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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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(Mark One)

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



For the quarterly period ended June 30, 2005



OR



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



Commission File Number 000-50640



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SUMTOTAL SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|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)



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



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein,
and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    x



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



The number of shares outstanding of the issuers Common Stock, par value $0.001, as of August 3, 2005 was approximately 21,185,916 shares.



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##### Table of Contents



SUMTOTAL SYSTEMS, INC.



FORM 10Q



For the Quarter Ended June 30, 2005



TABLE OF CONTENTS



|                               |  |                                                                                                           |  |   
|------------------------------ |  | --------------------------------------------------------------------------------------------------------- |  | --
|                               |  | Page                                                                                                     
|PART I  FINANCIAL INFORMATION |  |                                                                                                          
|                               |  |                                                                                                          
|Item 1.                        |  | Consolidated Financial Statements                                                                         |  |   
|                               |  | Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004                           |  | 3 
|                               |  | Condensed Consolidated Statements of Operations for the three and six-months ended June 30, 2005 and 2004 |  | 4 
|                               |  | Condensed Consolidated Statements of Cash Flows for the six-months ended June 30, 2005 and 2004           |  | 5 
|                               |  | Notes to Condensed Consolidated Financial Statements                                                      |  | 6 
|                               |  |                                                                                                          
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                     |  | 17
|                               |  |                                                                                                          
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                                                |  | 43
|                               |  |                                                                                                          
|Item 4.                        |  | Controls and Procedures                                                                                   |  | 43
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                                          
|                               |  |                                                                                                          
|Item 1.                        |  | Legal Proceedings                                                                                         |  | 47
|                               |  |                                                                                                          
|Item 2.                        |  | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                          |  | 47
|                               |  |                                                                                                          
|Item 3.                        |  | Defaults upon Senior Securities                                                                           |  | 47
|                               |  |                                                                                                          
|Item 4.                        |  | Submission of Matters to a Vote of Securities Holders                                                     |  | 47
|                               |  |                                                                                                          
|Item 5.                        |  | Other Information                                                                                         |  | 47
|                               |  |                                                                                                          
|Item 6.                        |  | Exhibits and Reports on Form 8-K                                                                          |  | 48
|                               | 
|SIGNATURES                     |  | 49                                                                                                       



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##### Table of Contents

PART I  FINANCIAL INFORMATION



|Item 1. | Consolidated Financial Statements
|------- | ---------------------------------



SUMTOTAL SYSTEMS, INC. AND SUBSIDIARI
ES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands)



|                                                                                                             |  |               |          |   |                   |   |          |  
|------------------------------------------------------------------------------------------------------------ |  | ------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                             |  | June 30, 2005 |          |   | December 31, 2004 |  
|Assets                                                                                                       |  |               |          |   |                   |   |          |  
|Current assets:                                                                                              |  |               |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                    |  | $             | 31,996   |   |                   | $ | 25,508   |  
|Restricted cash                                                                                              |  |               | 82       |   |                   |   | 82       |  
|Short-term investments                                                                                       |  |               | 4,656    |   |                   |   | 9,128    |  
|Accounts receivable, net of allowance for sales returns and doubtful accounts of $755 and $729, respectively |  |               | 15,880   |   |                   |   | 18,531   |  
|Prepaid expenses and other current assets                                                                    |  |               | 1,771    |   |                   |   | 1,781    |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Total current assets                                                                                         |  |               | 54,385   |   |                   |   | 55,030   |  
|                                                                                                             |  |              
|Property and equipment, net                                                                                  |  |               | 2,755    |   |                   |   | 2,472    |  
|Goodwill                                                                                                     |  |               | 27,659   |   |                   |   | 27,659   |  
|Intangible assets, net                                                                                       |  |               | 7,392    |   |                   |   | 9,491    |  
|Other assets                                                                                                 |  |               | 1,910    |   |                   |   | 1,140    |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Total assets                                                                                                 |  | $             | 94,101   |   |                   | $ | 95,792   |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Liabilities and Stockholders Equity                                                                         |  |               |          |   |                   |   |          |  
|Current liabilities:                                                                                         |  |               |          |   |                   |   |          |  
|Accounts payable                                                                                             |  | $             | 2,685    |   |                   | $ | 3,334    |  
|Accrued compensation and benefits                                                                            |  |               | 3,792    |   |                   |   | 5,148    |  
|Other accrued liabilities                                                                                    |  |               | 3,822    |   |                   |   | 3,403    |  
|Restructuring accrual                                                                                        |  |               | 144      |   |                   |   | 506      |  
|Deferred revenue                                                                                             |  |               | 19,471   |   |                   |   | 14,749   |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Total current liabilities                                                                                    |  |               | 29,914   |   |                   |   | 27,140   |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Other accrued liabilities, non-current                                                                       |  |               | 76       |   |                   |   |         |  
|Deferred revenue, non-current                                                                                |  |               | 213      |   |                   |   | 373      |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Total liabilities                                                                                            |  |               | 30,203   |   |                   |   | 27,513   |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Commitments and contingencies                                                                                |  |               |         |   |                   |   |         |  
|                                                                                                             |  |              
|Stockholders equity:                                                                                        |  |               |          |   |                   |   |          |  
|Preferred stock                                                                                              |  |               |         |   |                   |   |         |  
|Common stock                                                                                                 |  |               | 21       |   |                   |   | 21       |  
|Additional paid-in capital                                                                                   |  |               | 323,631  |   |                   |   | 321,620  |  
|Deferred stock-based compensation                                                                            |  |               | (1,755   | ) |                   |   | (1,012   | )
|Accumulated other comprehensive income (loss)                                                                |  |               | 179      |   |                   |   | (150     | )
|Accumulated deficit                                                                                          |  |               | (258,178 | ) |                   |   | (252,200 | )
|                                                                                                             |  |               |          |   |                   |   |          |  
|Total stockholders equity                                                                                   |  |               | 63,898   |   |                   |   | 68,279   |  
|                                                                                                             |  |               |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                   |  | $             | 94,101   |   |                   | $ | 95,792   |  
|                                                                                                             |  |               |          |   |                   |   |          |  



Refer to the
accompanying notes to the Condensed Consolidated Financial Statements.



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SUMTOTAL SY
STEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)



|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                                              |  | Three-MonthsEnded June 30, |        |   | Six-MonthsEnded June 30, |  
|                                                              |  | 2005                       |        |   | 2004                     |   |        | 2005 |  |   | 2004   |  
|Revenue:                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|License                                                       |  | $                          | 5,114  |   |                          | $ | 5,956  |      |  | $ | 10,657 |   |  | $ | 8,128   |  
|Service and maintenance                                       |  |                            | 10,773 |   |                          |   | 8,129  |      |  |   | 21,970 |   |  |   | 13,061  |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Total revenue                                                 |  |                            | 15,887 |   |                          |   | 14,085 |      |  |   | 32,627 |   |  |   | 21,189  |  
|                                                              |  |                            |        |  
|Cost of revenue:                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|License                                                       |  |                            | 706    |   |                          |   | 80     |      |  |   | 860    |   |  |   | 204     |  
|Service and maintenance                                       |  |                            | 4,834  |   |                          |   | 4,962  |      |  |   | 10,000 |   |  |   | 7,756   |  
|Amortization of intangible assets                             |  |                            | 711    |   |                          |   | 1,407  |      |  |   | 2,099  |   |  |   | 1,901   |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Total cost of revenue                                         |  |                            | 6,251  |   |                          |   | 6,449  |      |  |   | 12,959 |   |  |   | 9,861   |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Gross margin                                                  |  |                            | 9,636  |   |                          |   | 7,636  |      |  |   | 19,668 |   |  |   | 11,328  |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Operating expenses:                                           |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Research and development                                      |  |                            | 2,909  |   |                          |   | 2,977  |      |  |   | 5,829  |   |  |   | 5,282   |  
|Sales and marketing                                           |  |                            | 5,923  |   |                          |   | 5,876  |      |  |   | 12,127 |   |  |   | 10,040  |  
|General and administrative                                    |  |                            | 3,895  |   |                          |   | 2,565  |      |  |   | 7,476  |   |  |   | 4,843   |  
|Restructuring charge                                          |  |                            |       |   |                          |   | 248    |      |  |   |       |   |  |   | 1,137   |  
|In-process research and development                           |  |                            |       |   |                          |   |       |      |  |   |       |   |  |   | 1,326   |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Total operating expenses                                      |  |                            | 12,727 |   |                          |   | 11,666 |      |  |   | 25,432 |   |  |   | 22,628  |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Loss from operations                                          |  |                            | (3,091 | ) |                          |   | (4,030 | )    |  |   | (5,764 | ) |  |   | (11,300 | )
|                                                              |  |                            |        |  
|Interest expense                                              |  |                            | (1     | ) |                          |   | (18    | )    |  |   | (1     | ) |  |   | (121    | )
|Interest income                                               |  |                            | 190    |   |                          |   | 59     |      |  |   | 355    |   |  |   | 106     |  
|Other expense, net                                            |  |                            | (434   | ) |                          |   | (75    | )    |  |   | (507   | ) |  |   | (358    | )
|Equity in losses of an affiliate                              |  |                            |       |   |                          |   |       |      |  |   |       |   |  |   | (169    | )
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Loss before provision for income taxes                        |  |                            | (3,336 | ) |                          |   | (4,064 | )    |  |   | (5,917 | ) |  |   | (11,842 | )
|Provision for income taxes                                    |  |                            | 30     |   |                          |   | 38     |      |  |   | 61     |   |  |   | 76      |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Net loss                                                      |  | $                          | (3,366 | ) |                          | $ | (4,102 | )    |  | $ | (5,978 | ) |  | $ | (11,918 | )
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Net loss per share, basic and diluted                         |  | $                          | (0.16  | ) |                          | $ | (0.20  | )    |  | $ | (0.29  | ) |  | $ | (0.74   | )
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Weighted average common shares outstanding, basic and diluted |  |                            | 20,911 |   |                          |   | 20,429 |      |  |   | 20,854 |   |  |   | 16,109  |  
|                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  



