##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



---



FORM 10-Q



---



(Mark One)

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



For the quarterly period ended September 30, 2005



OR



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



For the transition period  to



Commission File Number 000-50640



---



SUMTOTAL SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 42-1607228                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



1808 North Shoreline
Boulevard

Mountain View, California 94043

(Address of principal executive offices, including zip code)



(650) 934-9500

(Registrants telephone number, including area code)



---



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  x    No ̈



Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act.):    Yes ̈No  x



The number of shares
outstanding of the issuers Common Stock, par value $0.001, including shares held in escrow, as of November 2, 2005 was approximately 25,174,112 shares.



---



---

##### Table of Contents

SUMTOTAL SYSTEMS, INC.



FORM 10Q



For the Quarter Ended September 30, 2005



TABLE OF CONTENTS



|                               |  |                                                                                                                 |  |   
|------------------------------ |  | --------------------------------------------------------------------------------------------------------------- |  | --
|                               |  | Page                                                                                                           
|PART I 
FINANCIAL INFORMATION |  |                                                                                                                
|                               |  |                                                                                                                
|Item 1.                        |  | Condensed Consolidated Financial Statements (unaudited)                                                         |  |   
|                               |  | Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004                            |  | 3 
|                               |  | Condensed Consolidated Statements of Operations for the three and nine-months ended September 30, 2005 and 2004 |  | 4 
|                               |  | Condensed Consolidated Statements of Cash Flows for the nine-months ended September 30, 2005 and 2004           |  | 5 
|                               |  | Notes to the unaudited Condensed Consolidated Financial Statements                                              |  | 6 
|                               |  |                                                                                                                
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                           |  | 19
|                               |  |                                                                                                                
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                                                      |  | 42
|                               |  |                                                                                                                
|Item 4.                        |  | Controls and Procedures                                                                                         |  | 42
|                               | 
|PART II 
OTHER INFORMATION    |  |                                                                                                                
|                               |  |                                                                                                                
|Item 1.                        |  | Legal Proceedings                                                                                               |  | 46
|                               |  |                                                                                                                
|Item 2.                        |  | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                |  | 46
|                               |  |                                                                                                                
|Item 3.                        |  | Defaults upon Senior Securities                                                                                 |  | 46
|                               |  |                                                                                                                
|Item 4.                        |  | Submission of Matters to a Vote of Securities Holders                                                           |  | 47
|                               |  |                                                                                                                
|Item 5.                        |  | Other Information                                                                                               |  | 47
|                               |  |                                                                                                                
|Item 6.                        |  | Exhibits                                                                                                        |  | 47
|                               | 
|SIGNATURES                     |  | 48                                                                                                             



2



---

##### Table of Contents

PART I  FINANCIAL INFORMATION



Item 1. Consolidated Financial Statements



SUMTOTAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands)



|                                                                                                             |  |                    |          |   |                   |   |          |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------ | -------- | - | ----------------- | - | -------- | -
|                                                                                                             |  | September 30, 2005 |          |   | December 31, 2004 |  
|Assets                                                                                                       |  |                    |          |   |                   |   |          |  
|Current assets:                                                                                              |  |                    |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                    |  | $                  | 29,554   |   |                   | $ | 25,508   |  
|Restricted cash                                                                                              |  |                    | 82       |   |                   |   | 82       |  
|Short-term investments                                                                                       |  |                    | 3,610    |   |                   |   | 9,128    |  
|Accounts receivable, net of allowance for sales returns and doubtful accounts of $926 and $729, respectively |  |                    | 13,872   |   |                   |   | 18,531   |  
|Prepaid expenses and other current assets                                                                    |  |                    | 3,989    |   |                   |   | 1,781    |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Total current assets                                                                                         |  |                    | 51,107   |   |                   |   | 55,030   |  
|                                                                                                             |  |                   
|Property and equipment, net                                                                                  |  |                    | 3,391    |   |                   |   | 2,472    |  
|Goodwill                                                                                                     |  |                    | 27,659   |   |                   |   | 27,659   |  
|Intangible assets, net                                                                                       |  |                    | 6,650    |   |                   |   | 9,491    |  
|Other assets                                                                                                 |  |                    | 1,133    |   |                   |   | 1,140    |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Total assets                                                                                                 |  | $                  | 89,940   |   |                   | $ | 95,792   |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Liabilities and Stockholders Equity                                                                         |  |                    |          |   |                   |   |          |  
|Current liabilities:                                                                                         |  |                    |          |   |                   |   |          |  
|Accounts payable                                                                                             |  | $                  | 2,161    |   |                   | $ | 3,334    |  
|Accrued compensation and benefits                                                                            |  |                    | 3,445    |   |                   |   | 5,148    |  
|Other accrued liabilities                                                                                    |  |                    | 3,434    |   |                   |   | 3,403    |  
|Restructuring accrual                                                                                        |  |                    | 104      |   |                   |   | 506      |  
|Deferred revenue                                                                                             |  |                    | 15,893   |   |                   |   | 14,749   |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Total current liabilities                                                                                    |  |                    | 25,037   |   |                   |   | 27,140   |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Other accrued liabilities, non-current                                                                       |  |                    | 154      |   |                   |   |         |  
|Deferred revenue, non-current                                                                                |  |                    | 117      |   |                   |   | 373      |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Total liabilities                                                                                            |  |                    | 25,308   |   |                   |   | 27,513   |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Commitments and contingencies                                                                                |  |                    |          |   |                   |   |          |  
|                                                                                                             |  |                   
|Stockholders equity:                                                                                        |  |                    |          |   |                   |   |          |  
|Preferred stock                                                                                              |  |                    |         |   |                   |   |         |  
|Common stock                                                                                                 |  |                    | 21       |   |                   |   | 21       |  
|Additional paid-in capital                                                                                   |  |                    | 323,799  |   |                   |   | 321,620  |  
|Deferred stock-based compensation                                                                            |  |                    | (1,394   | ) |                   |   | (1,012   | )
|Accumulated other comprehensive income (loss)                                                                |  |                    | 253      |   |                   |   | (150     | )
|Accumulated deficit                                                                                          |  |                    | (258,047 | ) |                   |   | (252,200 | )
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Total stockholders equity                                                                                   |  |                    | 64,632   |   |                   |   | 68,279   |  
|                                                                                                             |  |                    |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                   |  | $                  | 89,940   |   |                   | $ | 95,792   |  
|                                                                                                             |  |                    |          |   |                   |   |          |  



Refer to the
accompanying Notes to the unaudited Condensed Consolidated Financial Statements.



3



---

##### Table of Contents

SUMTOTAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)



|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|--------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                                          |  | Three-MonthsEnded September 30, |        |   | Nine-Months Ended September 30, |  
|                                                          |  | 2005                            |        |   | 2004                            |   |        | 2005 |  |   | 2004   |  
|Revenue:                                                  |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|License                                                   |  | $                               | 6,629  |   |                                 | $ | 5,634  |      |  | $ | 17,286 |   |  | $ | 13,762  |  
|Service and maintenance                                   |  |                                 | 11,780 |   |                                 |   | 9,653  |      |  |   | 33,750 |   |  |   | 22,714  |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Total revenue                                             |  |                                 | 18,409 |   |                                 |   | 15,287 |      |  |   | 51,036 |   |  |   | 36,476  |  
|Cost of revenue:                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|License                                                   |  |                                 | 212    |   |                                 |   | 168    |      |  |   | 1,072  |   |  |   | 372     |  
|Service and maintenance                                   |  |                                 | 5,368  |   |                                 |   | 4,614  |      |  |   | 15,368 |   |  |   | 12,370  |  
|Amortization of intangible assets                         |  |                                 | 742    |   |                                 |   | 1,507  |      |  |   | 2,841  |   |  |   | 3,408   |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Total cost of revenue                                     |  |                                 | 6,322  |   |                                 |   | 6,289  |      |  |   | 19,281 |   |  |   | 16,150  |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Gross margin                                              |  |                                 | 12,087 |   |                                 |   | 8,998  |      |  |   | 31,755 |   |  |   | 20,326  |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Operating expenses:                                       |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Research and development                                  |  |                                 | 3,068  |   |                                 |   | 2,910  |      |  |   | 8,897  |   |  |   | 8,192   |  
|Sales and marketing                                       |  |                                 | 5,673  |   |                                 |   | 5,527  |      |  |   | 17,800 |   |  |   | 15,567  |  
|General and administrative                                |  |                                 | 3,288  |   |                                 |   | 2,965  |      |  |   | 10,899 |   |  |   | 7,883   |  
|Restructuring charge                                      |  |                                 |       |   |                                 |   |       |      |  |   |       |   |  |   | 1,137   |  
|In-process research and development                       |  |                                 |       |   |                                 |   |       |      |  |   |       |   |  |   | 1,326   |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Total operating expenses                                  |  |                                 | 12,029 |   |                                 |   | 11,402 |      |  |   | 37,596 |   |  |   | 34,105  |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Income (loss) from operations                             |  |                                 | 58     |   |                                 |   | (2,404 | )    |  |   | (5,841 | ) |  |   | (13,779 | )
|Interest expense                                          |  |                                 | (4     | ) |                                 |   |       |      |  |   | (5     | ) |  |   | (121    | )
|Interest income                                           |  |                                 | 227    |   |                                 |   | 97     |      |  |   | 582    |   |  |   | 203     |  
|Other income (expense), net                               |  |                                 | (121   | ) |                                 |   | 42     |      |  |   | (493   | ) |  |   | (241    | )
|Equity in losses of an affiliate                          |  |                                 |       |   |                                 |   |       |      |  |   |       |   |  |   | (169    | )
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Income (loss) before provision (benefit) for income taxes |  |                                 | 160    |   |                                 |   | (2,265 | )    |  |   | (5,757 | ) |  |   | (14,107 | )
|Provision (benefit) for income taxes                      |  |                                 | 29     |   |                                 |   | (47    | )    |  |   | 90     |   |  |   | 29      |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net income (loss)                                         |  | $                               | 131    |   |                                 | $ | (2,218 | )    |  | $ | (5,847 | ) |  | $ | (14,136 | )
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net income (loss) per share, basic                        |  | $                               | 0.01   |   |                                 | $ | (0.11  | )    |  | $ | (0.28  | ) |  | $ | (0.80   | )
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net income (loss) per share, diluted                      |  | $                               | 0.01   |   |                                 | $ | (0.11  | )    |  | $ | (0.28  | ) |  | $ | (0.80   | )
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Weighted average common shares outstanding, basic         |  |                                 | 21,207 |   |                                 |   | 20,535 |      |  |   | 20,973 |   |  |   | 17,601  |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Weighted average common shares outstanding, diluted       |  |                                 | 21,550 |   |                                 |   | 20,535 |      |  |   | 20,973 |   |  |   | 17,601  |  
|                                                          |  |                                 |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  



Refer to the
accompanying Notes to the unaudited Condensed Consolidated Financial Statements.



4



---

##### Table of Contents

SUMTOTAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



|                                                                                          |  |                                 |        |   |      |   |         |  
|----------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------- | -
|                                                                                          |  | Nine-Months Ended September 30, |       
|                                                                                          |  | 2005                            |        |   | 2004 |  
|Cash flows from operating activities:                                                     |  |                                 |        |   |      |   |         |  
|Net loss                                                                                  |  | $                               | (5,847 | ) |      | $ | (14,136 | )
|Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |  |                                 |        |   |      |   |         |  
|Depreciation and amortization                                                             |  |                                 | 1,320  |   |      |   | 1,151   |  
|Amortization of intangible assets                                                         |  |                                 | 2,841  |   |      |   | 3,426   |  
|Accretion of interest on short-term investments                                           |  |                                 | (121   | ) |      |   |        |  
|Loss on disposal of property and equipment                                                |  |                                 | 49     |   |      |   | 394     |  
|Provision for (recovery of) sales returns and doubtful accounts                           |  |                                 | 197    |   |      |   | (212    | )
|Amortization of discount on debt                                                          |  |                                 |       |   |      |   | 89      |  
|Stock-based compensation                                                                  |  |                                 | 712    |   |      |   | 1,119   |  
|In-process research and development                                                       |  |                                 |       |   |      |   | 1,326   |  
|Equity in losses of an affiliate                                                          |  |                                 |       |   |      |   | 169     |  
|Changes in assets and liabilities, net of effects of acquisitions:                        |  |                                 |        |   |      |   |         |  
|Accounts receivable                                                                       |  |                                 | 4,462  |   |      |   | 6,368   |  
|Prepaid expenses and other assets                                                         |  |                                 | (485   | ) |      |   | 297     |  
|Other assets                                                                              |  |                                 | 7      |   |      |   | 1,100   |  
|Accounts payable                                                                          |  |                                 | (1,173 | ) |      |   | (382    | )
|Accrued compensation and benefits                                                         |  |                                 | (1,703 | ) |      |   | (726    | )
|Other accrued liabilities                                                                 |  |                                 | 185    |   |      |   | (1,947  | )
|Restructuring accrual                                                                     |  |                                 | (402   | ) |      |   | (79     | )
|Deferred revenue                                                                          |  |                                 | 888    |   |      |   | 2,481   |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Net cash provided by operating activities                                                 |  |                                 | 930    |   |      |   | 438     |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Cash flows from investing activities:                                                     |  |                                 |        |   |      |   |         |  
|Purchases of property and equipment                                                       |  |                                 | (2,322 | ) |      |   | (664    | )
|Proceeds on sale of property and equipment                                                |  |                                 | 19     |   |      |   |        |  
|Cash acquired in acquisitions, net of cash payments                                       |  |                                 |       |   |      |   | 25,432  |  
|Cash used in asset purchase agreements, net of cash received                              |  |                                 |       |   |      |   | (488    | )
|Purchases of restricted cash                                                              |  |                                 |       |   |      |   | (54     | )
|Sales of restricted cash                                                                  |  |                                 |       |   |      |   | 125     |  
|Purchases of short-term investments                                                       |  |                                 | (6,877 | ) |      |   | (4,544  | )
|Sales of short-term investments                                                           |  |                                 | 12,516 |   |      |   | 2,998   |  
|Capitalized costs associated with pending acquisition                                     |  |                                 | (1,723 | ) |      |   |        |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Net cash provided by investing activities                                                 |  |                                 | 1,613  |   |      |   | 22,805  |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Cash flows from financing activities:                                                     |  |                                 |        |   |      |   |         |  
|Repayments on line of credit                                                              |  |                                 |       |   |      |   | (3,974  | )
|Proceeds from the issuance of common stock and exercises of common stock options          |  |                                 | 1,085  |   |      |   | 1,030   |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Net cash provided by (used in) financing activities                                       |  |                                 | 1,085  |   |      |   | (2,944  | )
|                                                                                          |  |                                 |        |   |      |   |         |  
|Effect of foreign exchange rate changes on cash and cash equivalents                      |  |                                 | 418    |   |      |   | 340     |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Net increase in cash and cash equivalents                                                 |  |                                 | 4,046  |   |      |   | 20,639  |  
|Cash and cash equivalents at beginning of period                                          |  |                                 | 25,508 |   |      |   | 12,709  |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Cash and cash equivalents at end of period                                                |  | $                               | 29,554 |   |      | $ | 33,348  |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Supplemental disclosure of cash flow information                                          |  |                                 |        |   |      |   |         |  
|Interest paid                                                                             |  | $                               | 5      |   |      | $ | 121     |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Taxes paid                                                                                |  | $                               | 203    |   |      | $ | 69      |  
|                                                                                          |  |                                 |        |   |      |   |         |  
|Supplemental disclosure of non-cash investing and financing activities                    |  |                                 |        |   |      |   |         |  
|Common stock issued in acquisition of Docent, Inc.                                        |  | $                               |       |   |      | $ | 55,663  |  
|                                                                                          |  |                                 |        |   |      |   |         |  



Refer to the
accompanying Notes to the unaudited Condensed Consolidated Financial Statements.



5



---

##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



NOTE 1: DESCRIPTION OF BUSINESS



SumTotal Systems, Inc. develops, markets, distributes and supports an integrated suite of enterprise learning software products. SumTotal Systems
markets are worldwide and include a broad range of industries. SumTotal Systems was formed on March 18, 2004, as a result of the acquisition of Docent by Click2learn, Inc. (Click2learn). The terms SumTotal Systems,
SumTotal and the Company refer to Click2learn prior to March 18, 2004 and SumTotal Systems, Inc. thereafter.



NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Basis of Presentation



The accompanying financial data as of September 30, 2005, and for the three and nine-months ended September 30, 2005 and 2004 has been prepared
by SumTotal Systems, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States (GAAP) have been condensed or omitted pursuant to such rules and regulations. Certain other insignificant amounts have been reclassified to conform to the current period presentation.
The December 31, 2004 Condensed Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by GAAP. However, SumTotal Systems believes that the disclosures are adequate to make the
information presented not misleading.



In the opinion of
management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (which include normal recurring adjustments, except as disclosed herein) necessary to present fairly SumTotal Systems financial
position, results of operations and cash flows for the interim periods presented. The results of operations for the three and nine-months ended September 30, 2005 are not necessarily indicative of the operating results for the full fiscal year
or any future periods.



Principles of Consolidation



The accompanying unaudited condensed consolidated financial statements
include the financial statements of SumTotal Systems and its wholly owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation. Investments in a 20% to 50% owned company, which consisted only of Click2learn
Japan KK, were accounted for using the equity method of accounting in the three and nine-months ended September 30, 2004. On August 5, 2004, we sold our interest in Click2learn Japan KK to Softbank Media and Marketing, and as a result, we
no longer have any equity related expenses relating to the losses of this company.



Use of Estimates



The preparation of
financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements
and reported amounts of revenue and expenses during the reporting period. Such estimates and assumptions are based on historical experience, where applicable, and other assumptions. On an ongoing basis, SumTotal Systems evaluates estimates,
including those related to revenue, the allowance for sales returns and doubtful accounts, intangible assets and restructuring. Actual results could differ from those estimates.



Revenue Recognition



SumTotal Systems recognizes revenue pursuant to the requirements of AICPA Statement of Position (SOP) No. 97-2, Software Revenue
Recognition, as amended by SOP No. 98-9, Software Revenue Recognition with Respect to Certain Arrangements. Under SOP No. 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence
of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable and collectability is probable.



For all sales, SumTotal Systems typically uses either a binding purchase order or signed agreement, depending on the nature of the transaction, as
evidence of an arrangement. Sales through its significant resellers are evidenced by a master agreement governing the relationship.



6



---

##### Table of Contents

Enterprise customers have the option of purchasing perpetual licenses, time-based licenses or
subscription license bundles that include hosting and maintenance and support. For perpetual software license fees in arrangements that do not include customization or consulting services, delivery typically is deemed to occur when the product is
shipped to customers. SumTotal Systems subscription licenses require license holders to pay a monthly fee, which is based on the number of users. SumTotal Systems recognizes revenue on subscription license bundles on a straight-line basis over
the life of the subscription and records the revenue as service and maintenance revenue. Customers with perpetual or time-based licenses may also outsource to SumTotal Systems the hosting of their system on a third partys server for a monthly
fee and an initial set-up fee, which is recognized ratably over the initial hosting period.



At the time of each transaction, SumTotal Systems assesses whether the software license fee associated with its revenue is fixed or determinable and whether or not collection is probable. If a significant portion of a
fee is due after SumTotal Systems normal payment terms, currently up to net ninety days (payment terms beyond ninety days are considered to be extended terms), then SumTotal Systems does not consider the fee to be fixed or determinable. In
these cases, revenue is deferred and recognized when payments become due and payable.



Probability of collection is based on a number of factors, including past transaction history with the customer and the current financial condition of the customer. Collateral is not requested from customers. If
SumTotal Systems determines at the time of the transaction that collection of a fee is not probable, revenue is deferred until the time collection becomes reasonably assured, generally when payment is received.



For multiple element arrangements, when Company-specific objective evidence
of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one of the delivered elements in the arrangement SumTotal Systems recognizes revenue under the residual method. Under the residual method, at the
outset of the arrangement with a customer, revenue is deferred for the fair value of its undelivered elements such as consulting services and product support and upgrades, and revenue is recognized for the remainder of the arrangement fee
attributable to the elements initially delivered, such as software licenses, when the criteria in SOP No. 97-2 have been met. Company-specific objective evidence is established for support and upgrades of standard products based upon the
amounts that SumTotal Systems charges when support and upgrades are sold separately. Company-specific objective evidence is established for consulting and installation services based on the hourly rates SumTotal Systems charges for its employees
when they are performing these services provided SumTotal Systems has the ability to accurately estimate the hours required to complete a project based upon its experience with similar projects.



SumTotal Systems also earns revenues from services performed in connection
with consulting arrangements. For those contracts that include contract milestones or acceptance criteria, SumTotal Systems recognizes revenue as such milestones are achieved or as such acceptance occurs. In some instances, the acceptance criteria
in the contract requires acceptance after all services are complete and all other elements have been delivered. Revenue recognition is deferred until those requirements are met.



Professional services under fixed price contracts are recognized proportionally as services are provided or, if available,
by using output measures such as milestones. Provisions for any estimated losses on uncompleted contracts are made in the period in which such losses become evident. Professional services from time and materials contracts and training services are
recognized as services are performed.



Revenue from
non-refundable minimum royalty agreements from distributors or resellers is recognized upon delivery of the product to the distributor or reseller, provided no significant obligations remain outstanding and the conditions of SOP No. 97-2 have
been met. If minimum royalties are exceeded, the additional royalties are recognized as revenue when earned, based upon the receipt of royalty reports.



