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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the Quarterly period ended June 30, 2004



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



Commission File Number 1-14007



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SONIC FOUNDRY, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|MARYLAND                                                       |  | 39-1783372                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



222 West Washington
Ave, Suite 775, Madison, WI 53703

(Address of principal executive offices)



(608)443-1600

(Registrants telephone number including area code)



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



Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



State the number of shares outstanding of each
of the issuers common equity as of the last practicable date:



|                              |  |                           
|----------------------------- |  | --------------------------
|Class                         |  | Outstanding August 6, 2004
|Common Stock, $0.01 par value |  | 29,680,187                



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##### Table of Contents

TABLE OF CONTENTS



|        |  |                                                                                                               |  |         
|------- |  | ------------------------------------------------------------------------------------------------------------- |  | --------
|        |  |                                                                                                               |  | PAGE NO.
|PART I  |  | FINANCIAL INFORMATION                                                                                         |  |         
|        |  |                                                                                                              
|Item 1. |  | Consolidated Financial Statements                                                                             |  |         
|        |  |                                                                                                              
|        |  | Consolidated Balance Sheets  June 30, 2004 (Unaudited) and September 30, 2003                                |  | 3       
|        |  |                                                                                                              
|        |  | Consolidated Statements of Operations (Unaudited)  Three months and Nine months ended June 30, 2004 and 2003 |  | 4       
|        |  |                                                                                                              
|        |  | Consolidated Statements of Cash Flows (Unaudited)  Nine months ended June 30, 2004 and 2003                  |  | 5       
|        |  |                                                                                                              
|        |  | Notes to Consolidated Financial Statements (Unaudited)                                                        |  | 6       
|        |  |                                                                                                              
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                         |  | 10      
|        |  |                                                                                                              
|Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                                                    |  | 15      
|        |  |                                                                                                              
|Item 4. |  | Controls and Procedures                                                                                       |  | 15      
|        |  |                                                                                                              
|PART II |  | OTHER INFORMATION                                                                                             |  |         
|        |  |                                                                                                              
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                                           |  | 16      
|        |  |                                                                                                              
|Item 6. |  | Exhibits and Reports on Form 8-K                                                                              |  | 16      



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##### Table of Contents

Sonic Foundry, Inc.

Consolidated Balance Sheets

(in thousands except for share data)



|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                                              |  | June 30, 2004 |          |   | September 30,2003 |  
|                                                                                                                                                                                              |  | (unaudited)   |          |   |                   |  
|Assets                                                                                                                                                                                        |  |               |          |   |                   |   |          |  
|Current Assets:                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                                     |  | $             | 4,545    |   |                   | $ | 12,623   |  
|Short-term investments                                                                                                                                                                        |  |               | 4,550    |   |                   |   |         |  
|Accounts receivable, net of allowances of $49 and $40                                                                                                                                         |  |               | 1,062    |   |                   |   | 508      |  
|Accounts receivable, other                                                                                                                                                                    |  |               | 26       |   |                   |   | 139      |  
|Inventories                                                                                                                                                                                   |  |               | 240      |   |                   |   | 111      |  
|Prepaid expenses and other current assets                                                                                                                                                     |  |               | 443      |   |                   |   | 214      |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Total current assets                                                                                                                                                                          |  |               | 10,866   |   |                   |   | 13,595   |  
|Property and equipment:                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Leasehold improvements                                                                                                                                                                        |  |               | 180      |   |                   |   | 132      |  
|Computer equipment                                                                                                                                                                            |  |               | 981      |   |                   |   | 741      |  
|Furniture and fixtures                                                                                                                                                                        |  |               | 177      |   |                   |   | 96       |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Total property and equipment                                                                                                                                                                  |  |               | 1,338    |   |                   |   | 969      |  
|Less accumulated depreciation                                                                                                                                                                 |  |               | 555      |   |                   |   | 381      |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Net property and equipment                                                                                                                                                                    |  |               | 783      |   |                   |   | 588      |  
|Other assets:                                                                                                                                                                                 |  |               |          |   |                   |   |          |  
|Goodwill and other intangibles, net                                                                                                                                                           |  |               | 7,688    |   |                   |   | 7,726    |  
|Capitalized software development costs, net of amortization of $717and $508                                                                                                                   |  |               | 683      |   |                   |   | 892      |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Total other assets                                                                                                                                                                            |  |               | 8,371    |   |                   |   | 8,618    |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Total assets                                                                                                                                                                                  |  | $             | 20,020   |   |                   | $ | 22,801   |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Liabilities and stockholders equity                                                                                                                                                          |  |               |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                                          |  |               |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                                              |  | $             | 885      |   |                   | $ | 1,065    |  
|Accrued liabilities                                                                                                                                                                           |  |               | 763      |   |                   |   | 1,263    |  
|Unearned revenue                                                                                                                                                                              |  |               | 415      |   |                   |   | 194      |  
|Current portion of capital lease obligations                                                                                                                                                  |  |               |         |   |                   |   | 48       |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                                     |  |               | 2,063    |   |                   |   | 2,570    |  
|                                                                                                                                                                                              |  |              
|Deferred rent                                                                                                                                                                                 |  |               | 29       |   |                   |   |         |  
|                                                                                                                                                                                              |  |              
|Stockholders equity:                                                                                                                                                                         |  |               |          |   |                   |   |          |  
|Preferred stock, $.01 par value, authorized 5,000,000 shares; none issued and outstanding                                                                                                     |  |               |         |   |                   |   |         |  
|5% preferred stock, Series B, voting, cumulative, convertible, $.01 par value (liquidation preference at par), authorized 10,000,000 shares,
none issued and outstanding                      |  |               |         |   |                   |   |         |  
|Common stock, $.01 par value, authorized 100,000,000 shares; 29,661,565 and 28,684,449 issued and 29,591,315 and 28,614,199 outstanding at
June 30, 2004 and September 30, 2003, respectively |  |               | 297      |   |                   |   | 287      |  
|Additional paid-in capital                                                                                                                                                                    |  |               | 169,315  |   |                   |   | 168,106  |  
|Accumulated deficit                                                                                                                                                                           |  |               | (151,489 | ) |                   |   | (147,532 | )
|Receivable for common stock issued                                                                                                                                                            |  |               | (27      | ) |                   |   | (462     | )
|Treasury stock, at cost, 70,250 shares                                                                                                                                                        |  |               | (168     | ) |                   |   | (168     | )
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                                    |  |               | 17,928   |   |                   |   | 20,231   |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                                    |  | $             | 20,020   |   |                   | $ | 22,801   |  
|                                                                                                                                                                                              |  |               |          |   |                   |   |          |  



See accompanying notes



3



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##### Table of Contents

Sonic Foundry, Inc

Statements of Operations

(in thousands except for share data)