Refer to the
accompanying notes to the Condensed Consolidated Financial Statements.



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SUMTOTAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



|                                                                                          |  |                          |        |   |      |   |         |  
|----------------------------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------- | -
|                                                                                          |  | Six-MonthsEnded June 30, |       
|                                                                                          |  | 2005                     |        |   | 2004 |  
|Cash flows from operating activities:                                                     |  |                          |        |   |      |   |         |  
|Net loss                                                                                  |  | $                        | (5,978 | ) |      | $ | (11,918 | )
|Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |  |                          |        |   |      |   |         |  
|Depreciation and amortization                                                             |  |                          | 887    |   |      |   | 785     |  
|Amortization of intangible assets                                                         |  |                          | 2,099  |   |      |   | 1,901   |  
|Accretion on interest on short-term investments                                           |  |                          | (89    | ) |      |   |        |  
|Loss on disposal of property and equipment                                                |  |                          | 26     |   |      |   | 373     |  
|Provision for (recovery of) sales returns and doubtful accounts                           |  |                          | 26     |   |      |   | (279    | )
|Amortization of discount on debt                                                          |  |                          |       |   |      |   | 89      |  
|Stock-based compensation                                                                  |  |                          | 383    |   |      |   | 845     |  
|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, net                                                                  |  |                          | 2,625  |   |      |   | 6,193   |  
|Prepaid expenses and other assets                                                         |  |                          | 10     |   |      |   | (273    | )
|Other assets                                                                              |  |                          | (770   | ) |      |   | 1,494   |  
|Accounts payable                                                                          |  |                          | (649   | ) |      |   | (506    | )
|Accrued compensation and benefits                                                         |  |                          | (1,326 | ) |      |   |        |  
|Other accrued liabilities                                                                 |  |                          | 465    |   |      |   | (1,790  | )
|Restructuring accrual                                                                     |  |                          | (362   | ) |      |   | 218     |  
|Deferred revenue                                                                          |  |                          | 4,562  |   |      |   | 2,880   |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Net cash provided by operating activities                                                 |  |                          | 1,909  |   |      |   | 1,507   |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Cash flows from investing activities:                                                     |  |                          |        |   |      |   |         |  
|Purchases of property and equipment                                                       |  |                          | (1,215 | ) |      |   | (558    | )
|Proceeds on sale of property and equipment                                                |  |                          | 12     |   |      |   |        |  
|Cash acquired in acquisitions, net of cash payments                                       |  |                          |       |   |      |   | 25,432  |  
|Purchases of short-term investments                                                       |  |                          | (4,285 | ) |      |   | (2,497  | )
|Sales of short-term investments                                                           |  |                          | 8,841  |   |      |   | 2,998   |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Net cash provided by investing activities                                                 |  |                          | 3,353  |   |      |   | 25,375  |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Cash flows from financing activities:                                                     |  |                          |        |   |      |   |         |  
|Borrowings on line of credit                                                              |  |                          |       |   |      |   | 2,400   |  
|Repayments on line of credit                                                              |  |                          |       |   |      |   | (6,010  | )
|Net proceeds from the issuance of common stock and exercises of common stock options      |  |                          | 885    |   |      |   | 695     |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Net cash provided by (used in) financing activities                                       |  |                          | 885    |   |      |   | (2,915  | )
|                                                                                          |  |                          |        |   |      |   |         |  
|Effect of foreign exchange rate changes on cash                                           |  |                          | 341    |   |      |   | 290     |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Net increase in cash and cash equivalents                                                 |  |                          | 6,488  |   |      |   | 24,257  |  
|Cash and cash equivalents at beginning of period                                          |  |                          | 25,508 |   |      |   | 12,862  |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Cash and cash equivalents at end of period                                                |  | $                        | 31,996 |   |      | $ | 37,119  |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Supplemental disclosure of cash flow information                                          |  |                          |        |   |      |   |         |  
|Interest paid                                                                             |  | $                        | 1      |   |      | $ | 121     |  
|                                                                                          |  |                          |        |   |      |   |         |  
|Taxes paid (refunded)                                                                     |  | $                        | 156    |   |      | $ | 68      |  
|                                                                                          |  |                          |        |   |      |   |         |  
|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 Condensed Consolidated Financial Statements.



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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 June 30, 2005, and for the three and six-months ended June 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 GAAP have been condensed or
omitted pursuant to such rules and regulations. 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 six-months ended June 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 for the three and six-months ended June 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.



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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.



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 considers the fee to not 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 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 the Company 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 as services are provided or 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. Subscription licenses are a bundled offering
that include time-based licenses, hosting and maintenance and support and the related revenue is recognized as service



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and maintenance revenue on a straight-line basis over the life of the subscription. SumTotal Systems typically bills these contracts in advance and records
the billed amounts in deferred revenue.



Net Loss Per Share



Basic and diluted net loss per share is computed by
dividing the net 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 as the
effect is anti-dilutive, due to SumTotal Systems net loss in each period. Potential common shares are comprised of common stock subject to repurchase rights, incremental shares of common and preferred stock issuable upon the exercise of stock
options or warrants and shares issuable upon conversion of convertible preferred stock. As SumTotal Systems had a net loss for each of the periods presented, basic and diluted net loss per share are the same. No preferred stock was issued and
outstanding as of June 30, 2005 or 2004.



Excluded from the
computation of diluted loss per share for the three and six-months ended June 30, 2005 are options to acquire approximately 5,426,000 shares of common stock with a weighted average share price of $8.23 and warrants to acquire approximately 1,646,000
shares of common stock with a weighted average share price of $8.58 because their effects would be anti-dilutive. Excluded from the computation of diluted loss per share for the three and six-months ended June 30, 2004 are options to acquire
approximately 6,314,000 shares of common stock with a weighted average share price of $8.57 and warrants to acquire approximately 2,163,000 shares of common stock with a weighted average share price of $10.83 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 six-months ended June 30, 2005 and 2004 presented below (in thousands):



|                                        |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|--------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                        |  | Three-MonthsEnded June 30, |        |   | Six-MonthsEnded June 30, |  
|                                        |  | 2005                       |        |   | 2004                     |   |        | 2005 |  |   | 2004   |  
|Net loss                                |  | $                          | (3,366 | ) |                          | $ | (4,102 | )    |  | $ | (5,978 | ) |  | $ | (11,918 | )
|Unrealized loss on investments          |  |                            | (1     | ) |                          |   |       |      |  |   | (5     | ) |  |   |        |  
|Foreign currency translation adjustment |  |                            | 288    |   |                          |   | 75     |      |  |   | 334    |   |  |   | 290     |  
|                                        |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|                                        |  | $                          | (3,079 | ) |                          | $ | (4,027 | )    |  | $ | (5,649 | ) |  | $ | (11,628 | )
|                                        |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  



SumTotal Systems
total comprehensive loss for the three and six-months ended June 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 foreign currency translation adjustments of $184,000 and $150,000 at June 30, 2005 and December 31, 2004,
respectively, and an unrealized loss on investments of $5,000 at June 30, 2005.



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 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



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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 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 the 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 SumTotal Systems is the first fiscal quarter of 2006.



