UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549


___________________





FORM
10-Q


__________________





(Mark
One)




x  QUARTERLY REPORT
UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008.





o  TRANSITION REPORT
UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
TRANSITION PERIOD FROM _____________ TO _____________.





Commission
File Number 000-50813





St.
Bernard Software, Inc.


(Exact
Name of Small Business Issuer as Specified in Its Charter)








Delaware
            20-0996152(State
      or other Jurisdiction of incorporation)
            (I.R.S.
      Employer Identification No.)





15015
Avenue of Science


San
Diego, California


(Address
of Principal Executive Office)





(858)
676-2277


(Issuer’s
Telephone Number, Including Area Code)








Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yesý Noo




Indicate
by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer”, “accelerated filer”, and “smaller
reporting company” in Rule 12b-2 of the Securities Exchange Act of 1934.
(Check one):




Large
accelerated filer oAccelerated filer oNon-accelerated
filer oSmaller reporting companyx





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





As of
November 12, 2008 there were 14,783,090 shares of the registrant’s common stock
outstanding.
















ST.
BERNARD SOFTWARE, INC.


For the
Quarter Ended September 30, 2008


Form
10-Q


INDEX






PART I – Financial Information
            3Item 1.
            Consolidated Financial Statements
            4Item 2.
            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
            15Item 3.
            Quantitative and Qualitative Disclosures About Market
      Risk
            29Item 4(T).
            Controls and Procedures
            29PART II – Other Information
            30Item 1.
            Legal Proceedings
            30Item 1A.
            Risk Factors
            30Item 6.
            Exhibits
            31Signatures
            33
































2








PART
I – FINANCIALINFORMATION




Forward-Looking
Statements




This
Quarterly Report on Form 10-Q includes “forward-looking statements”. To the
extent that the information presented in this Quarterly Report discusses
financial projections, information or expectations about our business plans,
results of operations, products or markets, or otherwise makes statements about
future events, such statements are forward-looking.





Certain
statements contained in this report including, but not limited to, statements
that can be identified by the use of forward-looking terminology such as “may,”
“expect,” “anticipate,” “predict,” “believe,” “plan,” “estimate” or “continue”
or the negative thereof or other variations thereon or comparable terminology,
are forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995, and involve a number of risks and uncertainties.
The actual results of the future events described in such forward-looking
statements in this interim report could differ materially from those stated in
such forward-looking statements due to various factors, including but not
limited to, the fact that we derive a majority of our revenue from sales of a
few product lines, our ability to manage our direct sales and OEM distribution
channels effectively, our ability to successfully promote awareness of our brand
and the need for our products, risks associated with the IT security industry
and those other risks and uncertainties detailed in filings with the Securities
and Exchange Commission, including this Quarterly Report on Form
10-Q.





You are
cautioned not to place undue reliance on these forward-looking statements, which
speak only as of the date of this Form 10-Q.





All
forward-looking statements included herein attributable to any of us, or any
person acting on our behalf are expressly qualified in their entirety by the
cautionary statements contained or referred to in this section. Except to the
extent required by applicable laws and regulations, we undertake no obligations
to update these forward-looking statements to reflect events or circumstances
after the date of this document or to reflect the occurrence of unanticipated
events.





3




Item 1.
            ConsolidatedFinancial
Statements




St.
      Bernard Software, Inc.Consolidated
      Balance SheetsSeptember
      30, 2008
                
                
                December
      31, 2007(Unaudited)AssetsCurrent
      AssetsCash
      and cash equivalents
                
                $
                722,000
                
                
                $
                1,297,000Accounts
      receivable - net of allowance for doubtfulaccounts
      of $83,000 and $59,000 at September 30, 2008 and
                
                
                3,580,000
                
                
                
                3,255,000December
      31, 2007, respectivelyInventories
      - net
                
                
                384,000
                
                
                
                158,000Prepaid
      expenses and other current assets
                
                
                508,000
                
                
                
                440,000Total
      current assets
                
                
                5,194,000
                
                
                
                5,150,000Fixed
      Assets - Net
                
                
                884,000
                
                
                
                1,301,000Other
      Assets
                
                
                174,000
                
                
                