(Unaudited)



|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                                                            |  | Three Months Ended June 30, |        |   | Nine Months Ended June 30, |  
|                                                                                                                                            |  | 2004                        |        |   | 2003                       |   |        | 2004 |  |   | 2003   |  
|Continuing Operations                                                                                                                       |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Revenue:                                                                                                                                    |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product sales                                                                                                                               |  | $                           | 959    |   |                            | $ | 343    |      |  | $ | 2,253  |   |  | $ | 705    |  
|Customer support fees                                                                                                                       |  |                             | 110    |   |                            |   |       |      |  |   | 266    |   |  |   | 25     |  
|Other                                                                                                                                       |  |                             | 85     |   |                            |   |       |      |  |   | 475    |   |  |   | 4      |  
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total revenue                                                                                                                               |  |                             | 1,154  |   |                            |   | 343    |      |  |   | 2,994  |   |  |   | 734    |  
|Cost of revenue                                                                                                                             |  |                             | 443    |   |                            |   | 195    |      |  |   | 1,198  |   |  |   | 538    |  
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Gross margin                                                                                                                                |  |                             | 711    |   |                            |   | 148    |      |  |   | 1,796  |   |  |   | 196    |  
|                                                                                                                                            |  |                             |        |  
|Operating expenses:                                                                                                                         |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Selling and marketing expenses                                                                                                              |  |                             | 1,176  |   |                            |   | 641    |      |  |   | 2,722  |   |  |   | 2,128  |  
|General and administrative expenses                                                                                                         |  |                             | 738    |   |                            |   | 980    |      |  |   | 2,063  |   |  |   | 2,343  |  
|Product development expenses                                                                                                                |  |                             | 420    |   |                            |   | 330    |      |  |   | 1,181  |   |  |   | 1,136  |  
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total operating expense                                                                                                                     |  |                             | 2,334  |   |                            |   | 1,951  |      |  |   | 5,966  |   |  |   | 5,607  |  
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss from operations                                                                                                                        |  |                             | (1,623 | ) |                            |   | (1,803 | )    |  |   | (4,170 | ) |  |   | (5,411 | )
|Other income (expense), net                                                                                                                 |  |                             | 25     |   |                            |   | (3     | )    |  |   | 81     |   |  |   | (2     | )
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss from continuing operations                                                                                                             |  |                             | (1,598 | ) |                            |   | (1,806 | )    |  |   | (4,089 | ) |  |   | (5,413 | )
|                                                                                                                                            |  |                             |        |  
|Discontinued operations:                                                                                                                    |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss from operations of discontinued operations including $0 and $89 of income tax benefit in the three and nine months ended June 30,
2003 |  |                             |       |   |                            |   | (923   | )    |  |   |       |   |  |   | (2,768 | )
|Gain (loss) on disposal of discontinued operations                                                                                          |  |                             |       |   |                            |   | (1,788 | )    |  |   | 132    |   |  |   | (1,788 | )
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) from discontinued operations                                                                                                  |  |                             |       |   |                            |   | (2,711 | )    |  |   | 132    |   |  |   | (4,556 | )
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|                                                                                                                                            |  |                             |        |  
|Net loss                                                                                                                                    |  | $                           | (1,598 | ) |                            | $ | (4,517 | )    |  | $ | (3,957 | ) |  | $ | (9,969 | )
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss per common share:                                                                                                                      |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Continuing operations                                                                                                                       |  | $                           | (0.05  | ) |                            | $ | (0.06  | )    |  | $ | (0.14  | ) |  | $ | (0.20  | )
|Discontinued operations                                                                                                                     |  |                             |       |   |                            |   | (0.10  | )    |  |   |       |   |  |   | (0.16  | )
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net loss per common share  basic and diluted                                                                                               |  | $                           | (0.05  | ) |                            | $ | (0.16  | )    |  | $ | (0.14  | ) |  | $ | (0.36  | )
|                                                                                                                                            |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  



See accompanying notes



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##### Table of Contents

Sonic Foundry, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)



|                                                                             |  |                            |        |   |      |   |        |  
|---------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ---- | - | ------ | -
|                                                                             |  | Nine months ended June 30, |       
|                                                                             |  | 2004                       |        |   | 2003 |  
|Operating activities                                                         |  |                            |        |   |      |   |        |  
|Net loss                                                                     |  | $                          | (3,957 | ) |      | $ | (9,969 | )
|Adjustments to reconcile net loss to net cash used in operating activities:  |  |                            |        |   |      |   |        |  
|(Gain) loss on sale of discontinued operations                               |  |                            | (132   | ) |      |   | 1,788  |  
|Amortization of intangible assets and capitalized software development costs |  |                            | 247    |   |      |   | 323    |  
|Depreciation and amortization of property and equipment                      |  |                            | 174    |   |      |   | 2,132  |  
|Amortization of debt discount and debt issue costs                           |  |                            |       |   |      |   | 2,762  |  
|Noncash compensation charges and charges for stock warrants and options      |  |                            | 193    |   |      |   | 257    |  
|Loss on sale of property and equipment                                       |  |                            |       |   |      |   | 15     |  
|Changes in operating assets and liabilities:                                 |  |                            |        |   |      |   |        |  
|Accounts receivable                                                          |  |                            | (554   | ) |      |   | 747    |  
|Accounts receivable, other                                                   |  |                            | 113    |   |      |   | (47    | )
|Inventories                                                                  |  |                            | (129   | ) |      |   | (43    | )
|Prepaid expenses and other assets                                            |  |                            | (213   | ) |      |   | 6      |  
|Accounts payable, accrued liabilities and deferred rent                      |  |                            | (651   | ) |      |   | (653   | )
|Unearned revenue                                                             |  |                            | 221    |   |      |   | 90     |  
|                                                                             |  |                            |        |   |      |   |        |  
|Total adjustments                                                            |  |                            | (731   | ) |      |   | 7,377  |  
|                                                                             |  |                            |        |   |      |   |        |  
|Net cash used in operating activities                                        |  |                            | (4,688 | ) |      |   | (2,592 | )
|                                                                             |  |                           
|Investing activities                                                         |  |                            |        |   |      |   |        |  
|Net purchase of short-term investments                                       |  |                            | (4,550 | ) |      |   |       |  
|Proceeds from sale of discontinued operations, net                           |  |                            | 132    |   |      |   | 4,876  |  
|Proceeds from sale of property and equipment                                 |  |                            |       |   |      |   | 15     |  
|Purchases of property and equipment                                          |  |                            | (369   | ) |      |   | (51    | )
|                                                                             |  |                            |        |   |      |   |        |  
|Net cash provided by (used in) investing activities                          |  |                            | (4,787 | ) |      |   | 4,840  |  
|                                                                             |  |                           
|Financing activities                                                         |  |                            |        |   |      |   |        |  
|Proceeds from issuance of common stock, net of issuance costs                |  |                            | 1,445  |   |      |   | 70     |  
|Proceeds from debt issuances                                                 |  |                            |       |   |      |   | 1,069  |  
|Payments on long-term debt and capital leases                                |  |                            | (48    | ) |      |   | (4,585 | )
|Payments on line of credit, net                                              |  |                            |       |   |      |   | (451   | )
|                                                                             |  |                            |        |   |      |   |        |  
|Net cash provided by (used in) financing activities                          |  |                            | 1,397  |   |      |   | (3,897 | )
|Effect of exchange rate changes on cash                                      |  |                            |       |   |      |   | 116    |  
|                                                                             |  |                            |        |   |      |   |        |  
|Net decrease in cash                                                         |  |                            | (8,078 | ) |      |   | (1,533 | )
|Cash and cash equivalents at beginning of period                             |  |                            | 12,623 |   |      |   | 3,704  |  
|                                                                             |  |                            |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                   |  | $                          | 4,545  |   |      | $ | 2,171  |  
|                                                                             |  |                            |        |   |      |   |        |  
|Supplemental cash flow information:                                          |  |                            |        |   |      |   |        |  
|Interest paid                                                                |  | $                          |       |   |      | $ | (561   | )
|Income taxes refunded (paid)                                                 |  |                            | (79    | ) |      |   | 180    |  
|Non-cash transactions - Capital lease acquisitions                           |  |                            |       |   |      |   | 38     |  



See accompanying notes



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##### Table of Contents

Notes to Consolidated Financial Statements

(Unaudited)



1. Basis of Presentation and Significant Accounting Policies



Sonic Foundry, Inc. (the Company) is in the business of
developing automated rich-media application software and systems, (our Media Systems business). Our current operations were formed in October 2001 when we acquired the assets and assumed certain liabilities of Mediasite, Inc.
(Mediasite). The Mediasite assets included a 33% equity interest in a Japanese entity, Mediasite KK (MSKK), formed to distribute Mediasite products in Japan. Since the acquisition we have fully reserved against the value of
our equity interest in MSKK.