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 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 outstanding unvested options, 446,000 of which are held by Section 16 Officers, will become exercisable immediately upon SumTotal Systems compliance with NASDAQ and SEC rules.



The purpose of the acceleration is to enable SumTotal Systems to avoid
recognizing the future compensation expense associated with the adoption of SFAS No. 123R, Share-Based Payment. SFAS No. 123R, when effective, will require all share-based payments to employees, including granting of employee stock options,
to be recognized as compensation expense on SumTotal Systems consolidated statement of operations, rather than as a disclosure in the Notes to the Consolidated Financial Statements, based on their fair values. SFAS No. 123R will become
effective for SumTotal Systems beginning in the first quarter of fiscal year 2006. 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 based on generally accepted accounting principles because there was not a modification of the option grants. SumTotal Systems
also believes that because the options to be 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.



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The following table displays the impact to the net loss if SumTotal Systems were to change its accounting
policy in accordance with SFAS No. 123,Accounting for Stock-Based Compensation, and SFAS No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure, and retroactively restate all prior periods as if SumTotal Systems
had adopted SFAS No. 123 for all periods presented (in thousands, except per share amounts):



|                                                                                                                      |  |                            |         |   |                          |   |        |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                      |  | Three-MonthsEnded June 30, |         |   | Six-MonthsEnded June 30, |  
|                                                                                                                      |  | 2005                       |         |   | 2004                     |   |        | 2005 |  |   | 2004    |  
|Net loss, as reported                                                                                                 |  | $                          | (3,366  | ) |                          | $ | (4,102 | )    |  | $ | (5,978  | ) |  | $ | (11,918 | )
|Add: Stock-based employee compensation expenses included in reported net loss, net of tax                             |  |                            | 151     |   |                          |   | 258    |      |  |   | 383     |   |  |   | 845     |  
|Deduct: Stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax |  | $                          | (10,199 | ) |                          | $ | (1,278 | )    |  | $ | (11,979 | ) |  | $ | (3,107  | )
|                                                                                                                      |  |                            |         |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Pro forma net loss                                                                                                    |  | $                          | (13,414 | ) |                          | $ | (5,122 | )    |  | $ | (17,603 | ) |  | $ | (14,180 | )
|                                                                                                                      |  |                            |         |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Weighted average common shares outstanding, basic and diluted                                                         |  |                            | 20,911  |   |                          |   | 20,429 |      |  |   | 20,854  |   |  |   | 16,109  |  
|                                                                                                                      |  |                            |         |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share, basic and diluted:                                                                                |  |                            |         |   |                          |   |        |      |  |   |         |   |  |   |         |  
|As reported                                                                                                           |  | $                          | (0.16   | ) |                          | $ | (0.20  | )    |  | $ | (0.29   | ) |  | $ | (0.74   | )
|Pro forma                                                                                                             |  | $                          | (0.64   | ) |                          | $ | (0.25  | )    |  | $ | (0.84   | ) |  | $ | (0.88   | )



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 $3.76 and $6.22 for the three-months ended June 30, 2005 and 2004,
respectively. The weighted average fair value of options granted was $4.01 and $6.28 for the six-months ended June 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 six-months ended June 30, 2005 and 2004, respectively:



|                          |  |                            |  |                             |  |                          |  |                             |  |                 |  |             |  |          |  |         
|------------------------- |  | -------------------------- |  | --------------------------- |  | ------------------------ |  | --------------------------- |  | --------------- |  | ----------- |  | -------- |  | --------
|                          |  | Options                    |  | Employee StockPurchase Plan |  | Options                  |  | Employee StockPurchase Plan
|                          |  | Three-MonthsEnded June 30, |  | Three-MonthsEnded June 30,  |  | Six-MonthsEnded June 30, |  | Six-MonthsEnded June 30,   
|                          |  | 2005                       |  | 2004                        |  | 2005                     |  | 2004                        |  | 2005            |  | 2004        |  | 2005     |  | 2004    
|Dividend yield            |  | 0%                         |  | 0%                          |  | 0%                       |  | 0%                          |  | 0%              |  | 0%          |  | 0%       |  | 0%      
|                          |  |                            |  |                             |  |                          |  |                            
|Volatility                |  | 1.0625                     |  | 1.19                        |  | 0.39                     |  | 0.79                        |  | 1.0625-1.08     |  | 1.19-1.20   |  | 0.39     |  | 0.79    
|                          |  |                            |  |                             |  |                          |  |                            
|Risk free interest rates  |  | 3.63%-4.13%                |  | 1.48%-3.86%                 |  | 2.79%                    |  | 1.01%                       |  | 3.63%-4.13%     |  | 1.48%-3.86% |  | 2.79%    |  | 1.01%   
|                          |  |                            |  |                             |  |                          |  |                            
|Expected lives of options |  | 3.97 years                 |  | 1-5 years                   |  | 6 months                 |  | 6 months                    |  | 3.97-4.19 years |  | 1-5 years   |  | 6 months |  | 6 months



In the three-months
ended June 30, 2005 and 2004, SumTotal Systems recorded $121,000 and $258,000 in stock-based compensation expense relating to common stock options issued to former Docent employees, $0 and $233,000 in stock-based compensation expense relating to
increasing the amount of shares available for purchase in the SumTotal Systems Employee Stock Purchase Plan, as required by FIN No. 44, Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB 25, $0
and $291,000 in stock-based compensation expense relating to accelerated option vesting for certain employees, and $30,000 and $0 in stock-based compensation expense relating to restricted stock issued to SumTotal executives, respectively.



In the six-months ended June 30, 2005 and 2004, SumTotal
Systems recorded $353,000 and $321,000 in stock-based compensation expense relating to common stock options issued to former Docent employees, $0 and $233,000 in stock-based compensation expense relating to increasing the amount of shares available
for purchase in the SumTotal Systems Employee Stock Purchase Plan, as required by FIN No. 44, Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB 25, $0 and $291,000 in stock-based compensation
expense relating to accelerated option vesting for certain employees, and $30,000 and $0 in stock-based compensation expense relating to restricted stock issued to SumTotal executives, respectively.



Recent Accounting Pronouncements



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections, which provides guidance on the accounting for, and reporting of, accounting changes and error corrections. SFAS No. 154 requires



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retrospective application to the prior periods financial statements of voluntary changes in accounting principle and changes required by an accounting
pronouncement in the event the pronouncement does not include specific transition provisions. SFAS No. 154 shall be effective for accounting changes made in fiscal years beginning after December 15, 2005, however the adoption of SFAS No. 154 is not
expected to have a material affect on SumTotal Systems 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 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 second half of 2005.



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. SumTotal Systems is currently evaluating the potential impact of the adoption of
EITF No. 03-01 on its results of operations, cash flows and financial condition.



NOTE 3: ACQUISITIONS, INTANGIBLE ASSETS AND GOODWILL



On March 18, 2004, Click2learn acquired Docent, a leading provider of integrated applications, services and content solutions proven to directly drive business performance through learning, 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.



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



|                                                        |  |   |       
|------------------------------------------------------- |  | - | ------
|Fair value of SumTotal Systems common stock issued (1) |  | $ | 55,663
|Acquisition related costs (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 trading-day period two days before and after October 20, 2003, the date of the
merger agreement, using the exchange ratio of 0.3188.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The acquisition related costs 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
|                                      |  |               |        |                                                |     



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



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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 June 30, 2005 are as follows (in thousands):



|                                      |  |                       |        |                         |   |        |                     |  |   |       
|------------------------------------- |  | --------------------- | ------ | ----------------------- | - | ------ | ------------------- |  | - | ------
|                                      |  | Gross Carrying Amount |        | AccumulatedAmortization |   |        | Net Carrying Amount
|Goodwill                              |  | $                     | 28,092 |                         | $ | (433   | )                   |  | $ | 27,659
|                                      |  |                       |        |                         |   |        |                     |  |   |       
|Intangible assets:                    |  |                       |        |                         |   |        |                     |  |   |       
|Acquired technology                   |  | $                     | 9,652  |                         | $ | (5,183 | )                   |  | $ | 4,469 
|Customer installed-base relationships |  |                       | 3,054  |                         |   | (886   | )                   |  |   | 2,168 
|Customer hosted relationships         |  |                       | 1,014  |                         |   | (260   | )                   |  |   | 754   
|Customer contract relationships       |  |                       | 2,225  |                         |   | (2,225 | )                   |  |   |      
|                                      |  |                       |        |                         |   |        |                     |  |   |       
|                                      |  | $                     | 15,945 |                         | $ | (8,554 | )                   |  | $ | 7,391 
|                                      |  |                       |        |                         |   |        |                     |  |   |       



Expected future
amortization expense related to intangible assets is approximately $1,483,000 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: 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 six-months ended June 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 six-months ended June 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 5: BANK CREDIT FACILITY



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.



