furnished  Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                 |

 

*                    Managementcontracts and compensatory plans and arrangements required to be filed asexhibits pursuant to Item 15(c) of this Annual Report on Form 10-K.

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