Until last year, we were engaged
in three businesses  Media Services, Desktop Software and Media Systems. Our media services operation (Media Services) provided format conversion, tape duplication, film restoration and other services to the media, broadcast and
entertainment industries. On May 16, 2003, the Company completed the sale of the Media Services business to Deluxe Media Services.



The desktop software business (Desktop Software) designed, developed, marketed and supported software products for digitizing, converting,
editing and publishing audio, video, and/or multimedia content. On July 30, 2003, the Company completed the sale of the Desktop Software business to a subsidiary of Sony Pictures Digital.



All revenue and expenses included in the results of operations of both the Media Services business and the Desktop Software
business have been presented as discontinued operations (the Discontinued Operations) and previously reported consolidated financial statements have been restated to reflect the discontinued operations presentation. See Note 2 
Managements Plan and Discontinued Operations.



Reclassifications



Certain reclassifications have been made to the
consolidated statements of operations for the three and nine-month periods ended June 30, 2003 in connection with the Companys presentation of discontinued desktop software operations. Such reclassifications affect the amount of research and
development costs and debt extinguishment costs included in discontinued desktop software operations versus continuing operations; and decrease the loss from continuing operations (and correspondingly increase the loss from discontinued desktop
software operations). The reclassification did not impact the Companys previously reported net loss.



Interim Financial Data



The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States (GAAP) for complete financial statements and should be read in conjunction with the
Companys annual report filed on Form 10-K for the fiscal year ended September 30, 2003. In the opinion of management, all adjustments (consisting only of adjustments of a normal and recurring nature) considered necessary for a fair
presentation of the results of operations have been included. Operating results for the three and nine month period ended June 30, 2004 are not necessarily indicative of the results that might be expected for the year ended September 30, 2004.



Revenue Recognition



General



Revenue is recognized when persuasive evidence of an arrangement exists, delivery occurs or services are rendered, the sales
price is fixed or determinable and collectibility is reasonably assured. Revenue is deferred when undelivered products or services are essential to the functionality of delivered products, customer acceptance is uncertain, significant obligations
remain, or the fair value of undelivered elements is unknown. The Company does not offer customers the right to return product, other than for warranty repairs, and does not offer price protection, rebates or other offerings that occur under sales
programs and accordingly, does not reduce revenue for such programs. The following policies apply to the Companys major categories of revenue transactions.



Product Sales



Products are considered delivered, and revenue is recognized, when title and risk of loss have been transferred to the customer. Under the terms and
conditions of the sale, this occurs at the time of shipment to the customer. Product revenue currently represents sales of our Mediasite product, excluding the revenue generated from service-related solutions, which is discussed below.



6



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##### Table of Contents

Customer Support Fees



We sell support contracts to our Mediasite customers, typically one year in length, and record the related revenue ratably over the contractual period.
Our support contracts cover phone and electronic technical support availability over and above the level provided by our distributors as well as an extension of the standard hardware warranty from 90 days to one year. Hardware warranty service is
performed by the manufacturer we contract with to build the units. Time and material contracts, such as training fees, are recognized as revenue when services are rendered. Service amounts invoiced to customers in excess of revenue recognized are
recorded as unearned revenue until the revenue recognition criteria are met.



Other



Other revenue consists of software licensing
of our Publisher product and custom software development performed under time and materials or fixed fee arrangements. Software licensing is recorded when persuasive evidence of an arrangement exists, delivery occurs, the sales price is fixed or
determinable and collectibility is reasonably assured. Custom software development includes fees recorded pursuant to long-term contracts (including research grants), using the percentage of completion method of accounting, when significant
customization or modification of a product is required.



Revenue Arrangements
that Include Multiple Elements



Revenue for transactions that
include multiple elements such as hardware, software, training, and support agreements is allocated to each element based on its relative fair value and recognized for each element when the revenue recognition criteria have been met for such
element. Fair value is generally determined based on the price charged when the element is sold separately. In the absence of fair value of a delivered element, revenue is allocated first to the fair value of the undelivered elements and the
residual revenue to the delivered elements. The Company recognizes revenue for delivered elements only when all of the following criteria are satisfied: undelivered elements are not essential to the functionality of delivered elements, uncertainties
regarding customer acceptance are resolved, and the fair value for all undelivered elements is known.



Shipping and Handling



Costs
related to shipping and handling are included in cost of sales for all periods presented.



Credit Evaluation



We perform
ongoing credit evaluations of our customers financial condition and generally do not require collateral. We maintain allowances for potential credit losses and such losses have been within our expectations.



Cash and Cash Equivalents



The Company considers all highly liquid investments, generally with a
maturity of three months or less, to be cash equivalents.



Inventories



Inventory at June 30, 2004 consists of the following:



|                |  |   |    
|--------------- |  | - | ---
|Raw Materials   |  | $ | 10 
|Work in Process |  |   | 83 
|Finished Goods  |  |   | 147
|                |  |   |    
|                |  | $ | 240
|                |  |   |    



Stock Based Compensation



As permitted by SFAS No. 123, Accounting for
Stock-Based Compensation, the Company follows Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, in accounting for its stock option plans. Had the Company accounted for its stock option plans
based upon the fair value at the grant date for options granted under the plan, based on the provisions of SFAS No. 123, the Companys pro forma net loss and pro forma net loss per share would have been as follows (for purposes of pro forma
disclosures, the estimated fair value of the options is amortized to expense over the options vesting period):



|                                                                          |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |         |  
|------------------------------------------------------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                                                          |  | Three Months Ended June 30, |        |   | Nine Months Ended June 30, |  
|                                                                          |  | 2004                        |        |   | 2003                       |   |        | 2004 |  |   | 2003   |  
|Net loss as reported                                                      |  | $                           | (1,598 | ) |                            | $ | (4,517 | )    |  | $ | (3,957 | ) |  | $ | (9,969  | )
|Stock-based compensation using fair value method                          |  |                             | (113   | ) |                            |   | 21     |      |  |   | (225   | ) |  |   | (394    | )
|Impact of discounted employee stock purchase plan using fair value method |  |                             | (1     | ) |                            |   | (7     | )    |  |   | (7     | ) |  |   | (26     | )
|                                                                          |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |         |  
|Pro forma net loss                                                        |  | $                           | (1,712 | ) |                            | $ | (4,503 | )    |  | $ | (4,189 | ) |  | $ | (10,389 | )
|Pro forma net loss per share  basic and diluted                          |  | $                           | (0.06  | ) |                            | $ | (0.16  | )    |  | $ | (0.14  | ) |  | $ | (0.37   | )



7



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##### Table of Contents

Pro forma information regarding net loss and net loss per share and has been determined as if the Company
had accounted for its employee stock options under the minimum value method of SFAS No. 123 for option grants made prior to the Companys initial public offering and the Black-Scholes method for grants made subsequent to such offering. With the
exception of volatility (which is ignored in the case of the minimum value method), the following weighted-average assumptions were used for all periods presented: risk-free interest rates of 1.7% to 6%, dividend yields of 0%; expected common stock
market price volatility factors ranging from .50 to 2.59 and a weighted-average expected life of the option of one to five years.