NOTE 6: 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 costs for a building in Mountain View, California that was exited in September 2002.



During the first quarter of fiscal 2004, SumTotal Systems recorded an $889,000 restructuring charge, which consisted of $717,000 in employee severance
costs and $172,000 in facility exit costs. Employee severance consists of severance and other benefits resulting from a reduction in force across all Company functions of thirty-three



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employees. Facility costs 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 costs and $155,000 in facility exit costs. 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 costs represent the fair value of the lease liabilities relating to the partial closure of a facility in Bellevue, Washington which includes
contractual sublease income.



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



|                   |  |                              |     |                  |   |      |                          |  |   |    
|------------------ |  | ---------------------------- | --- | ---------------- | - | ---- | ------------------------ |  | - | ---
|                   |  | Balance at December 31, 2004 |     | CashExpenditures |   |      | Balance at June 30, 2005
|Vacated facilities |  | $                            | 506 |                  | $ | (362 | )                        |  | $ | 144
|                   |  |                              |     |                  |   |      |                          |  |   |    
|                   |  | $                            | 506 |                  | $ | (362 | )                        |  | $ | 144
|                   |  |                              |     |                  |   |      |                          |  |   |    



|                   |  |                             |   |                          |   |           |  |                  |       |  |                          |      |   |  |   |      
|------------------ |  | --------------------------- | - | ------------------------ | - | --------- |  | ---------------- | ----- |  | ------------------------ | ---- | - |  | - | -----
|                   |  | Balance atDecember 31, 2003 |   | Purchase PriceAllocation |   | Additions |  | CashExpenditures |       |  | Balance at June 30, 2004
|Vacated facilities |  | $                           |  |                          | $ | 800       |  | $                | 327   |  | $                        | (181 | ) |  | $ | 946  
|Employee severance |  |                             |  |                          |   |          |  |                  | 810   |  |                          | (738 | ) |  |   | 72   
|                   |  |                             |   |                          |   |           |  |                  |       |  |                          |      |   |  |   |      
|                   |  | $                           |  |                          | $ | 800       |  | $                | 1,137 |  | $                        | (919 | ) |  | $ | 1,018
|                   |  |                             |   |                          |   |           |  |                  |       |  |                          |      |   |  |   |      



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.



NOTE 7: COMMITMENTS AND CONTINGENCIES



Contractual obligations at June 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
|Operating leases                             |  | $                      | 5,224 |                 | $ | 1,549     |  | $         | 1,384 |           | $ | 1,279     |  | $ | 781 |  | $ | 231
|Accrued restructured facility lease payments |  |                        | 144   |                 |   | 84        |  |           | 26    |           |   | 23        |  |   | 11  |  |   |   
|                                             |  |                        |       |                 |   |           |  |           |       |           |   |           |  |   |     |  |   |    
|                                             |  | $                      | 5,368 |                 | $ | 1,633     |  | $         | 1,410 |           | $ | 1,302     |  | $ | 792 |  | $ | 231
|                                             |  |                        |       |                 |   |           |  |           |       |           |   |           |  |   |     |  |   |    



Rent expense under
operating leases was approximately $678,000 and $$477,000 during the three-months ended June 30, 2005 and 2004, respectively, and $1,227,000 and $858,000 during the six-months ended June 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 2010. 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.



From time-to-time, third parties assert patent infringement claims against SumTotal Systems in the form of letters, lawsuits, and other forms of
communication. Currently, SumTotal Systems is engaged in several lawsuits regarding patent issues and has been notified of a number of other potential patent disputes. In addition, from time-to-time, SumTotal Systems is subject to other legal
proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights. SumTotal Systems does not believe, based on current knowledge, that any of the
foregoing legal proceedings or claims are likely to have a material adverse effect on its financial position, results of operations or cash flows. 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 SumTotal Systems 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



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favorable to SumTotal Systems, or if SumTotal Systems is forced to alter its website or its software products) may cause a material adverse effect on its
future business, operating results and/or financial condition.



NOTE 8:
GUARANTEES, WARRANTIES AND INDEMNIFICATION



SumTotal
Systems has adopted 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 9: 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 considered to be 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 six-months
ended June 30, 2005 and 2004 (in thousands):



|               |  |                            |        |                          |   |        |  |      |        |  |   |       
|-------------- |  | -------------------------- | ------ | ------------------------ | - | ------ |  | ---- | ------ |  | - | ------
|               |  | Three-MonthsEnded June 30, |        | Six-MonthsEnded June 30,
|               |  | 2005                       |        | 2004                     |   | 2005   |  | 2004
|United States  |  | $                          | 11,763 |                          | $ | 10,645 |  | $    | 24,292 |  | $ | 16,437
|Europe         |  |                            | 2,997  |                          |   | 2,616  |  |      | 5,807  |  |   | 3,546 
|Other Americas |  |                            | 520    |                          |   | 230    |  |      | 1,287  |  |   | 312   
|Asia/Pacific   |  |                            | 607    |                          |   | 594    |  |      | 1,241  |  |   | 894   
|               |  |                            |        |                          |   |        |  |      |        |  |   |       
|               |  | $                          | 15,887 |                          | $ | 14,085 |  | $    | 32,627 |  | $ | 21,189
|               |  |                            |        |                          |   |        |  |      |        |  |   |       



Long-lived assets,
which represent property, plant and equipment, goodwill and other intangible assets, net of accumulated depreciation and amortization, by geographic location are as follows (in thousands):



|              |  |               |        |                   |   |       
|------------- |  | ------------- | ------ | ----------------- | - | ------
|              |  | June 30, 2005 |        | December 31, 2004
|North America |  | $             | 38,704 |                   | $ | 39,959
|Europe        |  |               | 288    |                   |   | 203   
|India         |  |               | 583    |                   |   | 439   
|Asia/Pacific  |  |               | 141    |                   |   | 161   
|              |  |               |        |                   |   |       
|              |  | $             | 39,716 |                   | $ | 40,762
|              |  |               |        |                   |   |       



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No customer accounted for greater than 10% of SumTotal Systems total consolidated revenues in the
three and six-months ended June 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 June 30, 2005. One customer accounted for 15% of SumTotal Systems accounts receivable, net of allowance
for sales returns and doubtful accounts at December 31, 2004.



NOTE 10:
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 11:
SUBSEQUENT EVENTS



On July 13, 2005, SumTotal Systems
entered into a five year lease for new office premises for its U.K. operations. SumTotal Systems plans to move into the new location during September 2005, and at that point, will exit its current location. As of June 30, 2005, the remaining lease
obligation on the current premises through November 2007 was $446,000.



On August 3, 2005, SumTotal Systems announced the signing of a definitive merger agreement to acquire Pathlore Software Corporation (Pathlore) for approximately $48 million. At the closing of the acquisition, Pathlore
shareholders will receive approximately $29 million in cash and 4 million shares of SumTotal Systems common stock. The Company will also incur additional cash obligations due to deal-related and severance expenses. The company plans to fund the cash
element of the transaction, in part, by establishing a new $22.5 million credit facility. The proposed transaction has been approved by the SumTotal and Pathlore Boards of Directors. Completion of the acquisition will be subject to Pathlore
stockholder approval, customary closing conditions, and the issuance of a permit from the Commissioner of Corporations for the State of California so that the issuance of the Companys stock will be exempt from registration under the Securities
Act of 1933. The proposed transaction is expected to close within 90 days.



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|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 Condensed Consolidated Financial Statements and related Notes contained
elsewhere within this document. Operating results for the three and six-months ended June 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. 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.



The Companys revenue in the quarter ended June 30, 2005 was $15.9 million, an increase of 13% from $14.1 million in
the same quarter in 2004. For the six month period ended June 30, 2005 revenue was $32.6 million which was 54% higher than $21.2 million in the first six months of 2004. The 2004 numbers include the period from January 1stto March 18, 2004 which was 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 customer to SumTotal



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maintenance and hosting contracts, as well as selling implementation and other services to the existing installed base and to new customers.



Gross margins improved to 61% and 60% in the three and six month periods
ended June 30, 2005, respectively compared to 54% and 53% in the same periods in 2004 as a result of the revenue growth and good control of costs.



Operating expenses in the quarter ended June 30, 2005 were $12.7 million which was $1.0 million higher than $11.7 million in 2004. We incurred expenses
associated with completing our management assessment of internal controls required under section 404 of the Sarbanes-Oxley Act of 2003 of $1.2 million in the 2005 quarter compared to $0.1 million in the second quarter of 2004.