Revenue from time-based licenses, subscription licenses, hosting agreements and support agreements is recognized on a straight-line basis over the life of
the contract. SumTotal Systems typically bills these contracts in advance and records the billed amounts in deferred revenue.



Net Income (Loss) Per Share



Basic and diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of shares of
common stock outstanding during the period, less outstanding unvested shares. The calculation of diluted net loss per share excludes potential common shares, the effect of which are anti-dilutive. Potential common shares are comprised of common
stock subject to repurchase rights, incremental shares of common stock issuable upon the exercise of stock options or warrants.



7



---

##### Table of Contents

Excluded from the computation of diluted income (loss) per share for the three-months ended
September 30, 2005 are out-of-the-money options to acquire approximately 3,335,103 shares of common stock with a weighted average share price of $10.71 and warrants to acquire approximately 1,642,437 shares of common stock with a weighted
average share price of $8.50 because their effects would be anti-dilutive. Excluded from the computation of diluted loss per share for the three-months ended September 30, 2004 are options to acquire approximately 2,478,172 shares of common
stock with a weighted average share price of $10.91 and warrants to acquire approximately 1,967,034 shares of common stock with a weighted average share price of $10.33 because their effects would be anti-dilutive.



Excluded from the computation of diluted loss per share for the nine-months
ended September 30, 2005 are options to acquire approximately 4,312,780 shares of common stock with a weighted average share price of $8.94 and warrants to acquire approximately 1,642,437 shares of common stock with a weighted average share
price of $8.50 because their effects would be anti-dilutive. Excluded from the computation of diluted loss per share for the nine-months ended September 30, 2004 are options to acquire approximately 2,455,571 shares of common stock with a
weighted average share price of $10.93 and warrants to acquire approximately 1,967,034 shares of common stock with a weighted average share price of $10.33 because their effects would be anti-dilutive.



Comprehensive Loss and Accumulated Other Comprehensive Loss



The following table sets forth the components of comprehensive loss for the
three and nine-months ended September 30, 2005 and 2004 presented below (in thousands):



|                                        |  |                                 |     |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|--------------------------------------- |  | ------------------------------- | --- | - | ------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                        |  | Three-MonthsEnded September 30, |     |   | Nine-Months Ended September 30, |  
|                                        |  | 2005                            |     |   | 2004                            |   |        | 2005 |  |   | 2004   |  
|Net income (loss)                       |  | $                               | 131 |   |                                 | $ | (2,218 | )    |  | $ | (5,847 | ) |  | $ | (14,136 | )
|Unrealized loss on investments          |  |                                 | (8  | ) |                                 |   |       |      |  |   | (15    | ) |  |   |        |  
|Foreign currency translation adjustment |  |                                 | 82  |   |                                 |   | (51    | )    |  |   | 418    |   |  |   | (340    | )
|                                        |  |                                 |     |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|                                        |  | $                               | 205 |   |                                 | $ | (2,269 | )    |  | $ | (5,444 | ) |  | $ | (14,476 | )
|                                        |  |                                 |     |   |                                 |   |        |      |  |   |        |   |  |   |         |  



SumTotal Systems
total comprehensive loss for the three and nine-months ended September 30, 2005 and 2004 consisted of net loss, unrealized loss on investments and the change in foreign currency translation adjustments. The tax effects on the unrealized loss on
investments and foreign currency translation adjustments have not been significant. Accumulated other comprehensive loss consists of an unrealized gain on foreign currency translation adjustments of $286,000 and an unrealized loss of $132,000 at
September 30, 2005 and December 31, 2004, respectively, and an unrealized loss on investments of $33,000 and $18,000 at September 30, 2005 and December 31, 2004, respectively.



Stock-Based Compensation



The intrinsic-value-based method of accounting prescribed by Accounting
Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees,and related interpretations including Financial Accounting Standards Board (FASB) Interpretation Number (FIN)
No. 44,Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB 25, has been applied to account for SumTotal Systems fixed-plan stock options. Under this method, compensation expense is recorded
only if the current market price of the underlying stock exceeded the exercise price on the date of the grant. SFAS No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a
fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, SumTotal Systems has elected to continue to apply the intrinsic-value-based method of accounting described above and has adopted only
the disclosure requirements of SFAS No. 123.



In December
2004, the FASB issued SFAS No. 123R, Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or
liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions
using the intrinsic value method as prescribed by APB No. 25, Accounting for Stock Issued to Employees, and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in the
consolidated statement of operations. The statement requires companies to assess the most appropriate model to calculate the value of the options. SumTotal Systems currently uses the Black-Scholes option pricing model to value options and is
currently assessing which model SumTotal Systems may use in the future under the statement and may deem an alternative model to be the most appropriate. The use of a different model to value options may result in a different fair value than the use
of the Black-Scholes option pricing model. In addition, there are a number of other requirements under the new standard



8



---

##### Table of Contents

that will result in differing accounting treatment than currently required. These differences include, but are not
limited to, the accounting for the tax benefit on employee stock options and for stock issued under the Employee Stock Purchase Plan (ESPP). In addition to the appropriate fair value model to be used for valuing share-based payments, we
will also be required to determine the transition method to be used at the date of adoption. SumTotal Systems will account for SFAS No. 123R under the prospective transition method beginning in the first fiscal quarter of 2006, which requires
that compensation expense be recorded for all unvested stock options and restricted stock.



Upon adoption, this statement will have a significant impact on SumTotal Systems consolidated financial statements as SumTotal Systems will be required to expense the fair value of its stock option grants and
stock purchases under the ESPP rather than disclose the impact on the consolidated net loss within the footnotes as is the current practice. The amounts disclosed within the footnotes are not necessarily indicative of the amounts that will be
expensed upon the adoption of SFAS No. 123R. Compensation expense calculated under SFAS No. 123R may differ from amounts currently disclosed within the footnotes based on changes in the fair value of SumTotal Systems common stock,
changes in the number of options granted or the terms of such options, the treatment of tax benefits and changes in interest rates or other factors. In addition, upon adoption of SFAS No. 123R, SumTotal Systems may choose to use a different
valuation model to value the compensation expense associated with employee stock options.



On May 31, 2005, the Board of Directors of SumTotal Systems approved the acceleration of vesting of certain unvested and out-of-the-money stock options with exercise prices equal to or greater than $5.60 per
share previously awarded to its employees, including its Section 16 officers, under each of the SumTotal Systems equity compensation plans. This approval was based on a recommendation of the Compensation Committee of the Board of
Directors, which consists entirely of independent directors, and the exercise price of $5.60 per share reflects an approximate 10% premium over the average closing price of SumTotal Systems common stock over the previous ninety days. The
acceleration of vesting was effective for stock options outstanding as of May 20, 2005. Options to purchase approximately 1.6 million shares of common stock, or 64% of SumTotal Systems then outstanding unvested options, 446,000 of
which are held by Section 16 Officers, became fully exercisable on August 1, 2005.



The purpose of the acceleration was to enable SumTotal Systems to avoid recognizing the future compensation expense associated with the unvested options upon adoption of SFAS No. 123R, Share-Based Payment.
The pre-tax charge to be avoided amounts to approximately $7.0 million over the course of the remainder of the original vesting periods, which, on average, is approximately 1.9 years from January 1, 2006. The acceleration of the vesting of
these options did not result in a charge under APB No. 25, as the exercise price of these options exceeded the fair value of the common stock on the date of the modification. SumTotal Systems also believes that because the options accelerated
have exercise prices in excess of the current market value of the SumTotal Systems common stock, the options have limited economic value and are not fully achieving their original objective of incentive compensation and employee retention.



The following table displays the impact to the net loss if
SumTotal Systems were to use the fair value method in SFAS No. 123,Accounting for Stock-Based Compensation:



|                                                                                                                      |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                      |  | Three-Months Ended September 30, |        |   | Nine-Months Ended September 30, |  
|                                                                                                                      |  | 2005                             |        |   | 2004                            |   |        | 2005 |  |   | 2004    |  
|Net income (loss), as reported                                                                                        |  | $                                | 131    |   |                                 | $ | (2,218 | )    |  | $ | (5,847  | ) |  | $ | (14,136 | )
|Add: Stock-based employee compensation expenses included in reported net loss, net of tax                             |  |                                  | 329    |   |                                 |   | 274    |      |  |   | 712     |   |  |   | 1,119   |  
|Deduct: Stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax |  | $                                | (992   | ) |                                 | $ | (2,252 | )    |  | $ | (12,835 | ) |  | $ | (5,359  | )
|                                                                                                                      |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Pro forma net loss                                                                                                    |  | $                                | (532   | ) |                                 | $ | (4,196 | )    |  | $ | (17,970 | ) |  | $ | (18,376 | )
|                                                                                                                      |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Weighted average common shares outstanding, basic and diluted                                                         |  |                                  | 21,207 |   |                                 |   | 20,535 |      |  |   | 20,973  |   |  |   | 17,601  |  
|                                                                                                                      |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share, basic and diluted:                                                                                |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|As reported                                                                                                           |  | $                                | 0.01   |   |                                 | $ | (0.11  | )    |  | $ | (0.28   | ) |  | $ | (0.80   | )
|Pro forma                                                                                                             |  | $                                | (0.03  | ) |                                 | $ | (0.20  | )    |  | $ | (0.86   | ) |  | $ | (1.04   | )



9



---

##### Table of Contents

These pro forma amounts may not be representative of the effects on reported net loss for future years as
options vest over several years and additional awards are generally made each year.



The weighted average fair value of options granted was $4.45 and $4.84 for the three-months ended September 30, 2005 and 2004, respectively. The weighted average fair value of options granted was $4.52 and $6.21
for the nine-months ended September 30, 2005 and 2004, respectively. SumTotal Systems calculated the value of stock-based awards on the date of grant using the Black-Scholes option pricing model based on the assumptions set forth in the
following table for the three and nine-months ended September 30, 2005 and 2004, respectively:



|                          |  |                                  |  |                                  |  |                                 |  |                                 |  |                    |  |               |  |          |  |              
|------------------------- |  | -------------------------------- |  | -------------------------------- |  | ------------------------------- |  | ------------------------------- |  | ------------------ |  | ------------- |  | -------- |  | -------------
|                          |  | Options                          |  | Employee Stock Purchase Plan     |  | Options                         |  | Employee StockPurchase Plan    
|                          |  | Three-Months Ended September 30, |  | Three-Months Ended September 30, |  | Nine-Months Ended September 30, |  | Nine-Months Ended September 30,
|                          |  | 2005                             |  | 2004                             |  | 2005                            |  | 2004                            |  | 2005               |  | 2004          |  | 2005     |  | 2004         
|Dividend yield            |  | 0%                               |  | 0%                               |  |                                |  | 0%                              |  | 0%                 |  | 0%            |  | 0%       |  | 0%           
|Volatility                |  | 1.06                             |  | 1.15                             |  |                                |  | 0.59                            |  | 1.06  1.08        |  | 1.15  1.20   |  | 0.39     |  | 0.59  0.79  
|Risk free interest rates  |  | 3.85% - 4.16%                    |  | 3.32% - 3.74%                    |  |                                |  | 1.77%                           |  | 3.63%  4.16%      |  | 1.48% - 3.86% |  | 2.79%    |  | 1.01% - 1.77%
|Expected lives of options |  | 1 day - 4 years                  |  | 5 years                          |  |                                |  | 6 months                        |  | 1 day - 4.19 years |  | 1 - 5 years   |  | 6 months |  | 6 months     



In the three-months
ended September 30, 2005 and 2004, stock-based compensation expense relating to common stock options and restricted stock was $329,000 and $274,000, respectively. Stock-based compensation expense relating to common stock options issued to
former Docent employees was $119,000 and $274,000 for the nine-months ended September 30, 2005 and 2004, respectively. Stock-based compensation expense relating to restricted stock options issued to certain executives was $74,000 for the
three-months ended September 30, 2005. Stock-based compensation expense relating to the extension of the cancellation date for certain common stock options held by terminated employees was $136,000 for the three-months ended September 30,
2005.



In the nine-months ended September 30, 2005 and
2004, SumTotal Systems recorded $712,000 and $1,119,000 in stock-based compensation expense relating to common stock options and restricted stock, respectively. Stock-based compensation expense relating to common stock options issued to former
Docent employees was $472,000 and $595,000 for the nine-months ended September 30, 2005 and 2004, respectively. In the nine-months ended September 30, 2005, stock-based compensation expense relating to restricted stock options issued to
certain executives was $104,000. In the nine-months ended September 30, 2005, stock-based compensation expense relating to the extension of the cancellation date for certain common stock options held by terminated employees was $136,000. In the
nine-months ended September 30, 2004, SumTotal Systems recognized $291,000 as a result of accelerated options vesting to certain employees and $233,000 as a result of increasing the amount of shares available for purchase in the SumTotal
Systems ESPP as a result of the acquisition of Docent.



Recent Accounting
Pronouncements



In June 2005, the FASB ratified
the EITFs Issue No. 05-06, Determining the Amortization Period for Leasehold Improvements. EITF No. 05-06 provides that the amortization period used for leasehold improvements acquired in a business combination or purchased
significantly after the inception of a lease be the shorter of (a) the useful life of the assets or (b) a term that includes required lease periods and renewals that are reasonably assured upon the acquisition or the purchase. The
provisions of EITF No. 05-06 are effective on a prospective basis for leasehold improvements purchased or acquired beginning in our first quarter of fiscal 2006. SumTotal Systems does not believe the adoption of EITF No. 05-06 will have a
material effect on its consolidated financial position, results of operations or cash flows.



In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting
Changes in Interim Financial Statements. SFAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles required recognition of a
cumulative effect adjustment within net income of the period of the change. SFAS No. 154 requires retrospective application to prior periods financial



10



---

##### Table of Contents

statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the
change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, it does not change the transition provisions of any existing accounting pronouncements. SumTotal Systems does not
believe the adoption of SFAS No. 154 will have a material effect on its consolidated financial position, results of operations or cash flows.



In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-1, Application of FASB Statement No. 109, Accounting for
Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (AJCA), which introduces a special 9% tax deduction on qualified production activities. FSP No. 109-1
clarifies that this tax deduction should be accounted for as a special tax deduction in accordance with SFAS No. 109. SumTotal Systems will not be able to claim this tax benefit until the fourth quarter of fiscal 2005. The adoption of these new
tax provisions is not expected to have a material impact on SumTotal Systems consolidated financial position, results of operations or cash flows.



In December 2004, the FASB issued FSP No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the
American Jobs Creations Act of 2004. The AJCA introduces a limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a United States (U.S.) taxpayer (repatriation provision),
provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance for the repatriation provision. SumTotal Systems has not completed its evaluation of the effects of the repatriation provision and expects to complete
the evaluation during the fourth quarter of 2005.



In
December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.SFAS No. 153 addresses the measurement of exchanges of nonmonetary
assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for nonmonetary asset exchanges beginning in our first quarter of fiscal 2006. SumTotal Systems
does not believe the adoption of SFAS No. 153 will have a material effect on its consolidated financial position, results of operations or cash flows.



In March 2004, the EITF reached a consensus on Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments. EITF No. 03-01 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities,and SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and non-marketable equity securities accounted for under the cost method. The EITF developed a basic three-step model to evaluate whether an
investment is other-than-temporarily impaired. On September 30, 2004, the FASB approved the issuance of FASB Staff Position EITF No. 03-1-1, which delays the effective date until additional guidance is issued for the application of the
recognition and measurement provisions of EITF No. 03-01 to investments in securities that are impaired.



NOTE 3: ACQUISITIONS, INTANGIBLE ASSETS AND GOODWILL



On March 18, 2004, Click2learn acquired Docent, a leading provider of integrated applications, services and content solutions and formed SumTotal Systems. The reasons for the acquisition included the belief that
the combined company will be a strong, viable leader in the business performance and learning management software industry, with increased financial strength and operational efficiencies.



On March 18, 2004, stockholders of Click2learn received 0.3188 shares of common stock in SumTotal Systems for each
common share of Click2learn held, or approximately 52% of the total outstanding common stock of SumTotal Systems, without taking into account the exercise of options prior to the closing date. On March 18, 2004, stockholders of Docent received
0.7327 shares of common stock in SumTotal Systems for each common share of Docent held, or approximately 48% of the total outstanding common stock of SumTotal Systems, without taking into account the exercise of options prior to the closing date.
Outstanding options and warrants were converted into options and warrants for the purchase of shares in SumTotal Systems in accordance with the same exchange ratios. The transaction was accounted for as an acquisition of Docent by Click2learn under
the purchase method of accounting in accordance with SFAS No. 141, Business Combinations.



The total purchase consideration consists of the following (in thousands):



|                                                        |  |   |       
|------------------------------------------------------- |  | - | ------
|Fair value of SumTotal Systems common stock issued (1) |  | $ | 55,663
|Acquisition-related expenses (2)                        |  |   | 2,120 
|SumTotal Systems stock options granted (3)             |  |   | 9,252 
|                                                        |  |   |       
|                                                        |  | $ | 67,035
|                                                        |  |   |       

---

|(1) | The fair value of SumTotal Systems common stock issued represents 9,748,102 shares of SumTotal Systems issued for Docents common stock outstanding on March 18,
2004, with a value of $5.71 per share. The $5.71 per share is equal to Click2learns average last sale price per share as reported on the NASDAQ National Market for the four trading-day period two days before and two days after October 20,
2003, the date of the merger agreement, using the exchange ratio of 0.3188.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



11



---

##### Table of Contents

|(2) | The acquisition-related expenses consist of banking, legal and accounting fees, printing costs and other directly related charges.
|--- | ----------------------------------------------------------------------------------------------------------------------------------



|(3) | SumTotal Systems stock options granted in exchange for Docent stock options were valued at $9.3 million using the Black-Scholes valuation model assuming no dividend yield,
volatility from 0.9205 to 1.2923, risk free interest rate from 1.25% to 2.26% and expected lives of options ranging from 1.05 years to 3.2 years. The intrinsic value of unvested stock options was $2.1 million which will be amortized over the
remaining vesting periods. The $2.1 million of deferred stock-based compensation represents the unearned portion, as of December 31, 2003, of the intrinsic value of Docents common stock options assumed in the acquisition. The deferred
stock-based compensation is being amortized on an accelerated basis over the remaining vesting periods of one to four years consistent with the graded vesting approach described in FIN No. 28, Accounting for Stock Appreciation Rights and
Other Variable Stock Option or Award Plans. Unvested stock options held by certain directors and officers of both Click2learn and Docent were entitled to accelerated vesting as a result of the transaction. SumTotal Systems recognized stock-based
compensation of $291,000 as a result of accelerated vesting to certain employees.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The total purchase consideration has been allocated to the assets and liabilities acquired, including identifiable intangible assets, based on their
respective fair values at the acquisition date and resulting in excess purchase consideration over the net tangible and identifiable intangible assets acquired of $24.8 million. The following condensed balance sheet data presents the fair value of
the assets and liabilities acquired (in thousands):



|                                          |  |   |        |  
|----------------------------------------- |  | - | ------ | -
|Assets acquired:                          |  |   |        |  
|Cash and cash equivalents                 |  | $ | 27,552 |  
|Short-term investments                    |  |   | 501    |  
|Accounts receivable                       |  |   | 5,841  |  
|Prepaid expenses and other current assets |  |   | 920    |  
|Property and equipment                    |  |   | 2,021  |  
|Intangible assets                         |  |   | 11,257 |  
|Other assets                              |  |   | 414    |  
|In-process research and development       |  |   | 1,326  |  
|Goodwill                                  |  |   | 24,782 |  
|                                          |  |   |        |  
|                                          |  |   | 74,614 |  
|                                          |  |   |        |  
|Deferred stock based compensation         |  |   | 2,085  |  
|                                          |  |   |        |  
|Liabilities acquired:                     |  |   |        |  
|Accounts payable and accrued liabilities  |  |   | (6,578 | )
|Restructuring accrual                     |  |   | (800   | )
|Deferred revenue                          |  |   | (2,286 | )
|                                          |  |   |        |  
|                                          |  |   | (9,664 | )
|                                          |  |   |        |  
|Total consideration                       |  | $ | 67,035 |  
|                                          |  |   |        |  



Goodwill of $24.8
million, representing the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired in the acquisition, will not be amortized, but is instead tested for impairment at least annually, consistent with the
guidance in SFAS No. 142,Goodwill and Other Intangible Assets. In addition, a portion of the purchase price was allocated to the following identifiable intangible assets (in thousands, except years):



|                                      |  |               |        |                                                |     
|------------------------------------- |  | ------------- | ------ | ---------------------------------------------- | ----
|                                      |  | PurchasePrice |        | Estimated Weighed AverageUseful Lives in Years
|Core/developed technology             |  | $             | 5,413  |                                                | 4.00
|Customer installed-base relationships |  |               | 2,605  |                                                | 6.00
|Customer hosted relationships         |  |               | 1,014  |                                                | 5.00
|Customer contract relationships       |  |               | 2,225  |                                                | 1.00
|                                      |  |               |        |                                                |     
|                                      |  | $             | 11,257 |                                                | 3.96
|                                      |  |               |        |                                                |     



12



---

##### Table of Contents

SumTotal Systems assigned $1.3 million to acquired IPR&D that had not yet reached technological
feasibility and had no alternative future use. SumTotal Systems wrote off these assets at the date of acquisition in accordance with FIN No. 4, Applicability of FASB No. 2, Business Combinations Accounted for by the Purchase Method.
To estimate the value of the IPR&D, the expected cash flows attributed to the completed portion of the IPR&D were calculated. These cash flows considered the contribution of the core/developed technology, the risks related to the development
of the IPR&D and the percent complete as of the valuation date as well as the expected life cycle of the technology. Finally, the cash flows attributed to the completed portion of the IPR&D, net of the core/developed technology contribution,
were discounted to their present value, using a discount rate of 25%, to estimate the value of the IPR&D. These projects were completed as part of the releases of SumTotal Suite 7.0 and 7.1 in December 2004 and April 2005, respectively.