Effective July 1, 2004 the Company terminated the discounted employee stock purchase plan.



Per share computation



The following table sets forth the computation of basic and diluted loss per share:



|                                                                                                                                                   |  |                             |  |                            |  |            |  |           
|-------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- |  | -------------------------- |  | ---------- |  | ----------
|                                                                                                                                                   |  | Three Months Ended June 30, |  | Nine Months Ended June 30,
|                                                                                                                                                   |  | 2004                        |  | 2003                       |  | 2004       |  | 2003      
|Denominator                                                                                                                                        |  |                             |  |                            |  |            |  |           
|                                                                                                                                                   |  |                             |  |                           
|Denominator for basic and diluted loss per share  weighted average common shares                                                                  |  | 29,571,762                  |  | 27,788,900                 |  | 29,386,536 |  | 27,758,695
|Securities outstanding at the end of each period, but not included in the computation of diluted earnings per share because they are
antidilutive: |  |                             |  |                            |  |            |  |           
|Options and warrants                                                                                                                               |  | 1,911,650                   |  | 6,847,512                  |  | 1,736,650  |  | 6,876,304 



Accounting Pronouncements



In November 2002, the EITF reached a consensus on
Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (EITF 00-21). EITF 00-21 establishes criteria to determine whether an arrangement that contains multiple deliverables should be divided into separate units
of accounting and how the arrangement consideration should be allocated among the separate units. EITF 00-21 was effective for arrangements entered into after June 30, 2003.



In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46). FIN 46 requires a company to consolidate any variable interest entities for which the company has a controlling financial interest. FIN 46 also requires disclosures about the variable interest entities that the Company is not required to
consolidate, but in which it has a significant variable interest. The Company adopted the consolidation requirements of FIN 46 on February 1, 2003.



The adoption of EITF 00-21 and FIN 46 had no effect on the Companys financial position, results of operations or stockholders equity.



2. Managements Plan and Discontinued Operations



In the fall of 2002, the Company determined that operations of our Desktop
Software and Media Services businesses, along with our existing cash reserves, would not provide sufficient cash flow to fund planned growth of the systems division and make remaining subordinated debt payments. In response, the Company retained an
advisor to evaluate the sale of certain operating assets.



8



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##### Table of Contents

Media Services



The Company completed the sale of assets utilized in the Media Services business on May 16, 2003 with Deluxe Media Services (Deluxe). The
transaction included all assets utilized in the Companys Media Services business primarily affecting business conducted from and employees in the Companys Santa Monica California and Toronto Canada facilities. Under terms of the
agreement, Deluxe acquired the Media Services business for approximately $5.6 million including cash of $4.5 million plus an estimate of $1.1 million for net working capital and assumption of certain capital leases. The Company received $5.2 million
at close with the remainder due upon a final determination of actual working capital. The Company received $350 thousand of the remainder in September 2003 and settled on a final payment of $241 thousand in January 2004. The Company recorded a gain
on sale of discontinued operations of $185 thousand in 2004 to reflect the amount that the January 2004 payment and other settlements exceeded the working capital estimates. Overall, the disposition of the Media Services business resulted in a
cumulative loss of $1.8 million. Details of the discontinued Media Services business are as follows (in thousands):



|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|-------------------- |  | --------------------------- |  | ---- | -------------------------- | - | ---- | - | ---- | - | ------ | -
|                     |  | Three Months Ended June 30, |  |      | Nine Months Ended June 30, |  
|                     |  | 2004                        |  | 2003 |                            |   | 2004 |   | 2003 |  
|Revenues             |  |                            |  | $    | 998                        |   |      |  |      | $ | 4,943  |  
|Cost of revenues     |  |                            |  |      | 770                        |   |      |  |      |   | 4,036  |  
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|Gross margin         |  |                            |  |      | 228                        |   |      |  |      |   | 907    |  
|Operating expenses   |  |                            |  |      | 662                        |   |      |  |      |   | 2,741  |  
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|Operating loss       |  |                            |  |      | (434                       | ) |      |  |      |   | (1,834 | )
|Other income         |  |                            |  |      | 69                         |   |      |  |      |   | 138    |  
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|Loss from operations |  |                            |  | $    | (365                       | ) |      |  |      | $ | (1,696 | )
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  



Desktop Software



The Company entered into an amended and restated asset purchase agreement
with a subsidiary of Sony Pictures Digital, dated June 6, 2003 and effective May 2, 2003, to sell the assets of the Companys Desktop Software business for $19 million cash and assumption of certain trade payables, accrued liabilities and
capital leases associated with the Desktop Software business. The transaction was completed on July 30, 2003. The negotiated price of the transaction contemplated net working capital balances at March 31, 2003 with any difference between the values
at March 31, 2003 and the date of close reflected as a post closing adjustment. The Companys net working capital decreased during the period preceding close due to improved collections of customer accounts, leading to an adjustment in the
purchase price of $497 thousand which was paid to Sony Pictures Digital in December 2003. The Company recorded a gain on the disposal of the Desktop Software business in the fourth fiscal quarter of 2003 of $13.9 million. Upon final settlement in
December 2003, the Company recorded a $53 thousand loss. Details of the discontinued Desktop Software business are as follows (in thousands):



|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|-------------------------- |  | --------------------------- |  | ---- | -------------------------- | - | ---- | - | ---- | - | ------ | -
|                           |  | Three Months Ended June 30, |  |      | Nine Months Ended June 30, |  
|                           |  | 2004                        |  | 2003 |                            |   | 2004 |   | 2003 |  
|Revenues                   |  |                            |  | $    | 3,068                      |   |      |  |      | $ | 11,119 |  
|Cost of revenues           |  |                            |  |      | 443                        |   |      |  |      |   | 1,829  |  
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|Gross margin               |  |                            |  |      | 2,625                      |   |      |  |      |   | 9,290  |  
|Operating expenses         |  |                            |  |      | 2,147                      |   |      |  |      |   | 6,794  |  
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|Operating income           |  |                            |  |      | 478                        |   |      |  |      |   | 2,496  |  
|Interest and other expense |  |                            |  |      | (1,036                     | ) |      |  |      |   | (3,568 | )
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|Loss from operations       |  |                            |  | $    | (558                       | ) |      |  |      | $ | (1,072 | )
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  



3. Related Party Transactions



During the three and nine month periods ended June 30,
2004, the Company recorded Mediasite product revenue of $48 thousand and $96 thousand to MSKK, a Japanese reseller in which the Company has a 33% equity interest.



9



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##### Table of Contents

ITEM 2 MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Risks and Uncertainties



The following discussion of the consolidated financial position and results of operations of the Company should be read in conjunction with the
consolidated financial statements and notes thereto included elsewhere in this form 10-Q and the Companys annual report filed on form 10-K for the fiscal year ended September 30, 2003. In addition to historical information, this discussion
contains forward-looking statements such as statements of the Companys expectations, plans, objectives and beliefs. These statements use such words as may, will, expect, anticipate,
believe, plan, and other similar terminology.



Actual results could differ materially from expectations due to changes in the market acceptance of our products, competition, market introduction or product development delays; all of which would impact our strategy to develop a network of
inside regional sales managers and distribution partners that target customer opportunities for multi-unit and repeat purchases. If the Company does not achieve multi-unit and repeat purchases our business will be harmed.