Overall the Company improved its loss from $4.1 million in the second quarter
of 2004 to $3.3 million in the second quarter of 2005. For the six month period the loss improved from $11.8 million in 2004 to $6.0 million in 2005.



Despite the additional expenses incurred as a result of Sarbanes-Oxley compliance, the Company has made good progress in controlling expenses and
achieving the synergies anticipated from the acquisition of Docent and combined with the revenue growth has made progress in reducing it losses. In addition, the Company has been able to generate positive cash flow from operating activities and
increased its combined cash, cash equivalents and short-term investments balances in the first six months of 2005.



As of June 30, 2005, we had $32.0 million in cash and cash equivalents and $4.7 million in short-term investments. These balances, together with the cash
generated from operations, provide sufficient funds to finance operations for at least the next twelve months.



Critical Accounting Policies and Estimates



In most cases, the accounting treatment of a particular transaction is specifically dictated by Generally Accepted Accounting Principles (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 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.



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Results of Operations



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



|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|--------------------------------------------- |  | -------------------------- | -- |  | ------------------------ | -- |  | ----- | -- |  | ----- | --
|                                              |  | Three-MonthsEnded June 30, |    |  | Six-MonthsEnded June 30, |   
|                                              |  | 2005                       |    |  | 2004                     |    |  | 2005  |    |  | 2004  |   
|Revenue:                                      |  |                            |    |  |                          |    |  |       |    |  |       |   
|License                                       |  | 32.2                       | %  |  | 42.3                     | %  |  | 32.7  | %  |  | 38.4  | % 
|Service and maintenance                       |  | 67.8                       |    |  | 57.7                     |    |  | 67.3  |    |  | 61.6  |   
|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|Total revenue                                 |  | 100.0                      |    |  | 100.0                    |    |  | 100.0 |    |  | 100.0 |   
|                                              |  |                            |    | 
|Cost of revenue:                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|License and amortization of intangible assets |  | 8.9                        |    |  | 10.6                     |    |  | 9.1   |    |  | 0.9   |   
|Service and maintenance                       |  | 30.4                       |    |  | 35.2                     |    |  | 30.6  |    |  | 36.6  |   
|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|Total cost of revenue                         |  | 39.3                       |    |  | 45.8                     |    |  | 39.7  |    |  | 46.5  |   
|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|Gross margin                                  |  | 60.7                       |    |  | 54.2                     |    |  | 60.3  |    |  | 53.5  |   
|                                              |  |                            |    | 
|Operating expenses:                           |  |                            |    |  |                          |    |  |       |    |  |       |   
|Research and development                      |  | 18.3                       |    |  | 21.1                     |    |  | 17.9  |    |  | 24.9  |   
|Sales and marketing                           |  | 37.3                       |    |  | 41.7                     |    |  | 37.2  |    |  | 47.4  |   
|General and administrative                    |  | 24.5                       |    |  | 18.2                     |    |  | 22.9  |    |  | 22.9  |   
|Restructuring charge                          |  |                           |    |  | 1.8                      |    |  |      |    |  | 5.4   |   
|In-process research and development           |  |                           |    |  |                         |    |  |      |    |  | 6.2   |   
|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|Total operating expenses                      |  | 80.1                       |    |  | 82.8                     |    |  | 77.9  |    |  | 106.8 |   
|                                              |  |                            |    | 
|Loss from operations                          |  | (19.5                      | )  |  | (28.6                    | )  |  | (17.6 | )  |  | (53.3 | ) 
|Other income (expense), net                   |  | (1.5                       | )  |  | (0.3                     | )  |  | (0.5  | )  |  | (2.6  | ) 
|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|Loss before income taxes                      |  | (21.0                      | )  |  | (28.9                    | )  |  | (18.1 | )  |  | (55.9 | ) 
|Provision for income taxes                    |  | (0.2                       | )  |  | (0.2                     | )  |  | (0.2  | )  |  | (0.3  | ) 
|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   
|Net loss                                      |  | (21.2                      | )% |  | (29.1                    | )% |  | (18.3 | )% |  | (56.2 | )%
|                                              |  |                            |    |  |                          |    |  |       |    |  |       |   



Revenue



Total revenue increased $1.8 million, or 13%, to $15.9 million for the
three-months ended June 30, 2005, from $14.1 million for the same period in 2004.



Total revenue increased $11.4 million, or 54%, to $32.6 million for the six-months ended June 30, 2005, from $21.2 million for the same period in 2004.



For the three-months ended June 30, 2005, revenue from foreign sales increased $0.7 million, or 24%, to $4.1 million, as
compared to $3.4 million for the same period in 2004, and accounted for approximately 26% of total revenue. The increase occurred across all regions with particular strength in southern and central Europe as a result of better sales coverage and in
Canada and Latin America where the 2004 second quarter numbers were unusually low.



For the six-months ended June 30, 2005, revenue from foreign sales increased $3.6 million, or 77%, to $8.3 million, as compared to $4.7 million for the same period in 2004, and accounted for approximately 26% 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



No customers accounted for greater than 10% of our total consolidated revenue
in the three or six-months ended June 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



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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 revenue. For
the three-months ended June 30, 2005, license revenue decreased $0.9 million, or 15%, to $5.1 million, as compared to $6.0 million for the same period in 2004. The three-months ended June 30, 2004 was favorably impacted by two sales totaling $1.2
million that were delayed from the prior quarter because these contracts were not fully executed by SumTotal until after March 31, 2004. In the period ended June 30, 2005, revenue included the resale of an OEM product for $0.8 million. The remaining
difference was primarily related to sales occurring in the three months ended June 30, 2005 on which revenue could not be recognized as a result of future product deliverables and acceptances.



For the six-months ended June 30, 2005, license revenue increased $2.6
million, or 32%, to $10.7 million, as compared to $8.1 million for the same period in 2004. Approximately $2.8 million of the increase was the result of adding the Docent platform to our portfolio of products. The OEM resale discussed above
increased revenue $0.8 million. These increases were offset by sales on which revenue could not be recognized, as a result of future product deliverables and acceptances.



Prices per license seat are not comparable for the periods discussed above, since the product mix has changed significantly.



We had $6.0 million and $3.3 million in deferred license
revenue at June 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 revenue.Service and maintenance revenue for the three and six-months ended June 30,
2005 and 2004 consisted of the following (in thousands):



|                             |  |                            |        |                          |   |       |  |      |        |  |   |       
|---------------------------- |  | -------------------------- | ------ | ------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|                             |  | Three-MonthsEnded June 30, |        | Six-MonthsEnded June 30,
|                             |  | 2005                       |        | 2004                     |   | 2005  |  | 2004
|Maintenance                  |  | $                          | 4,326  |                          | $ | 2,425 |  | $    | 8,514  |  | $ | 4,264 
|Hosting                      |  |                            | 1,876  |                          |   | 1,673 |  |      | 3,718  |  |   | 2,551 
|Training                     |  |                            | 781    |                          |   | 823   |  |      | 1,516  |  |   | 1,230 
|Consulting                   |  |                            | 3,671  |                          |   | 3,112 |  |      | 7,921  |  |   | 4,880 
|Application service provider |  |                            | 119    |                          |   | 96    |  |      | 301    |  |   | 136   
|                             |  |                            |        |                          |   |       |  |      |        |  |   |       
|                             |  | $                          | 10,773 |                          | $ | 8,129 |  | $    | 21,970 |  | $ | 13,061
|                             |  |                            |        |                          |   |       |  |      |        |  |   |       



For the three-months
ended June 30, 2005, service and maintenance revenue increased $2.7 million, or 33%, to $10.8 million, as compared to $8.1 million for the same period in 2004 due. Maintenance revenue increased $1.9 million, or 79% to $4.3 million for the
three-months ended June 30, 2005, from $2.4 million for the same period in 2004. $0.9 million of this increase was the result of 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 second half of 2004 and the first half of 2005. Hosting revenue increased $0.2 million, or 12%, to $1.9 million for the three-months ended June 30, 2005, from $1.7 million for the
same period in 2004 as a result of adding new customers. Training revenue remained constant at $0.8 million for the three-months ended June 30, 2005 and 2004. Consulting revenue increased $0.6 million, or 19%, to $3.7 million for the three-months
ended June 30, 2005, from $3.1 million for the same period in 2004. Consulting revenue continues to increase as new and existing customers purchase incremental services including upgrades relating to SumTotal 7.0 and 7.1.