                215,000Goodwill
                
                
                7,568,000
                
                
                
                7,568,000Total
      Assets
                
                $
                13,820,000
                
                
                $
                14,234,000Liabilities
      and Stockholders’ DeficitCurrent
      LiabilitiesShort-term
      borrowings
                
                $
                2,462,000
                
                
                $
                1,566,000Accounts
      payable
                
                
                1,565,000
                
                
                
                3,026,000Accrued
      compensation expenses
                
                
                898,000
                
                
                
                1,188,000Accrued
      expenses and other current liabilities
                
                
                356,000
                
                
                
                406,000Current
      portion of capitalized lease obligations
                
                
                159,000
                
                
                
                153,000Deferred
      revenue
                
                
                10,439,000
                
                
                
                9,589,000Total
      current liabilities
                
                
                15,879,000
                
                
                
                15,928,000Deferred
      Rent
                
                
                138,000
                
                
                
                232,000Capitalized
      Lease Obligations, Less Current Portion
                
                
                51,000
                
                
                
                170,000Deferred
      Revenue
                
                
                6,537,000
                
                
                
                5,860,000Total
      liabilities
                
                
                22,605,000
                
                
                
                22,190,000Commitments
      and ContingenciesStockholders’
      DeficitPreferred
      stock, $0.01 par value; 5,000,000 sharesauthorized;
      no shares issued and outstanding
                
                
                -
                
                
                
                -Common
      stock, $0.01 par value; 50,000,000 sharesauthorized;
      14,783,090 and 14,760,052 shares issuedand
      outstanding at September 30, 2008 and December 31, 2007,respectively
                
                
                148,000
                
                
                
                148,000Additional
      paid-in capital
                
                
                40,093,000
                
                
                
                39,079,000Accumulated
      deficit
                
                
                (49,026,000
                )
                
                
                (47,183,000
                )Total
      stockholders’ deficit
                
                
                (8,785,000
                )
                
                
                (7,956,000
                )Total
      Liabilities and Stockholders’ Deficit
                
                $
                13,820,000
                
                
                $
                14,234,000The
      accompanying notes are an integral part of these consolidated financial
      statements.






4




St.
      Bernard Software, Inc.Unaudited
      Consolidated Statements of OperationsThree
      months ended September 30,
              
              
              Nine
      months ended September 30,2008
              
              
              2007
              
              
              2008
              
              
              2007RevenuesSubscription
              
              $
              3,519,000
              
              
              $
              3,582,000
              
              
              $
              10,250,000
              
              
              $
              10,955,000Appliance
              
              
              906,000
              
              
              
              622,000
              
              
              
              2,668,000
              
              
              
              2,249,000License
              
              
              2,000
              
              
              
              253,000
              
              
              
              18,000
              
              
              
              1,668,000Total
      Revenues
              
              
              4,427,000
              
              
              
              4,457,000
              
              
              
              12,936,000
              
              
              
              14,872,000Cost
      of RevenuesSubscription
              
              
              545,000
              
              
              
              912,000
              
              
              
              1,658,000
              
              
              
              3,012,000Appliance
              
              
              612,000
              
              
              
              400,000
              
              
              
              1,848,000
              
              
              
              1,736,000License
              
              
              -
              
              
              
              4,000
              
              
              
              5,000
              
              
              
              55,000Total
      Cost of Revenues
              
              
              1,157,000
              
              
              
              1,316,000
              
              
              
              3,511,000
              
              
              
              4,803,000Gross
      Profit
              
              
              3,270,000
              
              
              
              3,141,000
              
              
              
              9,425,000
              
              
              
              10,069,000Sales
      and marketing expenses
              
              
              1,828,000
              
              
              
              2,848,000
              
              
              
              5,709,000
              
              
              
              10,322,000Research
      and development expenses
              
              
              629,000
              
              
              
              1,157,000
              
              
              
              2,128,000
              
              
              
              4,806,000General
      and administrative expenses
              
              
              1,322,000
              
              
              
              1,690,000
              
              
              
              3,897,000
              
              
              
              6,559,000Impairment
      expenses
              
              
              -
              
              
              