Other factors that may impact actual results include: our ability to
effectively integrate acquired businesses, global and local business conditions, legislation and governmental regulations, competition, our ability to effectively maintain and update our product portfolio, shifts in technology, political or economic
instability in local markets, and currency and exchange rate fluctuations, as well as other issues which may be identified from time to time in Sonic Foundrys Securities and Exchange Commission filings and other public announcements.



Overview



Sonic Foundry, Inc. is in the business of developing automated rich-media application software and systems, (our Media
Systems business). The Media Systems business was formed in October 2001, when our wholly-owned subsidiary, Sonic Foundry Systems Group, Inc. acquired the assets and assumed certain liabilities of Mediasite. Our internally developed software
code, coupled with our acquired systems technology, includes advanced publishing tools and media access technologies operating across multiple digital delivery platforms to significantly enhance a host of enterprise-based media applications. Our
solutions are based on unique and, in some cases, patented technologies that enhance media communications through the extensive use of rich-media, defined as a media element that combines graphics, text, video, audio and metadata in a single data
file. The core products include Mediasite (formerly called Mediasite Live) and Publisher. Mediasite is a system that can record presentations and stream them live over the Internet or archive them for on-demand playback. Publisher is a software
product for creating accessible and searchable rich media presentations.



Our Media Services and Desktop Software businesses were sold in fiscal 2003 and are reported under the caption of discontinued operations. The sale of our Media Services and Desktop Software businesses significantly
affect the comparability of our results of operations from year to year. You should read the following discussion of our results of operations and financial condition in conjunction with our consolidated financial statements and related notes
thereto included in this quarterly report and our Annual Report on Form 10-K.



Critical Accounting Policies



We have
identified the following as critical accounting policies of our Company and have discussed the development, selection of estimates and the disclosure regarding them with the audit committee of the board of directors:



| |  | Revenue recognition and allowance for doubtful accounts;
| | - | --------------------------------------------------------



| |  | Impairment of long-lived assets; and
| | - | ------------------------------------



| |  | Valuation allowance for net deferred tax assets.
| | - | ------------------------------------------------



Revenue Recognition and Allowance for Doubtful Accounts



We recognize revenue for product sales and licensing of software products upon shipment, provided that collection is determined to be probable and no
significant obligations remain. The Company does not offer rights of return and typically delivers products either to value added resellers based on end-user customer orders or direct to the end user. We sell post-contract support (PCS)
contracts on our Mediasite units. Revenue is recorded separately from the sale of the product and recognized over the life of the support contract using vendor specific objective evidence of the value of the support services. Please refer to Note 1
of our Notes to Consolidated Financial Statements for further information on our revenue recognition policies.



10



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##### Table of Contents

The preparation of our consolidated financial statements also requires us to make estimates regarding the
collectability of our accounts receivables. We specifically analyze the age of accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the
allowance for doubtful accounts.



Impairment of long-lived assets



We assess the impairment of goodwill and capitalized
software development costs on an annual basis or whenever events or changes in circumstances indicate that the fair value of these assets is less than the carrying value. Factors we consider important which could trigger an impairment review include
the following:



| |  | poor economic performance relative to historical or projected future operating results;
| | - | ---------------------------------------------------------------------------------------



| |  | significant negative industry, economic or company specific trends;
| | - | -------------------------------------------------------------------



| |  | changes in the manner of our use of the assets or the plans for our business; and
| | - | ---------------------------------------------------------------------------------



| |  | loss of key personnel
| | - | ---------------------



If we determine that the fair value of goodwill is less than its carrying value, based upon the annual test or the existence of one or more of the above
indicators of impairment, we would then measure impairment based on a comparison of the implied fair value of goodwill with the carrying amount of goodwill. To the extent the carrying amount of goodwill is greater than the implied fair value of
goodwill, we would record an impairment charge for the difference.



We evaluate all of our long-lived assets, including intangible assets other than goodwill, for impairment in accordance with the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS
No. 144 requires that long-lived assets and intangible assets other than goodwill be evaluated for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected
undiscounted cash flows attributable to that asset. Should events indicate that any of our long-lived assets are impaired, the amount of such impairment will be measured as the difference between the carrying value and the fair value of the impaired
asset and recorded in earnings during the period of such impairment.



Valuation allowance for net deferred tax assets



Deferred income taxes are provided for temporary differences between financial reporting and income tax basis of assets and liabilities, and are measured using currently enacted tax rates and laws. Deferred income taxes also arise from the
future benefits of net operating loss carryforwards. A valuation allowance equal to 100% of the net deferred tax assets has been recognized due to uncertainty regarding future realization.



Results of Continuing Operations



Revenue



Revenue from our Media Systems business include the sales of our Mediasite product and Mediasite customer support contracts
as well as fees charged for the licensing of Mediasite Publisher products and custom software development. The primary focus is on the platform of Mediasite, and, to a lesser extent, Mediasite Publisher. These products are marketed to government agencies, educational institutions, and corporations who need to deploy, manage, index and
distribute video content on IP-based networks. We reach our customers through reseller networks, a direct sales effort and partnerships with system integrators.



Q3-2004 compared to Q3-2003



Revenues in Q3-2004 totaled $1.15 million compared to Q3-2004 sales of $343 thousand. Significant revenue items included:



| |  | $959 thousand of product revenue from the sale of 68 Mediasite units versus $343 thousand from the sale of 27 Mediasite units in 2003.
| | - | --------------------------------------------------------------------------------------------------------------------------------------



| |  | $110 thousand from Mediasite service plans and training and installation services. Service plans are typically 18% of the product sales price and recognized over the term (usually
12 months) of the service contract. As of June 30, 2004 our balance in unamortized service contracts was $415 thousand. We will recognize approximately $150 thousand of that balance in the upcoming quarter.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | $71 thousand from the research grant with the Department of Justice. To date, we have recognized $185 thousand from the grant total of nearly $500 thousand. The remainder is
expected to be recognized over the next 4 to 5 quarters as costs are incurred.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | $6 thousand of Mediasite Publisher license fees and related consulting services to suppliers of the Federal government.
| | - | -----------------------------------------------------------------------------------------------------------------------



11



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##### Table of Contents

YTD-2004 (nine months) compared to YTD-2003 (nine months)



Revenues for YTD-2004 totaled $2.99 million compared to YTD-2003 sales of $734 thousand.
Revenues consisted of the following:



| |  | $2.3 million product revenue from the sale of 178 Mediasite units versus $705 thousand from the sale of 66 Mediasite units in 2003.
| | - | -----------------------------------------------------------------------------------------------------------------------------------



| |  | $266 thousand from Mediasite service plans and services versus $25 thousand in 2003.
| | - | ------------------------------------------------------------------------------------



| |  | $185 thousand from the research grant from the Department of Justice.
| | - | ---------------------------------------------------------------------



| |  | $242 thousand of Mediasite Publisher license fees and related consulting services to suppliers of the Federal Government.
| | - | -------------------------------------------------------------------------------------------------------------------------