The results of operations of Docent since March 19, 2004
are included in SumTotal Systems consolidated statements of operations.



Goodwill and other intangibles, at September 30, 2005 and December 31, 2004 are as follows (in thousands):



|                                      |  |                       |        |                         |   |        |                                          |  |   |       
|------------------------------------- |  | --------------------- | ------ | ----------------------- | - | ------ | ---------------------------------------- |  | - | ------
|                                      |  | Gross CarryingAmount  |        | AccumulatedAmortization |   |        | Net CarryingAmount atSeptember 30, 2005 
|Goodwill                              |  | $                     | 28,092 |                         | $ | (433   | )                                        |  | $ | 27,659
|                                      |  |                       |        |                         |   |        |                                          |  |   |       
|Intangible assets:                    |  |                       |        |                         |   |        |                                          |  |   |       
|Acquired technology                   |  | $                     | 9,652  |                         | $ | (5,757 | )                                        |  | $ | 3,895 
|Customer installed-base relationships |  |                       | 3,054  |                         |   | (1,002 | )                                        |  |   | 2,052 
|Customer hosted relationships         |  |                       | 1,014  |                         |   | (311   | )                                        |  |   | 703   
|Customer contract relationships       |  |                       | 2,225  |                         |   | (2,225 | )                                        |  |   |      
|                                      |  |                       |        |                         |   |        |                                          |  |   |       
|                                      |  | $                     | 15,945 |                         | $ | (9,295 | )                                        |  | $ | 6,650 
|                                      |  |                       |        |                         |   |        |                                          |  |   |       
|                                      |  |                       |       
|                                      |  | Gross Carrying Amount |        | AccumulatedAmortization |   |        | Net Carrying Amount at December 31, 2004
|Goodwill                              |  | $                     | 28,092 |                         | $ | (433   | )                                        |  | $ | 27,659
|                                      |  |                       |        |                         |   |        |                                          |  |   |       
|Intangible assets:                    |  |                       |        |                         |   |        |                                          |  |   |       
|Acquired technology                   |  | $                     | 9,652  |                         | $ | (4,033 | )                                        |  | $ | 5,619 
|Customer installed-base relationships |  |                       | 3,054  |                         |   | (516   | )                                        |  |   | 2,538 
|Customer hosted relationships         |  |                       | 1,014  |                         |   | (158   | )                                        |  |   | 856   
|Customer contract relationships       |  |                       | 2,225  |                         |   | (1,747 | )                                        |  |   | 478   
|                                      |  |                       |        |                         |   |        |                                          |  |   |       
|                                      |  | $                     | 15,945 |                         | $ | (6,454 | )                                        |  | $ | 9,491 
|                                      |  |                       |        |                         |   |        |                                          |  |   |       



Amortization expense
related to intangible assets was approximately $742,000 and $1,524,000 in the three-months ended September 30, 2005 and 2004, respectively.



Amortization expense related to intangible assets was approximately $2,841,000 and $3,425,000 in the nine-months ended September 30, 2005 and 2004,
respectively.



Expected future amortization expense related to
intangible assets is approximately $742,000 for the remainder of 2005, $2,336,000 in 2006, $2,020,000 in 2007, $965,000 in 2008, $494,000 in 2009 and $93,000 in 2010.



NOTE 4: ASSET PURCHASE AGREEMENTS



During the third quarter of fiscal 2004, SumTotal Systems acquired the assets and certain liabilities of two foreign distributors and settled all disputes
regarding exclusive sales agreements in both regions. Formerly, these distributors were in markets where SumTotal Systems had more than one exclusive distributor resulting from the acquisition of Docent by Click2learn.



On July 12, 2004, SumTotal Systems purchased the remaining 80.1 percent
share of Docent Asia Pacific Pty Ltd. of Sydney, Australia that it did not already own. Docent Asia Pacific Pty. Ltd. had been accounted for using the equity method



13



---

##### Table of Contents

of accounting. On the same date, SumTotal Systems also entered into an agreement with Impart Corporation Pty Ltd., a
sub-distributor for Docent Asia Pacific Pty Ltd to continue to represent SumTotal Systems in selected accounts until April 2005 and to settle all outstanding claims. The total consideration for these transactions was $550,000 in cash which was
allocated to the assets and liabilities received, including identifiable intangible assets, based on their respective fair values at the acquisition date. The $104,000 attributed to the distributor settlement is included in sales and marketing
expense for the year ended December 31, 2004.



The portion
of the purchase price allocated to customer contracts, $261,000, is included in intangible assets on the consolidated balance sheet and was amortized on a straight-line basis over a period of ten months, ending in May 2005. The portion of the
purchase price allocated to customer relationships, $148,000, is included in intangible assets on the consolidated balance sheet and is being amortized on a straight-line basis over a period of five years.



On August 5, 2004, SumTotal Systems purchased the assets and certain
scheduled liabilities of Click2learn Japan KK, which was formerly a joint venture of which SumTotal Systems owned 36%, for the commitment to pay a 5% royalty on all revenues earned in Japan over the following six years and a $320,000 non-refundable
prepayment of that royalty, which was originally capitalized in prepaid assets and is being amortized to cost sales. If the 5% royalty payments on all revenues earned in Japan over the six years exceed $320,000, the future royalty expenses will be
recorded to cost of revenue in the period they are incurred. SumTotal Systems also agreed to provide Softbank certain licenses and support at no charge over the next ten years.



The portion of the purchase price allocated to customer contracts, $39,000, is included in intangible assets on the
consolidated balance sheet and was amortized on a straight-line basis over a period of ten months, ending in June 2005.



NOTE 5: CAPITALIZED COSTS IN ASSOCIATION WITH PENDING ACQUISITION



During the third quarter of fiscal 2005, SumTotal Systems incurred $1,723,000 in costs associated with the pending acquisition of Pathlore Software
Corporation (Pathlore). These costs consisted of $155,000 in due diligence consulting costs, $1,218,000 in legal fees and $350,000 in bankers fees.



NOTE 6: EQUITY INVESTMENT IN SUBSIDIARY



In 2000, Click2learn Japan KK, a Japanese corporation, was formed to promote SumTotal Systems products in Japan. SumTotal Systems recognized losses
of $0 and $169,000 in the three and nine-months ended September 30, 2004, representing its equity share in the losses of Click2learn Japan KK. No sales were made to Click2learn Japan KK in the three and nine-months ended September 30,
2004. As part of the asset purchase agreement with Softbank Media & Marketing Corporation, Softbank Publishing Inc. and Toppan Forms Co. Ltd. on August 5, 2004, we transferred our shares in Click2learn Japan KK to Softbank Media and
Marketing, as a result we will have no further equity related expenses relating to the losses of this company.



NOTE 7: BANK CREDIT FACILITIES



In March 2004, SumTotal Systems cancelled its $10.0 million working capital line at Silicon Valley Bank. SumTotal Systems paid a fee of $70,000 to Silicon Valley Bank associated with the cancellation that is recorded in general and
administrative expenses and incurred a charge of $67,000 associated with warrants related to the line of credit that is recorded in interest expense.



Concurrent with the closing of the Pathlore Acquisition on October 4, 2005, SumTotal Systems entered into a credit facility with Wells Fargo
Foothill, Inc, (Wells Fargo) principally to fund a portion of the acquisition price, and to provide for its ongoing working capital requirements. Under the terms of the facility, Wells Fargo Foothill, Inc. loaned SumTotal Systems $17.5
million to complete the acquisition of Pathlore (the Term Loan) and provided a revolving credit facility to a



14



---

##### Table of Contents

maximum of $5.0 million (the Revolver) to meet the working capital requirements of the business. The amounts
outstanding bear interest at Wells Fargos Base Rate plus 2%, unless SumTotal Systems elects to be charged at the London Interbank Offered Rate (LIBOR) plus 3.5%. The term loan is due in installments of $1,093,750 quarterly
commencing January 1, 2006 and is secured by SumTotal Systems assets. The Term Loan and any remaining balance on the Revolver are due and payable on October 5, 2009. The credit facility is subject to certain restrictive covenants
which include, but are not limited to, maintaining certain earnings before interest, taxes, depreciation and amortization (EBITDA) levels, leverage ratios, as well as restrictions on capital expenditures, indebtedness, distributions,
investments, and on change of control. In the event that SumTotal Systems cannot achieve the financial results necessary to maintain compliance with these covenants, SumTotal Systems could be declared in default and be required to sell or liquidate
its assets to repay outstanding debt of approximately $17.5 million.



NOTE
8: RESTRUCTURING



The acquisition of Docent by Click2learn
in the first quarter of fiscal 2004, forming SumTotal Systems, caused excess facilities and redundant employee positions.



$800,000 of the Docent purchase price has been allocated to the liability for future rental expenses for a building in Mountain View, California that was
exited in September 2002. The lease on the building ended in May 2005.



During the first quarter of fiscal 2004, SumTotal Systems recorded an $889,000 restructuring charge, which consisted of $717,000 in employee severance expenses and $172,000 in facility exit expenses. Employee severance consists of severance
and other benefits resulting from a reduction in force across all Company functions of thirty-three employees. Facility expenses represent the fair value of the lease liabilities relating to the closure of a facility in Framingham, Massachusetts
which includes contractual sublease income.



During the second
quarter of fiscal 2004, SumTotal Systems recorded an additional $248,000 restructuring charge, which consisted of $93,000 in employee severance expenses and $155,000 in facility exit expenses. Employee severance consists of severance and other
benefits resulting from a reduction of three service and maintenance employees and one sales and marketing employee. Facility expenses represent the fair value of the lease liability, which considers contractual sublease income, related to a
partially closed facility in Bellevue, Washington.



The
following tables depict this restructuring activity for the nine-months ended September 30, 2005 and 2004 (in thousands):



|                   |  |                              |     |                  |   |      |                               |  |   |    
|------------------ |  | ---------------------------- | --- | ---------------- | - | ---- | ----------------------------- |  | - | ---
|                   |  | Balance at December 31, 2004 |     | CashExpenditures |   |      | Balance at September 30, 2005
|Vacated facilities |  | $                            | 506 |                  | $ | (402 | )                             |  | $ | 104
|                   |  |                              |     |                  |   |      |                               |  |   |    
|                   |  | $                            | 506 |                  | $ | (402 | )                             |  | $ | 104
|                   |  |                              |     |                  |   |      |                               |  |   |    



|                   |  |                             |   |                          |   |           |  |                  |       |  |                               |        |   |  |   |    
|------------------ |  | --------------------------- | - | ------------------------ | - | --------- |  | ---------------- | ----- |  | ----------------------------- | ------ | - |  | - | ---
|                   |  | Balance atDecember 31, 2003 |   | Purchase PriceAllocation |   | Additions |  | CashExpenditures |       |  | Balance at September 30, 2004
|Vacated facilities |  | $                           |  |                          | $ | 800       |  | $                | 327   |  | $                             | (406   | ) |  | $ | 721
|Employee severance |  |                             |  |                          |   |          |  |                  | 810   |  |                               | (810   | ) |  |   |   
|                   |  |                             |   |                          |   |           |  |                  |       |  |                               |        |   |  |   |    
|                   |  | $                           |  |                          | $ | 800       |  | $                | 1,137 |  | $                             | (1,216 | ) |  | $ | 721
|                   |  |                             |   |                          |   |           |  |                  |       |  |                               |        |   |  |   |    



Accrued amounts for
vacated facilities will be paid over the remaining lease terms of the Framingham, Massachusetts and Bellevue, Washington facilities, which end in January 2006 and December 2008, respectively.



15



---

##### Table of Contents

NOTE 9: COMMITMENTS AND CONTINGENCIES



Contractual obligations at September 30, 2005 are as follows (in thousands):



|                                                              |  |                        |       |   |                 |   |       |           |  |   |           |   |  |           |       |   |           |   |                    |   |  |   |     |  |   |    
|------------------------------------------------------------- |  | ---------------------- | ----- | - | --------------- | - | ----- | --------- |  | - | --------- | - |  | --------- | ----- | - | --------- | - | ------------------ | - |  | - | --- |  | - | ---
|                                                              |  | Payments Due by Period
|                                                              |  | Total                  |       |   | Less Than1 Year |   |       | 12 Years |  |   | 23 Years |   |  | 34 Years |       |   | 45 Years |   | GreaterThan5 Years
|Operating leases                                              |  | $                      | 6,473 |   |                 | $ | 1,698 |           |  | $ | 1,556     |   |  | $         | 1,354 |   |           | $ | 735                |   |  | $ | 311 |  | $ | 819
|Accrued restructured facility lease payments                  |  |                        | 305   |   |                 |   | 130   |           |  |   | 79        |   |  |           | 77    |   |           |   | 19                 |   |  |   |    |  |   |   
|Contractual sublease income included in restructuring accrual |  |                        | (201  | ) |                 |   | (79   | )         |  |   | (54       | ) |  |           | (54   | ) |           |   | (14                | ) |  |   |    |  |   |   
|                                                              |  |                        |       |   |                 |   |       |           |  |   |           |   |  |           |       |   |           |   |                    |   |  |   |     |  |   |    
|                                                              |  | $                      | 6,577 |   |                 | $ | 1,749 |           |  | $ | 1,581     |   |  | $         | 1,377 |   |           | $ | 740                |   |  | $ | 311 |  | $ | 819
|                                                              |  |                        |       |   |                 |   |       |           |  |   |           |   |  |           |       |   |           |   |                    |   |  |   |     |  |   |    



Rent expense under
operating leases was approximately $575,000 and $550,000 during the three-months ended September 30, 2005 and 2004, respectively, and $1,802,000 and $1,762,000 during the nine-months ended September 30, 2005 and 2004, respectively.



SumTotal Systems has entered into various arrangements with
hosting services vendors and various non-cancelable operating facility lease agreements for its offices throughout the U.S. and for its international subsidiaries with original lease periods expiring through 2015. In addition, SumTotal Systems is
under contract to fulfill its obligations for facility leases for offices that were subleased to third party companies under restructuring plans.



On July 13, 2005, SumTotal Systems entered into a five year lease for new office premises for its U.K. operations and moved into the new location
during September 2005. SumTotal Systems continues to use the existing premises, but plans to exit this location by the end of fiscal 2005. As of September 30, 2005, the remaining lease obligation on the current premises through November 2007
was $400,000.



From time-to-time, we are involved in legal
proceedings or threats of legal proceedings arising in the ordinary course of business. We are not a party to any litigation or other legal proceeding that, in the opinion of management, is reasonably likely to have a material adverse effect on our
business, operating results and financial condition, except as described below.



IpLearn, LLC v. Docent, Case No. CV-02-2636 DLJ (Docent Case); and IpLearn, LLC v. Click2learn.com, Inc., Case No. CV-04-00685 DLJ (Click2learn Case). On May 31, 2002, IpLearn filed a
patent infringement case against Docent, and in February 2004, a patent infringement case against Click2learn. In October 2004, the Docent Case and the Click2learn Case were consolidated into one case, IPLearn, LLC v. SumTotal Systems, Inc., Case
No. CV-02-02636 DLJ (the SumTotal Case). The action is pending before the Northern District of California and concerned the same patent family. IpLearn, around the same time as the Docent Case was filed, sued several other manufacturers
of on-line learning software. IpLearn alleges that certain Docent and Click2learn software products infringe eight IpLearn patents that relate to online learning. IpLearn is seeking injunctive relief and unspecified monetary damages. The case is
still in the discovery phase. On September 16, 2005, we filed two summary judgment motions, one alleging that three of IpLearns patents are invalid. The second summary judgment motion seeks dismissal of the infringement claims against the
Docent products because, two and a half years after IpLearn filed its case against the Docent products, IpLearn has failed to make a prima facie case that the Docent products infringe. The judge issued a ruling indicating that he would set a
briefing and hearing schedule for the summary judgment motions at the Markman hearing, which is currently scheduled for November 18, 2005. In advance of the November 18, 2005 hearing, the parties have entered into settlement discussions.



SumTotal Systems entered into these discussions because of the
uncertainties inherent in any litigation, as well as the distraction to management and the expenses associated with litigation. At this point, there is no agreement between the parties, including without limitation, an agreement on the scope of any
potential settlement in terms of which patents the settlement would apply to, or the amount of such settlement, although, most recently, a range from $0 to approximately $5.4 million has been discussed. SumTotal Systems believes, at the time of this
filing, that a loss from settlement or judgment is less than probable and therefore the Company has not established an accrual for this potential loss. SumTotal Systems expects there may be further discussions through November 18, 2005, and
potentially thereafter. SumTotal Systems cannot be certain, however, that if the parties were to reach a settlement at some point in the future (a) when such settlement would occur, if ever; (b) whether such settlement, if any, would be within the
range stated above; or (c) the scope of such settlement, if any.



IP Innovation, LLC, v. Thomson Learning, Inc. et al., Case No. H-02-2031, Southern District of Texas. In December 2002, IP Innovation, LLC filed a patent infringement case against Docent and seven other defendants in the U.S. District Court
for the Southern District of Texas. IP Innovation asserted a claim regarding a computer graphics patent, asserting that



16



---

##### Table of Contents

the patent covers the use of Hypertext Markup Language (HTML) in graphics software used in computer systems.
Plaintiff sought an injunction and unspecified monetary damages. In April 2004, Docent filed a motion for summary judgment for non-infringement, which was granted in July 2004. In August 2004, IP Innovation filed a notice of appeal of the summary
judgment award. In August 2004, Docent filed a claim for attorneys fees, which was denied in October 2004. IP Innovation filed its Opening Brief in connection with its appeal of the Summary Judgment award in January 2005. Docent filed its
opposition brief, along with an appeal of the attorneys fees order, in April 2005. On September 21, 2005, the U.S. Court of Appeals Federal Circuit scheduled a hearing of the appeal in IP Innovation, LLC v. eCollege.com, Digital Think,
Inc., and Docent, Inc. for November 9, 2005.



SumTotal
Systems believes that the patent infringement cases are without merit, and is defending, and plans to continue to defend, against them vigorously. However, the results of litigation cannot be predicted with certainty. Defending each of these
actions, regardless of the outcome, may be costly, time-consuming, distract management personnel and have a negative effect on our business. An adverse outcome in any of these actions (including a judgment or settlement where SumTotal Systems may be
required to license patents on terms that may or may not be favorable to the Company, an injunction that would prevent SumTotal Systems from shipping its product, or would force the Company to alter its software products) may cause a material
adverse effect on the Companys future business, operating results and/or financial condition.



NOTE 10: GUARANTEES, WARRANTIES AND INDEMNIFICATION



SumTotal Systems follows the provisions of FIN No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45
provides expanded accounting guidance surrounding liability recognition and disclosure requirements related to guarantees. In the ordinary course of business, SumTotal Systems is not subject to potential obligations under guarantees that fall within
the scope of FIN No. 45 except for standard indemnification and warranty provisions that are contained within many of its customer license and service agreements and give rise only to the disclosure requirements prescribed by FIN
No. 45.



Indemnification and warranty provisions
contained within SumTotal Systems customer license and service agreements are generally consistent with those prevalent in the industry. The duration of product warranties are generally between 90 to 365 days following delivery of the
products. Significant obligations under customer indemnification or warranty provisions have not been incurred historically and are not expected in the future. Accordingly, accruals for potential customer indemnification or warranty-related
obligations are not maintained.



SumTotal Systems has entered
into indemnification agreements with its directors and certain of its officers that will require SumTotal Systems, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or
officers. SumTotal Systems has also agreed to indemnify certain former officers, directors and employees of acquired companies in connection with the acquisition of such companies. SumTotal Systems maintains director and officer insurance, which may
cover certain liabilities arising from its obligation to indemnify its directors and officers and former directors, officers and employees of acquired companies, in certain circumstances.



NOTE 11: SEGMENT INFORMATION



SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, requires that companies report separately in the financial
statements certain financial and descriptive information about operating segments profit or loss, certain specific revenue and expense items and segment assets. The method for determining what information is reported is based on the way that
management organizes the operating segments for making operational decisions and assessments of financial performance. SumTotal Systems chief operating decision maker is the Chief Executive Officer (CEO). The CEO reviews financial
information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. The consolidated financial information reviewed by the CEO is similar to the information presented in the accompanying
condensed consolidated financial statements of operations. Currently, management does not use product line financial performance as a basis for business operating decisions. Therefore, SumTotal Systems has determined that it operates in a single
reportable segment.



Revenues by geographic region which are
based on the location of the customers are as follows for the three and nine-months ended September 30, 2005 and 2004 (in thousands):



|              |  |                                  |        |                                 |   |        |  |      |        |  |   |       
|------------- |  | -------------------------------- | ------ | ------------------------------- | - | ------ |  | ---- | ------ |  | - | ------
|              |  | Three-Months Ended September 30, |        | Nine-Months Ended September 30,
|              |  | 2005                             |        | 2004                            |   | 2005   |  | 2004
|North America |  | $                                | 15,206 |                                 | $ | 11,590 |  | $    | 40,785 |  | $ | 28,339
|Europe        |  |                                  | 2,493  |                                 |   | 3,100  |  |      | 8,300  |  |   | 6,646 
|Asia/Pacific  |  |                                  | 710    |                                 |   | 597    |  |      | 1,951  |  |   | 1,491 
|              |  |                                  |        |                                 |   |        |  |      |        |  |   |       
|              |  | $                                | 18,409 |                                 | $ | 15,287 |  | $    | 51,036 |  | $ | 36,476
|              |  |                                  |        |                                 |   |        |  |      |        |  |   |       



17



---

##### Table of Contents

One customer, Citigroup Technology, Inc., accounted for 15% of SumTotal Systems total consolidated
revenues in the three-months ended September 30, 2005. One other customer, Lowes, accounted for 13% of SumTotal Systems total consolidated revenues in the three-months ended September 30, 2004. No customer accounted for greater
than 10% of SumTotal Systems total consolidated revenues in the nine-months ended September 30, 2005 or 2004.