              3,262,000
              
              
              
              -
              
              
              
              3,262,000Total
      Operating Expenses
              
              
              3,779,000
              
              
              
              8,957,000
              
              
              
              11,734,000
              
              
              
              24,949,000Loss
      from Operations
              
              
              (509,000
              )
              
              
              (5,816,000
              )
              
              
              (2,309,000
              )
              
              
              (14,880,000
              )Other
      (Income) ExpenseInterest
      expense - net
              
              
              230,000
              
              
              
              73,000
              
              
              
              530,000
              
              
              
              145,000Gain
      on sale of assets
              
              
              (244,000
              )
              
              
              (7,967,000
              )
              
              
              (564,000
              )
              
              
              (11,430,000
              )Other
      Income (loss)
              
              
              9,000
              
              
              
              (98,000
              )
              
              
              (435,000
              )
              
              
              (107,000
              )Total
      Other Income
              
              
              (5,000
              )
              
              
              (7,992,000
              )
              
              
              (469,000
              )
              
              
              (11,392,000
              )Income
      (Loss) Before Income Taxes
              
              
              (504,000
              )
              
              
              2,176,000
              
              
              
              (1,840,000
              )
              
              
              (3,488,000
              )Income
      tax expense
              
              
              -
              
              
              
              -
              
              
              
              3,000
              
              
              
              4,000Net
      Income (Loss)
              
              $
              (504,000
              )
              
              $
              2,176,000
              
              
              $
              (1,843,000
              )
              
              $
              (3,492,000
              )Income
      (Loss) Per Common Share - Basic
              
              $
              (0.03
              )
              
              $
              0.15
              
              
              $
              (0.12
              )
              
              $
              (0.24
              )Income
      (Loss) Per Common Share - Diluted
              
              $
              (0.03
              )
              
              $
              0.15
              
              
              $
              (0.12
              )
              
              $
              (0.24
              )Weighted
      Average Shares Outstanding - Basic
              
              
              14,783,090
              
              
              
              14,759,671
              
              
              
              14,775,832
              
              
              
              14,772,774Weighted
      Average Shares Outstanding - Diluted
              
              
              14,783,090
              
              
              
              14,804,689
              
              
              
              14,775,832
              
              
              
              14,772,774The
      accompanying notes are an integral part of these consolidated financial
      statements.








5






St.
      Bernard Software, Inc.Unaudited
      Consolidated Statement of Stockholders' DeficitAdditionalCommon Stock
              
              
              Paid-in
              
              
              AccumulatedShares
              
              
              Amount
              
              
              Capital
              
              
              Deficit
              
              
              TotalBalance
      at December 31, 2007
              
              
              14,760,052
              
              
              $
              148,000
              
              
              $
              39,079,000
              
              
              $
              (47,183,000
              )
              
              $
              (7,956,000
              )Common
      stock issued under the employee stock purchase plan
              
              
              23,038
              
              
              
              -
              
              
              
              11,000
              
              
              
              -
              
              
              
              11,000Stock-based
      compensation expense
              
              
              -
              
              
              
              -
              
              
              
              668,000
              
              
              
              -
              
              
              
              668,000Value
      of warrants issued in connection with debt
              
              
              -
              
              
              
              -
              
              
              
              335,000
              
              
              
              -
              
              
              
              335,000Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (1,843,000
              )
              
              
              (1,843,000
              )Balance
      at September 30, 2008
              
              
              14,783,090
              
              
              $
              148,000
              
              
              $
              40,093,000
              
              
              $
              (49,026,000
              )
              
              $
              (8,785,000
              )The
      accompanying notes are an integral part of these consolidated financial
      statements.












