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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 September 30, 2004



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.)



2444 Charleston Road
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 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 October 29, 2004 was approximately 20,646,383 shares.



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.



FORM 10 Q



For the Quarter Ended September 30, 2004



TABLE OF CONTENTS



|                               |  |                                                                                                                 |  |   
|------------------------------ |  | --------------------------------------------------------------------------------------------------------------- |  | --
|                               |  | Page                                                                                                           
|                               | 
|PART I  FINANCIAL INFORMATION |  |                                                                                                                
|                               |  |                                                                                                                
|Item 1.                        |  | Consolidated Financial Statements (unaudited)                                                                   |  |   
|                               |  |                                                                                                                
|                               |  | Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003                            |  | 3 
|                               |  |                                                                                                                
|                               |  | Condensed Consolidated Statements of Operations for the three and nine-months ended September 30, 2004 and 2003 |  | 4 
|                               |  |                                                                                                                
|                               |  | Condensed Consolidated Statements of Cash Flows for the nine-months ended September 30, 2004 and 2003           |  | 5 
|                               |  |                                                                                                                
|                               |  | Notes to Condensed Consolidated Financial Statements                                                            |  | 6 
|                               |  |                                                                                                                
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                           |  | 18
|                               |  |                                                                                                                
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                                                      |  | 42
|                               |  |                                                                                                                
|Item 4.                        |  | Controls and Procedures                                                                                         |  | 43
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                                                
|                               |  |                                                                                                                
|Item 1.                        |  | Legal Proceedings                                                                                               |  | 44
|                               |  |                                                                                                                
|Item 2.                        |  | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                |  | 44
|                               |  |                                                                                                                
|Item 3.                        |  | Defaults upon Senior Securities                                                                                 |  | 44
|                               |  |                                                                                                                
|Item 4.                        |  | Submission of Matters to a Vote of Securities Holders                                                           |  | 44
|                               |  |                                                                                                                
|Item 5.                        |  | Other Information                                                                                               |  | 44
|                               |  |                                                                                                                
|Item 6.                        |  | Exhibits and Reports on Form 8-K                                                                                |  | 45
|                               | 
|SIGNATURES                     |  | 46                                                                                                             



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PART I  FINANCIAL
INFORMATION



Item 1. Consolidated Financial Statements (unaudited)



SUMTOTAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands)



|                                                                                                             |  |                   |          |   |                  |   |          |  
|------------------------------------------------------------------------------------------------------------ |  | ----------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                             |  | September 30,2004 |          |   | December 31,2003 |  
|Assets                                                                                                       |  |                   |          |   |                  |   |          |  
|Current assets:                                                                                              |  |                   |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                    |  | $                 | 35,430   |   |                  | $ | 12,862   |  
|Short-term investments                                                                                       |  |                   | 47       |   |                  |   |         |  
|Accounts receivable, net of allowance for sales returns and doubtful accounts of $729 and $927, respectively |  |                   | 12,089   |   |                  |   | 10,359   |  
|Prepaid expenses and other current assets                                                                    |  |                   | 1,468    |   |                  |   | 795      |  
|                                                                                                             |  |                   |          |   |                  |   |          |  
|Total current assets                                                                                         |  |                   | 49,034   |   |                  |   | 24,016   |  
|Property and equipment, net                                                                                  |  |                   | 2,639    |   |                  |   | 1,508    |  
|Goodwill                                                                                                     |  |                   | 27,878   |   |                  |   | 2,877    |  
|Intangible assets, net                                                                                       |  |                   | 10,878   |   |                  |   | 2,560    |  
|Other assets                                                                                                 |  |                   | 1,141    |   |                  |   | 1,704    |  
|                                                                                                             |  |                   |          |   |                  |   |          |  
|Total assets                                                                                                 |  | $                 | 91,570   |   |                  | $ | 32,665   |  
|                                                                                                             |  |                   |          |   |                  |   |          |  
|Liabilities and Stockholders Equity                                                                         |  |                   |          |   |                  |   |          |  
|Current liabilities:                                                                                         |  |                   |          |   |                  |   |          |  
|Line of credit                                                                                               |  | $                 |         |   |                  | $ | 3,521    |  
|Accounts payable                                                                                             |  |                   | 2,786    |   |                  |   | 1,786    |  
|Accrued compensation and benefits                                                                            |  |                   | 3,338    |   |                  |   | 2,612    |  
|Other accrued liabilities                                                                                    |  |                   | 2,975    |   |                  |   | 889      |  
|Restructuring accrual                                                                                        |  |                   | 721      |   |                  |   |         |  
|Deferred revenue                                                                                             |  |                   | 12,071   |   |                  |   | 5,361    |  
|                                                                                                             |  |                   |          |   |                  |   |          |  
|Total current liabilities                                                                                    |  |                   | 21,891   |   |                  |   | 14,169   |  
|                                                                                                             |  |                   |          |   |                  |   |          |  
|Stockholders equity:                                                                                        |  |                   |          |   |                  |   |          |  
|Common stock                                                                                                 |  |                   | 21       |   |                  |   | 33       |  
|Additional paid-in capital                                                                                   |  |                   | 321,437  |   |                  |   | 255,092  |  
|Deferred stock-based compensation                                                                            |  |                   | (1,354   | ) |                  |   |         |  
|Accumulated other comprehensive loss                                                                         |  |                   | (121     | ) |                  |   | (461     | )
|Accumulated deficit                                                                                          |  |                   | (250,304 | ) |                  |   | (236,168 | )
|                                                                                                             |  |                   |          |   |                  |   |          |  
|Total stockholders equity                                                                                   |  |                   | 69,679   |   |                  |   | 18,496   |  
|                                                                                                             |  |                   |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                   |  | $                 | 91,570   |   |                  | $ | 32,665   |  
|                                                                                                             |  |                   |          |   |                  |   |          |  



See accompanying notes
to Condensed Consolidated Financial Statements.



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SUMTOTAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)



|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                              |  | Three-Months Ended September 30, |        |   | Nine-Months Ended September 30, |  
|                                                              |  | 2004                             |        |   | 2003                            |   |        | 2004 |  |   | 2003    |  
|Revenue:                                                      |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|License                                                       |  | $                                | 5,634  |   |                                 | $ | 2,625  |      |  | $ | 13,762  |   |  | $ | 7,570  |  
|Service and maintenance                                       |  |                                  | 9,653  |   |                                 |   | 4,888  |      |  |   | 22,714  |   |  |   | 16,073 |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Total revenue                                                 |  |                                  | 15,287 |   |                                 |   | 7,513  |      |  |   | 36,476  |   |  |   | 23,643 |  
|Cost of revenue:                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|License                                                       |  |                                  | 168    |   |                                 |   | 137    |      |  |   | 372     |   |  |   | 440    |  
|Service and maintenance                                       |  |                                  | 4,614  |   |                                 |   | 2,391  |      |  |   | 12,370  |   |  |   | 7,512  |  
|Amortization of intangible assets                             |  |                                  | 1,507  |   |                                 |   | 353    |      |  |   | 3,408   |   |  |   | 823    |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Total cost of revenue                                         |  |                                  | 6,289  |   |                                 |   | 2,881  |      |  |   | 16,150  |   |  |   | 8,775  |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Gross margin                                                  |  |                                  | 8,998  |   |                                 |   | 4,632  |      |  |   | 20,326  |   |  |   | 14,868 |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Operating expenses:                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Research and development                                      |  |                                  | 2,910  |   |                                 |   | 1,633  |      |  |   | 8,192   |   |  |   | 4,365  |  
|Sales and marketing                                           |  |                                  | 5,527  |   |                                 |   | 2,860  |      |  |   | 15,567  |   |  |   | 9,134  |  
|General and administrative                                    |  |                                  | 2,932  |   |                                 |   | 1,467  |      |  |   | 7,775   |   |  |   | 4,217  |  
|Restructuring charge                                          |  |                                  |       |   |                                 |   |       |      |  |   | 1,137   |   |  |   |       |  
|In-process research and development                           |  |                                  |       |   |                                 |   |       |      |  |   | 1,326   |   |  |   |       |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Total operating expenses                                      |  |                                  | 11,369 |   |                                 |   | 5,960  |      |  |   | 33,997  |   |  |   | 17,716 |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Loss from operations                                          |  |                                  | (2,371 | ) |                                 |   | (1,328 | )    |  |   | (13,671 | ) |  |   | (2,848 | )
|Interest expense                                              |  |                                  |       |   |                                 |   | (27    | )    |  |   | (121    | ) |  |   | (122   | )
|Interest income                                               |  |                                  | 97     |   |                                 |   | 19     |      |  |   | 203     |   |  |   | 21     |  
|Other income (expense), net                                   |  |                                  | 9      |   |                                 |   |       |      |  |   | (349    | ) |  |   |       |  
|Equity in losses of an affiliate                              |  |                                  |       |   |                                 |   | (25    | )    |  |   | (169    | ) |  |   | (75    | )
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Loss before provision for income taxes                        |  |                                  | (2,265 | ) |                                 |   | (1,361 | )    |  |   | (14,107 | ) |  |   | (3,024 | )
|Provision (credit) for income taxes                           |  |                                  | (47    | ) |                                 |   | 8      |      |  |   | 29      |   |  |   | 26     |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Net loss                                                      |  | $                                | (2,218 | ) |                                 | $ | (1,369 | )    |  | $ | (14,136 | ) |  | $ | (3,050 | )
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Net loss per share, basic and diluted                         |  | $                                | (0.11  | ) |                                 | $ | (0.13  | )    |  | $ | (0.80   | ) |  | $ | (0.35  | )
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Weighted average common shares outstanding, basic and diluted |  |                                  | 20,535 |   |                                 |   | 10,361 |      |  |   | 17,601  |   |  |   | 8,837  |  
|                                                              |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  



See accompanying notes
to Condensed Consolidated Financial Statements.