No customer accounted for greater than 10% of SumTotal Systems accounts receivable, net of allowance for sales returns and doubtful accounts at
September 30, 2005. One customer, Lloyds TSB, accounted for 15% of SumTotal Systems accounts receivable, net of allowance for sales returns and doubtful accounts at December 31, 2004.



NOTE 12: RELATED PARTY TRANSACTION



In March 2004, subsequent to the acquisition of Docent, SumTotal Systems
forgave the $139,000 outstanding loan of Mr. Mandelkern, a former member of the Docent Board of Directors and the former Executive Vice President, Chief Technology Officer and co-founder of Docent, and recorded the transaction as a general and
administrative expense.



NOTE 13: SUBSEQUENT EVENTS



On October 4, 2005, SumTotal Systems completed its acquisition of
Pathlore for approximately $48.0 million. The Pathlore acquisition will enhance SumTotal Systems position in the learning industry through the combination of its legacy products, and Pathlores technologies, services, distribution
channels and customer contacts. Pathlore shareholders received approximately $29.2 million in cash and an aggregate of 4.0 million shares of SumTotal Systems common stock, valued at approximately $4.70 per share. SumTotal Systems incurred
additional cash obligations due to deal-related and severance expenses. SumTotal Systems funded the cash element of the transaction, in part, by establishing a new $22.5 million credit facility. The total purchase consideration is being allocated to
the assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the acquisition date, and will be reflected in the Annual Report on Form 10-K for the year ending December 31, 2005.



Concurrent with the closing of the Pathlore Acquisition on
October 4, 2005, the Company entered into a credit facility with Wells Fargo, principally to fund a portion of the acquisition price, and to provide for the ongoing working capital requirements of the Company. For terms and details of the
credit facility, refer to Note 7 Bank Credit Facilities.



On October 17, 2005, the Compensation Committee of the Board of Directors approved retention bonuses for David Crussell, Sanjay Dholakia, Neil Laird, Kevin Oakes and Erika Rottenberg. Each of these individuals
will receive a retention bonus equal in amount to 1.5 times such individuals annual base salary in effect on October 19, 2005, aggregating approximately $1.9 million, which shall be payable in two equal cash payments, the first on
October 19, 2006, and the second on October 19, 2007, on the condition that such individual is still employed by SumTotal Systems on the date of payment; provided that if the employee is earlier terminated: (a) without
cause or (b) for good reason, as such terms are defined in each individuals Change of Control agreement, the full amount of the bonus then unpaid shall be payable, upon delivery of a full release in satisfactory
form to the Company, on the date that is six months following the date of termination of employment. These obligations shall survive, and not be affected by, a Change of Control and are binding upon the Company and its successors.



On October 19, 2005, SumTotal Systems announced that R. Andrew Eckert,
CEO and Director, resigned to accept a CEO position in a different industry. Current SumTotal Systems Chair of the Board, Donald Fowler, was appointed as interim CEO by the SumTotal Systems Board of Directors and shall retain the position of Chair
of the Board. Jack Acosta, the current Chair of the Audit Committee, was appointed as the Boards lead independent Director.



18



---

##### Table of Contents

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



Forward-Looking Statements



The following discussion and analysis should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and related Notes
contained elsewhere within this document. Operating results for the three and nine-months ended September 30, 2005 are not necessarily indicative of the results that may be expected for any future periods, including the full fiscal year.
Reference should also be made to the Annual Consolidated Financial Statements, Notes thereto and Managements Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors contained in the SumTotal Systems Annual
Report on Form 10-K for the year ended December 31, 2004.



This Quarterly Report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a safe harbor for forward-looking statements to encourage
companies to provide prospective information so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected
results. All statements other than statements of historical fact we make in this Quarterly Report are forward-looking. Such forward-looking statements including the words may, plans, expects,
anticipates, intends, targets, goals, seeks, believes, potential, continue and similar language, including variations of such words and include, but are
not limited to, statements regarding the following: our belief that our available cash resources, combined with cash flows generated from revenues, will be sufficient to meet our presently anticipated working capital, capital expense and business
expansion requirements for at least the next 12 months; our belief that current litigation and other legal proceedings will not have a material adverse effect on our business, operating results and financial condition; statements about future
business operations; marketing statements; industry leadership; internal controls and procedures; statements about our new product, SumTotal 7.0 Series; revenue recognition; financial performance including, but not limited to, estimated revenues,
bookings, operating expenses, gross margins, and profit, and market conditions that include risks and uncertainties are based on information that is available to us at the date of this Quarterly Report on Form 10-Q and reflects managements
then current expectations, estimates, beliefs, assumptions and goals and objectives, and are subject to uncertainties that are difficult, if not impossible, to predict. Our actual results may differ significantly from those projected in the
forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to those discussed in the section Managements Discussion and Analysis of Financial Condition and Results of Operations
 Factors That May Affect Future Results of Operations. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to
publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.



Executive Summary



SumTotal Systems was formed on March 18, 2004, as a result of the acquisition of Docent, Inc. (Docent) by Click2learn, Inc
(Click2Learn). We are a leading developer and provider of enterprise learning solutions for companies, government agencies and educational institutions. We design, develop, market, license and support an integrated suite of enterprise
software products and related services that allow our customers to cost-effectively create, personalize and manage the delivery of learning and knowledge content. Our products combine collaborative content development, comprehensive learning
management and virtual classroom systems into a single, integrated product suite with a unified architecture and user experience. We provide our enterprise learning products and services to large customers across a broad range of geographies and
industries, with over 40% of the Fortune 50 and over 35% of the Global 50 among our clients. We serve clients in industries such as financial services, health care, computer software, manufacturing, media, natural resources, networking,
telecommunications, transportation, utilities, government and education.



Our revenue in the three-months ended September 30, 2005 was $18.4 million, an increase of 20% from $15.3 million in the comparable period in 2004. Our revenue in the nine-months ended September 30, 2005 was
$51.0 million, an increase of 40% from $36.5 million in the comparable period in 2004. The 2004 numbers include the period from January 1 to March 18, 2004, which was the period prior to the acquisition of Docent, Inc. The growth was
primarily the result of additional services business as we were successful in signing up existing Docent customers to SumTotal Systems maintenance and hosting contracts, as well as selling licenses and implementation and other services to the
existing installed base and to new customers.



Gross margins
improved to 66% and 62% in the three and nine-months ended September 30, 2005, respectively compared to 59% and 56% in the comparable periods in 2004 as a result of a reduction in the amortization of intangible assets.



Operating expenses in the three-months ended September 30, 2005 were
$12.0 million, an increase of $0.6 million, or 5%, from $11.4 million in the comparable period in 2004. Expenses associated with completing our management assessment of internal controls over financial reporting required under Sarbanes-Oxley
Section 404 increased to $0.7 million in the three-months ended September 30, 2005, from $0.4 million in the comparable period in 2004.



19



---

##### Table of Contents

Overall, we improved our net loss from $2.2 million in the three-months ended September 30, 2004 to
a net income of $0.1 million in the comparable period in 2005. In the nine-months ended September 30, 2005, the loss improved to $5.8 million in 2005, from $14.1 million in the comparable period in 2004.



Despite the additional expenses incurred as a result of Sarbanes-Oxley
compliance, we have made good progress in controlling expenses and achieving the synergies anticipated from the acquisition of Docent and combined with the revenue growth have made progress in reducing our losses. In addition, we have been able to
generate positive cash flow from operating activities for the nine-months ended September 30, 2005.



As of September 30, 2005, we had $29.6 million in cash and cash equivalents and $3.6 million in short-term investments. These balances, together with
the cash generated from operations and the credit facility of $22.5 million entered into in October 2005, provide sufficient funds to finance operations for at least the next twelve months and to fund the Pathlore Software Corporation acquisition
described later.



Critical Accounting Policies and Estimates



In most cases, the accounting treatment of a particular transaction is
specifically dictated by GAAP and does not require managements judgment in its application. However, certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for
calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments reflect practices, information provided by our customers and other assumptions that we believe are reasonable under
the circumstances. Our estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the condensed consolidated financial statements in the period in which they are determined to be necessary. Actual results may
differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates include:



| |  |  | revenue recognition;
| | - |  | --------------------



| |  |  | estimating allowances for sales returns and the allowance for doubtful accounts;
| | - |  | --------------------------------------------------------------------------------



| |  |  | goodwill and intangible assets;
| | - |  | -------------------------------



| |  |  | restructuring; and
| | - |  | ------------------



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



Our senior management has reviewed these critical accounting policies and related disclosures with our Disclosure Committee and the Audit Committee of our
Board of Directors. Refer to the Notes to the unaudited Condensed Consolidated Financial Statements, which contain additional information regarding our accounting policies and other disclosures required by GAAP.



We have had no significant changes in our critical accounting policies and
estimates since our previous filing on our Annual Report on Form 10-K, as filed with the SEC on August 1, 2005, and our Quarterly Report on Form 10-Q for the six months ended June 30, 2005, as filed with the SEC on August 9, 2005.



Results of Operations



The following table presents our results of operations as a percentage of
total revenue in the three and nine-months ended September 30, 2005 and 2004:



|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|--------------------------------------------- |  | -------------------------------- | - |  | ------------------------------- | -- |  | ----- | -- |  | ----- | --
|                                              |  | Three-Months Ended September 30, |   |  | Nine-Months Ended September 30, |   
|                                              |  | 2005                             |   |  | 2004                            |    |  | 2005  |    |  | 2004  |   
|Revenue:                                      |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|License                                       |  | 36.0                             | % |  | 36.9                            | %  |  | 33.9  | %  |  | 37.7  | % 
|Service and maintenance                       |  | 64.0                             |   |  | 63.1                            |    |  | 66.1  |    |  | 62.3  |   
|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|Total revenue                                 |  | 100.0                            |   |  | 100.0                           |    |  | 100.0 |    |  | 100.0 |   
|                                              |  |                                  |   | 
|Cost of revenue:                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|License and amortization of intangible assets |  | 5.2                              |   |  | 10.9                            |    |  | 7.7   |    |  | 10.4  |   
|Service and maintenance                       |  | 29.1                             |   |  | 30.2                            |    |  | 30.1  |    |  | 33.9  |   
|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|Total cost of revenue                         |  | 34.3                             |   |  | 41.1                            |    |  | 37.8  |    |  | 44.3  |   
|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|Gross margin                                  |  | 65.7                             |   |  | 58.9                            |    |  | 62.2  |    |  | 55.7  |   
|                                              |  |                                  |   | 
|Operating expenses:                           |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|Research and development                      |  | 16.7                             |   |  | 19.0                            |    |  | 17.4  |    |  | 22.5  |   
|Sales and marketing                           |  | 30.8                             |   |  | 36.2                            |    |  | 34.9  |    |  | 42.7  |   
|General and administrative                    |  | 17.9                             |   |  | 19.4                            |    |  | 21.4  |    |  | 21.6  |   
|Restructuring charge                          |  |                                 |   |  |                                |    |  |      |    |  | 3.1   |   
|In-process research and development           |  |                                 |   |  |                                |    |  |      |    |  | 3.6   |   
|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|Total operating expenses                      |  | 65.4                             |   |  | 74.6                            |    |  | 73.7  |    |  | 93.5  |   
|                                              |  |                                  |   | 
|Income (loss) from operations                 |  | 0.3                              |   |  | (15.7                           | )  |  | (11.5 | )  |  | (37.8 | ) 
|Other income (expense), net                   |  | 0.6                              |   |  | 0.9                             |    |  | 0.2   |    |  | (0.9  | ) 
|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|Income (loss) before income taxes             |  | 0.9                              |   |  | (14.8                           | )  |  | (11.3 | )  |  | (38.7 | ) 
|Provision (benefit) for income taxes          |  | 0.2                              |   |  | (0.3                            | )  |  | 0.2   |    |  | 0.1   |   
|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   
|Net income (loss)                             |  | 0.7                              | % |  | (14.5                           | )% |  | (11.5 | )% |  | (38.8 | )%
|                                              |  |                                  |   |  |                                 |    |  |       |    |  |       |   



20



---

##### Table of Contents

Revenue



Total revenue increased $3.1 million, or 20%, to $18.4 million in the three-months ended September 30, 2005, from $15.3 million in the comparable
period in 2004.



Total revenue increased $14.5 million, or 40%,
to $51.0 million in the nine-months ended September 30, 2005, from $36.5 million in the comparable period in 2004.



In the three-months ended September 30, 2005, revenue from sales outside North America decreased $0.5 million, or 13%, to $3.2 million, from $3.7
million in the comparable period in 2004, and accounted for approximately 17% of total revenue. The decrease occurred primarily in Europe, where revenues decreased $0.6 million between the comparable periods. Asia/Pacific sales increased $0.1
million between the comparable periods, primarily due to increased sales in Japan.



In the nine-months ended September 30, 2005, revenue from sales outside North America increased $2.2 million, or 27%, to $10.3 million, from $8.1 million in the comparable period in 2004, and accounted for
approximately 20% of total revenue. The increase in international revenue is due to a greater international presence resulting from the acquisition of Docent on March 18, 2004. Docent had well established sales operations in Europe, Japan and
Latin America.



One customer, Citigroup Technology, Inc,
accounted for 15% of SumTotal Systems total consolidated revenues in the three-months ended September 30, 2005. One other customer, Lowes, accounted for 13% of SumTotal Systems total consolidated revenues in the three-months
ended September 30, 2004. No customer accounted for greater than 10% of SumTotal Systems total consolidated revenues in the nine-months ended September 30, 2005 or 2004.



We experience quarterly seasonality in the licensing of our products and delivery of our services. Typically, revenues at
Docent, Click2learn and SumTotal Systems have been lower in our first and second fiscal quarters than in the immediately preceding fourth fiscal quarter because (i) many of our customers utilize a significant portion of their capital budgets at
the end of their fiscal year, (ii) the majority of our customers begin a new fiscal year on January 1, and (iii) capital expenditures tend to be lower in an organizations first fiscal quarter than in its fourth fiscal quarter.
We anticipate that this seasonality will continue. Please refer to Factors That May Affect Future Results of Operations - Our quarterly operating results are uncertain and may fluctuate significantly, which could negatively affect the value
of your investment for a further discussion of other factors which may influence seasonality in our operating results.



License revenueIn the three-months ended September 30, 2005, license revenue increased $1.0 million, or 18%, to $6.6 million, from
$5.6 million in the comparable period in 2004. The increase was primarily related to the recognition of revenue from earlier fiscal 2005 deferred license sales on which revenue could not be recognized in earlier quarterly periods as a result of
future product deliverables and acceptances.



In the
nine-months ended September 30, 2005, license revenue increased $3.5 million, or 26%, to $17.3 million, from $13.8 million in the comparable period in 2004. The increase was primarily related to larger average license deals booked as well as
increased overall bookings throughout the nine-months ended September 30, 2005 versus the comparable period in 2004. In addition, Docent sales from January 1, 2004 to March 18, 2004 are not included in our revenue in the nine-months
ended September 30, 2004.



21



---

##### Table of Contents

Prices per license seat are not comparable in the periods discussed above, as the product mix has changed
significantly due to the introduction of SumTotal 7.0 and 7.1.



We had $4.3 million and $3.3 million in deferred license revenue at September 30, 2005 and December 31, 2004, respectively, consisting of numerous contracts that should mostly become recognizable as revenue over the next six
months.



Service and maintenance revenueService
and maintenance revenue in the three and nine-months ended September 30, 2005 and 2004 consisted of the following (in thousands):



|                             |  |                                  |        |                                 |   |       |  |      |        |  |   |       
|---------------------------- |  | -------------------------------- | ------ | ------------------------------- | - | ----- |  | ---- | ------ |  | - | ------
|                             |  | Three-Months Ended September 30, |        | Nine-Months Ended September 30,
|                             |  | 2005                             |        | 2004                            |   | 2005  |  | 2004
|Maintenance                  |  | $                                | 5,043  |                                 | $ | 3,536 |  | $    | 13,557 |  | $ | 7,800 
|Hosting                      |  |                                  | 1,994  |                                 |   | 1,658 |  |      | 5,712  |  |   | 4,209 
|Training                     |  |                                  | 1,014  |                                 |   | 473   |  |      | 2,530  |  |   | 1,703 
|Consulting                   |  |                                  | 3,615  |                                 |   | 3,875 |  |      | 11,536 |  |   | 8,755 
|Application service provider |  |                                  | 114    |                                 |   | 111   |  |      | 415    |  |   | 247   
|                             |  |                                  |        |                                 |   |       |  |      |        |  |   |       
|                             |  | $                                | 11,780 |                                 | $ | 9,653 |  | $    | 33,750 |  | $ | 22,714
|                             |  |                                  |        |                                 |   |       |  |      |        |  |   |       



In the three-months
ended September 30, 2005, service and maintenance revenue increased $2.1 million, or 22%, to $11.8 million, from $9.7 million in the comparable period in 2004. Maintenance revenue increased $1.5 million, or 43% to $5.0 million in the
three-months ended September 30, 2005, from $3.5 million in the comparable period in 2004 due to Docent customers that were under contract as of the acquisition date renewing their contracts with SumTotal. The balance of the increase was the
result of adding new customers throughout the past year. Hosting revenue increased $0.3 million, or 20%, to $2.0 million in the three-months ended September 30, 2005, from $1.7 million in the comparable period in 2004 as a result of adding new
customers. Training revenue increased $0.5 million, or 114%, to $1.0 million in the three-months ended September 30, 2005, from $0.5 million in the comparable period in 2004 due to the addition of the Docent installed customer-base. Consulting
revenue decreased $0.3 million, or 7%, to $3.6 million in the three-months ended September 30, 2005, from $3.9 million in the comparable period in 2004 due primarily to decreased consulting services related to the Docent installed customer-base
in the three-months ended September 30, 2005 versus the comparable period in 2004.



In the nine-months ended September 30, 2005, service and maintenance revenue increased $11.1 million, or 49%, to $33.8 million, from $22.7 million in the comparable period in 2004 due to increased sales to
existing customers, as well as to new customers. Maintenance revenue increased $5.8 million, or 74%, to $13.6 million in the nine-months ended September 30, 2005, from $7.8 million in the comparable period in 2004. The increase is due to the
addition of the Docent installed base with the balance primarily due to the addition of new customers. Hosting revenue increased $1.5 million, or 36%, to $5.7 million in the nine-months ended September 30, 2005, from $4.2 million in the
comparable period in 2004 due primarily to the addition of the Docent installed customer-base. Training revenue increased $0.8 million, or 49%, to $2.5 million in the nine-months ended September 30, 2005, from $1.7 million in the comparable
period in 2004, all of which was the result of the Docent business being included for the full period. Consulting revenue increased $2.7 million, or 32%, to $11.5 million in the nine-months ended September 30, 2005, from $8.8 million in the
comparable period in 2004, primarily due to incremental consulting services such as upgrades relating to SumTotal 7.0 and 7.1.



Price changes in service and maintenance revenue had no material effect on the three and nine-months ended September 30, 2005, compared to the same
periods in 2004.



Cost of Revenue



In the three-months ended September 30, 2005 and 2004, total cost of
revenue remained constant at $6.3 million. This was the result of a decrease in the amortization of intangible assets offset by an increase in third party consulting services.



In the nine-months ended September 30, 2005, total cost of revenue increased $3.1 million, or 19%, to $19.3 million,
from $16.2 million in the comparable period in 2004. This was a result of the addition of service and maintenance personnel on March 18, 2004 resulting from the acquisition of Docent, expenses associated with hosting the Docent customer
installed-base and additional third party consulting expenses associated with Docent product implementations in Europe.



Cost of licenseIn the three-months ended September 30, 2005 and 2004, total cost of license revenue remained constant at $0.2 million.



22



---

##### Table of Contents

In the nine-months ended September 30, 2005, total cost of license revenue increased $0.7 million,
or 188%, to $1.1 million, from $0.4 million in the comparable period in 2004. This increase is primarily due to the purchase of third party software for resale in the three-months ended June 30, 2005.



Gross margin for license, including amortization of intangibles, in the
three-months ended September 30, 2005, increased to 86% from 70% in the comparable period in 2004. This increase is mainly due to the reduction of amortization of intangible assets offset by the cost of software purchased for resale.



Gross margin for license, including amortization of
intangibles, in the nine-months ended September 30, 2005, increased slightly to 77% from 73% in the comparable period in 2004. This increase is mainly due to the reduction of amortization of intangible assets offset by the cost of software
purchased for resale.



Our cost of license revenue includes the
cost of third party software and content we resell.



Cost
of service and maintenanceIn the three-months ended September 30, 2005, total cost of service and maintenance revenue increased $0.8 million, or 16%, to $5.4 million, from $4.6 million in the comparable period in 2004. The increase is
due to the addition of service and maintenance personnel and an increase in the use of third party consulting services.