6




St.
      Bernard Software, Inc.Unaudited
      Consolidated Statements of Cash FlowsNine
      months ended September 30,2008
                  
                  
                  2007Cash
      Flows From Operating ActivitiesNet
      loss
                  
                  $
                  (1,843,000
                  )
                  
                  $
                  (3,492,000
                  )Adjustments
      to reconcile net loss to net cashused
      in operating activities:Depreciation
      and amortization
                  
                  
                  455,000
                  
                  
                  
                  927,000Allowance
      for doubtful accounts
                  
                  
                  24,000
                  
                  
                  
                  (256,000
                  )Gain
      on sale of assets
                  
                  
                  (563,000
                  )
                  
                  
                  (11,430,000
                  )Impairment
      of intangible assets related to the acquisition of
AgaveOne
                  
                  
                  -
                  
                  
                  
                  3,262,000Stock-based
      compensation expense
                  
                  
                  668,000
                  
                  
                  
                  841,000Noncash
      interest expense
                  
                  
                  246,000
                  
                  
                  
                  7,000Increase
      (decrease) in cash resulting from changes in:Accounts
      receivable
                  
                  
                  (349,000
                  )
                  
                  
                  1,351,000Inventories
                  
                  
                  (226,000
                  )
                  
                  
                  (59,000
                  )Prepaid
      expenses and other assets
                  
                  
                  (64,000
                  )
                  
                  
                  (218,000
                  )Accounts
      payable
                  
                  
                  (1,461,000
                  )
                  
                  
                  (1,421,000
                  )Accrued
      expenses and other current liabilities
                  
                  
                  (344,000
                  )
                  
                  
                  (482,000
                  )Deferred
      revenue
                  
                  
                  1,526,000
                  
                  
                  
                  1,254,000Net
      cash used in operating activities
                  
                  
                  (1,931,000
                  )
                  
                  
                  (9,716,000
                  )Cash
      Flows From Investing ActivitiesAdditional
      costs related to an acquisition
                  
                  
                  -
                  
                  
                  
                  (109,000
                  )Purchases
      of fixed assets
                  
                  
                  (7,000
                  )
                  
                  
                  (286,000
                  )Proceeds
      from the sale of assets
                  
                  
                  570,000
                  
                  
                  
                  7,413,000Net
      cash provided by investing activities
                  
                  
                  563,000
                  
                  
                  
                  7,018,000Cash
      Flows From Financing ActivitiesProceeds
      from stock option and warrant exercises
                  
                  
                  -
                  
                  
                  
                  30,000Proceeds
      from the sales of stock under the employee stock purchase
    plan
                  
                  
                  11,000
                  
                  
                  
                  15,000Principal
      payments on capitalized lease obligations
                  
                  
                  (114,000
                  )
                  
                  
                  (86,000
                  )Net
      increase in short-term borrowings
                  
                  
                  896,000
                  
                  
                  
                  704,000Net
      cash provided by financing activities
                  
                  
                  793,000
                  
                  
                  
                  663,000Net
      Decrease in Cash and Cash Equivalents
                  
                  
                  (575,000
                  )
                  
                  
                  (2,035,000
                  )Cash
      and Cash Equivalents at Beginning of Period
                  
                  
                  1,297,000
                  
                  
                  
                  4,842,000Cash
      and Cash Equivalents at End of Period
                  
                  $
                  722,000
                  
                  
                  $
                  2,807,000Supplemental
      Disclosures of Cash Flow Information:Cash
      paid during the period for:Interest
                  
                  $
                  265,000
                  
                  
                  $
                  205,000Income
      taxes
                  
                  $
                  -
                  
                  
                  $
                  2,000
  Non
      Cash Investing and Financing Activities:In
      January 2008, the Company issued warrants to purchase up to 140,350 shares
      of the of
      the Company's common stock in connection with the amendment of a loan
      agreement.  Deferred
      debt issuance costs of $58,000 were recorded based on the estimated
      fair value of the warrants. See Note
    3.In
      January 2008, the Company issued warrants to purchase up to 460,526 shares
      of
      the Company's common stock in connection with a loan agreement. Debt
      discount of $151,000
      was recorded based on the estimated relative fair value of the
      warrants. See Note
      3.In
      July 2008, the Company issued warrants to purchase up to 450,000 sharesof the Company's
      common stock in connection with a loan agreement.  Deferred
      debt
      issuance costs of $125,000 were recorded based on the estimated fair value
      of the
      warrants.  See Note 3.During the
      nine months ended September 30, 2007,
      the Company entered into capitalizedlease
      obligations for the purchase of $219,000 in fixed assets.In
      April 2007, the shares issued in conjunction with the purchase of AgaveOne
      were reduced by
      66,667 shares or $250,000 as a result of indemnification
      claims.In
      May 2007, the Company issued 100,000 warrants in conjunction with a loan
      agreement with
      a bank.  See Note 3.