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SUMTOTAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



|                                                                                |  |                                 |         |   |      |   |        |  
|------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------ | -
|                                                                                |  | Nine-Months Ended September 30, |        
|                                                                                |  | 2004                            |         |   | 2003 |  
|Cash flows from operating activities:                                           |  |                                 |         |   |      |   |        |  
|Net loss                                                                        |  | $                               | (14,136 | ) |      | $ | (3,050 | )
|Adjustments to reconcile net loss to net cash provided by operating activities: |  |                                 |         |   |      |   |        |  
|Depreciation and amortization                                                   |  |                                 | 1,151   |   |      |   | 1,064  |  
|Amortization of intangible assets                                               |  |                                 | 3,426   |   |      |   | 823    |  
|Loss on disposal of property and equipment                                      |  |                                 | 394     |   |      |   |       |  
|Recovery of sales returns and doubtful accounts                                 |  |                                 | (212    | ) |      |   | (88    | )
|Amortization of discount on debt                                                |  |                                 | 89      |   |      |   | 66     |  
|Stock-based compensation                                                        |  |                                 | 1,119   |   |      |   |       |  
|In-process research and development                                             |  |                                 | 1,326   |   |      |   |       |  
|Equity in losses of an affiliate                                                |  |                                 | 169     |   |      |   | 75     |  
|Net change in certain operating assets and liabilities                          |  |                                 | 7,112   |   |      |   | 370    |  
|                                                                                |  |                                 |         |   |      |   |        |  
|Net cash provided by (used in) operating activities                             |  |                                 | 438     |   |      |   | (740   | )
|                                                                                |  |                                 |         |   |      |   |        |  
|Cash flows from investing activities:                                           |  |                                 |         |   |      |   |        |  
|Purchases of property and equipment                                             |  |                                 | (664    | ) |      |   | (602   | )
|Cash acquired in acquisitions, net of cash payments                             |  |                                 | 25,432  |   |      |   |       |  
|Cash used in asset purchase agreements, net of cash received                    |  |                                 | (488    | ) |      |   |       |  
|Purchases of short-term investments                                             |  |                                 | (2,544  | ) |      |   |       |  
|Sales of short-term investments                                                 |  |                                 | 2,998   |   |      |   |       |  
|Other                                                                           |  |                                 |        |   |      |   | (50    | )
|                                                                                |  |                                 |         |   |      |   |        |  
|Net cash provided by (used in) investing activities                             |  |                                 | 24,734  |   |      |   | (652   | )
|                                                                                |  |                                 |         |   |      |   |        |  
|Cash flows from financing activities:                                           |  |                                 |         |   |      |   |        |  
|Net borrowings (repayments) on line of credit                                   |  |                                 | (3,974  | ) |      |   | 351    |  
|Net proceeds from the issuance of common stock                                  |  |                                 | 1,030   |   |      |   | 12,264 |  
|                                                                                |  |                                 |         |   |      |   |        |  
|Net cash provided by (used in) financing activities                             |  |                                 | (2,944  | ) |      |   | 12,615 |  
|                                                                                |  |                                 |         |   |      |   |        |  
|Effect of foreign exchange rate changes on cash                                 |  |                                 | 340     |   |      |   | 100    |  
|                                                                                |  |                                 |         |   |      |   |        |  
|Net increase in cash and cash equivalents                                       |  |                                 | 22,568  |   |      |   | 11,323 |  
|Cash and cash equivalents at beginning of period                                |  |                                 | 12,862  |   |      |   | 3,586  |  
|                                                                                |  |                                 |         |   |      |   |        |  
|Cash and cash equivalents at end of period                                      |  | $                               | 35,430  |   |      | $ | 14,909 |  
|                                                                                |  |                                 |         |   |      |   |        |  



See accompanying notes
to 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, Inc. (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 unaudited condensed consolidated financial statements of SumTotal Systems include the accounts of SumTotal Systems and its wholly-owned
subsidiaries. All inter-company transactions have been eliminated in consolidation.



These statements reflect all normal recurring adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position and results of operations for the periods presented.
Interim results of operations for the three and nine-months ended September 30, 2004 are not necessarily indicative of the operating results for the full fiscal year. Factors that may affect such operating results, include, but are not limited to,
those discussed in Factors That May Affect Future Results of Operations. Certain information and footnote disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted
in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).



These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements
and related notes included in Click2learns Annual Report on Form 10-K for the year ended December 31, 2003.



All share and per share data included in the consolidated financial statements have been retroactively adjusted to reflect the conversion of Click2learn
shares into SumTotal Systems shares at a ratio of 0.3188 SumTotal Systems shares for each Click2learn share on March 18, 2004. See Note 3 below, Acquisition, Intangible Assets and Goodwill.



Revenue Recognition



SumTotal Systems recognizes revenue pursuant to the requirements of American
Institute of Certified Public Accountants (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 collectible.



For all sales, SumTotal Systems 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.



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. Enterprise customers have the option of purchasing perpetual licenses, time-based licenses or subscription license bundles that
include hosting and maintenance and support. 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.



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SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



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 reasonably assured. If a significant portion of a fee is due after SumTotal Systems normal payment terms, currently 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 it becomes 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 reasonably assured,
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.



Professional services under fixed price contracts are recognized as services are provided or by using the percentage-of-completion method of accounting, based on the ratio of costs incurred, including labor hours, to
the total estimated project cost. 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 on the contractual reporting obligations.



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 includes time-based licenses, hosting and maintenance and support. Subscription licenses are recognized on a straight-line basis over the life of the subscription and are recorded as
service and maintenance revenue. SumTotal Systems typically bills these contracts in advance and records the billed amounts in deferred revenue.



Goodwill and Other Intangible Assets



Goodwill represents the excess of costs over the fair value of assets acquired in a business combination. Goodwill and intangible assets acquired in a
purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement of Financial Accounting Standards (SFAS)
No. 142, Goodwill and Other Intangible Assets. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values and are reviewed for impairment in accordance with SFAS
No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.



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SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



Impairment of Long-Lived Assets



Long-lived assets, such as property, plant and equipment and purchased intangibles subject to amortization, are reviewed for
impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to the
estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of
the asset group exceeds the fair value of the asset group.



Goodwill and intangible assets not subject to amortization are tested annually for impairment and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is
recognized to the extent that the carrying amount exceeds the assets fair value.



Net Loss Per Share



Basic net loss per
share is computed by dividing the net loss by the weighted average number of common shares outstanding during the period. Diluted per share amounts reflect the weighted average number of common and dilutive shares outstanding during the period. As
SumTotal Systems had a net loss for each of the periods presented, basic and diluted net loss per share are the same.



Excluded from the computation of diluted loss per share for the three-months ended September 30, 2004 are options to acquire approximately 2,478,172
shares of common stock and warrants to acquire approximately 1,967,034 shares of common stock because their effects would be anti-dilutive.



Excluded from the computation of diluted loss per share for the nine-months ended September 30, 2004 are options to acquire approximately 2,455,571 shares
of common stock and warrants to acquire approximately 1,967,034 shares of common stock because their effects would be anti-dilutive.



The change in common stock and additional paid-in capital reflects the stock option exercises, stock purchases for the Employee Stock Purchase Plan on
January 31, 2004 and July 31, 2004 and common stock and common stock options issued associated with the acquisition of Docent.



Derivative Financial Instruments



SumTotal Systems had no derivative financial instruments outstanding at September 30, 2004 or December 31, 2003.



Comprehensive Loss and Accumulated Other Comprehensive Loss



The following table sets forth the components of comprehensive loss for the
periods presented below (in thousands):



|                                        |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|--------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                        |  | Three-Months EndedSeptember 30, |        |   | Nine-Months EndedSeptember 30, |  
|                                        |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003    |  
|Net loss                                |  | $                               | (2,218 | ) |                                | $ | (1,369 | )    |  | $ | (14,136 | ) |  | $ | (3,050 | )
|Foreign currency translation adjustment |  |                                 | (51    | ) |                                |   | (27    | )    |  |   | (340    | ) |  |   | 100    |  
|                                        |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|                                        |  | $                               | (2,269 | ) |                                | $ | (1,396 | )    |  | $ | (14,476 | ) |  | $ | (2,950 | )
|                                        |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  



Accumulated other
comprehensive loss was $121,000 and $461,000 at September 30, 2004 and December 31, 2003, respectively, and is all related to foreign currency translation adjustments.



8



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



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 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 March 2004, the FASB issued a proposed Statement, Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95, that addresses the
accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the companys equity instruments or that
may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions using the intrinsic method that SumTotal Systems currently uses and generally would
require that such transactions be accounted for using a fair-value-based method and recognized as expense in the consolidated statement of operations. The effective date of the proposed standard is for periods beginning after June 15, 2005. It is
expected that the final standard will be issued before December 31, 2004 and should it be finalized in its current form, it will have a significant impact on the consolidated statement of operations as SumTotal Systems will be required to expense
the fair value of its stock option grants and stock purchases under its employee stock purchase plan. The following table displays the impact to SumTotal Systems operating expenses if it 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 it had adopted SFAS No. 123 for all periods
presented (in thousands, except per share amounts):



|                                                                                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|--------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                                      |  | Three-Months EndedSeptember 30, |        |   | Nine-Months EndedSeptember 30, |  
|                                                                                                                      |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003    |  
|Net loss, as reported                                                                                                 |  | $                               | (2,218 | ) |                                | $ | (1,369 | )    |  | $ | (14,136 | ) |  | $ | (3,050 | )
|Add: Stock-based employee compensation expenses included in reported net loss                                         |  |                                 | 274    |   |                                |   |       |      |  |   | 1,119   |   |  |   |       |  
|Deduct: Stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax |  | $                               | (2,252 | ) |                                | $ | (944   | )    |  | $ | (5,359  | ) |  | $ | (3,145 | )
|                                                                                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma net loss                                                                                                    |  | $                               | (4,196 | ) |                                | $ | (2,313 | )    |  | $ | (18,376 | ) |  | $ | (6,195 | )
|                                                                                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Weighted average common shares outstanding, basic and diluted                                                         |  |                                 | 20,535 |   |                                |   | 10,361 |      |  |   | 17,601  |   |  |   | 8,837  |  
|                                                                                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net loss per share, basic and diluted:                                                                                |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|As reported                                                                                                           |  | $                               | (0.11  | ) |                                | $ | (0.13  | )    |  | $ | (0.80   | ) |  | $ | (0.35  | )
|Pro forma                                                                                                             |  | $                               | (0.20  | ) |                                | $ | (0.22  | )    |  | $ | (1.04   | ) |  | $ | (0.70  | )



9



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



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



|                          |  |                                 |  |                                 |  |                                 |  |                                 |  |             |  |             |  |             |  |           
|------------------------- |  | ------------------------------- |  | ------------------------------- |  | ------------------------------- |  | ------------------------------- |  | ----------- |  | ----------- |  | ----------- |  | ----------
|                          |  | Options                         |  | Employee Stock Purchase Plan    |  | Options                         |  | Employee Stock Purchase Plan   
|                          |  | Three-Months EndedSeptember 30, |  | Three-Months EndedSeptember 30, |  | Nine-Months Ended September 30, |  | Nine-Months Ended September 30,
|                          |  | 2004                            |  | 2003                            |  | 2004                            |  | 2003                            |  | 2004        |  | 2003        |  | 2004        |  | 2003      
|Dividend yield            |  | 0%                              |  | 0%                              |  | 0%                              |  | 0%                              |  | 0%          |  | 0%          |  | 0%          |  | 0%        
|Volatility                |  | 1.15                            |  | 1.13                            |  | 0.59                            |  | 1.12                            |  | 1.15 - 1.20 |  | 1.13-1.30   |  | 0.59-0.79   |  | 1.12      
|Risk free interest rates  |  | 3.32%-3.74%                     |  | 2.85%                           |  | 1.77%                           |  | 3.05%                           |  | 1.48%-3.86% |  | 2.46%-2.85% |  | 1.01%-1.77% |  | 3.05%     
|Expected lives of options |  | 5 years                         |  | 5 years                         |  | 6 months                        |  | 1.25 years                      |  | 1-5 years   |  | 5 years     |  | 6 months    |  | 1.25 years



In 2004, SumTotal
Systems recorded $233,000 in stock-based compensation expense relating to increasing the amount of shares available for purchase in the SumTotal Employee Stock Purchase Plan, per FIN No. 44, Accounting for Certain Transactions Involving Stock
Compensation, $595,000 in stock-based compensation expense relating to common stock options issued to former Docent employees and $291,000 in stock-based compensation expense relating to accelerated options vesting to certain employees.