Gross Margin



The significant components of cost of systems include:



| |  | Material and freight costs for the Mediasite units. Costs for Q3-2004 and YTD-2004 amounted to $353 thousand and $909 thousand, which resulted in Mediasite gross margins 
excluding support revenue  of 63% and 60%. The gross margin on Mediasite sales varies with product and customer mix; our rack mount (RL) units carry a higher margin than our mobile units (ML) and we offer reduced
pricing on units used to establish new markets such as ASP, and to demonstrate Mediasite to end customers. The table below highlights key measurements over the past 3 quarters:
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                               |  |         |          |   |         |   |          |         |  |   |          |  
|---------------------------------------------- |  | ------- | -------- | - | ------- | - | -------- | ------- |  | - | -------- | -
|                                               |  | Q1-2004 |          |   | Q2-2004 |   |          | Q3-2004 | 
|Units Sold                                     |  |         | 44       |   |         |   | 66       |         |  |   | 68       |  
|Mobile to Rack Ratio                           |  |         | 1.5 to 1 |   |         |   | 2.5 to 1 |         |  |   | 2.8 to 1 |  
|Average Sales Price, excluding support (000s) |  | $       | 13.7     |   |         | $ | 10.5     |         |  | $ | 14.1     |  
|Gross Margins, excluding support               |  |         | 62       | % |         |   | 51       | %       |  |   | 63       | %



We expect that
Mediasite margins will continue to exceed 60% in the upcoming quarters. We expect the release of the new RL design in June 2004 (and of enhanced rack designs in the fall of 2004) will reduce the Mobile to Rack ratio and positively impact gross
margins. We also anticipate royalty revenues from ASP customers beginning in Q4-2004 and license revenues from separate server software applications in the fall, which will also improve margins.



| |  | Q3-2004 costs included $3 thousand of amortization related to a new RL design released in June 2004. We capitalized $86 thousand related to development and purchase of initial
prototype units paid to our Mediasite hardware supplier. Those capitalized costs are included in inventory and will be expensed over the next 2 years.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Amortization of Mediasite acquisition amounts assigned to purchased technology and other identified intangibles. We will amortize approximately $85 thousand per quarter over the
next 2 years for the identified intangibles of the Mediasite purchase.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Royalties to Carnegie Mellon University on the sales of Mediasite Publisher technology for 2004 totaled $10 thousand.
| | - | ---------------------------------------------------------------------------------------------------------------------



Operating Expenses



Selling and Marketing Expenses



Selling and marketing expenses include wages and commissions for sales, marketing, business development and customer support personnel, print advertising,
tradeshows and various other promotional expenses for our products. Timing of these costs may vary greatly depending on introduction of new products and services, entrance into new markets or participation in major tradeshows.



Q3-2004 compared to Q3-2003



The $535 thousand or 83% increase from Q3-2003 to Q3-2004 resulted from numerous items.
Significant differences included:



| |  | In June of 2004 we presented at the InfoComm tradeshow. The show targets the professional audiovisual systems market. Our total expenditures for show related activities and travel,
including InfoComm, was $150 thousand. In Q3-2003 our total trade show activity was $80 thousand.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Growth in sales staff from five to thirteen positions during fiscal 2004 increased salaries, benefits, recruiting and travel and entertainment by $193 thousand over Q3-2003.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Growth in revenues led to an increase in commissions and incentives of $85 thousand over Q3-2003.
| | - | -------------------------------------------------------------------------------------------------



| |  | Mediasite units used by sales, training and support staff are expensed when they are removed from inventory. Units used as loaners to key accounts for 30 to 90 trial
periods are also expensed when removed from inventory. The cost of internal and loaner units for Q3-2004 was $70 thousand.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| |  | Professional fees to research and marketing groups, state and federal government lobbyists and to our public relations firm amounted to nearly $190 thousand in Q3-2004, a $100
thousand increase over the prior year. In Q2-2004 we issued 50,000 warrants valued at approximately $90 thousand to a public relations firm. The value of the warrants is being amortized over the 11 month term of a services agreement. $24 thousand of
non-cash amortization is included in the Q3-2004 total.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



YTD-2004 compared to YTD-2003



The $594 thousand or 28%
increase from YTD-2004 to YTD-2003 resulted from many of the same items mentioned in the quarter discussion above, offset by Q1-2003 severance expense of just over $300 thousand related to the elimination of two executive level positions. YTD
increases in the major categories include:



| |  | Excluding the $300 thousand of severance expense, YTD-2004 salaries, benefits, travel and entertainment and recruiting increased by over $200 thousand.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | YTD-2004 commissions exceeded YTD-2003 by over $175 thousand due to the growth in revenues.
| | - | -------------------------------------------------------------------------------------------



| |  | YTD-2004 fees to research groups, state and federal government lobbyists and our public relations firm amounted to $410 thousand, a $250 thousand increase over the prior year.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | YTD-2004 cost associated with increasing the pool of internal and key account loaner equipment amounted to approximately $130 thousand.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------



As of June 30, 2004 we had 19 employees in Selling, Marketing and Customer Support. We
anticipate Selling and Marketing headcount of 21 in Q4-2004 and modest growth in fiscal 2005.



General and Administrative Expenses



General and administrative (G&A) expenses consist of personnel and related costs associated with the facilities, finance, legal, human resource and information technology departments, as well as other
expenses not fully allocated to functional areas.



Q3-2004
compared to Q3-2003



G&A decreased $242 thousand or
25% from Q3-2003 to Q3-2004. In Q3-2003 we accrued $335 thousand of remaining lease expense for two Pittsburgh, PA facilities no longer utilized in operations. Fees for strategy, investor relations and advisory groups that were not in place last
year amounted to $81 thousand (including $54 thousand of non-cash fees related to issuance of warrants) in Q3-2004. With the exception of professional fees, unallocated G&A costs remained fairly constant from period to period. Professional fees
(accounting, legal, consulting, advisory board and transfer/registration fees) and insurance premiums made up 44% of the Q3-2004 G&A total while salaries and benefits were 34%.



YTD-2004 compared to YTD-2003



G&A decreased $280 thousand or 12% from YTD-2003 to YTD-2004. The lease charge and professional fees mentioned above
were the primary contributors to the variance. Professional fees (accounting, legal, consulting, advisory board and transfer/registration fees) and insurance premiums made up 49% of the YTD-2004 G&A total while salaries and benefits were 35%.
Advisory board and investor relation fees include $126 thousand of non-cash fees related to issuance of warrants.



As of June 30, 2004 we had 10 full-time employees in G&A. We do not anticipate additional growth in G&A headcount in fiscal 2005.



Product Development Expenses



Product development expenses include salaries and wages of the software
research and development staff and an allocation of benefits, facility and administrative expenses. Fluctuations in product development expenses correlate directly to changes in headcount.



Q3-2004 compared to Q3-2003



Q3-2004 R&D expenses increased $90 thousand, or 27% from Q3-2003. In 2004
we hired three additional engineers in order to accelerate development of enhancements to our existing Mediasite product as well as development of channel specific add-on components and future versions of the Mediasite product. We also added three
additional employees to staff the Department of Justice and other contract work. In Q3-2004, 80% of R&D costs related to salaries and benefits.



13



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##### Table of Contents

YTD-2004 compared to YTD-2003



YTD-2004 R&D expenses increased $45 thousand, or 4% from YTD-2003. 2003 Attrition and workforce reductions of the now
closed Pittsburgh location offset a portion the recent growth in staff. The prior year reduction in staff reflected a decision to focus on the Mediasite product and offer no near term upgrades of the Mediasite Publisher product. In YTD-2004, 80% of
R&D costs related to salaries and benefits.



As of June 30,
2004 we had 16 employees in Research and Development. We do not anticipate additional growth in R&D headcount in fiscal 2005. We do not anticipate that any fiscal 2004 software development efforts will qualify for capitalization under SFAS No.
86 Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed.