For the six-months ended June 30, 2005, service and maintenance revenue
increased $8.9 million, or 68%, to $22.0 million, as compared to $13.1 million for the same period in 2004 due to increased sales to existing customers, as well as to new customers. Maintenance revenue increased $4.2 million, or 98%, to $8.5 million
for the six-months ended June 30, 2005, from $4.3 million for the same period in 2004. The increase included approximately $3.3 million related to the addition of the Docent installed base with the balance primarily due to the addition of new
customers. Hosting revenue increased $1.1 million, or 42%, to $3.7 million for the six-months ended June 30, 2005, from $2.6 million for the same period in 2004. Including the Docent installed base for the full six months added approximately $0.9
million of this increase. Training revenue increased $0.3 million, or 25%, to $1.5 million for the six-months ended June 30, 2005, from $1.2 million for the same period in 2004, all of which was the result of



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the Docent business being included for the full period. Consulting revenue increased $3.0 million, or 61%, to $7.9 million for the six-months ended June 30,
2005, from $4.9 million for the same period in 2004. The Docent installed base added $2.5 million with the balance of the increase 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 six-months ended June 30, 2005, as compared to the same period in 2004.



Cost of Revenue



For the three-months ended
June 30, 2005, total cost of revenue decreased $0.1 million, or 2%, to $6.3 million, as compared to $6.4 million for the same period in 2004. This was the result of the decrease in the amortization of intangible assets and the decrease in third
party consulting services offset by the increase in purchased software and the increase in service and maintenance personnel.



For the six-months ended June 30, 2005, total cost of revenue increased $3.1 million, or 31%, to $13.0 million, as compared to $9.9 million for the same
period in 2004. This was a result of the increase in the amortization of intangible assets, the addition of service and maintenance personnel on March 18, 2004 resulting from the acquisition of Docent, costs associated with hosting the Docent
customer installed-base and additional third party consulting costs associated with Docent product implementations in Europe.



Cost of license.For the three-months ended June 30, 2005, total cost of license revenue increased to $0.7 million, as compared to $0.1
million for the same period in 2004. This increase is due to a large license revenue transaction which required the Company to purchase software for resale from a third party.



For the six-months ended June 30, 2005, total cost of license revenue increased to $0.9 million, as compared to $0.2 million
for the same period in 2004. This increase is primarily due to the purchase of third party software in the three-month period ended June 30, 2005.



Gross margin for license, including amortization of intangibles, for the three-months ended June 30, 2005, decreased slightly to 72% from 75% for the same
period in 2004. This decrease 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, for the six-months ended June 30, 2005, decreased slightly to 72% from 74% for the same
period in 2004. This decrease is mainly due to the reduction of amortization of intangible assets offset by the increase in purchased software.



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



Cost of service and maintenance.For the three-months ended June 30, 2005, total cost of service and
maintenance revenue decreased $0.2 million, or 4%, to $4.8 million, as compared to $5.0 million for the same period in 2004. The decrease is due to the addition of service and maintenance personnel offset by a larger decrease in the use of third
party consulting services.



For the six-months ended June 30,
2005, total cost of service and maintenance revenue increased $2.2 million, or 28%, to $10.0 million, as compared to $7.8 million for the same period in 2004. The increase is primarily due to the addition of thirty-four Docent service and
maintenance personnel following the merger with Docent on March 18, 2004.



Gross margin for service and maintenance increased to 55% for the three-months ended June 30, 2005 from 39% 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 costs.



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Gross margin for service and maintenance increased to 54% for the six-months ended June 30, 2005 from 41%
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
costs.



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 intangibles.Under 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. We recorded amortization expenses of $0.2 million for the three-months ended June 30, 2005 and 2004.
We recorded amortization expenses of $0.5 million for the six-months ended June 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 an 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.



For the three-months ended June 30, 2005, amortization of intangible assets decreased $0.7 million, or 50%, to $0.7 million, as compared to $1.4 million
for the same period in 2004. The decrease for the three-months ended June 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
the first quarter of 2005.



For the six-months ended June 30,
2005, amortization of intangible assets increased $0.2 million, or 11%, to $2.1 million, as compared to $1.9 million for the same period in 2004. The increase for the six-months ended June 30, 2005 is primarily due to $1.1 million of amortization
associated with the intangible assets acquired as a result of the merger with Docent, offset by a reduction in amortization expenses resulting from other intangible assets which were fully amortized in the later fiscal quarters of 2004 and the first
quarter of 2005.



Operating Expenses



Research and development.For the three-months ended June 30,
2005, total research and development cost decreased $0.1 million, or 3%, to $2.9 million, as compared to $3.0 million for the same period in 2004. Expenses relating to research and development personnel for the three-months ended June 30, 2005
increased $0.1 million or 4%, to $2.8 million, as compared to $2.7 million for the same period in 2004. The increase is due to the net addition of fourteen research and development personnel. Consulting expenses for the three-months ended June 30,
2005 decreased to $0.1 million, as compared to $0.3 million for the same period in 2004. Additional consultants were needed to support work on our product platform throughout 2004.



For the six-months ended June 30, 2005, total research and development cost increased $0.5 million, or 9%, to $5.8 million,
as compared to $5.3 million for the same period in 2004. Expenses relating to research and development personnel for the six-months ended June 30, 2005 increased $0.9 million, or 20%, to $5.5 million, as compared to $4.6 million for the same 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 additional external consultants. Consulting expenses for the six-months ended June 30,
2005 decreased to $0.3 million, as compared to $0.7 million for the same period in 2004. Additional consultants were needed to support work on our product platform throughout 2004.



We expect research and development expenses to increase slightly on a quarterly basis through the end of fiscal 2005 due to
additional consulting services relating to future versions of SumTotal 7.0 Series.



Sales and marketing.For the three-months ended June 30, 2005 and 2004, total sales and marketing cost remained constant at $5.9 million. Expenses relating to sales and marketing personnel for the
three-months ended



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June 30, 2005 increased $0.1 million, or 2%, to $5.4 million, as compared to $5.3 million for the same period in 2004. Marketing programs expenses remained
relatively unchanged between the two periods.



For the
six-months ended June 30, 2005, total sales and marketing cost increased $2.1 million, or 21%, to $12.1 million, as compared to $10.0 million for the same period in 2004. Expenses relating to sales and marketing personnel for the six-months ended
June 30, 2005 increased $2.2 million, or 26%, to $10.8 million, as compared to $8.6 million for the same period in 2004. Marketing programs expenses remained relatively unchanged between periods.



General and administrative.For the three-months ended June 30,
2005, total general and administrative cost increased $1.3 million, or 50%, to $3.9 million, as compared to $2.6 million for the same period in 2004. Expenses relating to general and administrative personnel for the three-months ended June 30, 2005
increased $0.4 million, or 22%, to $2.2 million, as compared to $1.8 million for the same period in 2004. In addition, for the three-months ended June 30, 2005, we incurred $1.1 million in additional accounting expenses and consulting fees
associated with compliance with Sarbanes-Oxley Section 404.



For the six-months ended June 30, 2005, total general and administrative cost increased $2.7 million, or 56%, to $7.5 million, as compared to $4.8 million for the same period in 2004. Expenses relating to general and administrative
personnel for the six-months ended June 30, 2005 increased $0.5 million, or 13%, to $4.3 million, as compared to $3.8 million for the same period in 2004. In addition, for the six-months ended June 30, 2005, we incurred $1.9 million in additional
accounting expenses and consulting fees associated with compliance with Sarbanes-Oxley Section 404.



We expect general and administrative expenses to decrease approximately $0.5 million in the third fiscal quarter of 2005 due to the completion of fiscal
2004 Sarbanes-Oxley Section 404 work and then remain relatively constant throughout the remainder of fiscal 2005.



Restructuring charge.The 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 costs and $172,000 in facility exit costs. Employee severance consists of severance and other benefits resulting from a
reduction in force across all Company functions of thirty-three employees. Facility costs represent the closure of a facility in Framingham, Massachusetts and include the fair value of payments required under lease contract and contractual sublease
income.



During the second quarter of fiscal 2004, we recorded
an additional $248,000 restructuring charge, which consisted of $93,000 in employee severance costs and $155,000 million in facility exit costs. 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 costs 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 development.Associated
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 compensation.For the
three-months ended June 30, 2005 and 2004, stock-based compensation expense relating to common stock options and restricted stock was $151,000 and $258,000, respectively. Stock-



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based compensation expense relating to common stock options issued to former Docent employees was $121,000 and $258,000 for the three-months ended June 30,
2005 and 2004, respectively. Stock-based compensation expense relating to restricted stock options issued to SumTotal executives was $30,000 for the three-months ended June 30, 2005.