Recent Accounting Pronouncements



In March 2004, the Emerging Issues Task Force of the FASB (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
03-1-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-01 to investments in securities that are impaired. The adoption of EITF No. 03-01 is not
expected to have a material affect on SumTotal Systems results of operations and financial condition.



Reclassifications



A reclassification of $1.9 million from accounts receivable to deferred revenue at December 31, 2003 was made to conform to SumTotal Systems current year presentation.



A reclassification of $636,000 to property and equipment, net from intangible assets at December 31, 2003 was made to
conform to SumTotal Systems current year presentation.



A
reclassification of $295,000 from common stock to additional paid-in capital at December 31, 2003 was made because the par value of common stock changed from $0.01 at December 31, 2003 to $0.001 on March 18, 2004, as a result of the merger with
Docent.



Certain other insignificant amounts have been
reclassified to conform to current period presentation.



NOTE 3:
ACQUISITION, INTANGIBLE ASSETS AND GOODWILL



On March 18,
2004, Click2learn acquired Docent, a leading provider of integrated 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.



10



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



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



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



|                                                       |  |   |       
|------------------------------------------------------ |  | - | ------
|Fair value of SumTotal Systems common stock issued (1) |  | $ | 55,663
|Acquisition related 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 9,748,253 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 and 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 merger. 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 $291,000 as a result of
accelerated vesting to certain employees.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



11



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



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 $25.0 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                         |  |   | 11,256 |  
|Other assets                              |  |   | 414    |  
|In-process research and development       |  |   | 1,326  |  
|Goodwill                                  |  |   | 25,001 |  
|                                          |  |   |        |  
|                                          |  |   | 74,832 |  
|                                          |  |   |        |  
|Deferred stock based compensation         |  |   | 2,085  |  
|                                          |  |   |        |  
|Liabilities acquired:                     |  |   |        |  
|Accounts payable and accrued liabilities  |  |   | (6,796 | )
|Restructuring accrual                     |  |   | (800   | )
|Deferred revenue                          |  |   | (2,286 | )
|                                          |  |   |        |  
|                                          |  |   | (9,882 | )
|                                          |  |   |        |  
|Total consideration                       |  | $ | 67,035 |  
|                                          |  |   |        |  



Goodwill of $25.0
million, representing the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired in the merger, will not be amortized, 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 |        | EstimatedWeighed AverageUseful Lives in Years
|Core/developed technology             |  | $             | 5,412  |                                               | 4.00
|Customer installed-base relationships |  |               | 2,605  |                                               | 6.00
|Customer hosted relationships         |  |               | 1,014  |                                               | 5.00
|Customer contract relationships       |  |               | 2,225  |                                               | 1.00
|                                      |  |               |        |                                               |     
|                                      |  | $             | 11,256 |                                               | 3.96
|                                      |  |               |        |                                               |     



SumTotal Systems
assigned $1.3 million to acquired in-process research and development (IPR&D) that had not yet reached technological feasibility and had no alternative future use. SumTotal Systems wrote off these assets at the date of acquisition in
accordance with FIN No. 4, Applicability of FASB No. 2, Business Combinations Accounted for by the Purchase Method. To estimate the value of the IPR&D, the expected cash flows attributed to the completed portion of the IPR&D were
calculated. These cash flows considered the contribution of the core/developed technology, the risks related to the development of the IPR&D and the percent complete as of the valuation date as well as the expected life cycle of the technology.
Finally, the cash flows attributed to the completed portion of the IPR&D, net of the core/developed technology contribution, were discounted to the present value to estimate the value of the IPR&D.



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



12



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



The following unaudited pro forma information represents the results of operations for SumTotal
Systems and Docent for the nine-months ended September 30, 2004 and 2003, as if the acquisition had been consummated as of January 1, 2004 and January 1, 2003, respectively. The Docent results of operations include the period of January 1, 2004 to
March 18, 2004. The deferred revenue allocation at closing had the effect of reducing the amount of revenue the combined company would recognize in periods subsequent to the merger compared to the amount of revenue Docent would have recognized in
the same period absent the transaction. Excluded from pro forma revenue is $0 and $0.4 million for the three-months ended September 30, 2004 and 2003, respectively for Docent. Excluded from pro forma revenue is $3.8 million and $4.2 million for the
nine-months ended September 30, 2004 and 2003, respectively for Docent. The pro forma net loss excludes amortization of intangible assets of $0 and $0.2 million for the three-months ended September 30, 2004 and 2003, respectively for Docent. The pro
forma net loss excludes amortization of intangible assets of $0.2 million and $0.7 million for the nine-months ended September 30, 2004 and 2003 for Docent. The Docent intangible assets were eliminated at the time of the merger. The pro forma net
loss for the nine-months ended September 30, 2004 includes the IPR&D assets written-off at the date of acquisition. This pro forma information does not purport to be indicative of what may occur in the future (in thousands, except per share
amounts):



|                                                              |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                              |  | Three-Months EndedSeptember 30, |        |   | Nine-Months EndedSeptember 30, |  
|                                                              |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003    |  
|Total revenue                                                 |  | $                               | 15,287 |   |                                | $ | 14,120 |      |  | $ | 38,421  |   |  | $ | 41,190  |  
|                                                              |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss                                                      |  | $                               | (2,218 | ) |                                | $ | (4,242 | )    |  | $ | (22,877 | ) |  | $ | (14,844 | )
|                                                              |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share, basic and diluted                         |  | $                               | (0.11  | ) |                                | $ | (0.21  | )    |  | $ | (1.12   | ) |  | $ | (0.80   | )
|                                                              |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Weighted average common shares outstanding, basic and diluted |  |                                 | 20,535 |   |                                |   | 20,109 |      |  |   | 20,351  |   |  |   | 18,585  |  
|                                                              |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  



Goodwill and other
intangibles are as follows (in thousands):



|                                      |  |                      |        |                         |   |        |                    |  |   |       
|------------------------------------- |  | -------------------- | ------ | ----------------------- | - | ------ | ------------------ |  | - | ------
|                                      |  | September 30, 2004  
|                                      |  | GrossCarrying Amount |        | AccumulatedAmortization |   |        | NetCarrying Amount
|Goodwill                              |  | $                    | 28,311 |                         | $ | (433   | )                  |  | $ | 27,878
|                                      |  |                      |        |                         |   |        |                    |  |   |       
|Intangible assets:                    |  |                      |        |                         |   |        |                    |  |   |       
|Acquired technology                   |  | $                    | 9,652  |                         | $ | (3,458 | )                  |  | $ | 6,194 
|Customer installed-base relationships |  |                      | 3,054  |                         |   | (311   | )                  |  |   | 2,743 
|Customer hosted relationships         |  |                      | 1,014  |                         |   | (108   | )                  |  |   | 906   
|Customer contract relationships       |  |                      | 2,225  |                         |   | (1,190 | )                  |  |   | 1,035 
|                                      |  |                      |        |                         |   |        |                    |  |   |       
|                                      |  | $                    | 15,945 |                         | $ | (5,067 | )                  |  | $ | 10,878
|                                      |  |                      |        |                         |   |        |                    |  |   |       



The change in the
gross goodwill carrying amount from December 31, 2003 to September 30, 2004 represents the addition of $25.0 million for the Docent acquisition. The changes in gross intangible assets carrying amounts from December 31, 2003 to September 30, 2004
represent the addition of $11.3 million for the Docent acquisition, the addition of $409,000 for the Docent Asia Pacific acquisition and the addition of $39,000 for the Click2learn Japan KK acquisition.



Expected future amortization expense related to intangible assets is
approximately $1,388,000 for the remainder of fiscal 2004, $3,583,000 in 2005, $2,335,000 in 2006, $2,020,000 in 2007, $965,000 in 2008, $494,000 in 2009 and $93,000 in 2010.



13



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



NOTE 4: ASSET PURCHASE AGREEMENTS



During the three-months ended September 30, 2004, SumTotal Systems acquired the assets and certain liabilities of two
foreign distributors and settled all disputes regarding exclusive sales agreements in both regions. Formerly, these distributors were in markets where SumTotal Systems had more than one exclusive distributor resulting from the merger of Click2learn
and Docent.



On July 12, 2004, SumTotal Systems purchased the
remaining 80.1 percent share of Docent Asia Pacific Pty Ltd. of Sydney, Australia. Docent Asia Pacific Pty. Ltd. had been accounted for using the equity method of accounting. On the same date, SumTotal Systems also entered into an agreement with
Impart Corporation Pty Ltd., a sub-distributor for Docent Asia Pacific Pty Ltd to continue to represent SumTotal Systems in selected accounts until April 2005 and to settle all outstanding claims. The total consideration for these transactions was
$550,000 in cash and was allocated to the consideration received, including identifiable intangible assets, based on their respective fair values at the acquisition date. The $104,000 attributed to the distributor settlement is included in sales and
marketing expense for the three and nine-months ended September 30, 2004.



The portions of the purchase price allocated to customer contracts, $261,000, and customer relationships, $148,000, are included in intangible assets on the condensed consolidated balance sheet and are being amortized
on a straight-line basis over periods of ten months and five years, respectively.



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



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



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. The line of credit
balance was $3.5 million at December 31, 2003.



NOTE 6: RESTRUCTURING



The fiscal 2004 merger of Click2learn and Docent, forming
SumTotal Systems, caused excess facilities and redundant employee positions. A restructuring charge was recognized for the cost to exit activities of Click2learn.



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 employees. 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 in force of three service and maintenance employees and one sales and marketing employee. Facility costs represent the closure of a facility in Framingham, Massachusetts and the partial closure of a facility in Bellevue,
Washington and include the fair value of payments required under the lease contract, less estimated sublease income. To determine the expected sublease income, certain estimates were made related to the time period over which the building would
remain vacant, sublease terms and sublease rates. The lease loss is an estimate and will be adjusted in the future upon changes in estimates of time to sublease and actual sublease rates.



14



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##### Table of Contents

SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



The following table depicts the 2004 restructuring activity (in thousands):



|                   |  |           |       |                  |   |      |                              |  |   |    
|------------------ |  | --------- | ----- | ---------------- | - | ---- | ---------------------------- |  | - | ---
|                   |  | Additions |       | CashExpenditures |   |      | Balance at September 30,2004
|Vacated facilities |  | $         | 327   |                  | $ | (76  | )                            |  | $ | 251
|Employee severance |  |           | 810   |                  |   | (810 | )                            |  |   |   
|                   |  |           |       |                  |   |      |                              |  |   |    
|                   |  | $         | 1,137 |                  | $ | (886 | )                            |  | $ | 251
|                   |  |           |       |                  |   |      |                              |  |   |    



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



$800,000 of the Docent purchase price has been allocated to accrue for a building in Mountain View, California that was
exited in September 2002. The following table depicts this restructuring activity during the nine-months ended September 30, 2004 (in thousands):



|                   |  |           |     |                  |   |      |                              |  |   |    
|------------------ |  | --------- | --- | ---------------- | - | ---- | ---------------------------- |  | - | ---
|                   |  | Additions |     | CashExpenditures |   |      | Balance at September 30,2004
|Vacated facilities |  | $         | 800 |                  | $ | (330 | )                            |  | $ | 470
|                   |  |           |     |                  |   |      |                              |  |   |    
|                   |  | $         | 800 |                  | $ | (330 | )                            |  | $ | 470
|                   |  |           |     |                  |   |      |                              |  |   |    



Accrued amounts for
vacated facilities will be paid over the lease term of the Mountain View, California facility, which ends in May 2005.