Other Income



Other
income is primarily interest income. We are currently investing in a certificates of deposit and overnight investment vehicles.



Discontinued Operations



In the fall of 2002, the Company determined that operations of our Desktop Software and Media Services business would not provide sufficient cash flow
along with our existing cash reserves to fund planned growth of the systems division and make remaining subordinated debt payments. In response, the Company retained an advisor to evaluate the sale of certain operating assets. On May 16, 2003, we
completed the sale of the assets used in our Media Services business to Deluxe Media Services for gross proceeds of $5.6 million cash, including an estimate of net working capital, plus assumption of certain leases and other obligations. On July 30,
2003 we completed the sale of the assets of our Desktop Software business to SP Acquisition Company, for $19.0 million cash and assumption of certain trade payables, accrued liabilities and capital leases associated with the Desktop Software
business. We have accounted for the sale of both businesses as discontinued operations in accordance with SFAS No. 144 Accounting for the Impairment and Disposal of Long-Lived Assets. Accordingly, the results of the Media Services
business and the Desktop Software business for all periods presented are included in the consolidated financial statements and MD&A as discontinued operations.



Details of the discontinued Media Services business are as follows:



|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|-------------------- |  | --------------------------- |  | ---- | -------------------------- | - | ---- | - | ---- | - | ------ | -
|                     |  | Three Months Ended June 30, |  |      | Nine Months Ended June 30, |  
|                     |  | 2004                        |  | 2003 |                            |   | 2004 |   | 2003 |  
|Revenues             |  |                            |  | $    | 998                        |   |      |  |      | $ | 4,943  |  
|Cost of revenues     |  |                            |  |      | 770                        |   |      |  |      |   | 4,036  |  
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|Gross margin         |  |                            |  |      | 228                        |   |      |  |      |   | 907    |  
|Operating expenses   |  |                            |  |      | 662                        |   |      |  |      |   | 2,741  |  
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|Operating loss       |  |                            |  |      | (434                       | ) |      |  |      |   | (1,834 | )
|Other income         |  |                            |  |      | 69                         |   |      |  |      |   | 138    |  
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  
|Loss from operations |  |                            |  | $    | (365                       | ) |      |  |      | $ | (1,696 | )
|                     |  |                             |  |      |                            |   |      |   |      |   |        |  



Details of discontinued Desktop
Software business are as follows:



|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|-------------------------- |  | --------------------------- |  | ---- | -------------------------- | - | ---- | - | ---- | - | ------ | -
|                           |  | Three Months Ended June 30, |  |      | Nine Months Ended June 30, |  
|                           |  | 2004                        |  | 2003 |                            |   | 2004 |   | 2003 |  
|Revenues                   |  |                            |  | $    | 3,068                      |   |      |  |      | $ | 11,119 |  
|Cost of revenues           |  |                            |  |      | 443                        |   |      |  |      |   | 1,829  |  
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|Gross margin               |  |                            |  |      | 2,625                      |   |      |  |      |   | 9,290  |  
|Operating expenses         |  |                            |  |      | 2,147                      |   |      |  |      |   | 6,794  |  
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|Operating income           |  |                            |  |      | 478                        |   |      |  |      |   | 2,496  |  
|Interest and other expense |  |                            |  |      | (1,036                     | ) |      |  |      |   | (3,568 | )
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  
|Loss from operations       |  |                            |  | $    | (558                       | ) |      |  |      | $ | (1,072 | )
|                           |  |                             |  |      |                            |   |      |   |      |   |        |  



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Liquidity and Capital Resources



Cash used in operating activities was $4.7 million for YTD-2004 compared to $2.6 million in YTD-2003. Significant YTD-2004
changes included: 1) increase in accounts receivable of $554 thousand, primarily related to timing of sales in Q3-2004 (the majority of sales for the quarter occurred in June); 2) increase of $129 thousand in inventory primarily related to $86 of
development and prototype costs, for an updated rack unit, that have been capitalized and are being amortized over two years; 3) $651 thousand decrease in accounts payable and accrued liabilities that had accumulated prior to the Desktop Software
transaction; 4) a $221 thousand increase in unearned revenue related to Mediasite service plans; and 4) an increase in prepaid assets primarily related to $100 thousand of tax deposits In YTD-2003 we had significant cash flows from the collection of
accounts receivable related to the Desktop Software business and the release of a new upgrade to a Desktop Software product. In YTD-2003 operations included the Media Services division through mid May.



Cash used in investing activities was $4.8 million in YTD-2004. YTD-2003
included the sale of Media Services which netted $4.9 million. The $4.6 million of short-term investments at June 30, 2004 include certificates of deposits maturing between December 2004 and June 2005. We anticipate maintaining short-term
investments in the 3 to 12 month range. Investing activities for the current year also included net proceeds from the final settlements from the sales of the Companys Media Services and Desktop Software businesses. Fixed asset additions of
$369 thousand in YTD-2004 include leasehold improvements for new office space, various equipment purchases and a $75 thousand investment in tradeshow equipment.



Cash provided by financing activities was $1.4 million in YTD-2004. Nearly the entire amount received related to option and warrant exercise proceeds.
The majority of option and warrant holders who exercised were employees terminated in the Desktop Software transaction. In YTD-2004, we also received $13 thousand in proceeds from our Employee Stock Purchase Plan. Prior activity included significant
debt, interest and capital lease payments, offset by borrowed funds. All debt and all but $48 thousand of capital leases were paid off at or soon after the closing of the Desktop Software sale.



We believe we can fund at least the next 12 months of operations with funds
on hand and have no plans to pursue any debt or lease arrangements at this time. In order to fund long term cash requirements and/or pursue complimentary business strategies, we may evaluate the issuance of stock to investors or strategic partners.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Derivative Financial Instruments



The Company is not party to any derivative financial instruments or other financial instruments for which the fair value disclosure would be required under SFAS No. 107, Disclosures about Fair Value of Financial
Instruments. The Companys cash equivalents consist of overnight investments in money market funds that are carried at cost which approximates fair value. Accordingly, we believe that the market risk of such investments is minimal.



Interest Rate Risk



The Companys cash equivalents and short-term investments are subject
to interest rate fluctuations, however, we believe this risk is immaterial due to the short-term nature of these investments.



Foreign Currency Exchange Rate Risk



All international sales of our products are denominated in US dollars.



Item 4. CONTROLS AND PROCEDURES



Evaluation of
Disclosure Controls and Procedures



Based on evaluations
at June 30, 2004, our principal executive officer and principal financial officer, with the participation of our management team, have concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the
Securities Exchange Act) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in
the rules and regulations of the SEC.