The
accompanying notes are an integral part of these consolidated financial
statements.


7
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
  
  1.
Summary of Significant Accounting Policies
  St. Bernard Software, Inc., a
Delaware corporation (“we,” “us,”  “our,” the “Company,” or “St.
Bernard”) is a software development company that designs, develops, and markets
Secure Content Management (“SCM”) and policy compliance solutions to small,
medium, and enterprise class customers. The Company sells its products through
distributors, dealers, and original equipment manufacturers (“OEM”), and
directly to network managers and administrators worldwide.
  Basis of
presentation
  The
consolidated balance sheet as of September 30, 2008, the consolidated statements
of operations for the three and nine months ended September 30, 2008 and 2007,
the consolidated statement of stockholders’ deficit for the nine months ended
September 30, 2008, and the consolidated statements of cash flows for the nine
months ended September 30, 2008 and 2007, are unaudited and reflect all
adjustments of a normal recurring nature which are, in the opinion of
management, necessary for a fair presentation of the financial position, results
of operations, stockholders’ deficit, and cash flows for the interim periods
presented. The consolidated balance sheet as of December 31, 2007 was derived
from the Company’s audited financial statements. Operating results for the
interim periods presented are not necessarily indicative of results to be
expected for the fiscal year ending December 31, 2008. These consolidated
financial statements should be read in conjunction with the Company’s December
31, 2007 consolidated financial statements and notes thereto included in the
Company’s Annual Report filed on Form 10-KSB with the Securities and Exchange
Commission on March 20, 2008.
  The
consolidated financial statements include our accounts and those of our
subsidiaries which include our operations in the UK and
Australia.  The Company closed its European and Australian sales and
marketing offices in 2007. All inter-company balances and transactions have been
eliminated in consolidation.
  Use
of estimates
  The
preparation of the consolidated financial statements in conformity with U.S
generally accepted accounting principles (“U.S. GAAP”) requires management to
make estimates and assumptions that affect certain reported amounts and
disclosures. Accordingly, actual results could differ from those estimates.
Significant estimates used in preparing the consolidated financial statements
include those assumed in computing revenue recognition, the allowance for
doubtful accounts, warranty liability, the valuation allowance on deferred tax
assets, testing goodwill for impairment, and stock-based
compensation.
  Liquidity
  As of
September 30, 2008, the Company had approximately $0.7 million of cash and cash
equivalents and a working capital deficit of $10.7
million.  Approximately $10.4 million of our current liability balance
at September 30, 2008 consists of deferred revenues, which represents amounts
that will be amortized into revenue as they are earned in future periods. The
Company also had a stockholders’ deficit of approximately $8.8 million at
September 30, 2008.
  The
Company has a history of losses and has not yet been able to achieve
profitability. For the three and nine months ended September 30, 2008, the
Company incurred net losses of $0.5 million and $1.8 million, respectively, and
through September 30, 2008 has recorded a cumulative net loss of $49.0 million.
During the fourth quarter of 2007 and through the second quarter of 2008, the
Company made substantial changes to the cost structure of its business. These
changes included the closure of its sales and marketing offices in Europe and
Australia, reducing headcount to be in line with the current size of its
business, renegotiating vendor contracts, and refocusing its marketing strategy
around its core business. In addition to these changes, the Company entered into
a Loan and Security Agreement (the “PFG Loan Agreement”) with Partners for
Growth II, L.P. (“PFG”) in July 2008 for the amount of $1.5 million. See Note
3.
  8
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements (Continued)
   