NOTE 7: SEGMENT INFORMATION



FASB 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 (in thousands):



|               |  |                                 |        |                                |   |       |  |      |        |  |   |       
|-------------- |  | ------------------------------- | ------ | ------------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|               |  | Three-Months EndedSeptember 30, |        | Nine-Months EndedSeptember 30,
|               |  | 2004                            |        | 2003                           |   | 2004  |  | 2003
|United States  |  | $                               | 10,963 |                                | $ | 6,727 |  | $    | 27,400 |  | $ | 20,732
|Europe         |  |                                 | 3,100  |                                |   | 489   |  |      | 6,646  |  |   | 1,893 
|Other Americas |  |                                 | 627    |                                |   | 51    |  |      | 939    |  |   | 499   
|Asia/Pacific   |  |                                 | 597    |                                |   | 246   |  |      | 1,491  |  |   | 518   
|               |  |                                 |        |                                |   |       |  |      |        |  |   |       
|               |  | $                               | 15,287 |                                | $ | 7,513 |  | $    | 36,476 |  | $ | 23,642
|               |  |                                 |        |                                |   |       |  |      |        |  |   |       



Long-lived assets by
geographic location are as follows (in thousands):



|              |  |                   |        |                  |   |      
|------------- |  | ----------------- | ------ | ---------------- | - | -----
|              |  | September 30,2004 |        | December 31,2003
|United States |  | $                 | 41,453 |                  | $ | 8,340
|Europe        |  |                   | 188    |                  |   | 51   
|India         |  |                   | 377    |                  |   | 258  
|Asia/Pacific  |  |                   | 518    |                  |   |     
|              |  |                   |        |                  |   |      
|              |  | $                 | 42,536 |                  | $ | 8,649
|              |  |                   |        |                  |   |      



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SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



Long-lived assets represent property, plant and equipment, goodwill and other intangible assets, net
of accumulated depreciation and amortization.



One customer
accounted for 13% of SumTotal Systems revenue for the three-months ended September 30, 2004. No customers accounted for more than 10% of SumTotal Systems revenue for the nine-months ended September 30, 2004. One customer accounted for
12% and 15% of SumTotal Systems revenue for the three and nine-months ended September 30, 2003, respectively.



No customers accounted for more than 10% of SumTotal Systems accounts receivable, net of allowance for sales returns and doubtful accounts at
September 30, 2004 and December 31, 2003.



NOTE 8: COMMITMENTS AND
CONTINGENCIES



Contractual obligations at September 30,
2004 are as follows (in thousands):



|                                             |  |                        |       |                |   |          |  |          |       |  |   |    
|-------------------------------------------- |  | ---------------------- | ----- | -------------- | - | -------- |  | -------- | ----- |  | - | ---
|                                             |  | Payments Due by Period
|                                             |  | Total                  |       | Lessthan 1Year |   | 1-3Years |  | 4-5Years
|Operating leases                             |  | $                      | 5,319 |                | $ | 1,975    |  | $        | 3,148 |  | $ | 196
|Accrued restructured facility lease payments |  |                        | 721   |                |   | 587      |  |          | 93    |  |   | 41 
|Software resale and distribution commitment  |  |                        | 679   |                |   | 679      |  |          |      |  |   |   
|                                             |  |                        |       |                |   |          |  |          |       |  |   |    
|                                             |  | $                      | 6,719 |                | $ | 3,241    |  | $        | 3,241 |  | $ | 237
|                                             |  |                        |       |                |   |          |  |          |       |  |   |    



SumTotal Systems has
entered into various arrangements with hosting services vendors and various non-cancelable operating facility lease agreements for its offices throughout the United States and for its international subsidiaries with original lease periods expiring
through 2009. In addition, SumTotal Systems is 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.



In September 2002, Docent entered into an agreement with a third-party software company to resell that companys product through April 2005. Under the agreement, Docent committed to purchase $1.0 million of the
software companys software over the first year of the agreement. In September 2003, Docent amended the agreement to extend the $1.0 million commitment until April 2005. If SumTotal Systems fails to resell $1.0 million of the third-party
companys software by April 2005, the third-party software company will be paid on the remaining unsold balance. SumTotal Systems is currently undertaking efforts to renegotiate this agreement and is evaluating its potential ability and intent
to fulfill this obligation. As of September 30, 2004, $321,000 had been purchased under this agreement.



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 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.



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SUMTOTAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



NOTE 9: GUARANTEES



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 generally does not exceed ninety 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.



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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 nine-months ended September 30, 2004 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 Click2learn Annual Report on Form 10-K for the
year ended December 31, 2003.



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, except as specifically described in this Quarterly Report; statements
about future business operations; marketing statements; industry leadership; internal controls and procedures; statements about our new product, SumTotal 7.0; 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. 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 products and services to customers across a broad range of industries including financial services, accounting, healthcare, insurance, technology, manufacturing,
telecommunications, transportation, utilities, government and education.



During the three-months ended September 30, 2004, the incoming license and large service engagement deals were forty-two compared to forty in the prior quarter. However, the deals were more heavily weighted to
services engagements with less large license deals booked in the quarter, which resulted in an average selling price of $210,000, as compared to $285,000 in the previous quarter. We believe this may, in part, be the result of customers and prospects
delaying license purchase decisions until our new product SumTotal 7.0 is released, which is planned for the fourth quarter.



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For the three-months ended September 30, 2004, we experienced an increase in our total net revenues of
approximately 9% or $1.2 million, as compared to the three-months ended June 30, 2004. The increase in net revenue was the result of additional services revenue as we completed and obtained acceptance on a number of services engagements and also
recorded additional maintenance revenue as more of the Docent installed customer-base renewed maintenance contracts with SumTotal Systems. These increases in services revenue of $1.5 million were partially offset by a small decline in license
revenue, which we believe is the result of customers delaying purchasing decisions until SumTotal 7.0 is released later in 2004. Revenue increased 104% or $7.8 million, as compared to the three-months ended September 30, 2003. This was primarily the
result of the Docent acquisition on March 18, 2004. The Docent revenue for the three-months ended September 30, 2003 was $7.0 million.



Gross margins improved to 59% in the three-months ended September 30, 2004, as compared to 54% in the three-months ended June 30, 2004 and 52% in the
three-months ended March 31, 2004. This is the result of our achieving synergies and productivity improvements following the acquisition of Docent. Gross margin in the three-months ended September 30, 2003 was 62%. The increase in expenses for
amortization of intangible assets as a result of the acquisition has the effect of reducing the gross margin percentage by 10%.



As a result of the increase in revenue, improved gross margins, as well as operating and other expenses being favorable as compared to the prior quarter,
the net loss for the three-months ended September 30, 2004 was reduced to $2.2 million, as compared to $4.1 million for the three-months ended June 30, 2004. The net loss for the three-months ended September 30, 2003 was $1.4 million.



We ended the quarter with $35.5 million in cash, cash equivalents and
short-term investments, as compared to $12.9 million at December 31, 2003, $34.8 million at March 31, 2004 and $37.1 million at June 30, 2004. We believe that this cash balance, together with the revenue we expect to generate, will be adequate to
fund operations for at least the next twelve months.



Critical Accounting
Policies and Estimates



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 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; and
| | - | -----------------------------------



| |  | restructuring.
| | - | --------------



We have had no significant changes in our critical accounting policies and estimates since our previous filing on Form 10-Q, as filed with the SEC on
August 12, 2004.



Results of Operations



Revenue



For the three-months ended September 30, 2004, total revenue increased 104% to $15.3 million, as compared to $7.5 million
for the three-months ended September 30, 2003. For the nine-months ended September 30, 2004, total revenue increased 55% to $36.5 million, as compared to $23.6 million for the nine-months ended September 30, 2003. The increases in revenue are
attributed to the addition of the Docent software platform and customer installed-base on March 18, 2004 resulting from the acquisition of Docent.



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For the three-months ended September 30, 2004, revenue from our foreign subsidiaries increased 438% to
$4.3 million, as compared to $0.8 million for the three-months ended September 30, 2003, and accounted for approximately 28% of total revenue. For the nine-months ended September 30, 2004 and 2003, revenue from our foreign subsidiaries increased
214% to $9.1 million, as compared to $2.9 million for the nine-months ended September 30, 2003, and accounted for approximately 25% of total revenue. The increases in international revenue are primarily attributed to a greater international presence
resulting from the acquisition of Docent.



License
Revenue. For the three-months ended September 30, 2004, license revenue increased 115% to $5.6 million, as compared to $2.6 million for the three-months ended September 30, 2003. Approximately $2.6 million of the additional license revenue
was from sales of the Docent software platform and approximately $0.4 million was from the sales of the Click2learn software platform. Price changes in per license seat prices had approximately a favorable 10% effect on the license revenues for the
three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003.



For the nine-months ended September 30, 2004, license revenue increased 82% to $13.8 million, as compared to $7.6 million for the nine-months ended
September 30, 2003. Approximately $5.4 million of the additional license revenue was from sales of the Docent software platform and approximately $0.8 million was from the sales of the Click2learn software platform. Price changes in per license seat
prices had approximately a favorable 5% effect on the license revenues for the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003.



Service and Maintenance Revenue.Service and maintenance revenue for the three and nine-months ended September
30, 2004 and 2003 consisted of the following (in thousands):



|                             |  |                                 |       |                                |   |       |  |      |        |  |   |       
|---------------------------- |  | ------------------------------- | ----- | ------------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|                             |  | Three-Months EndedSeptember 30, |       | Nine-Months EndedSeptember 30,
|                             |  | 2004                            |       | 2003                           |   | 2004  |  | 2003
|Maintenance                  |  | $                               | 3,536 |                                | $ | 1,708 |  | $    | 7,800  |  | $ | 4,221 
|Hosting                      |  |                                 | 1,658 |                                |   | 484   |  |      | 4,209  |  |   | 1,555 
|Training                     |  |                                 | 473   |                                |   | 321   |  |      | 1,703  |  |   | 1,130 
|Consulting                   |  |                                 | 3,875 |                                |   | 2,375 |  |      | 8,755  |  |   | 9,167 
|Application service provider |  |                                 | 111   |                                |   |      |  |      | 247    |  |   |      
|                             |  |                                 |       |                                |   |       |  |      |        |  |   |       
|                             |  | $                               | 9,653 |                                | $ | 4,888 |  | $    | 22,714 |  | $ | 16,073
|                             |  |                                 |       |                                |   |       |  |      |        |  |   |       



For the three-months
ended September 30, 2004, service and maintenance revenue increased 98% to $9.7 million, as compared to $4.9 million for the three-months ended September 30, 2003 due to increased sales to existing customers, as well as to new customers. Maintenance
revenue increased 106% to $3.5 million for the three-months ended September 30, 2004, from $1.7 million for the three-months ended September 30, 2003. Approximately $1.8 million of the maintenance revenue increase is due to the addition of the
Docent installed customer-base. Hosting revenue increased 240% to $1.7 million for the three-months ended September 30, 2004, from $0.5 million for the three-months ended September 30, 2003. Approximately $1.0 million and $0.2 million of the hosting
revenue increase is due to the addition of the Docent installed customer-base and increases in the Click2learn installed customer-base, respectively. Training revenue increased 67% to $0.5 million for the three-months ended September 30, 2004, from
$0.3 million for the three-months ended September 30, 2003 due to the addition of the Docent installed customer-base. Consulting revenue increased 63% to $3.9 million for the three-months ended September 30, 2004, from $2.4 million for the
three-months ended September 30, 2003. We recorded an additional $1.6 million of consulting revenue due to the addition of the Docent installed customer-base.