In the nine-months ended September 30, 2005, total cost of service and maintenance revenue increased $3.0 million, or 24%, to $15.4 million, from
$12.4 million in the comparable period in 2004. The increase is primarily due $2.2 million in costs associated with the addition of thirty-four Docent service and maintenance personnel following the merger with Docent on March 18, 2004 and $0.8
million due to an increase in the use of third party consulting services.



Gross margin for service and maintenance increased to 54% in the three-months ended September 30, 2005 from 52% in the comparable period in 2004. The improvements in gross margin for service and maintenance are
primarily due to maintenance renewal contracts being signed for the Docent maintenance installed customer-base and increased revenues without incremental expenses.



Gross margin for service and maintenance increased to 54% in the nine-months ended September 30, 2005 from 46% in the
same period in 2004. The improvements in gross margin for service and maintenance are primarily due to maintenance renewal contracts being signed for the Docent maintenance installed customer-base and increased revenues without incremental expenses.



Our cost of service and maintenance revenue includes salaries
and related expenses of our professional services organization and charges related to hosting activities and other third party services.



Amortization of intangiblesUnder SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise
Marketed, we capitalized certain project costs recorded after technological feasibility was established on our Virtual Classroom Server product, which is included in intangible asset on the balance sheet. We recorded amortization expenses of
$0.2 million in the three-months ended September 30, 2005 and 2004. We recorded amortization expenses of $0.7 million in the nine-months ended September 30, 2005 and 2004.



Under SFAS No. 142, Goodwill and Other Intangible Assets, we make judgments about the recoverability of
intangible assets whenever events or changes in circumstances indicate that impairment in the remaining value of the assets recorded on our balance sheet may exist. In order to estimate the fair value of intangible assets, we make various
assumptions about the future prospects for the business to which the asset relates and typically estimate future cash flows to be generated by these businesses.



In the three-months ended September 30, 2005, amortization of intangible assets decreased $0.8 million, or 53%, to $0.7 million, from $1.5 million
in the comparable period in 2004. The decrease in the three-months ended September 30, 2005 is primarily due to a reduction in amortization expenses resulting from other intangible assets which were fully amortized in the later fiscal quarters
of 2004 and early 2005.



In the nine-months ended
September 30, 2005, amortization of intangible assets decreased $0.6 million, or 17%, to $2.8 million, from $3.4 million in the comparable period in 2004. The decrease in the nine-months ended September 30, 2005 is primarily due to a
reduction in amortization expenses resulting from other intangible assets which were fully amortized in the later fiscal quarters of 2004 and early 2005.



Operating Expenses



Research and developmentIn the three-months ended September 30, 2005, total research and development increased $0.2 million, or 5%, to
$3.1 million, from $2.9 million in the comparable period in 2004. Expenses relating to research and



23



---

##### Table of Contents

development personnel in the three-months ended September 30, 2005 increased $0.4 million, or 16%, to $2.9 million,
from $2.5 million in the comparable period in 2004, due to increased salary costs for an additional thirteen personnel. Consulting expenses in the three-months ended September 30, 2005 decreased to $0.2 million, from $0.3 million in the
comparable period in 2004. Additional consultants were needed to support work on our product platform throughout 2004.



In the nine-months ended September 30, 2005, total research and development expenses increased $0.7 million, or 9%, to $8.9 million, from $8.2
million in the comparable period in 2004. Expenses relating to research and development personnel in the nine-months ended September 30, 2005 increased $1.4 million, or 20%, to $8.5 million, from $7.1 million in the comparable period in 2004.
The increase is due to the addition of nineteen Docent research and development personnel on March 18, 2004 resulting from the acquisition of Docent and for additional hires. Consulting expenses in the nine-months ended September 30, 2005
decreased $0.6 million, or 60%, to $0.4 million, from $1.0 million in the comparable period of 2004. Additional consultants were needed to support work on our product platform throughout 2004.



We expect research and development expenses to increase slightly in absolute
dollars through the end of fiscal 2005 due to additional consulting services and additional hiring relating to future versions of SumTotal 7.0 Series.



Sales and marketingIn the three-months ended September 30, 2005, total sales and marketing expenses increased $0.2 million, or 3%, to
$5.7 million, from $5.5 million in the comparable period in 2004. Expenses relating to sales and marketing personnel in the three-months ended September 30, 2005 increased $0.4 million, or 8%, to $5.3 million, from $4.9 million in the
comparable period in 2004, due to increased salary and commissions costs. Marketing programs expenses remained relatively unchanged at $0.3 million between the two comparable periods.



In the nine-months ended September 30, 2005, total sales and marketing cost increased $2.2 million, or 14%, to $17.8
million, from $15.6 million in the comparable period in 2004. Expenses relating to sales and marketing personnel in the nine-months ended September 30, 2005 increased $2.6 million, or 19%, to $16.1 million, from $13.5 million in the comparable
period in 2004, due to increased salaries, headcount and commissions costs. Marketing programs expenses in the nine-months ended September 30, 2005 increased $0.2 million, or 17%, to $1.4 million, from $1.2 million in the comparable period in
2004.



We expect sales and marketing expenses to increase in
absolute dollars due to additional personnel and commissions costs throughout the remainder of fiscal 2005.



General and administrative.In the three-months ended September 30, 2005, total general and administrative cost increased $0.3 million,
or 11%, to $3.3 million, from $3.0 million in the comparable period in 2004. For the three-months ended September 30, 2005, accounting expenses and consulting fees associated with compliance with Sarbanes-Oxley Section 404 increased $0.3
million, or 75%, to $0.7 million, from $0.4 million in the comparable period in 2004. Expenses relating to general and administrative personnel in the three-months ended September 30, 2005 increased $0.1 million, or 6%, to $1.8 million, from
$1.7 million in the comparable period in 2004. In addition, in the three-months ended September 30, 2005, expenses relating to outside services, including legal expenses, other consulting and certain human-resources related expenses, decreased
$0.2 million, or 33%, to $0.4 million, from $0.6 million in the comparable period in 2004.



In the nine-months ended September 30, 2005, total general and administrative cost increased $3.0 million, or 38%, to $10.9 million, from $7.9 million in the comparable period in 2004. Expenses relating to
general and administrative personnel in the nine-months ended September 30, 2005 increased $0.1 million, or 2%, to $5.8 million, from $5.7 million in the comparable period in 2004. In addition, in the nine-months ended September 30, 2005,
we incurred an additional $1.9 million in accounting expenses and consulting fees associated with compliance with Sarbanes-Oxley Section 404. Expenses relating to outside services, including legal expenses, other consulting and certain human
resources related expenses, increased $1.0 million, or 77%, to $2.3 million, from $1.3 million in the comparable period in 2004.



We expect general and administrative expenses to increase in absolute dollars due to additional hiring and costs associated with compliance with
Sarbanes-Oxley Section 404 throughout the remainder of fiscal 2005.



Restructuring chargeThe merger of Click2learn and Docent in the first quarter of fiscal 2004, forming SumTotal Systems, caused excess facilities and redundant employee positions.



During the first quarter of fiscal 2004, we recorded an $889,000
restructuring charge, which consisted of $717,000 million in employee severance expenses and $172,000 in facility exit expenses. Employee severance consists of severance and other benefits resulting from a reduction in force across all Company
functions of thirty-three employees. Facility expenses represent the closure of a facility in Framingham, Massachusetts and include the fair value of payments required under lease contract and contractual sublease income.



24



---

##### Table of Contents

During the second quarter of fiscal 2004, we recorded an additional $248,000 restructuring charge, which
consisted of $93,000 in employee severance expenses and $155,000 million in facility exit expenses. Employee severance consists of severance and other benefits resulting from a reduction of three service and maintenance employees and one sales and
marketing employee. Facility expenses represent the partial closure of a facility in Bellevue, Washington and include the fair value of payments required under lease contract and contractual sublease income.



In-process research and developmentIn connection with the
merger with Docent, SumTotal Systems assigned $1.3 million to in-process research and development (IPR&D) that had not yet reached technological feasibility and had no alternative future use. We wrote off these assets at the date of
acquisition in accordance with FIN No. 4, Applicability of FASB Statement No. 2 to Business Combination Accounted for by the Purchase Method. To estimate the value of the IPR&D, the expected cash flows attributed to the
completed portion of the IPR&D were estimated. These cash flows considered the contribution of the core/developed technology, the risks related to the development of the IPR&D and the percent complete as of the valuation date as well as the
expected life cycle of the technology. Finally, the cash flows attributed to the completed portion of the IPR&D, net of the core technology contribution, were discounted to the present value, using a discount rate of 25%, to estimate the value
of the IPR&D. Subsequent to the acquisition, we incurred approximately $1.7 million related to the development of these products. These projects were completed as part of the releases of SumTotal Suite 7.0 and 7.1 in December 2004 and April 2005
respectively.



Stock-based compensationIn the
three-months ended September 30, 2005 and 2004, stock-based compensation expense relating to common stock options and restricted stock was $329,000 and $274,000, respectively. Stock-based compensation expense relating to common stock options
issued to former Docent employees was $119,000 and $274,000 in the three-months ended September 30, 2005 and 2004, respectively. Stock-based compensation expense relating to restricted stock options issued to certain executives was $74,000 in
the three-months ended September 30, 2005. Stock-based compensation expense relating to the extension of the cancellation date for certain common stock options held by terminated employees was $136,000 in the three-months ended
September 30, 2005.



In the nine-months ended
September 30, 2005 and 2004, stock-based compensation expense relating to common stock options and restricted stock was $712,000 and $1,119,000, respectively. Stock-based compensation expense relating to common stock options issued to former
Docent employees was $472,000 and $595,000 in the nine-months ended September 30, 2005 and 2004, respectively. In the nine-month ended September 30, 2005, stock-based compensation expense relating to restricted stock options issued to
certain executives was $104,000. In the nine-months ended September 30, 2005, stock-based compensation expense relating to the extension of the cancellation date for certain common stock options held by terminated employees during the period in
which we were unable to issue common stock due to our non-compliance with financial reporting regulations of the NASDAQ National Market was $136,000. In the nine-months ended September 30, 2004, we recognized $291,000 as a result of accelerated
options vesting to certain employees and $233,000 as a result of increasing the amount of shares available for purchase in the SumTotal Systems ESPP as a result of the acquisition of Docent.



Unvested stock options held by certain directors and officers of both
Click2learn and Docent were entitled to accelerated vesting as a result of the transaction. Stock-based compensation expense is allocated based on the function of employees.



Interest expenseIn the three-months ended September 30, 2005, interest expense was $4,000 compared to $0
in the comparable period in 2004.



In the nine-months ended
September 30, 2005, interest expense decreased to $5,000, from $121,000 in the comparable period in 2004. These amounts were primarily related to the line of credit from with Silicon Valley Bank. In March 2004, we cancelled our $10.0 million
working capital line Silicon Valley Bank. We incurred a charge of $67,000 associated with the acceleration of vesting of warrants related to cancellation of our line of credit in the first quarter of fiscal 2004.



Interest incomeIn the three-months ended September 30,
2005, interest income increased $130,000, or 134%, to $227,000, from $97,000 in the comparable period in 2004. In the nine-months ended September 30, 2005, interest income increased $379,000, or 187%, to $582,000, from $203,000 in the
comparable period in 2004. Interest income increased due to increased interest rates applied to higher balances of cash and cash equivalents resulting from net cash acquired from the Docent merger, collections of accounts receivable and net proceeds
from the issuance of common stock.



Other income
(expenses), netIn the three-months ended September 30, 2005, other expense increased $163,000 to $121,000, from an income of $42,000 in the comparable period in 2004. The increase was entirely due to foreign exchange losses.



25



---

##### Table of Contents

In the nine-months ended September 30, 2005, other expense increased $252,000 to $493,000, from
$241,000 in the comparable period in 2004. The increase was primarily due to $493,000 in foreign exchange losses in the nine-months ended September 30, 2005, versus $340,000 in foreign exchange losses in the comparable period in 2004.



Equity in losses of an affiliateEquity in
losses of an affiliate related to Click2learn Japan KK, our former joint venture with Softbank Media & Marketing Corporation, Softbank Publishing Inc. and Toppan Forms Co. Ltd in Japan. We used the equity method of accounting whereby we
recorded our 19.9% ownership portion of the joint ventures net income or loss. In the three and nine-months ended September 30, 2005, our equity in losses of an affiliate decreased to $0, from $0 and $169,000 in the comparable periods in
2004, respectively. As part of the agreement with Softbank Media & Marketing Corporation, Softbank Publishing Inc. and Toppan Forms Co. Ltd. on August 5, 2004, we transferred our shares in Click2learn Japan KK to Softbank Media and
Marketing and as a result we will have no further losses from our equity investment in this company.



Foreign and state income taxesIn the three and nine-months ended September 30, 2005, we recorded a provision for income tax expense of
$29,000 and $90,000, respectively, related to foreign and state income taxes, as compared to a credit for income tax expense of $47,000 and a provision for income tax expense of $29,000 in the same periods in 2004, respectively.



Liquidity and Capital Resources



At September 30, 2005, our principal sources of liquidity were $29.6
million of cash and cash equivalents and $3.6 million of short-term investments.



We believe that our available cash resources, combined with cash flows generated from revenue, will be sufficient to meet our presently anticipated working capital and capital expense for at least the next twelve
months. However, in connection with the acquisition of Pathlore which was completed on October 4, 2005 and which involved a cash payment of approximately $29.2 million, we entered into a $22.5 million credit facility to assist in financing this
transaction. We will continue to monitor our cash and liquidity and will seek additional financing or make additional expense reductions if it becomes required. Our future liquidity and capital requirements will depend on numerous factors, including
our future revenues, the timing and extent of spending to support product development efforts and expansion of sales and marketing and general and administrative activities, the success of our existing and new product and service offerings and
competing technological and market developments. There can be no assurance that additional funding, if needed, will be available on terms acceptable to us, if at all.



Net cash provided by operating activities was $0.9 million in the nine-months ended September 30, 2005. The cash
provided during the period was primarily due to net collection of receivables of $4.5 million, a $0.8 million increase in deferred revenue due to additional invoiced bookings during the period, and non-cash activities consisting of $2.8 million for
the amortization of intangible assets, $1.3 million for depreciation and amortization of property and equipment, $0.7 million for stock-based compensation, a $0.2 million increase in the provision for sales returns and doubtful accounts and a $0.2
million increase in other accrued liabilities, offset by a net loss of $5.8 million, a $1.7 million decrease in accrued compensation and benefits, a $1.2 million decrease in accounts payable, a $0.5 million increase in prepaid expenses and other
current assets, a $0.4 million decrease in the restructuring accrual and $0.1 million in accretion on interest on short-term investments.



Net cash provided by operating activities was $0.4 million for the nine-months ended September 30, 2004. The cash provided during the period was due
to net collection of receivables of $6.4 million, primarily due to the acquisition of $5.8 million of Docent accounts receivable on March 18, 2004, a $2.5 million increase in deferred revenue due to additional bookings during the period, a $1.1
million decrease in other long-term assets, a $0.3 million decrease in prepaid expenses and other current assets and non-cash activities consisting of $3.4 million in the amortization of intangible assets, a $1.3 million write-off of IPR&D that
had not yet reached technological feasibility and had no alternative future use, $1.1 million for stock-based compensation, $1.2 million for depreciation and amortization of property and equipment, $0.4 million for a loss on the disposal of property
and equipment, $0.2 million for equity losses from affiliate, $0.1 million for amortization of discount on debt, offset by a net loss of $14.1 million, a $0.7 million decrease in accrued compensation and benefits, a $1.9 million decrease in accrued
liabilities, a $0.4 million decrease in accounts payable and non-cash activities consisting of a $0.2 million decrease for provision for sales returns and doubtful accounts.



Net cash provided by investing activities was $1.6 million in the nine-months ended September 30, 2005 due to $5.6
million in net sales of short-term investments, offset by $2.3 million in purchases of equipment and $1.7 million in capitalized costs associated with the pending Pathlore merger.



26



---

##### Table of Contents

Cash provided by investing activities was $22.8 million in the nine-months ended September 30, 2004
due to the $25.4 million of cash acquired, net of payments, in connection with the Docent merger, and $0.1 million in net sales of restricted cash, offset by $1.5 million in net purchases of short-term investments, $0.7 million in purchases of
equipment and $0.5 million in cash used for our asset purchase agreements with distributors in Japan and Australia.



Net cash provided by financing activities was $1.1 million in the nine-months ended September 30, 2005 due to proceeds from the issuance of common
stock through our ESPP and exercises of common stock options.



Net cash used in financing activities was $2.9 million in the nine-months ended September 30, 2004 due to cancellation the working capital line at Silicon Valley Bank that had a balance of $3.5 million at December 31, 2003 and the
repayment of a $0.4 million note payable resulting from our acquisition of Click2learn Japan KK, offset by $1.0 million in proceeds from the issuance of common stock. In March 2004, we cancelled our $10.0 million working capital line of credit at
Silicon Valley Bank. We paid a fee of $70,000 to Silicon Valley Bank associated with the cancellation and incurred a charge of $67,000 associated with warrants related to the line of credit.



Concurrent with the closing of the Pathlore Acquisition on October 4,
2005, SumTotal Systems entered into a credit facility with Wells Fargo principally to fund a portion of the acquisition price, and to provide for its ongoing working capital requirements. For terms and details of the credit facility, refer to
Note 7 Bank Credit Facilities in the unaudited Condensed Consolidated Financial Statements.



At September 30, 2005, our contractual obligations and commercial commitments were as follows (in thousands):



|                                                              |  |                        |       |   |                 |   |       |           |  |   |           |   |  |           |       |   |           |   |                    |   |  |   |     |  |   |    
|------------------------------------------------------------- |  | ---------------------- | ----- | - | --------------- | - | ----- | --------- |  | - | --------- | - |  | --------- | ----- | - | --------- | - | ------------------ | - |  | - | --- |  | - | ---
|                                                              |  | Payments Due by Period
|                                                              |  | Total                  |       |   | Less Than1 Year |   |       | 12 Years |  |   | 23 Years |   |  | 34 Years |       |   | 45 Years |   | GreaterThan5 Years
|Operating leases                                              |  | $                      | 6,473 |   |                 | $ | 1,698 |           |  | $ | 1,556     |   |  | $         | 1,354 |   |           | $ | 735                |   |  | $ | 311 |  | $ | 819
|Accrued restructured facility lease payments                  |  |                        | 305   |   |                 |   | 130   |           |  |   | 79        |   |  |           | 77    |   |           |   | 19                 |   |  |   |    |  |   |   
|Contractual sublease income included in restructuring accrual |  |                        | (201  | ) |                 |   | (79   | )         |  |   | (54       | ) |  |           | (54   | ) |           |   | (14                | ) |  |   |    |  |   |   
|                                                              |  |                        |       |   |                 |   |       |           |  |   |           |   |  |           |       |   |           |   |                    |   |  |   |     |  |   |    
|                                                              |  | $                      | 6,577 |   |                 | $ | 1,749 |           |  | $ | 1,581     |   |  | $         | 1,377 |   |           | $ | 740                |   |  | $ | 311 |  | $ | 819
|                                                              |  |                        |       |   |                 |   |       |           |  |   |           |   |  |           |       |   |           |   |                    |   |  |   |     |  |   |    



We have entered into
various arrangements with hosting services vendors and various non-cancelable operating facility lease agreements for our offices throughout the U.S. and for our international subsidiaries with original lease periods expiring through 2015. In
addition, we are under contract to fulfill facility leases for offices that were subleased to third party companies under restructuring plans.



Recent Accounting Pronouncements



Refer to the discussion of recent accounting pronouncements in Note 2 Summary of Significant Accounting Policies in our unaudited
Condensed Consolidated Financial Statements.



Factors That May Affect Future
Results of Operations



Set forth below and elsewhere in this report and
in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. All forward-looking statements
included in this document are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statement.



Our anticipated benefits of acquiring Pathlore Software Corporation may not be realized.



We expect that the Pathlore Software Corporation (Pathlore) acquisition will enhance our position in the
learning industry through the combination of our legacy product, and Pathlores technologies, products, services, distribution channels and customer contacts. We may not realize any of these benefits and the acquisition may result in the
deterioration or loss of significant business. For example, if our business, or the new Pathlore business fails to meet the demands of the marketplace, customer acceptance of products and services of the newly combined company could decline or
customer orders could be cancelled. In addition, we may not achieve the anticipated benefits of the acquisition as rapidly as, or to the extent,



27



---

##### Table of Contents

anticipated by our management and certain financial or industry analysts, and others may not perceive the same benefits
of the acquisition as our management does. For example, the sale of Pathlores products may not contribute to our results to the extent we expected for a number of reasons, including the integration risks described below.



In addition, the Pathlore acquisition decreased our cash position and will
dilute our existing stockholders percentage ownership. Further, some of our financial results will be negatively impacted due to certain purchase accounting rules which will result in a write-down of Pathlores deferred revenue and other
purchase accounting adjustments. We may also need to restructure aspects of our business in order to achieve anticipated synergies. These actions may result in restructuring charges, and may cause uncertainty among our employees, which may result in
the departure of certain key employees. The failure to effectively manage the acquisition and integration of Pathlore could disrupt our business and harm our financial results.



Each of these risks may result in a decrease in our stock price.



Customer and employee uncertainty related to the Pathlore acquisition could harm the
combined company.



Pathlore legacy customers may, in
response to the acquisition by us, delay or cancel purchasing decisions. Any delay or cancellation in purchasing decisions could seriously harm our business. Similarly, former Pathlore and SumTotal employees may experience uncertainty about their
future role with the combined company. This may adversely affect our ability to attract and retain key management, marketing and technical personnel.