  The
Company believes that its existing cash resources, combined with projected
billings, implemented cost reductions, and borrowing availability under existing
credit facilities, will provide sufficient liquidity for the Company to meet its
continuing obligations for the next twelve months. However, there can be no
assurances that projected revenue will be achieved or the improvement in
operating results will occur. In the event cash flow from operations is not
sufficient, the Company may require additional sources of financing in order to
maintain its current operations. These additional sources of financing may
include public or private offerings of equity or debt securities. Whereas
management believes it will have access to these financing sources, no assurance
can be given that additional sources of financing will be available on
acceptable terms, on a timely basis, or at all.
  Loss
per common share
  Basic
loss per common share is calculated by dividing the net loss for the period by
the weighted average number of shares of common stock outstanding during the
period. Diluted loss per common share includes the components of basic loss per
common share and also gives effect to dilutive common stock equivalents.
Potentially dilutive common stock equivalents include stock options and
warrants. No dilutive effect was calculated for the three months ended September
30, 2008 and nine months ended September 30, 2008 and 2007, as the Company
reported a net loss in each period and the effect would have been anti-dilutive.
However, for the three months ended September 30, 2007, 45,018 shares were
dilutive as the Company reported net income.
  New
accounting standards
  In
May 2008, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 162, “The Hierarchy of Generally Accepted
Accounting Principle”(“SFAS
162”).  SFAS 162 will provide framework for selecting accounting
principles to be used in preparing financial statements that are presented in
conformity with U.S. GAAP for nongovernmental entities.  SFAS 162 will
be effective 60 days following the Securities and Exchange Commission's approval
of the Public Company Accounting Oversight Board (PCAOB) amendments to AU
Section 411.  The Company is currently evaluating the impact, if any,
this statement will have on its financial position, cash flows, or results of
operations.
  In April
2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of Useful Life of
Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors
that should be considered in developing the renewal or extension assumptions
used to determine the useful life of a recognized intangible asset under FAS
142, “Goodwill and Other
Intangible Assets.” FSP FAS 142-3 also requires expanded disclosure
related to the determination of intangible asset useful lives. FSP FAS 142-3 is
effective for fiscal years beginning after December 15, 2008. Earlier adoption
is not permitted. The Company does not expect FSP FAS 142-3 to have a material
impact on its financial statements.
  On
February 15, 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities” (“SFAS 159”). SFAS No. 159 permits
all entities to choose, at specified election dates, to measure eligible items
at fair value (the “fair value option”). A business entity shall report
unrealized gains and losses on items for which the fair value option has been
elected in earnings (or another performance indicator if the business entity
does not report earnings) at each subsequent reporting date. Upfront costs and
fees related to items for which the fair value option is elected shall be
recognized in earnings as incurred and not deferred. The Company adopted SFAS
159 on January 1, 2008.  The adoption of SFAS 159 did not have a
material impact on its financial position, cash flows, or results of
operations.
  In
September 2006, FASB issuedSFAS No. 157,
“Fair Value
Measurements”(“SFAS 157”). This Statement defines fair value, establishes a framework
for measuring fair value in U.S. GAAP, and expands disclosures about fair value
measurements. This statement applies in those instances where other
accounting pronouncements require or permit fair value measurements and the
board of directors has previously concluded in those accounting pronouncements
that fair value is the relevant measurement attribute. Accordingly, this
statement does not require any new fair value measurements. However, for some
entities, the application of this Statement will change the current practice. In
February 2008, the FASB issued FSP FAS 157-2 which defers the effective date of
SFAS 157 for all non-financial assets and liabilities, except those items
recognized or disclosed at fair value on an annual or more frequent recurring
basis, until years beginning after November 15, 2008.  The Company’s
adoption of SFAS 157 for its financial assets and liabilities on January 1, 2008
did not have a material impact on the Company’s financial position, cash flows,
or results of operations.  The Company is currently reviewing the
adoption requirements related to our non-financial assets and liabilities and
has not yet determined the impact, if any, this will have on our financial
position, cash flows, or results of operations.
  9
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
(Continued)
   Reclassifications
  Certain
prior year reclassifications have been made for consistent presentation. These
reclassifications have no effect on previously reported net income.
  2.
Stock-based Compensation Expense
  Effective
January 1, 2006, the Company adopted the fair value recognition provisions
of Statement of Financial Accounting Standards, or SFAS, No. 123R (revised
2004), “Share-based Payment”(“SFAS 123R”) using the modified prospective method. Stock-based
compensation expense for all stock-based compensation awards granted after
January 1, 2006 are based upon the grant date fair value estimated in
accordance with SFAS 123R.
  The
Company has non-qualified and incentive stock option plans (together, the
“Plans”) providing for the issuance of options to employees and others as deemed
appropriate by the Board of Directors. Terms of options issued under the Plans
include an exercise price equal to the estimated fair value (as determined by
the Board of Directors) at the date of grant, vesting periods generally between
three and five years, and expiration dates not to exceed ten years from the date
of grant. The determination of fair value of the Company’s stock is derived
using the value of the stock price at the grant date.
  Calculating
stock-based compensation expense requires the input of highly subjective
assumptions, including the expected term of the stock-based compensation, the
expected stock price volatility factor, and the pre-vesting option forfeiture
rate. The weighted average fair value of options granted during the nine months
ended September 30, 2008 and 2007 was calculated using the Black-Scholes option
pricing model using the valuation assumptions in the table below. The Company
estimates the expected life of stock options granted based upon management’s
consideration of the historical life of the options and the vesting and
contractual period of the options granted. The Company estimates the expected
volatility factor of its common stock based on the weighted average of the
historical volatility of three publicly traded surrogates of the Company and the
Company’s implied volatility from its common stock price. The Company applies
its risk-free interest rate based on the U.S. Treasury yield in effect at the
time of the grant. The Company has no history or expectation of paying any cash
dividends on its common stock.  Forfeitures were estimated based on
historical experience.
  