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For the nine-months ended September 30, 2004, service and maintenance revenue increased 41% to $22.7
million, as compared to $16.1 million for the nine-months ended September 30, 2003 due to increased sales to existing customers, as well as to new customers. Maintenance revenue increased 86% to $7.8 million for the nine-months ended September 30,
2004, from $4.2 million for the nine-months ended September 30, 2003. Approximately $2.4 million and $1.2 million of the maintenance revenue increase is due to the addition of the Docent installed customer-base and increases in the Click2learn
installed customer-base, respectively. Hosting revenue increased 163% to $4.2 million for the nine-months ended September 30, 2004, from $1.6 million for the nine-months ended September 30, 2003. Approximately $2.2 million and $0.4 million of the
hosting revenue increase is due to the addition of the Docent installed customer-base and increases in the Click2learn installed customer-base, respectively. Training revenue increased 55% to $1.7 million for the nine-months ended September 30,
2004, from $1.1 million for the nine-months ended September 30, 2003. Approximately $0.5 million and $0.1 million of the training revenue increase is due to the addition of the Docent customer base and increases in the Click2learn installed
customer-base, respectively. Consulting revenue decreased 5% to $8.8 million for the nine-months ended September 30, 2004, from $9.2 million for the nine-months ended September 30, 2003 due to a $3.3 million decrease in Click2learn customer
installed-base consulting revenue that included $2.2 million in non-recurring consulting and implementation services performed for one customer, offset partially by Docent customer installed-base revenues of $2.9 million.



Price changes in service and maintenance revenue had no material effect on
the three and nine-months ended September 30, 2004, as compared to the three and nine-months ended September 30, 2003.



Cost of Revenue



For the three-months ended September 30, 2004, total cost of revenue increased 117% to $6.3 million, as compared to $2.9 million for the three-months
ended September 30, 2003. For the nine-months ended September 30, 2004, total cost of revenue increased 84% to $16.2 million, as compared to $8.8 million for the nine-months ended September 30, 2003. 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 September 30, 2004, total cost of license revenue increased to $0.2 million, as compared to $0.1 million for the three-months ended September 30, 2003. For the nine-months ended
September 30, 2004 and 2003, total cost of license revenue remained constant at $0.4 million. Our cost of license revenue includes the cost of third-party software and content we resell and the cost of manuals, production media and shipping costs.



Cost of Service and Maintenance.For the
three-months ended September 30, 2004, total cost of service and maintenance revenue increased 92% to $4.6 million, as compared to $2.4 million for the three months ended September 30, 2003. The increase is due to the addition of thirty-four Docent
service and maintenance personnel following the merger with Docent on March 18, 2004. For the three-months ended September 30, 2004, costs relating to service maintenance personnel increased 55% to $3.4 million, as compared to $2.2 million for the
three-months ended September 30, 2003. In addition, we incurred expenses of $0.6 million associated with providing hosting services for the Docent customer installed-base and $0.4 million for additional implementation third-party consulting costs
associated with Docent product implementations in Europe.



Gross margin remained constant for service and maintenance, increasing from 51% in the three-months ended September 30, 2003 to 52% in the three-months ended September 30, 2004.



For the nine-months ended September 30, 2004, total cost of service and maintenance revenue increased 65% to $12.4 million,
as compared to $7.5 million for nine-months ended September 30, 2003. The increase is due to the addition of an average of thirty-six Docent service and maintenance personnel following the merger with Docent on March 18, 2004. For the nine-months
ended September 30, 2004, costs relating to service maintenance personnel increased 50% to $10.5 million, as compared to $7.0 million for the nine-months ended September 30, 2003. In addition, we incurred an additional $0.8 million for costs
associated with providing hosting services for the Docent customer installed-base and $0.4 million for additional implementation third-party consulting costs associated with Docent product implementations in Europe.



Gross margin for service and maintenance decreased from 53% in the
nine-months ended September 30, 2003 to 46% in the nine-months ended September 30, 2004, primarily due to the addition of an average of thirty-six Docent service and maintenance personnel following the merger with Docent on March 18, 2004 and due to
approximately $2.9 million of service and maintenance deals in the nine-months ended September 30, 2004 which we could not record as revenue due to merger accounting principles.



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



We expect improvements in gross margin for service and maintenance as maintenance renewal contracts are signed for the Docent maintenance installed
customer-base.



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 and $0.7 million for the three and nine-months ended September 30, 2004, respectively.



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 indication of 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 estimated future cash flows to be generated by these businesses. We amortized intangible assets by $1.5 million and $3.4 million in the three and nine-months ended September 30,
2004, respectively.



For the three-months ended September 30,
2004, amortization of intangibles increased 275% to $1.5 million, as compared to $0.4 million for the three-months ended September 30, 2003. The increase for the three-months ended September 30, 2004 is due to $1.1 million of amortization associated
with the intangible assets acquired as a result of the merger with Docent and the asset purchase agreements with distributors in Japan and Australia.



For the nine-months ended September 30, 2004 amortization of intangibles increased 325% to $3.4 million, as compared to $0.8 million for the nine-months
ended September 30, 2003. The increase for the nine-months ended September 30, 2004 is due to $0.3 million of amortization associated with our Virtual Classroom Server product and $2.3 million of amortization associated with the intangible assets
acquired as a result of the merger with Docent and the asset purchase agreements with distributors in Japan and Australia.



Operating Expenses



Research and Development.For the three-months ended September 30, 2004, total research and development cost increased 81% to $2.9 million,
as compared to $1.6 million for three-months ended September 30, 2003. Expenses relating to research and development personnel for the three-months ended September 30, 2004 increased 67% to $2.5 million, as compared to $1.5 million for the
three-months ended September 30, 2003. 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 three-months ended September 30, 2004 increased to $0.3 million, as compared to $0.1 million for the three-months ended September 30, 2003. Additional consultants were needed to support work on upcoming releases of our product platform.



For the nine-months ended September 30, 2004 total research
and development cost increased 86% to $8.2 million, as compared to $4.4 million for the nine-months ended September 30, 2003. Expenses relating to research and development personnel for the nine-months ended September 30, 2004 increased 65% to $7.1
million, as compared to $4.3 million for the nine-months ended September 30, 2003. The increase is due to the addition of an average of forty Docent research and development personnel on March 18, 2004 resulting from the acquisition of Docent and
additional external consultants. Consulting expenses for the nine-months ended September 30, 2004 increased to $1.0 million, as compared to $0.1 million for the nine-months ended September 30, 2003. Additional consultants were needed to support work
on upcoming releases of our product platform.



We expect
research and development expenses to increase slightly in the three-months ended December 31, 2004 as a result of additional consulting services to complete SumTotal 7.0.



Sales and Marketing.For the three-months ended September 30, 2004, total sales and marketing cost increased
90% to $5.5 million, as compared to $2.9 million for the three-months ended September 30, 2003. Expenses relating to sales and marketing personnel for the three-months ended September 30, 2004 increased 96% to $4.9 million, as compared to $2.5
million for the three-months ended September 30, 2003. The increase is due to an additional twenty-three Docent sales and marketing personnel on March 18, 2004 resulting from the acquisition of Docent, resulting in increased expenses of $2.4
million.



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For the nine-months ended September 30, 2004, total sales and marketing cost increased 71% to $15.6
million, as compared to $9.1 million for the nine-months ended September 30, 2003. Expenses relating to sales and marketing personnel for the three-months ended September 30, 2004 increased 67% to $13.5 million, as compared to $8.1 million for the
three-months ended September 30, 2003. The increase is a result of $5.4 million for increased sales and marketing personnel due to the addition of twenty-three Docent sales and marketing personnel on March 18, 2004 resulting from the acquisition of
Docent, $0.5 million for additional marketing activity due to the launch of SumTotal Systems, and $0.4 million for the loss on disposal or abandonment of property and equipment, consisting of internal use sales management software used by
Click2learn in favor of the sales management software used by Docent.



We expect sales and marketing expenses to increase in the three-months ended December 31, 2004 as a result of marketing expenses for the launch of SumTotal 7.0 as well as additional sales commissions.



General and Administrative.For the three-months ended
September 30, 2004, total general and administrative cost increased 93% to $2.9 million, as compared to $1.5 million for the three-months ended September 30, 2003. Expenses relating to general and administrative personnel for the three-months ended
September 30, 2004 increased 46% to $1.9 million, as compared to $1.3 million for the three-months ended September 30, 2003. The increase is a result of $0.5 million for the addition of nineteen Docent general and administrative personnel on March
18, 2004 resulting from the acquisition of Docent. In addition, we incurred $0.4 million in accounting expenses associated with compliance with Section 404 of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Section 404) and $0.4 million
in legal expenses associated with post-merger activities and other legal matters.



For the nine-months ended September 30, 2004, total general and administrative cost increased 86% to $7.8 million, as compared to $4.2 million for the nine-months ended September 30, 2003. Expenses relating to general
and administrative personnel for the nine-months ended September 30, 2004 increased 50% to $5.7 million, as compared to $3.8 million for the nine-months ended September 30, 2003. The increase is a result of $1.9 million for the addition of an
average of twenty-five Docent general and administrative personnel on March 18, 2004 resulting from the acquisition of Docent. In addition, we incurred $0.7 million in stock-based compensation, including $0.5 million in stock-based compensation
related to the acceleration of stock options to certain employees, $0.6 million associated with post-merger activities and other legal matters and $0.4 million in accounting expenses associated with compliance with Sarbanes-Oxley Section 404.



We expect general and administrative expenses to increase
slightly on a quarterly basis through the end of fiscal 2004 due primarily to Sarbanes-Oxley Section 404 certification procedures and litigation expenses.



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, less estimated 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, less estimated 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 to estimate the value of the IPR&D.