Although we expect that the Pathlore acquisition will result in benefits to the combined company, those benefits may not occur or may be delayed because of integration
and other challenges.



Achieving the expected benefits of
the acquisition will depend in part on the integration of Pathlores legacy technology, products, operations, personnel and distribution channels in a timely and efficient manner. The challenges involved in this integration include:



| |  |  | incorporating Pathlores legacy technology and products into our line of products;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | integrating Pathlores legacy products into our business and distribution channels because we did not, until the acquisition, offer Pathlores products;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | integrating the former Pathlore technical team with our larger and more widely dispersed engineering organization;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | integrating the former Pathlore operations and financial reporting function into our operations and financial reporting systems; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | coordinating the efforts of the former Pathlores sales organization with our larger and more widely dispersed sales organization.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



The integration of the two businesses will be complex, time consuming and
expensive, may disrupt both companies businesses and may result in the loss of customers or key employees or the diversion of the attention of management, any of which could have a negative effect upon SumTotal Systems business and stock
price.



Any acquisition we make or attempt to make, including our
acquisition of Pathlore, could disrupt our business and harm our financial condition if we are not able to successfully close the acquisition or successfully integrate acquired businesses and technologies, or if we do close the acquisition, expected
benefits of the combination do not materialize.



We have
made and may continue to make acquisitions and investments in order to enhance our business. Acquisitions, whether or not consummated, require extensive efforts from numerous departments in the company. We have been, and, to the extent we acquire
other companies, will continue to, expend significant efforts on pursuing and closing the transactions. Such efforts are costly from both a personnel and financial perspective, distract key personnel from their ordinary responsibilities, and may or
may not ultimately result in the consummation of the acquisition. There can be no assurance that we will be able to timely close other acquisitions, or other business combinations we may make in the future on favorable terms or on a timely basis,
and failure to do so may negatively affect our financial results, customer, employee and investor confidence, and ultimately our stock price.



28



---

##### Table of Contents

Acquisitions involve numerous risks, including problems combining the purchased operations, technologies
or products, unanticipated costs, diversion of managements attention from our core business, adverse effects on existing business relationships with suppliers and customers, risks associated with entering markets in which we have no or limited
prior experience and potential loss of key employees. There can be no assurance that we will be able to successfully integrate Pathlore or any other businesses, products, technologies or personnel that we might acquire.



The integration of businesses that we have acquired into our business has
been and will continue to be a complex, time consuming and expensive process. Failure to operate as a combined organization utilizing common information and communication system, operating procedures, financial controls and human resources practices
could adversely impact the success of any business combination. For example, although we completed the combination of Docent and Click2learn in March 2004, integration of the products, product roadmap, operations and financial controls is a
continuing activity and will be for the foreseeable future. As a result of these activities, we may lose opportunities and employees, which could disrupt our business and harm our financial results.



Our credit facility requires compliance with certain restrictive covenants and if we
breach the covenants, we will be in default and the lender could demand repayment or foreclose on the loan.



The credit facility we established in conjunction with the acquisition of Pathlore, which closed October 4, 2005, requires compliance with certain
restrictive covenants. If we cannot achieve the financial results necessary to maintain compliance with these covenants, we could be declared in default and be required to sell or liquidate our assets to repay outstanding debt of approximately $17.5
million. These covenants include, but are not limited to, EBITDA levels, leverage ratios, capital expenditures, indebtedness, distributions, investments, and change of control restrictions. If we breach these covenants, there is no assurance that
the lender will waive the violation and the lender could demand repayment of the outstanding debt and could foreclose upon all or substantially all of our assets and the assets of our subsidiaries. These covenants may adversely affect our ability to
finance future operations, potential acquisitions or capital needs or to engage in other business activities that may be in our interest. As a result of our credit facility, we may be more leveraged than some of our competitors, which could place us
at a competitive disadvantage and make us more susceptible to downturns in our business in the event our income is not sufficient to cover our debt service requirements. Even if we are able to repay the debt, under the terms of the credit facility,
there are penalties for making pre-payments that would otherwise save us substantial future interest payments. The forced premature repayment of the loan due to a breach of the covenants or other default (i) could leave us without the ability
to control which assets were sold to satisfy the loan, and (ii) could leave us without sufficient assets to continue as a going concern. Each of these risks may cause concern among our customers or investors and therefore cause a decrease in
our sales or stock price.



We have a history of losses, we expect future
losses on a GAAP basis and we may not achieve GAAP profitability on a consistent basis.



Though we achieved profitability for the first time in the third quarter of fiscal year 2005, we may not be able to maintain profitability on a consistent basis, if at all.



We expect to derive substantially all of our revenue from the licensing of
our new business performance and learning technology software family of products, the SumTotal 7.0 Series, as well as our legacy products, Aspen Learning Management Server and Aspen Learning Content Management Server, Docent Learning Management
Server and Docent Learning Content Management System (Legacy Products) (SumTotal 7.0 Series and Legacy Products are hereinafter collectively called, SumTotal Systems Suite), and related services, including without limitation,
maintenance, services and hosting. We do not expect these product offerings to be sufficient to maintain GAAP profitability. Commencing at the end of the fourth quarter 2004 and beginning the first quarter 2005, we have begun our transition from our
Legacy Products to the SumTotal 7.0 Series, and services related to these offerings. If we fail to generate adequate revenues from the SumTotal Systems Suite and related services, we will continue to incur losses. In addition, in the future, we
expect to continue to incur additional non-cash expenses relating to the amortization of deferred compensation and purchased intangible assets that will contribute to our net losses. Further, starting with the first fiscal quarter of 2006, we will
be required to charge the expense related to all stock options to the statements of operations in accordance with SFAS No. 123R, Share Based Payments, which was issued by FASB in December 2004 which will have the impact of increasing our
reported GAAP losses. As a result of all of the foregoing, we expect to incur losses on a GAAP basis for the foreseeable future, and may not, despite our forecast, achieve profitability on an operational basis. Failure to meet or exceed our
forecasts or industry analysts projections could cause the price of our common stock to decline.



29



---

##### Table of Contents

Our products in general, and our newly released product and its updates, the SumTotal 7.0 Series, contain defects,
bugs and errors, known and unknown (collectively, Defects) and, if the Defects are material and we cannot fix such material Defects in a timely fashion, we may need to halt further sales or shipments of our products, delay introduction
of new products, and/or experience warranty claims.



Our
product offerings, both current and future, like all software programs generally, are complex and often contain unknown and undetected errors or performance problems despite internal and third party testing. New product offerings contain new
features and functionality which result in a greater likelihood of Defects. Many serious Defects are frequently found during the period immediately following introduction and initial shipment of new products or enhancements to existing products.
Although we attempted to discover and resolve all Defects in our new product line that we believed would be considered serious by our customers before shipment to them, SumTotal 7.0 Series is not error-free and some customers have notified us that
they consider some of the Defects in the SumTotal 7.0 Series to be serious. Nonetheless, we have, to date, been able to address, or are addressing, such concerns through professional services or maintenance, although we cannot assure you that we
will always be able to do so. The Defects, some of which were unknown to us, some that may yet to be discovered, and others that may manifest themselves in future releases of our product, could cause performance problems and result in material
adverse financial consequences, including without limitation, delay in recognizing, declining or lost revenues, delay in customer acceptance, warranty claims, refund requests, or litigation claims for breach of contract or other claims.



We offer warranties for product and services to our customers. Although we
have not experienced any material warranty claims and our historical return experiences have not been significant, past experience may not be indicative of increased future claims and returns. In addition, although our agreements contain provisions
designed to limit our exposure to potential liability claims, these provisions could be invalidated by unfavorable judicial decisions, or by federal, state, local or foreign laws or regulations, requiring us to incur significant expense or pay
substantial damages. Any of the above consequences could have a material adverse impact on our financial condition, results of operations, our reputation, or the market value of our common stock.



We may fail to successfully deploy SumTotal 7.0 Series on a timely basis, and we may
suffer unexpected problems and delays in upgrades from our Legacy Products to SumTotal 7.0 Series, including delays caused by lack of resources in our professional services group.



SumTotal 7.0 Series, our new product, has required, and will continue to require, the expenditure of significant resources
from all areas of our Company. In order to successfully market and sell the product, we must ensure broad-based cooperation and coordination from multiple departments, including engineering and marketing, and from multiple geographic regions,
including Bellevue, Washington, Mountain View, California, and Hyderabad, India. Our professional services group is new at deploying SumTotal 7.0 Series, and, although we believe we have made deployment timeframe estimations accurately, including
estimates for upgrading our existing customer base from our Legacy Products to SumTotal 7.0 Series, there is no assurance that our operations group will be able to deploy SumTotal 7.0 Series in accordance with our estimates. These failures may cause
us to delay recognizing revenue and customers to delay or cancel purchasing decisions, thereby causing a decline in the price of our common stock.



Our quarterly operating results are uncertain and may fluctuate significantly, which could negatively affect the value of your investment.



We have experienced substantial fluctuations in operating results, on a
quarterly and annual basis and expect these fluctuations will continue in the future. Our operating results will be affected by a number of factors, including, but not limited to:



| |  |  | the size and timing of product orders and the timing and execution of professional services engagements for SumTotal 7.0 Series and the Legacy Products;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the mix of revenue from products and services;
| | - |  | ----------------------------------------------



| |  |  | the ability to meet client project milestones;
| | - |  | ----------------------------------------------



| |  |  | the market acceptance of our products and services, especially SumTotal 7.0 Series and related services;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | ongoing costs and efforts in connection with compliance with Section 404 of the Sarbanes-Oxley Act;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | the timing of revenue and expense recognition;
| | - |  | ----------------------------------------------



| |  |  | the overall movement toward industry consolidation among both our competitors and our customers;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | recognition of impairment of existing assets; and
| | - |  | -------------------------------------------------



| |  |  | how well we execute on our strategy and operating plans.
| | - |  | --------------------------------------------------------



30



---

##### Table of Contents

Our future revenue is difficult to predict and we may not be able to adjust spending in response to
revenue shortfalls. Our limited operating history with our current business performance and learning management solutions and the rapidly evolving nature of the business performance and learning management market make prediction of future revenue
and expenses difficult. Expense levels are based, in part, on expectations as to future revenue and largely are fixed in the short-term. Other expenses, as a result of changes in the law or otherwise, such as expenses related to litigation or
compliance with Sarbanes-Oxley Section 404, may also increase and cause us to fall short of our forecasts. If we are unable to predict future revenue accurately, we may be unable to adjust spending in a timely manner to compensate for any
unexpected revenue shortfall, and may therefore fall short of our forecasts. Failure to meet our forecasts or industry analysts expectations would likely cause a decline in the price of our common stock.



Our stock price has been and may continue to be volatile.



The trading price of our common stock has been and is likely to continue to
be highly volatile. Our stock price is subject to continued fluctuations in response to a number of factors, including:



| |  |  | actual or anticipated variations in quarterly operating results;
| | - |  | ----------------------------------------------------------------



| |  |  | changes in financial estimates or recommendations by securities analysts;
| | - |  | -------------------------------------------------------------------------



| |  |  | compliance with Sarbanes-Oxley and, in particular, Section 404, including without limitation, the cost of identifying and remedying significant deficiencies and material
weaknesses in our internal controls;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | conditions or trends in business performance and learning management markets;
| | - |  | -----------------------------------------------------------------------------



| |  |  | announcements by us or our competitors of significant customer wins, technological innovations, new products or services;
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| |  |  | failure to accurately forecast sales of our software product, especially since we are reliant on the sales of a small number of relatively large orders;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | the seasonal fluctuations of our customers buying decisions;
| | - |  | -------------------------------------------------------------



| |  |  | additions or departures of key personnel;
| | - |  | -----------------------------------------



| |  |  | sales of our common stock; and
| | - |  | ------------------------------



| |  |  | general market conditions.
| | - |  | --------------------------



The stock market in general, and the market for enterprise software and technology companies in particular, recently has experienced extreme price and
volume fluctuations that have been unrelated or disproportionate to the operating performance of many of the affected companies. These broad market and industry factors may depress our stock price, regardless of our operating performance.



If our operating results were to be below the expectations of
public market analysts and investors, the market price of our common stock would likely decrease significantly. Fluctuations in the price and trading volume of our common stock may prevent stockholders from reselling their shares above the price at
which they purchased their shares.



In the past, companies that
have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation, like other litigation against us could
result in substantial costs, negative publicity and divert our managements attention, which could seriously harm our business and stock price.



Our recent stock performance may impair the carrying value of our goodwill and intangible assets.



Our common stock has declined from $8.00 per share on the first trading day following March 18, 2004 when the
acquisition of Docent was completed, to $4.64 per share on November 2, 2005. The carrying value of our goodwill and intangible assets on September 30, 2005 was $27.7 million and $6.6 million, respectively. A further sustained decline in
our stock price could trigger impairment of the carrying values of our goodwill and intangible assets and cause us to record an impairment charge to reduce the value of these assets to reflect their estimated fair values in future quarters.



31



---

##### Table of Contents

We may be unable to successfully manage the product transition to SumTotal 7.0 Series and/or subsequent releases.



We introduced SumTotal 7.0 in late December 2004,
SumTotal 7.1 in April 2005, and plan to launch subsequent product releases over the next year. We face numerous risks relating to product transitions, including customers delaying their purchasing decision until they have confidence in our new
product and until we have proven we can successfully install and implement SumTotal 7.0 Series. Due to the product transition, we may be unable to accurately forecast revenue from product sales and related services, the number and severity of
Defects and increased support requirements due to the complexity of the new product. If we fail to successfully manage the transition to this new product offering, our business and financial results may be adversely affected, which may cause a
decline in the price of our common stock.



Sales cycles are lengthy,
requiring considerable additional investment with no assurance of generating revenue from our efforts.



The period between our initial contact with a potential customer and a customers purchase of our products and services is lengthy, is getting
longer, and often extends over several fiscal quarters or a fiscal year. To sell our products and services successfully, we generally must educate our potential customers regarding the use and benefits of our products and services, which typically
requires significant time, capital and other resources. The delay or failure to complete sales in a particular quarter could reduce our revenue in that quarter, as well as subsequent quarters over which revenue for the sale would likely be
recognized. If the sales cycle unexpectedly lengthens in general or for one or more large orders, it would negatively affect the timing of our revenue, and our revenue growth would be harmed. Many of our potential customers are large enterprises
that generally take longer than smaller organizations to make significant business decisions. In addition, although we must expend and allocate resources prior to completing a sales transaction, we may never generate any revenue from these
activities.



Moreover, our revenue will be subject to
fluctuation as a result of general economic conditions and overall spending in the technology and enterprise software sectors. A weakening economy could result in organizations further delaying, canceling, or reducing capital expenditures generally
and spending on enterprise software applications in particular. A significant portion of our revenue is derived from the sale of products and services to large companies or government agencies, which historically have reduced their expenditures for
enterprise software applications during economic downturns.



There are
inherent limitations on the effectiveness of our internal controls and procedures that could impact our financial reporting and result in us failing to meet our financial projections.



Our management, including, without limitation, our Chief Executive Officer
and Chief Financial Officer, does not expect that our internal controls and procedures will prevent all errors and all fraud. A control system, no matter how well conceived or operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. The design of our control system reflects the fact that there are resource constraints. Because of the inherent limitations of all control systems, no evaluation of controls can provide absolute assurance
that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or
mistake. Additionally, controls and procedures can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of a control or procedure. The design of any system of controls and procedures
is also based in part on certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in
a cost-effective control system, misstatements due to error or fraud may occur and not be detected. In such event, we may not be able to recognize revenue we thought we could; we may not be able to meet our forecasts or industry analysts
projections; or we may be the subject of litigation, each of which would likely result in a decline in the price of our common stock.



Standards for compliance with Section 404 of the Sarbanes-Oxley Act of 2002 are burdensome and uncertain, and if we fail to comply in a timely manner, our
business could be harmed and our stock price could decline.



Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, our management is required to report on, and our independent auditors to attest to, the effectiveness of our internal controls over financial reporting, at least annually. The
rules governing the standards that must be met for management to assess our internal controls over financial reporting are new and complex, and require significant documentation, testing and possible remediation. The process of reviewing,
documenting and testing our internal controls over financial reporting will likely continue to result in increased expenses and the devotion of significant management and other internal resources. As we did in connection with 2004, we may encounter
problems or delays in completing the implementation of any changes necessary to make a favorable assessment of our internal controls



32



---

##### Table of Contents

over financial reporting at the end of the current fiscal year. During this process, if we are unable to effectively
remediate our material weaknesses, or if our management identifies one or more material weaknesses in our internal control over financial reporting, we will be unable to assert such internal control is effective.



Section 404 compliance is relatively new, and we were not able to comply
with the requirements of Section 404 for fiscal year 2004 on a timely basis. We have numerous material weaknesses, and have extensive remediation plans and requirements, not all of which have been developed, or, if developed, implemented. There
is no assurance that our remediation plans, both those developed, as well as those yet to be developed, will effectively address the material weaknesses, or that such changes in our control procedures will not create other material weaknesses. If
our management is unable to assert that our internal control over financial reporting is effective (or if our auditors are unable to attest that our management report is fairly stated or they are unable to express an opinion on the effectiveness of
our internal controls) we may not be able to timely file, or file at all, our periodic financial reports, and thus we will be subject to delisting. Even if we are able to file such reports, investor confidence in the accuracy and completeness of our
financial reports may be lost, and this would have an adverse effect on the price of our common stock.



In addition, we recently engaged new auditors for the fiscal year ending December 31, 2005. Since the auditors are newly engaged, we have not been
through the process related to managements report on internal controls and procedures and auditors attestation report with these auditors. Our new auditors may identify additional weaknesses in our controls and procedures that were not
identified during the 404 compliance process with our prior auditors. If we are unable to effectively remediate any additional material weaknesses identified by us or our auditors, we will be unable to asset such internal control is effective.



Recently enacted and proposed changes in securities laws and regulations
have increased, and are likely to continue to increase, our expenses.



Recently enacted and proposed changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, have increased, and will continue to increase, our expenses as
we devote resources to respond to the new requirements. The Sarbanes-Oxley Act mandates, among other things, that companies adopt new corporate governance measures, and it imposes comprehensive reporting and disclosure requirements; sets stricter
independence and financial expertise standards for audit committee members; and imposes increased civil and criminal penalties for companies, their chief executive officers, chief financial officers and directors for securities law violations. In
particular, we have incurred, and will continue to incur, additional administrative expense as we implement Sarbanes-Oxley Section 404, which requires management to report on, and our independent registered public accounting firm to attest to,
our internal controls. In addition, the NASDAQ National Market, on which our common stock is listed, has also adopted comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased and will
continue to increase the scope, complexity and cost of our corporate governance, reporting and disclosure practices, which could harm our results of operations and divert managements attention from business operations. We also expect these
developments to make it more difficult and more expensive for us to obtain director and officer liability insurance in the future, and we may be required to accept reduced coverage or incur substantially higher costs to maintain coverage. Further,
our directors and executive officers could face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficultly attracting and retaining qualified directors and executive officers,
which could adversely affect our business.



Our business may not generate
the cash needed to finance our operations or growth, and for that and other reasons we may need additional financing in the future, which we may be unable to obtain.



If our business does not generate the cash needed to finance our operations or growth, including potential business
acquisitions, we may need to obtain additional financing or take steps to restrict our operations in order to conserve existing cash. In addition, poor financial results or unanticipated expenses could give rise to additional financing requirements.
We may be unable to obtain financing on terms favorable to us, or at all. Further, it may be more difficult to obtain additional financing because of our credit facility. If we need to obtain financing and adequate funds are not available or are not
available on acceptable terms, we may be required to make further expense reductions, which could significantly restrict our operations and limit our ability to enhance our products, fund expansion, respond to competitive pressures or take advantage
of business opportunities.



Implementation of SFAS No. 123R,Share-Based Paymentin the first fiscal quarter of 2006 will negatively impact our operating results.



We are currently required to record stock-based compensation charges only if the employees stock option exercise price is less than the deemed fair
value of our common stock at the grant or measurement date, and in such event, we would



33



---

##### Table of Contents

record a charge only for the difference between the grant price and the deemed fair value. However, in December 2004, the
FASB issued SFAS No. 123R, Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or
liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions
using the intrinsic value method as prescribed by APB No. 25, Accounting for Stock Issued to Employees, and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in our
consolidated statement of operations. The statement requires companies to assess the most appropriate model to calculate the value of the options. We currently use the Black-Scholes option pricing model to value options and are currently assessing
which model we may use in the future under the statement and may deem an alternative model to be the most appropriate. The use of a different model to value options may result in a different fair value than the use of the Black-Scholes option
pricing model. In addition, there are a number of other requirements under the new standard that will result in differing accounting treatment than currently required. These differences include, but are not limited to, the accounting for the tax
benefit on employee stock options and for stock issued under our ESPP. In addition to the appropriate fair value model to be used for valuing share-based payments, we will also be required to determine the transition method to be used at date of
adoption. The allowed transition methods include prospective and retroactive adoption options. Under the retroactive options, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The
prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS No. 123R, while the retroactive methods would record compensation
expense for all unvested stock options and restricted stock beginning with the first period restated. The effective date of the new standard for our consolidated financial statements is the first fiscal quarter of 2006.