 Nine
      Months Ended
              
              Nine
      Months EndedSeptember
      30, 2008
              
              September
      30, 2007Average
      expected life (years)
              
              6.5
              
              6.5Average
      expected volatility factor
              
              71.5
              %
              75.0
              %Average
      risk-free interest rate
              
              3.8
              %
              4.8
              %Average
      expected dividend yield
              
              0
              
              0
  
  Total
stock-based compensation expense was approximately $334,000 and $260,000 for the
three months ended September 30, 2008 and 2007, respectively, and $668,000 and
$841,000 for the nine months ended September 30, 2008 and 2007, respectively.
The stock-based compensation expenses were charged to operating expenses. The
earnings per share effect as a result of the stock based compensation expense
was approximately $0.02 and $0.05, respectively, for the three and nine months
ended September 30, 2008. The tax effect was immaterial.
  10
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
(Continued)
   
  The
following is a summary of stock option activity under the Plans as of December
31, 2007 and changes during the nine months ended September 30,
2008:
  Number
      of
                Shares
                Outstanding
              
              
              Weighted
                Average
                Exercise
                PriceOptions
      outstanding at December 31, 2007
              
              
              2,074,861
              
              
              $
              1.77Granted
              
              
              1,084,500
              
              
              $
              0.48Exercised
              
              
              —
              
              
              $
              —Forfeited
              
              
              (597,594
              )
              
              $
              1.46Options
      outstanding at September 30, 2008
              
              
              2,561,767
              
              
              $
              1.30
   Additional
information regarding options outstanding as of September 30, 2008 is as
follows:
  
 Range of
                Exercise
                Prices
              
              Number
      of
                Shares
                Outstanding
              
              Weighted
                Average
                Remaining
                Contractual
                Life in Years
              
              Weighted
                Average
                Exercise
                Price
              
              Number
                Exercisable
              
              Weighted
                Average
                Exercise
                Price$0.36
              to
      $0.36
              