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Stock-Based Compensation.For the three and nine-months ended September 30, 2004,
stock-based compensation expense relating to common stock options was $274,000 and $1,119,000, respectively. There was no stock-based compensation for the three and nine-months ended September 30, 2003. Stock-based compensation expense is allocated
based on the function of employees. Stock-based compensation expense relating to common stock options issued to former Docent employees was $274,000 and $595,000 for the three and nine-months ended September 30, 2004, respectively. 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. In the nine-months ended September 30, 2004, we recognized $291,000 as a result of accelerated options
vesting to certain employees and $233,000 as a result of increasing the amount of shares available for purchase in the SumTotal Employee Stock Purchase Plan as a result of the acquisition of Docent. There was no stock-based compensation as a result
of accelerated options vesting to certain employees or increasing the amount of shares available for purchase in the SumTotal Employee Stock Purchase Plan as a result of the acquisition of Docent for the three-months ended September 30, 2003.



Interest Expense.For the three-months ended
September 30, 2004, interest expense decreased to $0, as compared to $27,000 for the three-months ended September 30, 2003. For the nine-months ended September 30, 2004, interest expense decreased to $121,000, as compared to $122,000 for the
nine-months ended September 30, 2003. 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 September 30, 2004, interest income increased 410% to $97,000, as compared to $19,000 for the
three-months ended September 30, 2003. For the nine-months ended September 30, 2004, interest expense increased 866% to $203,000, as compared to $21,000 for the nine-months ended September 30, 2003. 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 sales of common stock.



Other Income (Expenses), net.For the three-months ended September 30, 2004, other income was $9,000, as
compared to $0 for the three-months ended September 30, 2003.



For the nine-months ended September 30, 2004, other expense increased to $349,000, as compared to $0 for the nine-months ended September 30, 2003. The increase was primarily due to $340,000 in foreign exchange losses.



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
ownership portion of the joint ventures net income or loss. For the three-months ended September 30, 2004, our equity in losses of an affiliate decreased to $0, as compared to $25,000 for the three-months ended September 30, 2003. For the
nine-months ended September 30, 2004, our equity in losses of an affiliate were $169,000, compared to $75,000 for the nine-months ended September 30, 2003. 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 not have any future equity related expenses relating to the losses of this company.



Foreign and State Income Taxes.For the
three-months ended September 30, 2004, we recorded an income tax benefit of $47,000 related to foreign and state income taxes, as compared to an expense of $8,000 for the three-months ended September 30, 2003. For the nine-months ended September 30,
2004, we recorded income tax expense of $29,000 related to foreign and state income taxes, as compared to $26,000 for the nine-months ended September 30, 2003. The decreases are due to transfer pricing structures that were placed into service in
certain foreign subsidiaries.



Liquidity and Capital Resources



At September 30, 2004, our principal sources of liquidity
were our $35.4 million of cash and cash equivalents and $12.1 million of net accounts receivable, up from $12.9 million of cash and $10.4 million of net accounts receivable on December 31, 2003, respectively. The change in cash is due primarily to
the cash acquired in the acquisition, net of payments, of $25.4 million from the merger with Docent.



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We currently anticipate 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 twelve months. However, we will continue to monitor our cash and liquidity and will seek
additional financing or make additional expense reductions if it becomes required. Our future liquidity and capital requirements will depend on numerous factors, including our future revenues, the timing and extent of spending to support product
development efforts and expansion of sales and marketing and general and administrative activities, the success of our existing and new product and service offerings and competing technological and market developments. There can be no assurance that
additional funding, if needed, will be available on terms acceptable to us, if at all.



Net cash provided by operating activities was $0.4 million for the nine-months ended September 30, 2004. The cash provided during the period was due to net collection of receivables of $6.4 million, primarily due to
the acquisition of $5.8 million of Docent accounts receivable on March 18, 2004, a $2.5 million increase in deferred revenue due to additional bookings during the period, a $1.1 million decrease in other long-term assets, a $0.3 million decrease in
prepaid expenses and other current assets and non-cash activities consisting of $3.4 million for the amortization of intangible assets, a $1.3 million write-off of IPR&D that had not yet reached technological feasibility and had no alternative
future use, $1.1 million for stock-based compensation, $1.2 million for depreciation and amortization of property and equipment, $0.4 million for a loss on the disposal of property and equipment, $0.2 million for equity losses from affiliate, $0.1
million for amortization of discount on debt, offset by a net loss of $14.1 million, a $2.7 million decrease in accrued liabilities, a $0.4 million decrease in accounts payable and non-cash activities consisting of a $0.2 million decrease for
provision for sales returns and doubtful accounts.



Net cash
used in operating activities was $0.7 million for the nine-months ended September 30, 2003 due to cash provided by the net change in certain operating assets of $0.4 million and non-cash activities of $1.1 million for depreciation and amortization,
$0.1 million for amortization of discount on debt, $0.8 million for amortization of intangibles and $0.1 million for equity losses from affiliate, offset by a net loss of $3.1 million and $0.1 million for provision for returns and doubtful accounts.



Cash provided by investing activities was $24.7 million for
the nine-months ended September 30, 2004 due to the $25.4 million of cash acquired, net of payments, associated with the Docent merger and $0.5 million in net sales of short-term investments, offset by $0.7 million in purchases of equipment and $0.5
million in cash used for our asset purchase agreements with distributors in Japan and Australia.



Net cash used in investing activities was $0.7 million for the nine-months ended September 30, 2003, primarily due to $0.6 million used for purchases of
equipment.



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



Cash provided by financing activities was $12.6 million for the nine-months ended September 30, 2003, resulting from $12.3 million in proceeds from the
issuance of common stock and $0.3 million in net borrowings on our line of credit.



At September 30, 2004, our contractual obligations and commercial commitments were as follows (in thousands):



|                                             |  |                        |       |                |   |          |  |          |       |  |   |    
|-------------------------------------------- |  | ---------------------- | ----- | -------------- | - | -------- |  | -------- | ----- |  | - | ---
|                                             |  | Payments Due by Period
|                                             |  | Total                  |       | Lessthan 1Year |   | 1-3Years |  | 4-5Years
|Operating leases                             |  | $                      | 5,319 |                | $ | 1,975    |  | $        | 3,148 |  | $ | 196
|Accrued restructured facility lease payments |  |                        | 721   |                |   | 587      |  |          | 93    |  |   | 41 
|Software resale and distribution commitment  |  |                        | 679   |                |   | 679      |  |          |      |  |   |   
|                                             |  |                        |       |                |   |          |  |          |       |  |   |    
|                                             |  | $                      | 6,719 |                | $ | 3,241    |  | $        | 3,241 |  | $ | 237
|                                             |  |                        |       |                |   |          |  |          |       |  |   |    



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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 2009. 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.



In September 2002, Docent entered into an agreement with a third-party
software company to resell that companys product through April 2005. Under the agreement, Docent committed to purchase $1.0 million of the software companys software over the first year of the agreement. In September 2003, Docent amended
the agreement to extend the $1.0 million commitment until April 2005. If we fail to resell $1.0 million of the third-party companys software by April 2005, the third-party software company will be paid on the remaining unsold balance. We are
currently undertaking efforts to renegotiate this agreement and are evaluating our potential ability and intent to fulfill this obligation. As of September 30, 2004, $321,000 had been purchased under this agreement.



Recent Accounting Pronouncements



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 03-1-1, which delays the effective date until additional
guidance is issued for the application of the recognition and measurement provisions of EITF 03-01 to investments in securities that are impaired. The adoption of EITF No. 03-01 is not expected to have a material affect on our results of operations
and financial condition.



In March 2004, the FASB issued a
proposed Statement, Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity
instruments of the company or liabilities that are based on the fair value of the companys equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for
share-based compensation transactions using the intrinsic method that we currently use and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expense in the consolidated statement of
operations. The effective date of the proposed standard is for periods beginning after June 15, 2005. It is expected that the final standard will be issued before December 31, 2004 and should it be finalized in its current form, it will have a
significant impact on the consolidated statement of operations as we will be required to expense the fair value of our stock option grants and stock purchases under our employee stock purchase plan.



Factors That May Affect Future Results of Operations



Set forth below and elsewhere in this report 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.



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 Aspen Learning Management
Server and Aspen Learning Content Management Server, Docent Learning Management Server and Docent Learning Content Management System (collectively, SumTotal Systems Suite), and providing related services, which we do not expect to be
sufficient to achieve GAAP profitability. Commencing at the end of the fourth quarter 2004 and beginning of the first quarter 2005, we will be transitioning from our SumTotal Systems Suite to our new product offerings, primarily our new business
performance and learning technology software suite, SumTotal 7.0, and services related to these offerings (collectively, SumTotal 7.0). If we fail to generate adequate revenues from the SumTotal Systems Suite or our new products, 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. 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, either in the quarter ended December 31, 2004 or future quarters.
Failure to meet or exceed our forecasts or industry analysts projections could cause the price of our common stock to decline.



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



Prior to the merger transaction that formed SumTotal Systems, both Docent
and Click2learn experienced substantial fluctuations in operating results, on a quarterly and annual basis. We have experienced these fluctuations since the merger, and we 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 both the SumTotal Systems Suite and SumTotal 7.0;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



| |  | the market acceptance of our products and services;
| | - | ---------------------------------------------------



| |  | the ability to develop and market new or enhanced products and services in a timely manner and the market acceptance of these products and services;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | recognition of impairment of existing assets.
| | - | ---------------------------------------------



We believe that quarter-to-quarter comparisons of the historical financial results of Docent and Click2learn are not necessarily meaningful indicators of
our future operating results, and you should not rely on them as an indication of our future performance. If our quarterly operating results fail to meet our forecasts or the expectations of analysts, the price of our common stock could decline.



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



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



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



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



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



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



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



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



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



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



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



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



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



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



Our common stock has declined from $8.00 per share on March 18, 2004 when the acquisition of Docent was completed to $5.71
per share on November 11, 2004, providing us a total market capitalization of approximately $117.9 million. The carrying value of our goodwill and intangible assets on September 30, 2004 was $27.9 million and $10.9 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 fail to successfully develop and introduce SumTotal
7.0 on a timely basis.



SumTotal 7.0, our new product, is
very complex and has required, and will continue to require, the expenditure of significant resources from all areas of our Company. In order to successfully develop and launch 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. Numerous events may occur, including engineering delays, or
unexpected defects, bugs or errors, which may cause us to delay the launch of our new product beyond our expected launch date, the fourth quarter of fiscal year 2004. If we fail to successfully develop and introduce SumTotal 7.0 on a timely basis,
our business results may be adversely affected, including customers losing confidence in our company and thereby delaying their buying decisions further or electing to purchase software from our competitors, each of which may cause a decline in the
price of our common stock.



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Customers may delay purchasing decisions as a result of our new product release, SumTotal 7.0, anticipated at the end
of fiscal year 2004.



As we plan to introduce our new
business solution and learning technology software product, SumTotal 7.0, at the end of fiscal year 2004, we must manage the transition between our new product offering and our older products.



We must successfully manage the transition from our legacy products in order
to minimize a material reduction in closing sales contracts for the current SumTotal Suite products, as customers wait for the SumTotal 7.0 release and for us to provide sufficient assurance that SumTotal 7.0 provides customers the requisite
functionality, that the level of defects, bugs and errors in SumTotal 7.0 is acceptable, and that the product is sufficiently operational. When we introduce SumTotal 7.0 and subsequent product enhancements, we face numerous risks relating to product
transitions, including the inability 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 otherwise
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. 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.