Upon adoption, this statement will have a significant impact on our
consolidated financial statements as we will be required to expense the fair value of our stock option grants and stock purchases under the ESPP rather than disclose the impact on our consolidated net loss within the footnotes as is our current
practice found in Note 2 Summary of Significant Accounting Policies in the unaudited Condensed Consolidated Financial Statements. The amounts disclosed within the footnotes are not necessarily indicative of the amounts that will
be expensed upon the adoption of SFAS No. 123R. Compensation expense calculated under SFAS No. 123R may differ from amounts currently disclosed within the footnotes based on changes in the fair value of our common stock, changes in the
number of options granted or the terms of such options, the treatment of tax benefits and changes in interest rates or other factors. In addition, upon adoption of SFAS No. 123R, we may choose to use a different valuation model to value the
compensation expense associated with employee stock options.



On May 31, 2005, the Board of Directors of SumTotal Systems approved the acceleration of vesting of certain unvested and out-of-the-money stock options with exercise prices equal to or greater than $5.60 per share previously awarded to
its employees, including its Section 16 officers, under each of the SumTotal Systems equity compensation plans. Refer to the discussion of stock-based compensation in Note 2 Summary of Significant Accounting Policies in
our unaudited Condensed Consolidated Financial Statements.



We face intense
competition from other business performance and learning management software providers including Saba Software, Inc., Plateau Systems Ltd., Learn.com, GeoLearning, and International Business Machines Corporation, as well as other enterprise software
vendors such as SAP AG, Oracle Corporation and Siebel Systems, Inc., and we may be unable to compete successfully.



The business performance and learning management software market is highly fragmented and competitive, with no single company accounting for a dominant
share of the market. Our competitors vary in size, scope and the breadth of products and services offered. We will face competition from:



| |  |  | other developers of business performance and learning technology systems;
| | - |  | -------------------------------------------------------------------------



| |  |  | providers of other business performance and learning technology solutions;
| | - |  | --------------------------------------------------------------------------



| |  |  | large professional consulting firms and in-house information technology departments; and
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | developers of Web authoring tools.
| | - |  | ----------------------------------



There are relatively low barriers to entry in the business performance and learning technology market, and new competitors may enter this market in the
future. Increased competition may result in price reductions, reduced gross margins or loss of market share.



34



---

##### Table of Contents

Our principal competitors are Saba Software, Inc., Plateau Systems Ltd., International Business Machines
Corporation, Learn.com, GeoLearning, SAP AG, Oracle Corporation and Siebel Systems, Inc.



We may lose business, as well as market share, due to increased competition. In particular, vendors of other enterprise software applications such as enterprise resource planning, human resource management or customer
relationship management have begun to offer learning delivery and management functionality to extend their current product lines. Although these vendors offerings may not offer the same functionality as our products, bundling these offerings
with the remainder of their solutions could diminish our ability to sell our products and services to their customers or other prospects. Announcements by these companies of future products could delay purchasing decisions by their customers and our
prospects. Either diminished sales or delayed purchases could adversely affect our business.



Certain of our existing and potential competitors have longer operating histories and significantly greater financial, technical, marketing and other resources and therefore may be able to respond more quickly to new
or changing opportunities, technologies, standards and customer requirements or to compete more aggressively on pricing. Price competition would likely result in reduced gross margins and may prevent our products from yielding results sufficient for
our business to succeed.



Strategic relationships are important
in expanding the distribution reach of companies in the business performance and learning technology market. If competitors establish strategic relationships to resell or distribute their products through their strategic partners, our ability to
market and sell products and services successfully may be substantially diminished. In addition, the existence or announcement of strategic relationships involving competitors could adversely affect our ability to attract and retain customers.



Industry consolidation may lead to increased competition and may harm our
operating results.



There has been a trend toward industry
consolidation in the software market for several years. We expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations. We
believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers. This could lead to more variability in operating results and could have a material adverse effect on our
business, operating results, and financial condition. Furthermore, rapid consolidation may lead to fewer customers, with the effect that loss of major customers could have a material impact on results not anticipated in a customer marketplace
composed of more numerous participants.



A substantial amount of our
engineering activities are based in Hyderabad, India and are subject to contingencies and delays that arent typically experienced with stateside engineering efforts, and our Indian office, along with our Washington office, must be well
integrated.



We have an increasing reliance on our
engineering operations in Hyderabad, India to enable us to complete customer implementation projects and new releases of our products on time and within our established budgets. Should our operations in Hyderabad be disrupted for any significant
period of time, it could prevent us from completing customer implementations or new releases of our product offerings in a timely manner, which could cause our business to suffer.



Our efforts in Hyderabad and elsewhere abroad are subject to a number of risks inherent in international operations,
including:



| |  |  | diversion of management attention;
| | - |  | ----------------------------------



| |  |  | difficulties and costs of recruiting and retaining qualified engineers and other personnel in our foreign offices;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | different learning styles and cultures;
| | - |  | ---------------------------------------



| |  |  | intense and increasing competition from other technology companies with regard to hiring and retaining qualified personnel;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | increasing growth and development of the technology market in India generally, and in Hyderabad specifically; increasing competition and costs of hiring and retaining qualified
personnel;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | numerous and potentially conflicting regulatory requirements;
| | - |  | -------------------------------------------------------------



| |  |  | export controls, import tariffs and other barriers to trade;
| | - |  | ------------------------------------------------------------



| |  |  | changes in laws or governmental policies;
| | - |  | -----------------------------------------



35



---

##### Table of Contents

| |  |  | reduced protection of intellectual property rights;
| | - |  | ---------------------------------------------------



| |  |  | regional political and economic instability; and
| | - |  | ------------------------------------------------



| |  |  | fluctuations in currency exchange rates.
| | - |  | ----------------------------------------



If our Indian or other overseas operations fail, for any reason, to provide adequate and timely product enhancements, updates and fixes to us, our ability
to fix Defects in our SumTotal 7.0 Series, our ability to develop new versions of our SumTotal 7.0 Series, and our ability to respond to customer or competitive demands would be harmed and we would lose sales opportunities and customers.



In addition, we plan to have our engineering efforts based primarily out
of two offices  Bellevue, Washington and Hyderabad, India. If we fail to successfully staff either of these offices, or fail to ensure that these two offices work together, then we may experience delays in fixing Defects in SumTotal 7.0 Series
or in developing and releasing future versions of our product. In such event, our business and financial results may be adversely impacted and could result in a decline in the price of our common stock.



We are facing significant resource constraints in our professional services group.



The revenue from our professional services group is
growing, and is becoming an increasing percentage of our total revenue. For instance, in fiscal year 2004, professional services consulting revenue was approximately 23% of our overall revenue. At times, the demand for our professional services
exceeds our available resources. Even if we are successful in recruiting additional professional services personnel, which we cannot guarantee we will be, it will take time for the new personnel to become familiar with our products and to integrate
into our Company. As such, we may not be able to meet customer demands, thereby causing potential delays in, or adverse decisions in, purchasing decisions or upgrade challenges, causing customer dissatisfaction and potential warranty or breach of
contract claims. Each of these may result in a decline in revenue and/or stock price.



The business performance and learning management software market may not grow to a sufficient size or at a sufficient rate to sustain our business.



Corporate training and education historically have been conducted primarily through classroom instruction. Although
technology-based training applications have been available for many years, they currently account for only a small portion of the overall corporate learning market. Accordingly, our success will depend on the extent to which companies implement
business performance and learning management software solutions for the design, development, delivery and management of their corporate learning needs.



Many companies that have already invested substantial resources in traditional training methods may be reluctant to adopt a new strategy that may limit or
compete with their existing investments. Even if companies implement business performance and learning management software solutions, they may still choose to develop such solutions internally. If the use of business performance and learning
management software does not become widespread or if companies choose to develop such software internally rather than acquiring it from third parties, then our business performance and learning management software may not be commercially successful.



We outsource some of the management and maintenance of our hosted and ASP
solutions to third parties and will depend on them to provide adequate management and maintenance services.



We rely on third parties to provide key components of our networks and systems. For instance, we rely on third party Internet service providers to host
our SumTotal Systems Suite for customers who desire to have these solutions hosted. We also rely on third party communications service providers for the high-speed connections that link our web servers and office systems and our Internet service
providers Web servers and office systems to the Internet. Any Internet or communications systems failure or interruption could result in disruption of our service or loss or compromise of customer orders and data. These failures, especially if
they are prolonged or repeated, would make our services less attractive to customers, may subject us to customer liability, or may tarnish our reputation, thereby causing a decrease in our revenue and an accompanying decline in the price of our
common stock.



We face risks encountered in rapidly evolving markets and may
be unsuccessful in addressing these risks.



We face risks
frequently encountered in rapidly evolving markets. Specific risks we face relate to the demand for and market acceptance of our business performance and learning technology solutions including the risk that our new product



36



---

##### Table of Contents

suite, the SumTotal 7.0 Series, just recently introduced to the market, will fail to achieve market acceptance. We may
fail to adequately address these risks, and therefore our business may suffer. To address these risks, we must:



| |  |  | effectively market our business performance and learning technology software to new and existing customers;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | continue to enhance the technology upon which our business performance and learning technology software is based;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | successfully implement our business performance and learning technology software for our customers and generate continuing revenue from those customers; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | address and establish new technologies and technology standards.
| | - |  | ----------------------------------------------------------------



International operations may impose substantial burdens on our resources, divert managements attention or otherwise harm our business.



We rely on independent partners in many foreign countries to help conduct
our international operations and sales and marketing efforts. Our success in international markets consequently will depend to a large degree on the success of these independent partners, over which we have little control. If they are unwilling or
unable to dedicate sufficient resources to our relationships, our international operations will suffer. The operations of these partners are based outside the U.S. and therefore subject to risks distinct from those that face U.S.-based operations.



Conducting business outside of the U.S. is subject to certain
risks, including:



| |  |  | military action or political upheaval in the host countries could force these partners to terminate the services they are providing to us or to close their operations entirely;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | social unrest or disturbances;
| | - |  | ------------------------------



| |  |  | the burden of complying with a variety of foreign laws;
| | - |  | -------------------------------------------------------



| |  |  | language barriers;
| | - |  | ------------------



| |  |  | longer payment cycles and greater difficulty in collecting accounts receivable;
| | - |  | -------------------------------------------------------------------------------



| |  |  | reduced protection of intellectual property rights;
| | - |  | ---------------------------------------------------



| |  |  | fluctuating exchange rates; and
| | - |  | -------------------------------



| |  |  | price controls and other restrictions on foreign currency.
| | - |  | ----------------------------------------------------------



In addition, based on our limited history of working with these partners, we cannot be sure that our cost estimates will prove correct. Unanticipated
increases in our operating expenses in any given quarter would increase our net losses and could require us to obtain additional financing sooner than expected.



Economic, political and market conditions can adversely affect our revenue growth.



There are increasing signs of an improving economic environment. However, it may be too early to determine whether an
economic recovery will be broad, substantial and sustained, and whether any such recovery would translate to sustained higher levels of information technology spending. If demand for our software and related services does not continue to strengthen,
our revenue growth rates for new software licenses and, to a lesser extent, our revenue growth rates for software license updates and professional services will be adversely affected. In addition, the war on terrorism and the potential for other
hostilities in various parts of the world continue to contribute to a climate of economic and political uncertainty that could adversely affect our revenue growth and results.



Although our business depends materially on the condition of domestic and foreign economies, our management has no
competitive advantage in forecasting macroeconomic trends and developments relating to these general business conditions. Our management is, however, required to make forecasts in order to develop budgets, plan research and development strategies
and perform a wide variety of general management functions. To the extent that our forecasts are in error, because we are either overly optimistic or overly pessimistic about the performance of an economy, our performance can suffer because of a
failure to properly match corporate strategy with economic conditions.



37



---

##### Table of Contents

International laws and regulations may expose us to potential costs and litigation.



Our international operations increase our exposure to international laws and
regulations. If we cannot comply with foreign laws and regulations, which are often complex and subject to variation and unexpected changes, we could incur unexpected costs and potential litigation. For example, the governments of foreign countries
might attempt to regulate our products and services or levy sales or other taxes relating to our activities. In addition, foreign countries may impose tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers, any
of which could make it more difficult and costly for us to conduct our business.



We will need to expand sales through distributors, alliance partners, value-added resellers and systems integrators in order to develop our business and increase revenue.



We expect to increasingly rely on distributors, alliance partners, value-added resellers, and systems integrators for the
distribution and sale of our branded products globally. Our strategy contemplates the expansion of our distributor and reseller network both domestically and internationally. Our future success will depend in part on our ability to attract, train
and motivate new distributors and resellers and expand our relationships with current distributors and resellers. We may not be successful in expanding our distributor and reseller relationships, and our sales would suffer as a result. Further, we
will be required to invest significant additional resources in order to expand these relationships, and the cost of this investment may exceed the margins generated from this investment.



We have experienced and may continue to experience turnover of senior management and key personnel, which could harm our business or
operations.



Our success depends to a significant degree
on the performance of the senior management team and other key employees. Our Chief Executive Officer resigned in October 2005, and, as a result, even though our Board Chair is interim Chief Executive Officer, we are going through a period of
uncertainty while our Board conducts a search for a new Chief Executive Officer. There can be no assurance that once hired, the new Chief Executive Officer will be able to work with our management team effectively to successfully implement our
strategy. While our Section 16 officers and have been given two-year retention bonuses, there is no guarantee that such officers and other employees will remain employed with us. The loss of any of these individuals could harm our business. We
do not have employment agreements with our executives or with any other key employee, and we do not maintain key person life insurance for any officer or key employee.



Our success also depends on our ability to attract, integrate, motivate and retain highly skilled technical, sales and
marketing and professional services personnel. Competition for qualified personnel in the software industry, particularly engineering and other technical personnel, is intense and there can be no assurance that we will be able to attract and retain
highly skilled employees in sufficient numbers to sustain our current business or to support future growth.



Our lack of product diversification, and our reliance on the SumTotal Systems Suite, means that any decline in price or demand for our products and services would seriously harm our business.



Our SumTotal Systems Suite and our new product, SumTotal 7.0 Series and
successor products and related services are expected to continue to account for a significant majority of our revenue for the foreseeable future. Consequently, a decline in the price of, or demand for, the SumTotal Systems Suite and successor
products or services, or their failure to achieve broad market acceptance, would seriously harm our business and would likely result in the decline of our common stock.



We may not be able to adapt to rapidly changing technology and evolving industry standards and if, as a result, our products become
obsolete or there is a delay in meeting our customer needs, we would lose market share.



The business performance and learning management software market is characterized by rapidly changing technologies, frequent new product and service introductions, short development cycles and evolving industry
standards. The introduction of new products and services embodying new technologies and the emergence of new industry standards may render our products and services obsolete. Our success depends on our ability to adapt to a rapidly changing
landscape and to offer new products and services to address our customers changing demands. We may experience difficulties that delay or prevent the successful design, development, introduction or marketing of our products and services. To the
extent we in fact experience such delays, we may experience difficulty in attracting new customers and may lose existing customers.



We face the risk of liability for failures to meet unique customer requirements, and the risk of cost overruns on fixed-price projects.



The failure or inability to meet a customers unique expectations or
requirements for our products or in the performance of services could impair our reputation or result in a claim for damages, regardless of our responsibility for the



38



---

##### Table of Contents

failure. Although generally we attempt to contractually limit our liability for damages arising from Defects and other
mistakes in rendering professional services, these contractual protections are not always obtained and may not be enforced or otherwise may not protect us from liability. Our insurance may not be sufficient to cover these claims or may not even
cover these claims. In addition, some of our professional services projects are performed on a fixed-price basis rather than on a time and materials basis. If we do not complete fixed-price engagements within budget, on time and to clients
satisfaction, we bear the risk of cost overruns.



Market acceptance of new
platforms and operating environments may require us to undergo the expense of developing and maintaining compatible product lines.



Although our software products can be licensed for use with a variety of popular industry standard relational database management system platforms, there
may be existing or future platforms that achieve popularity in the marketplace which may not be architecturally compatible with our software product design. Moreover, existing or future user interfaces that achieve popularity within the business
application marketplace may or may not be architecturally compatible with our current software product design. Developing and maintaining consistent software product performance characteristics across all of these combinations could place a
significant strain on our resources and software product release schedules, which could adversely affect revenue and results of operations. To maintain software performance across accepted platforms and operating environments, to achieve market
acceptance of those that we support, or to adapt to popular new ones, our expenses may increase and our sales and revenues may be adversely affected.



Our disaster recovery plan does not include redundant back-up computer systems, and a disaster could severely damage our operations.



Our disaster recovery plan does not include redundant back-up computer
systems at an alternate site. A disaster could severely harm our business because our computer systems could be interrupted for an indeterminate length of time. Our operations depend on our ability to maintain and protect the computer systems needed
for our day-to-day operations. A number of these computer systems are located in Silicon Valley on or near known earthquake fault zones and flood plains. Although these systems are designed to be fault tolerant, they are vulnerable to damage from
fire, floods, earthquakes, power loss, telecommunications failures and other events. Any damage to our facility could lead to interruptions in the services we provide to our customers and loss of customer information, and could substantially if not
totally impair our ability to operate our business. The business interruption insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions.



Terrorism and the declaration of war by the U.S. against terrorism and other possible U.S.
military actions may adversely affect our business.



The
terrorist attacks that took place in the U.S. on September 11, 2001, the potential for future terrorist attacks in the U.S., the declaration of war by the U.S. against terrorism, the terrorist attack in the U.K. on July 7, 2005, the
military actions in Afghanistan and Iraq and other existing and possible U.S. military actions have created significant instability and uncertainty in the world which may continue to have a material adverse effect on world financial markets,
including financial markets in the U.S. In addition, such adverse political events may have an adverse impact on economic conditions in the U.S. Unfavorable economic conditions in the U.S. may have an adverse effect on our business operations
including, but not limited to, our ability to expand the market for our products, obtain financing as needed, enter into strategic relationships and effectively compete in the business performance and learning management market.



Security and privacy breaches could subject us to litigation and liability.



We host certain of our customers business
performance and learning management software implementations and provide access to that software using the Internet. Computer viruses could be introduced into our systems or those of our customers, which could disrupt the operation of our hosting
systems or make them inaccessible to users. We depend on Internet service providers and telecommunications companies and the efficient operation of their computer networks and other computer equipment to enable customers to access and use hosted
software implementations. Each of these partners has experienced significant outages in the past and could experience outages, delays and other difficulties due to system failures unrelated to our systems, which could cause our customers to believe
we were at fault and withhold payments due to us.



We could
become subject to litigation and liability if third parties penetrate security for our hosting systems or otherwise misappropriate our users confidential information, or if customers are unable to access and use hosted software
implementations. Advances in computer capabilities, new discoveries in the field of cryptography or other technological events or developments could result in compromises or breaches of our security systems. Anyone who circumvents our security
measures could misappropriate proprietary information or cause interruptions in our services or operations. We may be required to expend significant capital and other resources to protect against the threat of security breaches or service
interruptions or to alleviate problems caused by breaches or service interruptions.



39



---

##### Table of Contents

Our intellectual property is subject to, and may be subject to, additional legal challenges or unauthorized use or
claims of infringement, any of which could diminish the value of our products and services or deter customers from purchasing our products.



Our success depends in large part on our proprietary technology. We rely on a combination of copyrights, trade secret and trademark laws, contractual
restrictions, restrictions on disclosure and other methods to protect our proprietary technology. These legal protections afford only limited protection for our technology. We hold only two issued patents underlying the products developed by Docent
prior to the merger of Docent and Click2learn, and do not hold patents for any of the technology underlying Click2learns legacy Aspen product offering, nor any patents for SumTotal 7.0 Series. Furthermore, effective protection of intellectual
property rights is unavailable or limited in certain foreign countries. It may also be possible for third parties to copy or otherwise obtain and use our intellectual property or trade secrets without our authorization, and it may be possible for
third parties to independently develop substantially equivalent intellectual property. We cannot assure you that the protection of our proprietary rights will be adequate or that our competitors will not independently develop similar technology,
duplicate our products and services or design around any patents or other intellectual property rights we hold. Consequently the value of our products and services to our customers could diminish substantially.



From time-to-time, we are involved in legal proceedings or threats of legal
proceedings arising in the ordinary course of business. We are not a party to any litigation or other legal proceeding that, in the opinion of management, is not reasonably likely to have a material adverse effect on our business, operating results
and financial condition, except as described below.



IpLearn,
LLC v. Docent, Case No. CV-02-2636 DLJ (Docent Case); and IpLearn, LLC v. Click2learn.com, Inc., Case No. CV-04-00685 DLJ (Click2learn Case). On May 31, 2002, IpLearn filed a patent infringement case against Docent, and
in February 2004, a patent infringement case against Click2learn. In October 2004, the Docent Case and the Click2learn Case were consolidated into one case, IPLearn, LLC v. SumTotal Systems, Inc., Case No. CV-02-02636 DLJ (the SumTotal
Case). The action is pending before the Northern District of California and concerned the same patent family. IpLearn, around the same time as the Docent Case was filed, sued several other manufacturers of on-line learning software. IpLearn
alleges that certain Docent and Click2learn software products infringe eight IpLearn patents that relate to online learning. IpLearn is seeking injunctive relief and unspecified monetary damages. The case is still in the discovery phase. On
September 16, 2005, we filed two summary judgment motions, one alleging that three of IpLearns patents are invalid. The second summary judgment motion seeks dismissal of the infringement claims against the Docent products because, two and
a half years after IpLearn filed its case against the Docent products, IpLearn has failed to make a prima facie case that the Docent products infringe. The judge issued a ruling indicating that he would set a briefing and hearing schedule for the
summary judgment motions at the Markman hearing, which is currently scheduled for November 18, 2005. In advance of the November 18, 2005 hearing, the parties have entered into settlement discussions.