For the six-months ended June 30, 2005 and 2004, stock-based compensation expense relating to common stock options and
restricted stock was $383,000 and $845,000, respectively. Stock-based compensation expense relating to common stock options issued to former Docent employees was $353,000 and $321,000 for the six-months ended June 30, 2005 and 2004, respectively. In
the six-month ended June 30, 2005 stock-based compensation expense relating to restricted stock options issued to SumTotal executives was $30,000. In the six-months ended June 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 Employee Stock Purchase Plan 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 expense.For the three and six-months ended June 30, 2005, interest expense decreased to $1,000, as
compared to $18,000 and $121,000 for the same periods in 2004, respectively. 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 warrants related to cancellation of our line of credit in the first quarter of fiscal 2004.



Interest income.For the three-months ended June 30, 2005, interest income increased $131,000, or 222%, to $190,000, as compared to $59,000
for the same period in 2004. For the six-months ended June 30, 2005, interest income increased $249,000, or 235%, to $355,000, as compared to $106,000 for the same period in 2004. Interest income increased due to higher balances of cash and cash
equivalents resulting from our March 2004 net cash acquired from the Docent merger, collections of accounts receivable and net proceeds from the issuance of common stock.



Other income (expenses), net.For the three-months ended June 30, 2005, other expense increased $359,000, or
479%, to $434,000, as compared to $75,000 for the same period in 2004. The increase was primarily due to $271,000 in foreign exchange losses in the three-months ended June 30, 2005 and $163,000 for state and local fees in the same period in 2004.,
as compared to $42,000 in foreign exchange losses and $33,000 for state and local fees in the same period in 2004.



For the six-months ended June 30, 2005, other expense increased $149,000, or 42%, to $507,000, as compared to $358,000 for the same period in 2004. The
increase was primarily due to $364,000 in foreign exchange losses in the six-months ended June 30, 2005 and $143,000 for state and local fees in the same period in 2004., as compared to $322,000 in foreign exchange losses and $36,000 for state and
local fees in the same period in 2004.



Equity in losses
of an affiliate.Equity 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. For the three and six-months ended June 30, 2005, our equity in losses of an affiliate decreased to $0, as compared to $0 and
$169,000 for the same 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 taxes.For the three and six-months ended June 30, 2005, we recorded a provision for income tax expense of $30,000
and $61,000 related to foreign and state income taxes, as compared to a provision for income tax expense of $38,000 and $76,000 for the same periods in 2004, respectively.



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Liquidity and Capital Resources



At June 30, 2005, our principal sources of liquidity were our $32.0 million of cash and cash equivalents and $4.7 million of
short-term investments.



We currently anticipate 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 proposed
acquisition of Pathlore Software Corporation which was announced on August 3, 2005 and which involves a cash payment of $29.2 million, we plan on entering 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 $1.9 million for the six-months ended June 30, 2005. The cash provided during the period was primarily due
to net collection of receivables of $2.6 million, a $4.6 million increase in deferred revenue due to additional invoiced bookings during the period, and non-cash activities consisting of $2.1 million for the amortization of intangible assets, $0.9
million for depreciation and amortization of property and equipment, a $0.5 million increase in accrued liabilities, and $0.4 million for stock-based compensation, offset by a net loss of $6.0 million, a $1.3 million decrease in accrued compensation
and benefits, a $0.8 million increase in other long-term assets, a $0.6 million decrease in accounts payable and a $0.4 million decrease in the restructuring accrual.



Net cash provided by operating activities was $1.5 million for the six-months ended June 30, 2004. The cash provided during
the period was due to net collection of receivables of $6.2 million due primarily from the collections of the acquired accounts receivable from Docent, a $2.9 million increase in deferred revenue due to additional invoiced bookings during the
period, and non-cash activities consisting of $1.9 million for the amortization of intangible assets, a $1.5 million decrease in other long-term assets, $1.3 million for in-process research and development charges, $0.8 million for depreciation and
amortization of property and equipment, $0.8 million for stock-based compensation, $0.4 million for a loss on the disposal of property and equipment, a $0.4 million decrease in the restructuring accrual and $0.2 million in equity in losses of an
affiliate, offset by a net loss of $11.9 million, a $1.8 million decrease in accrued liabilities, a $0.5 million decrease in accounts payable, a $0.3 million increase in prepaid expenses and other assets and a $0.3 million increase for provision for
returns and doubtful accounts.



Net cash provided by investing
activities was $3.4 million for the six-months ended June 30, 2005 due to $4.6 million in net sales of short-term investments, offset by $1.2 million in purchases of equipment.



Net cash provided by investing activities was $25.4 million for the six-months ended June 30, 2004, primarily due to the
$25.4 million of cash acquired in acquisition, net of payments, associated with the Docent merger.



Net cash provided by in financing activities was $0.9 million for the six-months ended June 30, 2005 due to net proceeds from the issuance of common stock
through our Employee Stock Purchase Plan (ESPP) and exercises of common stock options.



Net cash used financing activities was $2.9 million for the six-months ended June 30, 2004 due primarily to extinguishing the working capital line at
Silicon Valley Bank that had a balance of $3.5 million at December 31, 2003, offset by net proceeds of $0.7 million from the issuance of common stock through our Employee Stock Purchase Plan (ESPP) and exercises of common stock options.
In March 2004, SumTotal Systems cancelled its $10.0 million working capital line at Silicon Valley Bank. SumTotal Systems paid a fee of $0.1 million to Silicon Valley Bank associated with the cancellation and incurred a charge of $0.1 million
associated with warrants related to the line of credit.



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At June 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
|Operating leases                             |  | $                      | 5,224 |                 | $ | 1,549     |  | $         | 1,384 |           | $ | 1,279     |  | $ | 781 |  | $ | 231
|Accrued restructured facility lease payments |  |                        | 144   |                 |   | 84        |  |           | 26    |           |   | 23        |  |   | 11  |  |   |   
|                                             |  |                        |       |                 |   |           |  |           |       |           |   |           |  |   |     |  |   |    
|                                             |  | $                      | 5,368 |                 | $ | 1,633     |  | $         | 1,410 |           | $ | 1,302     |  | $ | 792 |  | $ | 231
|                                             |  |                        |       |                 |   |           |  |           |       |           |   |           |  |   |     |  |   |    



We have entered into
various arrangements with hosting services vendors and various non-cancelable operating facility lease agreements for our offices throughout the United States and for our international subsidiaries with original lease periods expiring through 2010.
In addition, we are under contract to fulfill facility leases for offices that were subleased to third party companies under restructuring plans. The difference between the future operating lease liabilities and the fair market value of the
operating leases is accrued within the restructuring accrual balance.



Recent Accounting Pronouncements



See
discussion of recent accounting pronouncements in Note 2 of the Companys 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.



We have a history of losses, we
expect future losses on a GAAP basis and we may never achieve GAAP profitability.



We have not yet achieved profitability and may not do so. Even if we do achieve profitability, we may be unable to sustain or increase profitability on a quarterly or annual basis.



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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 achieve 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.



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



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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.



Any acquisition we make or attempt to make, including our recently announced intent to acquire Pathlore Software Corporation, 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. For example, we
recently entered into an agreement to acquire Pathlore Software Corporation for cash and shares of our common stock valued at approximately $48 million. Acquisitions, whether or not consummated, require extensive efforts from numerous departments in
the company. We have been, and will continue to, expend significant efforts on 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 close the Pathlore acquisition, or any other business combination we may make in the future, and failure to do so may negatively
affect our financial results, customer, employee and investor confidence, and ultimately our stock price.



The Pathlore acquisition, if consummated, will dilute our existing stockholders percentage ownership and decrease our cash position. In addition,
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. Further, we may 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.



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.



Failure to enter into a credit facility on favorable terms, or at all, will substantially deplete our cash position and could reduce our ability to compete and harm
our financial condition.



We recently announced the
acquisition of Pathlore Software Corporation for approximately $29.2 million in cash and 4,000,000 shares of our common stock. We intend to enter into a credit facility to, in part, fund this pending acquisition. This additional financing may not be
available on a timely basis or on terms acceptable to us, or at all. By way of example, if we are unable to negotiate a favorable interest rate, a greater portion of our cash flow from operations will have to be dedicated to the repayment or our
indebtedness and related interest, and will not be available for other business purposes. Additionally, this financing will likely require us to grant a lender a security interest in our assets.



In the event we are unsuccessful in raising additional funds, our cash
reserves would be substantially depleted by our obligations under the Pathlore acquisition agreement. Accordingly, if adequate funds are not available and



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we are compelled to use our existing cash reserves to fund the Pathlore acquisition, we may have to delay development or commercialization of other products
and services or defer the acquisition of additional complimentary products. Additionally, we may have to reduce marketing, customer support or other resources devoted to our existing products and services. Any of these results could harm our
financial condition.