Any failure to meet investor expectations for a given quarter as a result of delayed customer decisions, reduced order sizes or failed sales efforts would
likely cause a decline in the price of our common stock.



Our business and
results of operations are likely to be affected by the formation of SumTotal Systems based on the merger of Docent and Click2learn.



We believe the merger transaction between Docent and Click2learn that resulted in the formation of SumTotal Systems has had, and may continue to have, an
adverse effect on our revenue in future quarters as customers may delay, defer or cancel purchases due to potential uncertainty about the direction of SumTotal Systems product offerings and its support and service of existing products
following the merger. Decreased revenue could have a variety of adverse effects, including negative consequences to our relationships with, and ongoing obligations to, customers, suppliers, alliance partners, business partners, and others with whom
we have business relationships. In addition, our quarterly operating results and revenue could be substantially below the expectations of our forecasts or market analysts forecasts, which would likely cause a decline in the price of our common
stock.



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We may not achieve the benefits expected from the merger transaction which resulted in the formation of our new
company, SumTotal Systems, including increased revenues and reduced expenses, which may have a material adverse effect on our business and could result in loss of key personnel.



Achieving the benefits expected from the merger transaction between Docent and Click2learn that resulted in the formation of
SumTotal Systems continues to depend, in part, on the successful integration of technology, operations, engineering efforts and personnel, including sales personnel. The integration of Docent and Click2learn has been, and will continue to be, a
complex, time-consuming and expensive process and may disrupt our business if not carried out in a timely and efficient manner. The continuing challenges involved in this integration include:



| |  | retaining existing customers and strategic partners of each company;
| | - | --------------------------------------------------------------------



| |  | integrating and retaining our engineering teams in Bellevue, Washington, Mountain View, California, and Hyderabad, India;
| | - | -------------------------------------------------------------------------------------------------------------------------



| |  | retaining and integrating management and other key employees of our new company;
| | - | --------------------------------------------------------------------------------



| |  | coordinating research and development activities, both in the United States and in our expanding Indian engineering offices, to enhance customer support; develop bug fixes, upgrades
and updates; and develop new product offerings and technologies;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | integrating purchasing and procurement operations in multiple locations;
| | - | ------------------------------------------------------------------------



| |  | integrating worldwide legal, finance and other operational and administrative functions, including sales and contract execution operations;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------



| |  | combining product offerings and product lines effectively and quickly, and successfully marketing such products to our existing and future customer base;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | integrating sales efforts so that customers can easily conduct business with us;
| | - | --------------------------------------------------------------------------------



| |  | integrating sales operations on a worldwide basis in a rapid and efficient manner and ensuring compliance with our contract execution processes and internal controls and procedures;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | integrating engineering efforts to provide updates, upgrades and bug fixes for our existing products and for development of new products;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------



| |  | transitioning all facilities to a common information technology system;
| | - | -----------------------------------------------------------------------



| |  | offering the products and services of Docent and Click2learn to each others customers;
| | - | ---------------------------------------------------------------------------------------



| |  | coordinating marketing efforts; and
| | - | -----------------------------------



| |  | developing and maintaining uniform standards, controls, procedures, and policies.
| | - | ---------------------------------------------------------------------------------



We may not succeed in addressing these risks or any other problems encountered in connection with the merger transaction,
and the failure to successfully and timely integrate will have a negative impact on our operations, resulting in failing to meet our forecasts or market analysts forecasts, which could cause a decline in the price of our common stock.



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The failure to successfully develop and implement in a timely fashion internal contract execution controls and
procedures could impact our ability to recognize revenue in future quarters.



In connection with its review of our condensed consolidated financial statements for the quarter ended March 31, 2004, KPMG, LLP, our auditors (KPMG), noted in a letter to the Audit Committee of our Board
of Directors that we had a material weakness in our internal controls and procedures in our European operations under standards established by the AICPA. During its review, KPMG noted that license revenue aggregating approximately $1.2 million had
been recognized within our unadjusted trial balance on two transactions originating within our European operations in which, although the contracts governing the transactions were signed by the customers and the software licensed in the transactions
was delivered by March 31, 2004, the contracts were not countersigned by us by March 31, 2004. As a result, we had to adjust our financial statements prior to the announcement of our earnings for the three-months ended March 31, 2004. During the
quarters ended June 30, 2004 and September 30, 2004, we implemented and maintained a number of additional controls and procedures to help ensure that we countersign contracts in a timely fashion, and that we have documentary evidence that we have
done so. We believe that these actions, in conjunction with our standard controls and procedures, sufficiently addressed the weakness in our internal controls and procedures raised in KPMGs letter.



There is no assurance, however, that in the future, additional material
weaknesses will not arise in our internal controls or procedures related to our European operations or elsewhere that would result in our needing to delay the recognition of certain revenue and adjust our financial statements. The implementation of
these additional internal controls and procedures will require management resources and time, and failure to successfully implement these additional internal controls and procedures in a timely, effective and efficient manner, or the existence of
additional material weaknesses in our internal controls and procedures, could adversely affect our ability to recognize revenue in a timely fashion in future quarters. Failure to recognize revenue in a timely fashion may result in our not meeting
our forecasts or industry analysts projections, and would likely cause a decline in the price of our common stock.



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. Nonetheless, we believe the Company has established and
implemented sufficient controls and procedures to prevent material errors and fraud. Because of the inherent limitations of all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud,
if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls and procedures
can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of a control or procedure. The design of any system of controls and procedures is also based in part on certain assumptions
about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system,
misstatements due to error or fraud may occur and not be detected. In such event, we may not be able to recognize revenue we thought we could; we may not be able to meet our forecasts or industry analysts projections; or we may be the subject
of litigation, each of which would likely result in a decline in the price of our common stock.



In addition, in connection with the attestation process by our independent auditors, we may encounter problems or delays in completing the implementation
of any requested improvements and receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal controls over financial reporting, or if our independent auditors are unable to provide an unqualified attestation
report on our assessment, investor confidence and our stock price could be adversely affected.



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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 and beginning with our Annual Report on Form 10-K for the year ended December 31, 2004 our
management will be required to report on, and our independent auditors to attest to, the effectiveness of our internal controls over financial reporting as of December 31, 2004. 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. We are currently in the process of reviewing, documenting and testing our internal controls over
financial reporting, which has and will likely continue to result in increased expenses and the devotion of significant management and other internal resources. 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, 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. If we are unable to assert that our internal control over financial reporting is effective as of December 31, 2004 (or if our auditors are unable to attest that our managements report is fairly stated
or they are unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on the price of our common
stock.



In addition, rules describing the requirements for our
auditors to be able to attest to our compliance under Section 404 were adopted in June 2004, and we, along with our external service providers, are currently interpreting what qualifies as compliance with Section 404. Because the matter of Section
404 compliance is new, there is no precedent or proven method for such compliance, and our management must exercise significant judgment in our effort to comply with Section 404. As a result, we cannot be certain that we will comply with the
requirements of Section 404 in a timely manner. If we fail to comply in a timely manner, public perception of our internal controls could be damaged, causing our financial results to suffer and the price of our common stock to decline.



Recently enacted and proposed changes in securities laws and regulations are 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 Section 404 of the Sarbanes-Oxley Act, 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.



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.



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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.



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. Our limited operating history with the SumTotal
Systems Suite, and the lack of any operating history with our yet to be released new product, SumTotal 7.0, 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.



Changes in accounting standards or our accounting policy
relating to stock-based compensation may negatively affect our reported 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 date of grant, and in such event, we would record a charge only for the difference between the grant price and the deemed fair value. However, in March 2004, the FASB issued a proposed Statement, Share-Based
Payment, an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities
that are based on the fair value of the companys equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions
using the intrinsic method that we currently use and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expense in the consolidated statement of operations. The effective date of the
proposed standard is for periods beginning after June 15, 2005. It is expected that the final standard will be issued before December 31, 2004 and should it be finalized in its current form, it will have a significant impact on our consolidated
statement of operations as we will be required to expense the fair value of our stock option grants and stock purchases under our employee stock purchase plan. Please see Note 2 of the Condensed Consolidated Financial Statements for a table
displaying the impact to our operating expenses if we were to change our 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 we had adopted SFAS No. 123 for all periods presented.



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



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



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



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



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



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



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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., THINQ Learning Solutions, Inc., International Business Machines Corporation,
Pathlore Software Corporation, SAP AG, Oracle Corporation, Siebel Systems, Inc. and PeopleSoft, 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.



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.



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



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



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



| |  | difficulties and costs of staffing and managing foreign offices;
| | - | ----------------------------------------------------------------



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



| |  | intense 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.
| | - | ----------------------------------------



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If our operations in Hyderabad fail or are hampered, for any reason, our launch of SumTotal 7.0 may be
delayed beyond the end of fiscal year 2004. In addition, if our Indian operations fail, for any reason, to provide adequate and timely product enhancements, updates and fixes to us, our ability to develop our new product offerings and our ability to
respond to customer or competitive demands would be harmed and we would lose sales opportunities and customers. In addition, the loss of research and development personnel associated with this strategy will cause us to lose internal expertise, and
will impact our ability to release our new product, SumTotal 7.0, reducing our ability to respond to these demands independently if the partners fail to perform as required. In the event failures of our engineering operations in India cause a delay
in the release of SumTotal 7.0, or if the product is materially impacted by bugs, errors or defects, our business and financial results may be adversely impacted and could result in a decline in the price of our common stock.



Our reliance on the SumTotal Systems Suite means that a decline in the price of or demand
for the SumTotal Systems Suite could seriously harm our business.



The SumTotal Systems Suite and related services will account for the majority of our revenue in 2004 and, combined with our new product SumTotal 7.0 and related services, are expected to account for a majority of our revenue for the
foreseeable future. Consequently, a decline in the price of or demand for the SumTotal Systems Suite, especially as the marketplace awaits the release of our new product, SumTotal 7.0, or SumTotal 7.0s failure to achieve broad market
acceptance, would seriously harm our business and would likely result in a decline in the price of our common stock.



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



The business performance and learning management software market may not
grow to a sufficient size or at a sufficient rate for our business to succeed. 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
the Docent Enterprise 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, SumTotal 7.0, when 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;
| | - | -----------------------------------------------------------------------------------------------------------



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| |  | 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.
| | - | ----------------------------------------------------------------



Our products and services are subject to warranty claims. Increased warranty claims or returns or extended acceptance terms could harm our business.



We typically offer warranties for products and services for ninety days from
shipment of the products and services, and have allowed an additional warranty period to certain of our customers. Docent historically offered a ninety day limited warranty for all of its products and has allowed an additional warranty period to
certain of its customers. Click2learn typically offered a ninety day limited warranty for all of its products and services and allowed an additional warranty period to certain of its customers. Although Docents and Click2learns
historical return experiences have not been significant, returns or delays in the acceptance of the products and services may increase in the future. Significant returns or delay in acceptance would have an adverse effect on our revenue and could
negatively affect our financial results.