We entered into these discussions because of the uncertainties inherent in
any litigation, as well as the distraction to management and the expenses associated with litigation. At this point, there is no agreement between the parties, including without limitation, an agreement on the scope of any potential settlement in
terms of which patents the settlement would apply to, or the amount of such settlement, although, most recently, a range from $0 to approximately $5.4 million has been discussed. We believe, at the time of this filing, that a loss from settlement or
judgment is less than probable and therefore we have not established an accrual for this potential loss. We expect there may be further discussions through November 18, 2005, and potentially thereafter. We cannot be certain, however, that if the
parties were to reach a settlement at some point in the future (a) when such settlement would occur, if ever; (b) whether such settlement, if any, would be within the range stated above; or (c) the scope of such settlement, if any.



Nonetheless, patent infringement claims are expensive to defend and divert
management attention from operating our business. In addition, even though we may prevail initially in any particular case, as we experienced in the IP Innovation case, such matter may be subject to appeal by plaintiff and may subject us to
time-consuming and costly delays in final resolution of a particular case. In addition, now that we acquired Pathlore, we may be the subject of additional intellectual property infringement cases. In the event it is in fact determined that Docent,
Click2learn or Pathlore were, or we are, infringing the patents that are the subject of any of these claims or other third party patents or other intellectual property claims, we may be required to cease shipping, to pay damages, to license
technology on terms that may not be favorable to us or to alter our technology, website or software products, any of which may adversely affect our operating results and cause us to meet our forecasts or industry analysts forecasts, thereby
causing a possible decline in the price of our common stock.



40



---

##### Table of Contents

In addition, from time-to-time, we have received, and may in the future receive, notice of claims of
infringement of other parties proprietary rights. Such claims could result in costly litigation and could divert management and technical resources. They could also delay product shipment or require us to develop non-infringing technology or
enter into royalty or licensing agreements, which agreements may not be available on reasonable terms, or at all.



Our products include third party technology, the loss of which could materially harm our business. Errors in this third party software or our inability to continue to
license this software in the future could increase our costs and decrease our revenue.



We use some licensed third party technology components in our products. Future licenses to this technology may not be available to us on commercially reasonable terms, or at all. The loss of or inability to obtain or
maintain any of these technology licenses could result in delays in the introduction of new products or could force us to discontinue offering portions of our business performance and learning management solutions until equivalent technology, if
available, is identified, licensed and integrated. The operation of our products would be impaired if errors occur in the third party software that we incorporate, and we may incur additional costs to repair or replace the defective software. It may
be difficult for us to correct any errors in third party software because the software is not within our control. Accordingly, our revenue could decrease and our costs could increase in the event of any errors in this technology. Furthermore, we may
become subject to legal claims related to licensed technology based on product liability, infringement of intellectual property or other legal theories.



We may become subject to government regulation and legal uncertainties that could result in liability or increase the cost of doing business, thereby adversely
affecting our financial results.



We are not currently
subject to direct regulation by any domestic or foreign governmental agency, other than regulations applicable to businesses generally, such as export control laws and laws or regulations directly applicable to Internet commerce. However, due to the
increasing popularity and use of the Internet, it is possible that a number of laws and regulations may become applicable to us or may be adopted in the future with respect to the Internet covering issues such as taxation, user privacy, content,
right to access personal data, copyrights, distribution and characteristics and quality of services.



The applicability of existing laws governing issues such as taxation, property ownership, copyrights, and other intellectual property issues, encryption,
libel, export or import matters and personal privacy to the Internet is uncertain. The vast majority of these laws were adopted prior to the broad commercial use of the Internet and related technologies. As a result, they do not contemplate or
address the unique issues of the Internet and related technologies. Changes to these laws, including some recently proposed changes, could create uncertainty in the Internet marketplace. Such uncertainty could reduce demand for our services or
increase the cost of doing business due to increased costs of litigation or increased service delivery costs.



In addition, we could be liable for the misuse of personal information. The Federal Trade Commission, the European Union and certain state and local
authorities have been investigating certain Internet companies regarding their use of personal information. We could incur additional expenses if new regulations regarding the use of personal information are introduced or if these authorities choose
to investigate our privacy practices.



Anti-takeover provisions could make
the sale of the Company more difficult.



Our certificate
of incorporation and bylaws contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. For example, no potential acquirer would be able to call a special meeting of stockholders to
remove our board of directors. A potential acquirer would also not be able to act by written consent without a meeting. In addition, our board of directors has staggered terms that make it difficult to remove all directors at once. The acquirer
would also be required to provide advance notice of its proposal to remove directors at an annual meeting. The acquirer would not be able to cumulate votes at a meeting, which would require the acquirer to hold more shares to gain representation on
our board of directors than if cumulative voting were permitted.



Subject to our fiduciary duties, our board of directors may in the future adopt a stockholder rights plan. If the board adopts a stockholder rights plan, it may discourage a merger or tender offer involving our securities that is not
approved by our board of directors by increasing the cost of effecting any such transaction and, accordingly, could have an adverse impact on stockholders who may want to vote in favor of such merger or participate in such tender offer.



In addition, Section 203 of the Delaware General Corporation Law
limits business combination transactions with 15% stockholders that have not been approved by the issuers board of directors. These provisions and other similar provisions make it more difficult or impossible for a third party to acquire us
without negotiation. These provisions may apply even if the offer may be considered beneficial by some stockholders.



41



---

##### Table of Contents

Item 3. Quantitative and Qualitative Disclosures about Market Risk



Market Rate Risk.We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use
derivative financial instruments for speculative or trading purposes.



Interest Rate Risk.We hold our assets primarily in cash and cash equivalents, such as short-term marketable debt securities, money market funds and other cash equivalents and short-term investments such as commercial paper,
publicly traded common stock and treasury notes. We minimize risk by investing in financial instruments with original maturities of less than one year. As a result, if market interest rates were to increase immediately and uniformly by 10% from
levels at September 30, 2005, the fair value of cash and cash equivalents and short-term investments would not change by a material amount.



Foreign Currency Exchange Risk.We have foreign currency risk as a result of foreign subsidiary activities. In the three and nine-months
ended September 30, 2005 revenue from sales outside North America accounted for approximately 18% and 20% of total revenue, respectively, from 28% and 25%, in the comparable periods in 2004, respectively. All foreign subsidiaries use the local
currency as their functional currency.



Our exposure to foreign
exchange rate fluctuations arises in part from inter-company accounts in which costs incurred in the U.S. are charged to the foreign subsidiaries. These inter-company accounts are typically denominated in the functional currency of the foreign
subsidiary in order to centralize foreign exchange risk with the parent company in the U.S. We are also exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated in U.S. dollars in consolidation.
As exchange rates vary, certain transaction gains and losses may vary from expectations and adversely impact overall expected profitability. The effect of foreign exchange rate fluctuations in the three and nine-months ended September 30, 2005
was not material. Due to the substantial volatility of currency exchange rates, among other factors, we cannot predict the effect of exchange rate fluctuations on our future operating results.



We have not entered into any forward exchange contracts to hedge exposures
denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. However, in the event that our exposure to foreign currency risk increases, we may choose to hedge those exposures in the future.



Item 4. Controls and Procedures



(a)
Evaluation of Disclosure Controls and Procedures



Management, including our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended, as of September 30, 2005. Our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the
Exchange Act is recorded, processed, summarized and reported accurately and on a timely basis.



Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective as of September 30, 2005 because the material
weaknesses described below and in our Form 10-K for the period ended December 31, 2004 were not fully remediated as of September 30, 2005.



To address the material weaknesses described below, we performed additional analyses and other post-closing procedures to ensure our consolidated
financial statements were prepared in accordance with generally accepted accounting principles. Accordingly, management, including our Chief Executive Officer and Chief Financial Officer, believe the condensed consolidated financial statements
included in this report fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented.



(b) Managements Report on Internal Control Over Financial Reporting



Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and
15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles in the United States (U.S. GAAP).



42



---

##### Table of Contents

Our management assessed the effectiveness of our internal control over financial reporting as of
December 31, 2004. Managements assessment identified the following material weaknesses in the Companys internal control over financial reporting as of December 31, 2004:



1.Inadequate company-level controls.We did not maintain effective
company-level controls as defined in the Internal ControlIntegrated Frameworkpublished by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). These deficiencies related to each of the five components of
internal control as defined by COSO (control environment, risk assessment, control activities, information and communication, and monitoring). Specifically:



| |  |  | Our control environment did not sufficiently promote effective internal control over financial reporting throughout our management structure, and this material weakness was a
contributing factor in the development of other material weaknesses described below;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We had inadequately trained finance and accounting personnel with appropriate U.S. GAAP expertise. Accordingly, in certain circumstances, an effective secondary review of technical
accounting matters was not performed;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We had inadequate risk assessment controls, including inadequate mechanisms for anticipating and identifying financial reporting risks; and for reacting to changes in the operating
environment that could have a material effect on financial reporting;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We had inadequate monitoring controls, including the inadequate staffing and procedures to ensure periodic evaluations of internal controls to ensure that appropriate personnel
regularly obtain evidence that controls are functioning effectively and that identified control deficiencies are remediated timely;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The general controls over our IT environment were not adequately documented or monitored. In addition, access controls and segregation of duties between key IT functions were
inadequate;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We had inadequate access and change controls over end-user computing spreadsheets. Specifically, our controls over the completeness, accuracy, validity and restricted access and
review of certain spreadsheets used in the period-end financial reporting were either not designed appropriately or did not operate as designed; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | There was inadequate communication from management to employees regarding the general importance of controls and employees duties and control responsibilities.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



These deficiencies resulted in more than a
remote likelihood that a material misstatement of our annual or interim financial statements would not be prevented or detected.



2.Inadequate segregation of duties.We had inadequate procedures and controls to ensure proper segregation of duties within our purchasing, disbursements and
payroll processes and accounting systems. As a result, misappropriation of assets could occur and not be detected in a timely manner. These deficiencies resulted in more than a remote likelihood that a material misstatement of our annual or interim
financial statements would not be prevented or detected.



3. Inadequate
financial statement preparation and review procedures.We had inadequate policies, procedures and personnel to ensure that accurate, reliable interim and annual consolidated financial statements were prepared and reviewed on a timely basis.
Specifically, we had insufficient: a) levels of supporting documentation; b) review and supervision within the accounting and finance departments; c) preparation and review of footnote disclosures accompanying our financial statements; and d)
technical accounting resources. These deficiencies resulted in errors in the financial statements and more than a remote likelihood that a material misstatement of our annual or interim financial statements would not be prevented or detected.



4. Inadequate reviews of account reconciliations, analyses and journal
entries. We had inadequate review procedures over account reconciliations, account and transaction analyses, and journal entries. Specifically, deficiencies were noted in the following areas: a) management review of supporting documentation,
calculations and assumptions used to prepare the financial statements, including spreadsheets and account analyses; and b) management review of journal entries recorded during the financial statement preparation process. These deficiencies resulted
in misclassification errors between accounts receivable and deferred revenue; current and non-current deferred revenue; and other errors in the financial statements and more than a remote likelihood that a material misstatement of our annual or
interim financial statements would not be prevented or detected.



43



---

##### Table of Contents

5. Inadequate controls over purchases, payroll and disbursements.We had inadequate controls over purchases,
payroll and the disbursement of funds as well as the recording of accruals for purchases and expenses. Specifically,



| |  |  | Wire transfers and transfers between investment accounts were made with inadequate approvals;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | We did not have a policy requiring authorized purchase orders;
| | - |  | --------------------------------------------------------------



| |  |  | Invoices were paid with inadequate approvals;
| | - |  | ---------------------------------------------



| |  |  | The review of employee expense reports was inadequate;
| | - |  | ------------------------------------------------------



| |  |  | We did not have sufficient management review of commission payments; and
| | - |  | ------------------------------------------------------------------------



| |  |  | Period-end cut-off procedures in the procurement cycle were inadequate.
| | - |  | -----------------------------------------------------------------------



These weaknesses increase the likelihood that unauthorized purchases and disbursements could occur and not be detected in a timely manner. These
deficiencies resulted in errors in the financial statements and in more than a remote likelihood that a material misstatement of our annual or interim financial statements would not be prevented or detected.



6. Inadequate controls over revenue. Our review procedures over accounting for revenue
were not functioning effectively. Specifically:



| |  |  | Review procedures over the application of our revenue recognition policies for software license and service arrangements were inadequate;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Review procedures over the accounting for service projects, such as the review of documentation supporting project milestone delivery or professional service hours rendered were
inadequate;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Review procedures relating to customer invoices and the application of cash receipts and credit memos to accounts receivable were inadequate; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Review procedures relating to shipping documentation for the accuracy of revenue cut-off were inadequate.
| | - |  | ---------------------------------------------------------------------------------------------------------



These deficiencies resulted in more than a remote likelihood that a material misstatement of our annual or interim financial
statements would not be prevented or detected.



7. Inadequate controls over
investments. We did not have effective policies and procedures regarding the review of investments managed by a third party. This deficiency resulted in a misclassification error between cash equivalents and short-term investments and in more
than a remote likelihood that a material misstatement of our annual or interim financial statements would not be prevented or detected.



In making our assessment, management used the criteria set forth by COSO in Internal ControlIntegrated Framework. Because of the material
weaknesses described above, management concluded that, as of December 31, 2004, our internal control over financial reporting was not effective based on those criteria.



(c) Changes in Internal Control Over Financial Reporting



Our management is treating these material weaknesses very seriously and has undertaken the following actions to remediate
them:



For the quarter ended December 31, 2004:



| |  |  | Hired additional qualified personnel in accounting and IT. This includes a Vice President of Finance - Europe in November 2004, a Director of Information Technology in November 2004
and a Director of Revenue Accounting in December 2004
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



For the
quarter ended March 31, 2005:



| |  |  | Implemented enhanced procedures for the preparation and review of financial statements, review of account reconciliations, analyses and journal entries for the first quarter close
in 2005; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Implemented improved procurement cutoff procedures for the first quarter of 2005;
| | - |  | ---------------------------------------------------------------------------------



44



---

##### Table of Contents

For the quarter ended June 30, 2005:



| |  |  | Hired a new Corporate Controller in June 2005;
| | - |  | ----------------------------------------------



| |  |  | Implemented improved procedures in April 2005 to ensure that all wire and investment transfers were adequately approved;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | Implemented a tighter review of expense reports, commission payments and other disbursements during the second quarter of 2005; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | Implemented better monitoring of the companys investments to ensure compliance with policy and correct classification in the financial statements in the second quarter of
2005.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



For the quarter ended September 30, 2005:



| |  |  | Improved and streamlined the accounting process for domestic revenue transactions and tightened corresponding review and approval procedures;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Implemented new purchasing approval guidelines;
| | - |  | -----------------------------------------------



| |  |  | For our U.K. operations, we implemented improved procedures, segregation of duties and improved reviews of local financial statements, account reconciliations and journal entries
for the third quarter close in 2005; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Continued to hire additional qualified finance staff into the organization.
| | - |  | ---------------------------------------------------------------------------



These changes are part of our overall program that is intended to remediate material weaknesses by December 31, 2005.



45



---

##### Table of Contents

PART IIOTHER INFORMATION



Item 1. Legal Proceedings



From time-to-time, we are involved in legal proceedings or threats of legal proceedings arising in the ordinary course of business. We are not a party to any litigation or other legal proceeding that, in the opinion of management, is not
reasonably likely to have a material adverse effect on our business, operating results and financial condition, except as described below.



IpLearn, LLC v. Docent, Case No. CV-02-2636 DLJ (Docent Case); and IpLearn, LLC v. Click2learn.com, Inc., Case No. CV-04-00685 DLJ
(Click2learn Case). On May 31, 2002, IpLearn filed a patent infringement case against Docent, and in February 2004, a patent infringement case against Click2learn. In October 2004, the Docent Case and the Click2learn Case were
consolidated into one case, IPLearn, LLC v. SumTotal Systems, Inc., Case No. CV-02-02636 DLJ (the SumTotal Case). The action is pending before the Northern District of California and concerned the same patent family. IpLearn, around the
same time as the Docent Case was filed, sued several other manufacturers of on-line learning software. IpLearn alleges that certain Docent and Click2learn software products infringe eight IpLearn patents that relate to online learning. IpLearn is
seeking injunctive relief and unspecified monetary damages. The case is still in the discovery phase. On September 16, 2005, we filed two summary judgment motions, one alleging that three of IpLearns patents are invalid. The second
summary judgment motion seeks dismissal of the infringement claims against the Docent products because, two and a half years after IpLearn filed its case against the Docent products, IpLearn has failed to make a prima facie case that the Docent
products infringe. The judge issued a ruling indicating that he would set a briefing and hearing schedule for the summary judgment motions at the Markman hearing, which is currently scheduled for November 18, 2005. In advance of the November
18, 2005 hearing, the parties have entered into settlement discussions.



We entered into these discussions because of the uncertainties inherent in any litigation, as well as the distraction to management and the expenses associated with litigation. At this point, there is no agreement between the parties,
including without limitation, an agreement on the scope of any potential settlement in terms of which patents the settlement would apply to, or the amount of such settlement, although, most recently, a range from $0 to approximately
$5.4 million has been discussed. We believe, at the time of this filing, that a loss from settlement or judgment is less than probable and therefore we have not established an accrual for this potential loss. We expect there may be further
discussions through November 18, 2005, and potentially thereafter. We cannot be certain, however, that if the parties were to reach a settlement at some point in the future (a) when such settlement would occur, if ever; (b) whether such settlement,
if any, would be within the range stated above; or (c) the scope of such settlement, if any.



IP Innovation, LLC, v. Thomson Learning, Inc. et al., Case No. H-02-2031, Southern District of Texas. In December 2002, IP Innovation, LLC filed a patent infringement case against Docent and seven other defendants in
the U.S. District Court for the Southern District of Texas. IP Innovation asserted a claim regarding a computer graphics patent, asserting that the patent covers the use of Hypertext Markup Language (HTML) in graphics software used in
computer systems. Plaintiff sought an injunction and unspecified monetary damages. In April 2004, Docent filed a motion for summary judgment for non-infringement, which was granted in July 2004. In August 2004, IP Innovation filed a notice of appeal
of the summary judgment award. In August 2004, Docent filed a claim for attorneys fees, which was denied in October 2004. IP Innovation filed its Opening Brief in connection with its appeal of the Summary Judgment award in January 2005. Docent
filed its opposition brief, along with an appeal of the attorneys fees order, in April 2005. On September 21, 2005, the U.S. Court of Appeals Federal Circuit scheduled a hearing of the appeal in IP Innovation, LLC v. eCollege.com, Digital
Think, Inc., and Docent, Inc. for November 9, 2005.



We
believe that the patent infringement cases are without merit, and we are defending, and plan to continue to defend, against them vigorously. However, the results of litigation cannot be predicted with certainty. Defending each of these actions,
regardless of the outcome, may be costly, time-consuming, distract management personnel and have a negative effect on our business. An adverse outcome in any of these actions (including a judgment or settlement where we may be required to license
patents on terms that may or may not be favorable to us, an injunction that would prevent us from shipping our product, or if we are forced to alter our website or our software products) may cause a material adverse effect on our future business,
operating results and/or financial condition.



Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities



Not applicable.



Item 3. Defaults Upon Senior Securities



Not applicable.



46



---

##### Table of Contents

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



The Annual Meeting of Stockholders of SumTotal Systems, Inc. was held on Friday, September 23, 2005, at the Companys Corporate Headquarters in
Mountain View, California. The results of the voting on the matters submitted to the stockholders are as follows:



To elect two Class I members of the Companys Board of Directors to hold office until the 2008 Annual Meeting of Stockholders or until their
successors are duly elected and qualified or until such Directors death, resignation or removal.



|             |  |            |  |            |   |  |          |  |            |  
|------------ |  | ---------- |  | ---------- | - |  | -------- |  | ---------- | -
|             |  | Votes For  |  | % of Voted |   |  | Withheld |  | % of Voted |  
|Jack Acosta  |  | 17,513,950 |  | 99.7       | % |  | 53,076   |  | 0.3        | %
|Vijay Vashee |  | 17,391,440 |  | 99.0       | % |  | 175,586  |  | 1.0        | %



The Companys
Class II Directors continuing in office until the 2006 Annual Meeting are John Coné, Donald E. Fowler and Ali Kutay. The Class III Directors continuing in office until the 2007 Annual Meeting are Sally Narodick and Kevin Oakes. There is one
vacancy in Class III of the directors as a result of the resignation of our prior CEO from his position as CEO and as a director, effective as of October 17, 2005.



Item 5. Other Information



Not applicable.



Item 6. Exhibits



| | (a) | Exhibits
| | --- | --------



|     |  |                                                                                                                                                                                 
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.1 |  | SumTotal Systems, Inc. 2004 Equity Incentive Plan Restricted Stock Award Agreement Form.                                                                                        
|     | 
|10.2 |  | SumTotal Systems, Inc. Retention Bonus Agreement Form.                                                                                                                          
|     | 
|31.1 |  | Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|     | 
|31.2 |  | Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|     | 
|32.1 |  | Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 



47



---

##### Table of Contents

SIGNATURES



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



|                 |  |                                              
|---------------- |  | ---------------------------------------------
|                 |  | SUMTOTAL SYSTEMS, INC.                       
|                 | 
|November 7, 2005 |  | /s/ NEIL J. LAIRD                            
|Date             |  | Neil J. Laird                                
|                 |  | Chief Financial Officer                      
|                 |  | (Duly Authorized Officer and                 
|                 |  | Chief Financial and Chief Accounting Officer)



48