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##### Table of Contents

Changes in Internal Controls



There were no significant changes in our internal controls or in other factors that could significantly affect these
internal controls subsequent to the date of their most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



PART II

OTHER INFORMATION



Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



The Annual Meeting of Stockholders was held on May 24, 2004. A quorum consisting of approximately 76.7% of the Companys common stock issued and outstanding was represented either in person or by proxy. At the
meeting the following proposals were approved by the stockholders:



| | 1. | To elect David C. Kleinman and Paul S. Peercy as Class 1 Directors and Gary R. Weis as Class V Director. Arnold B. Pollard, Frederick H. Kopko, Jr, Rimas P. Buinevicius and Monty R.
Schmidt continued as directors following the meeting.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | To vote on a Proposal to amend the 1995 Stock Option Plan by increasing the aggregate number of shares of the Companys Common Stock that may be subject to options thereunder
from 4,000,000 to 7,000,000 and to amend the last date upon which options may be granted from January 1, 2005 to January 1, 2010.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3. | To vote on a Proposal to amend the Non-Employee Directors Stock Option Plan by increasing the aggregate number of shares of the Companys Common Stock that may be subject to
options thereunder from 600,000 to 900,000.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 4. | To ratify the appointment of Ernst & Young LLP as independent auditors of Sonic Foundry for the year ending September 30, 2004.
| | -- | -------------------------------------------------------------------------------------------------------------------------------



|                  |  |            |  |           |  |                 
|----------------- |  | ---------- |  | --------- |  | ----------------
|                  |  | For        |  | Against   |  | Abstain/Withheld
|Proposal #1:      |  |            |  |           |  |                 
|David C. Kleinman |  | 22,110,092 |  |           |  | 556,139         
|Paul S. Peercy    |  | 22,277,662 |  |           |  | 388,569         
|Gary R. Weis      |  | 22,113,882 |  |           |  | 552,349         
|                  |  |            | 
|Proposal #2       |  | 7,363,113  |  | 1,647,328 |  | 55,961          
|                  |  |            | 
|Proposal #3       |  | 7,337,334  |  | 1,686,177 |  | 42,891          
|                  |  |            | 
|Proposal #4       |  | 22,416,609 |  | 230,419   |  | 19,203          



Item 6. EXHIBITS AND REPORTS ON FORM 8-K



|(a) | Exhibits (see exhibit list)
|--- | ---------------------------



|(b) | Reports on Form 8-K
|--- | -------------------



On May 11, 2004, Registrant filed a report dated May 11, 2004 on Items 7 and 12 of Form 8-K with respect to second quarter fiscal 2004 financial results.



On July 19, 2004, Registrant filed a report dated July 12,
2004 on Item 4 of Form 8-K with respect to dismissal of Ernst & Young LLP as its independent public accountants and the appointment of Grant Thornton LLP as its new independent public accountants.



On August 3, 2004, Registrant filed a report dated August 3, 2004 on Items 7
and 12 of Form 8-K with respect to third quarter fiscal 2004 financial results.



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##### Table of Contents

ITEM 6(a)



|       |  |                                                                                                                                                                                                                                                                                                                                                                 
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NUMBER |  | DESCRIPTION                                                                                                                                                                                                                                                                                                                                                     
|3.1    |  | Amended and Restated Articles of Incorporation of the Registrant, filed as Exhibit No. 3.1 to the registration statement on amendment No. 2 to Form SB-2 dated April 3, 1998 (Reg. No.
333-46005) (the Registration Statement), and hereby incorporated by reference.                                                                                         
|       | 
|3.2    |  | Amended and Restated By-Laws of the Registrant, filed as Exhibit No. 3.2 to the Registration Statement, and hereby incorporated by reference.                                                                                                                                                                                                                   
|       | 
|10.1*  |  | Registrants 1995 Stock Option Plan, as amended, filed as Exhibit No. 4.1 to the Registration Statement on Form S-8 on September 8, 2000, and hereby incorporated by
reference.                                                                                                                                                                                 
|       | 
|10.2*  |  | Registrants Non-Employee Directors Stock Option Plan, filed as Exhibit No. 10.2 to the Registration Statement, and hereby incorporated by reference.                                                                                                                                                                                                          
|       | 
|10.3*  |  | Employment Agreement between Registrant and Rimas Buinevicius dated as of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, and
hereby incorporated by reference.                                                                                                                               
|       | 
|10.4*  |  | Employment Agreement between Registrant and Monty R. Schmidt dated as of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, and
hereby incorporated by reference.                                                                                                                                
|       | 
|10.5   |  | Commercial Lease between Ewart Associates, L.P. and Sonic Foundry Systems Group, Inc. (now known as Sonic Foundry Media Systems, Inc.), regarding 925 Liberty Avenue, Pittsburgh, PA 15222,
dated November 30, 2001, filed as Exhibit No. 10.23 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference.
|       | 
|10.6*  |  | Registrants 2001 Deferred Compensation Plan, filed as Exhibit 4.4 to Form S-8 on November 21, 2001 and hereby incorporated by reference.                                                                                                                                                                                                                       
|       | 
|10.7*  |  | Registrants Amended 1999 Non-Qualified Plan, filed as Exhibit 4.1 to Form S-8 on December 21, 2001, and hereby incorporated by reference.                                                                                                                                                                                                                      
|       | 
|10.8   |  | Amended and Restated License Agreement effective October 15, 2001 between Carnegie Mellon University and MediaSite, Inc. filed as Exhibit No. 10.31 to the Quarterly Report on Form 10-Q for
the quarter ended March 31, 2002 , and hereby incorporated by reference.                                                                                           
|       | 
|10.9   |  | Warrant Agreement filed as Exhibit 10.1 to Registration Statement No. 333-98795 on Form S-3 filed on August 27, 2002 and hereby incorporated by reference.                                                                                                                                                                                                      
|       | 
|10.10  |  | Promissory Note between Registrant and Aris A. Buinevicius and Claire Horne for $1,250,000 dated November 18, 2002 filed as Exhibit No. 10.27 to the Quarterly Report on Form 10-Q for the
quarter ended December 31, 2002 and hereby incorporated by reference.                                                                                                
|       | 
|10.11  |  | Asset Purchase Agreement among Deluxe Media Services, Inc. the Registrant, Sonic Foundry Media Services, Inc. and International Image Services, Inc., dated April 30, 2003 filed as Exhibit
99.2 to Form 8-K filed on May 21, 2003, and hereby incorporated by reference.                                                                                       
|       | 
|10.12  |  | Amended and Restated Asset Purchase Agreement, incorporated by reference from Appendix A of Schedule 14A filed on June 19, 2003 and hereby incorporated by reference.                                                                                                                                                                                           
|       | 
|10.14  |  | Commercial Lease between West Washington Associates LLC and Sonic Foundry, Inc. regarding 222 West Washington Ave., Suite 775, Madison, WI, dated August 1, 2003 filed as Exhibit 10.21 to Form
10-K filed on December 23, 2003 and hereby incorporated by reference.                                                                                           



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##### Table of Contents

|     |  |                                                                                 
|---- |  | --------------------------------------------------------------------------------
|     | 
|31.1 |  | Section 302 Certification of Chief Executive Officer                            
|     | 
|31.2 |  | Section 302 Certification of Chief Financial Officer                            
|     | 
|32   |  | Section 906 Certification of Chief Executive Officer and Chief Financial Officer



Registrant will furnish upon request
to the Securities and Exchange Commission a copy of all exhibits, annexes and schedules attached to each contract referenced in item 10.

---

|* | Compensatory Plan or Arrangement
|- | --------------------------------



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##### Table of Contents

SIGNATURES



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



|               |  |                     |  |                                                          
|-------------- |  | ------------------- |  | ---------------------------------------------------------
|               |  | Sonic Foundry, Inc.
|               |  | (Registrant)       
|               |  |                    
|August 6, 2004 |  | By:                 |  | /s/ Rimas P. Buinevicius                                 
|               |  |                     |  | Rimas P. Buinevicius Chairman and Chief Executive Officer
|               |  |                    
|August 6, 2004 |  | By:                 |  | /s/ Kenneth A. Minor                                     
|               |  |                     |  | Kenneth A. Minor Chief Financial Officer and Secretary   



19