Even if we are successful in raising
additional funds under a credit facility, the terms of that credit facility may impose substantial burdens on our ability to operate flexibly going forward. Any credit facility that we enter into is likely to contain covenants that will impose
substantial operating and financial restrictions on us. These covenants could 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.
Other restrictive covenants might include restrictions on our ability to incur additional debt; pay dividends or make investments, loans or advances; incur capital expenditures; create liens; use the proceeds from sales of assets or capital stock;
and/or enter into sale or leaseback transactions.



In addition,
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. Even if we are able to repay the debt in a
timely manner, under the terms of the credit facility, there will likely be penalties for making pre-payments that would otherwise save us substantial future interest payments. Also, even if we successfully negotiate a credit facility and borrow
funds, we may become 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. Each of these risks may cause concern among our customers or investors and therefore cause a decrease in our sales or stock price.



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.
| | - |  | --------------------------------------------------------



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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.



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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 $4.59 per share on August 5, 2005, providing us a total market capitalization of approximately $97.2 million. The carrying value of our goodwill and intangible assets on June
30, 2005 was $27.7 million and $7.4 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.



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. Further, the benefits of such controls were considered relative to
their costs, and the Company, based on its size, has had to make decisions not to establish and implement certain controls and procedures we may otherwise have established, because of the cost. 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



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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. 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 over financial reporting. During this process, 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.



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 obtain 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.



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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. 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.



Acquisitions or investments may drain capital and equity resources, divert managements attention or otherwise harm our business.



In the future we may acquire or make investments in other businesses, products or technologies. Such acquisitions or
investments may require that we pay significant cash, issue stock or incur substantial debt. Such acquisitions or investments may result in the loss of key personnel and the dilution of existing stockholders as a result of issuing equity securities.
In addition, such acquisitions or investments may require significant managerial attention, which may be diverted from our other operations. These capital, equity and managerial commitments may impair the operation of our business. Furthermore,
acquired businesses may not be effectively integrated, may be unable to maintain key pre-acquisition business relationships, may contribute to increased fixed costs and may expose us to unanticipated liabilities. Acquisitions and mergers of
high-technology companies are inherently risky, and no assurance can be given that future acquisitions, if any, will be successful and will not materially adversely affect our business, operating results or operating condition.



Our revenue may grow more slowly than we previously forecasted.



If our revenue does not increase at or above the rate we have forecasted or
the financial analysts expect, the price of our common stock may decline. Our future growth rates will depend on general economic conditions and on our ability to expand sales of our existing products and develop and market new products, which will
require significant expenses that we may not have sufficient resources to undertake.



We have a limited operating history on which to evaluate our current business and future prospects. The lack of any operating history with the SumTotal 7.0 Series makes it difficult to predict our future performance
and may not provide investors with a meaningful basis for evaluating an investment in our common stock.



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 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



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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 Notes to the 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, our Board of Directors 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 our employees, including our Section 16 officers, under each of our 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 reflects an approximate 10% premium over the average closing price of our common stock over the ninety-day period prior to its determination. 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 our outstanding unvested options, 446,000 of which are held by Section 16 Officers, will become
exercisable upon our compliance with NASDAQ and SEC rules.



The
purpose of the acceleration is to enable us to avoid recognizing the future compensation expense associated with the adoption of SFAS No. 123R, Share-Based Payment. SFAS No. 123R, when effective, will require all share-based payments to
employees, including granting of employee stock options, to be recognized as compensation expense on our consolidated statement of operations, rather than as a disclosure in the Notes to the Consolidated Financial Statements, based on their fair
values. SFAS No. 123R will become effective to us beginning in the first quarter of fiscal year 2006. 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 based on generally accepted accounting principles because there was not a modification of the option grants. We
also believe that because the options to be accelerated have exercise prices in excess of the current market value of our common stock, the options have limited economic value and are not fully achieving their original objective of incentive
compensation and employee retention. However, as a result of the acceleration, we will lose the retention value of the unvested options, and as a result, certain key employees may leave.



We face intense competition from other business performance and learning management software providers including Saba Software, Inc.,
Plateau Systems Ltd., International Business Machines Corporation and Pathlore Software 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;
| | - |  | -------------------------------------------------------------------------



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| |  |  | 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.



Our principal competitors are Saba Software, Inc., Plateau Systems Ltd., International Business Machines Corporation, Pathlore Software Corporation, 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.



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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;
| | - |  | -----------------------------------------



| |  |  | 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.



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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 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 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.



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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.



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



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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.



The loss of the services of our senior executives and key personnel would likely cause our
business to suffer.



Our success depends to a significant
degree on the performance of the senior management team and other key employees. 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 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.



Rapid change will require us to manage the
size of our employee base, particularly our direct sales force and global support staff.



The majority of our expenses are personnel-related costs such as employee compensation and benefits, along with the cost of the infrastructure (occupancy and equipment) to support our employee base. The failure to
adjust our employee base, particularly our direct sales force and technical and global services staff, to the appropriate level to support our revenues could materially and adversely affect our business, operating results and financial condition. In
addition, expanding the distribution of our products may place new and increased demands on our direct sales force and technical and sales support staff. Although we believe that we currently are investing sufficient resources in our direct sales
force and our technical and global services staff, there are only a limited number of qualified personnel in these areas. Our ability to achieve expanded distribution and revenue growth in the future will depend, in part, on our success in retaining
and in recruiting and training sufficient direct sales, technical and global services personnel. We may not be able to expand our direct sales force and technical support staff as necessary to support our operations and maintain or increase our
market share.



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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 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.



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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.



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.



Both Docent and Click2learn have been the subject of patent infringement cases. In May 2002, IpLearn, LLC filed suit against Docent and several other major developers of online learning software, alleging five patent
infringement claims related to online learning and seeks unspecified damages. In December 2002, IP Innovation filed suit against Docent and seven other defendants, alleging infringement of a patent covering the use of HTML (hypertext markup
language) in graphics software used in a computer system and seeks unspecified damages. In July 2004, Docent won its summary judgment motion for non-infringement, though IP Innovation has appealed that decision. In February 2004, IpLearn, LLC filed
suit against Click2learn alleging that its legacy Aspen product line infringes eight patents held by IpLearn. The IpLearn suits against Docent and Click2learn have been consolidated into one suit against SumTotal Systems. In each of these cases,
plaintiff seeks unspecified monetary damages and injunctive relief. After investigating and analyzing the claims, we believe that each of the cases is without merit, and we are defending, and plan to continue to defend, against each of them
vigorously.



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 the event it is in fact determined that Docent or Click2learn were, or we are, infringing the patents that are the subject of any of these claims or
other third party patents, 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.



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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.



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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.



|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 June 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. For the three and six-months ended June 30, 2005, international revenue from our foreign subsidiaries accounted for approximately 25% and 26% of total revenue, respectively, as compared to 24% and 22%, for the same 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, these results, when translated, may vary from expectations and adversely impact overall expected profitability. The effect of foreign exchange rate fluctuations
for the three and six-months ended June 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 June 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 June 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 June 30, 2005.



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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).



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.



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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.



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
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | 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;
| | - |  | ---------------------------------------------------------------------------------



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.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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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 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. A Markman hearing is currently scheduled for November 2005.



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 attorneys 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 attorneys fees order, in April 2005. No decision on
either appeal has been rendered.



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, 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.



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



Not applicable.



|Item 5. | Other Information
|------- | -----------------



Not applicable.



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##### Table of Contents

|Item 6. | Exhibits and Reports on Form 8-K
|------- | --------------------------------



|     |  |                                                                                                                                                                                      
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a)  |  | Exhibits.                                                                                                                                                                            
|     | 
|31.1 |  | Certifications 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 |  | Certifications 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.      
|     | 
|(b)  |  | Reports on Form 8-K.                                                                                                                                                                 
|     | 
|     |  | Report on Form 8-K filed on August 3, 2005, under Items 2.02 and 9.01, furnishing the press release containing financial information for the three ended June 30, 2005.              
|     | 
|     |  | Report on Form 8-K filed on August 3, 2005 under Items 1.01 and 9.01, furnishing merger agreement and the press release announcing our plan to acquire Pathlore Software
Corporation.



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##### 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.
|               |  |  | 
|August 9, 2005 |  |  |  |                        |  | /s/ NEIL J. LAIRD
|Date           |  |  |  |                        |  | Neil J. Laird    
|               |  |  |  |                        |  |                   |  | Chief Financial Officer                      
|               |  |  |  |                        |  |                   |  | (Duly Authorized Officer and                 
|               |  |  |  |                        |  |                   |  | Chief Financial and Chief Accounting Officer)



49