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 United States and therefore subject to risks distinct from those that face United States-based operations.



Conducting business outside of the United States 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;
| | - | ------------------------------



| |  | difficulties in staffing and managing foreign operations;
| | - | ---------------------------------------------------------



| |  | changes in regulatory requirements and tariffs;
| | - | -----------------------------------------------



| |  | difficulties in obtaining import and export licenses;
| | - | -----------------------------------------------------



| |  | political or economic constraints on international trade;
| | - | ---------------------------------------------------------



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



| |  | potentially harmful tax consequences;
| | - | -------------------------------------



| |  | 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.



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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 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 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 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 SumTotal 7.0 and successor products or services, or their failure to achieve broad market acceptance, would seriously harm our business.



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Our products may contain defects, bugs or errors or otherwise perform improperly.



Our products, both current and future, may contain defects, bugs or errors.
Complex enterprise software products frequently contain errors or failures, especially when first introduced or when new versions are released. Because our products, especially our new product, SumTotal 7.0, are complex software packages and contain
new features and functionality, there is a great likelihood, especially with SumTotal 7.0, that the product may contain significant defects, bugs or errors. In addition, since our product offering is targeted at enterprise customers with large
numbers of users, customers and potential customers may have a greater sensitivity to product defects or product integration than the market for software products generally. To date we have experienced errors in both the Aspen and Docent platforms,
in particular when new versions or functionality are first released, although such errors have not had a material impact on our business and generally have been corrected shortly after discovery. Although we have not experienced this to date,
serious product errors could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation, or increased service and warranty costs. In addition, while we believe our new product, SumTotal 7.0,
will not contain material defects, bugs or errors, we cannot be sure that there will not be unknown or unexpected defects, bugs or errors that will materially impact our customers ability to deploy our product. In such event, our revenue may
be impacted, which may cause a decline in the price 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
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.



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 product 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. In addition, most 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.



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Failure to integrate our two primary offices and our engineering efforts may cause our business to suffer.



We intend to maintain primary offices in Mountain View,
California, and Bellevue, Washington, and to have engineering operations in both of these offices, and in Hyderabad, India. If we fail to integrate management, sales, operations, research and development or support functions efficiently between and
among the primary offices, our business could suffer.



Reductions in
workforce may adversely affect the morale and performance of our personnel and our ability to hire new personnel.



In connection with our recent merger and in an effort to streamline operations, reduce costs and redundancies and bring our staffing and cost structure in
line with industry standards, we restructured our organization in the first and second quarters of fiscal year 2004. These efforts included substantial reductions in our workforce. There have been and may continue to be substantial costs associated
with the workforce reductions and other restructuring measures, and our plans may yield unanticipated consequences such as an inability to release our new product, SumTotal 7.0, within the expected timeframe, the end of fiscal year 2004. For
example, many of the employees who were terminated possessed specific knowledge or expertise that may prove to have been important to our operation. Further, shifting certain engineering resources to Hyderabad, India may create confusion,
misunderstandings or other unintended results, thereby causing additional bugs, functional limitations, or delays in the release of SumTotal 7.0. As a result of these staff reductions, realignment of engineering resources and other restructuring
measures, our ability to integrate our operations or to respond to unexpected challenges may be impaired, which may adversely affect our financial results.



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.



Increased complexity of our software may result in more difficult detection
and correction of errors, delays in the introduction of new products and more costly performance and warranty claims.



Our product offerings, like all software programs generally, may contain a number of undetected errors despite internal and third-party testing. Increased
complexity of our software and more sophisticated expectations of customers may result in higher costs to correct such errors and delay the introduction of new products or enhancements in the marketplace. Errors in our software could subject us to
litigation and liability based on performance and/or warranty claims. 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. If a claim against us were to be successful, we might be required to incur significant expense and pay substantial damages. Even if we were to prevail, the accompanying publicity could
adversely impact the demand for our products.



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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 United States against terrorism
and other possible United States military actions may adversely affect our business.



The terrorist attacks that took place in the United States on September 11, 2001, the potential for future terrorist attacks in the United States, the declaration of war by the United States against terrorism, the
military actions in Afghanistan and Iraq and other existing and possible United States 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 United States. In addition, such adverse political events may have an adverse impact on economic conditions in the United States. Unfavorable economic conditions in the United States may have an adverse
effect on our business operations including, but not limited to, our ability to expand the market for our products, obtain financing as needed, enter into strategic relationships and effectively compete in the business performance and learning
management market.



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



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



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



Our intellectual property may become subject to legal challenges, unauthorized use or infringement, any of which could diminish the value of our products and services.



Our success depends in large part on our proprietary technology. We rely on a combination of copyrights, trademarks, trade
secret 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. If we fail to successfully enforce our intellectual property
rights, the value of these rights, and consequently the value of our products and services to our customers, could diminish substantially. It may 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.



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Litigation may be necessary to enforce our intellectual property rights, to protect trade secrets or to
determine the validity and scope of the proprietary rights of others. Effective protection of intellectual property rights is unavailable or limited in some foreign countries. Our protection of our intellectual property rights may not provide us
with any legal remedy should our competitors independently develop similar technology, duplicate our products or services, or design around any intellectual property rights held by us.



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, though in July 2004, Docent won its summary judgment motion for
non-infringement. In addition, in May 1996, Richard B. Grant filed a complaint against Click2learn alleging that Click2learns ToolBook, CBC ToolBook and Multimedia ToolBook products infringe a patent owned by him and is seeking an injunction
and unspecified damages. In February 2004, IpLearn, LLC filed suit against Click2learn alleging that its legacy Aspen product line infringes several patents held by IpLearn. 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, the patent infringement claims against Docent and Click2learn
are expensive to defend and divert management attention from operating our company. In addition, even though Docent, Click2learn or SumTotal Systems may prevail initially in any particular 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 SumTotal Systems is, 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.



In addition, from time to time Click2learn and Docent have received, and the new company 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;
| | - | ---------



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| |  | user privacy;
| | - | -------------



| |  | content;
| | - | --------



| |  | right to access personal data;
| | - | ------------------------------



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



| |  | distribution; and
| | - | -----------------



| |  | characteristics and quality of services.
| | - | ----------------------------------------



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



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



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



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



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



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



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. We minimize risk by investing in financial instruments with maturity of three months or less. As a result,
if market interest rates were to increase immediately and uniformly by 10% from levels at September 30, 2004, the fair value of cash and cash equivalents would not change by a material amount.



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Foreign Currency Exchange Risk.We have foreign currency risk as a result of foreign
subsidiary activities. For the three-months ended September 30, 2004 and 2003, international revenue from our foreign subsidiaries accounted for approximately 28% and 10%, respectively, of total revenue. For the nine-months ended September 30, 2004
and 2003, international revenue from our foreign subsidiaries accounted for approximately 25% and 12%, respectively, of total revenue. 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 United States 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 United States. 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 nine-months ended September 30, 2004 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.



Item 4.
Controls and Procedures



Disclosure Controls and Procedures.We established, and maintain, a set of disclosure controls and procedures designed to ensure that information required to be disclosed in our filings made pursuant to the Securities
and Exchange Act of 1934 (the Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms. Our Chief Executive Officer and Chief Financial Officer have evaluated our
disclosure controls and procedures (as defined in the Exchange Act) as of the end of the period covered by this report and have determined that such disclosure controls and procedures are effective to ensure that the information required to be
disclosed in our filings is gathered, analyzed and disclosed with adequate timeliness, accuracy and completeness. We believe that a control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of
the control system are met, and no evaluation of controls can provide absolutely assurance that all control issues and instances of fraud, if any, within a company, have been detected.



Internal Controls and Procedures.In connection with the review of our financial statements for the
fiscal quarter ended March 31, 2004, KPMG, our independent auditors, noted in a letter to our Audit Committee (the KPMG Letter) that there was a matter involving our internal controls and procedures, and their operation, that KPMG
considered to be a material weakness under standards established by the AICPA. During its review, KPMG noted that license revenue aggregating approximately $1.2 million had been recognized within our unadjusted trial balance on two transactions
originating within our European operations which, although the contracts governing the transactions were signed by the customers and the software licensed in the transactions was delivered by March 31, 2004, the contracts had not been countersigned
by us by March 31, 2004. As a result, we had to adjust our financial statements prior to announcing our financial results for the first quarter of fiscal year 2004 on April 28, 2004, to remove the effect of these two transactions.



We have established, and maintain, a set of internal controls and procedures
designed to ensure that our financial reports fairly represent, in all material respects, the financial condition, results of operations, and cash flows for us for the quarter ended September 30, 2004. In addition, we implemented and maintained
additional controls and procedures as set forth in our Form 10-Q filed with the SEC on May 15, 2004 throughout the quarters ended June 30, 2004 and September 30, 2004. We believe that these additional controls and procedures, in conjunction with our
standard controls and procedures, addressed the material weakness raised in the KPMG Letter. We expect for these additional controls and procedures to be continually refined during the fourth quarter of fiscal year 2004 and, as appropriate, to
continue thereafter.



Other than as described above, there were
no significant changes in the companys internal controls over financial reporting identified in managements evaluation during the third quarter of fiscal 2004 that have materially affected or are reasonably likely to materially affect
the companys internal controls over financial reporting. To the knowledge of our Chief Executive Officer and our Chief Financial Officer, the financial statements, and other financial information included in this report, fairly present, in all
material respects, our financial conditions for the quarter ended September 30, 2004.



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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.



Richard B. Grant v. Asymetrix Corporation, No. CV-96-3635 HLH, Central District of California. On May 21, 1996, Richard B. Grant filed a complaint
alleging that our ToolBook, CBT Tool Book, and Multimedia ToolBook products infringe a patent owned by him. We have received an opinion from patent counsel that the products do not infringe this patent and that the patent is invalid. Plaintiff is
seeking an injunction and unspecified monetary damages. In September 2004, after the Court issued its Markman ruling, the Court stayed this matter pending the initial en banc decision of the Court of Appeals for the Federal Circuit in Edward H.
Phillips v. AWH Corporation et al.



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 on February 18,
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 concerns 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 of both Docent and
Click2learn software products infringe on five IpLearn patents that relate to online learning. IpLearn, in both cases, is seeking injunctive relief and unspecified monetary damages. The case is still in the discovery phase, and a Markman hearing is
currently scheduled for February 2005.



IP Innovation, LLC, v.
Thomas 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 United States 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 HTML (Hypertext Markup Language) 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.



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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|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 July 28, 2004, under Items 7 and 12, furnishing the press release containing financial information for the three-months ended
June 30, 2004.



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SIGNATURES



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



|                  |  |  |  |                                                                                                                 
|----------------- |  |  |  | ----------------------------------------------------------------------------------------------------------------
|                  |  |  |  | SUMTOTAL SYSTEMS, INC.                                                                                          
|                  |  | 
|November 15, 2004 |  |  |  | /s/ NEIL J. LAIRD                                                                                               
|Date              |  |  |  | Neil J. Laird Chief Financial Officer (Duly Authorized Officer and Chief Financial and Chief Accounting Officer)



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