              8,000
              
              9.77
              
              $
              0.36
              
              —
              
              $
              —$0.40
              to
      $0.40
              
              574,500
              
              9.89
              
              $
              0.40
              
              —
              
              $
              —$0.45
              to
      $0.54
              
              76,000
              
              9.60
              
              $
              0.50
              
              —
              
              $
              —$0.57
              to
      $0.57
              
              375,000
              
              9.16
              
              $
              0.57
              
              —
              
              $
              —$0.58
              to
      $0.58
              
              3,000
              
              9.50
              
              $
              0.58
              
              —
              
              $
              —$0.59
              to
      $0.59
              
              309,404
              
              8.94
              
              $
              0.59
              
              21,404
              
              $
              0.59$0.60
              to
      $1.80
              
              174,949
              
              6.95
              
              $
              1.01
              
              128,054
              
              $
              1.02$1.90
              to
      $1.90
              
              275,000
              
              8.22
              
              $
              1.90
              
              159,843
              
              $
              1.90$1.95
              to
      $1.95
              
              547,521
              
              7.84
              
              $
              1.95
              
              365,483
              
              $
              1.95$3.71
              to
      $5.20
              
              218,393
              
              6.11
              
              $
              4.05
              
              168,143
              
              $
              4.16$0.36
              to
      $5.20
              
              2,561,767
              
              8.52
              
              $
              1.30
              
              842,927
              
              $
              2.21
 
  The
aggregate intrinsic value of options outstanding and options exercisable at
September 30, 2008 was approximately $78,000 and $0, respectively. The aggregate
intrinsic value of options outstanding and options exercisable at September 30,
2007 was approximately $39,000 and $25,000, respectively. The aggregate
intrinsic value represents the total intrinsic value based upon the stock price
of $0.53 at September 30, 2008.
  As of
September 30, 2008, there was approximately $1.6 million of total unrecognized
compensation expense related to unvested share-based compensation arrangements
granted under the option plans. The cost is expected to be recognized over a
weighted average period of 2.19 years.
   11
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
(Continued)
   3.
Debt
  Credit
Facility
  On May
15, 2007, the Company entered into a Loan and Security Agreement with Silicon
Valley Bank, a California corporation (“SVB”) which was subsequently amended on
January 25, 2008 (“SVB Loan Amendment”).  Pursuant to the terms
of the SVB Loan Amendment, among other things, SVB (i) refinanced the
existing term loan with the proceeds of an advance under the revolving line of
credit (and terminated the term loan facility), (ii) reduced the revolving
line of credit provided to St. Bernard to an amount not to exceed $2,000,000,
(iii) increased the interest rate on the revolving line of credit to 3%
(from 2%) over the greater of the prime rate or 7.5%, (iv) modified the
tangible net worth covenant, and (v) took a security interest in St.
Bernard’s intellectual property. At September 30, 2008, the effective interest
rate was 10.5%.  As of September 30, 2008, the balance on the line of
credit with SVB was $1.7 million and the Company was in compliance with the
above stated covenants and restrictions.
  In
connection with the execution of the SVB Loan Amendment, St. Bernard issued
warrants to SVB, which allows SVB to purchase up to 140,350 shares of St.
Bernard common stock at an exercise price of $0.57 per share. The warrants
expire on the seventh anniversary of their issue date. The Company recorded
deferred debt issue costs in the amount of $58,000, based on the estimated fair
value allocated to the warrants using the following assumptions; 75.35%
volatility, risk free interest rate of 3.61%, an expected life of seven years
and no dividends.  Amortization of the debt issuance costs, including
amounts recorded as a debt discount for warrants previously issued for three and
nine months ended September 30, 2008, which is being recorded as interest
expense, was approximately $23,000 and $81,000, respectively. Furthermore, St.
Bernard agreed to grant SVB certain piggyback registration rights with respect
to the shares of common stock underlying the warrants.
  Bridge
Loan
  On
January 25, 2008, St. Bernard Software, Inc. entered into a Loan Agreement (the
"Agility Loan Agreement") with Agility Capital, LLC ("Agility"). Pursuant to the
terms of the Agility Loan Agreement, Agility provided St. Bernard with a
non-revolving term loan in the amount of $750,000, at a 15% fixed interest rate
(the “Agility Loan”). Beginning March 1, 2008, and on the first day of each
month thereafter until July 1, 2008, St. Bernard was required to pay to Agility
$25,000 plus accrued but unpaid interest. Beginning July 1, 2008, and on the
first day of each month thereafter, St. Bernard was required to pay Agility
$50,000 plus accrued interest.  The obligations under the Agility Loan
Agreement were secured by substantially all of St. Bernard's assets subordinated
by the SVB Loan Amendment.
  In July
2008, the entire outstanding balance on the Agility Loan, approximately
$562,000, was paid using the proceeds from a new loan from Partners for Growth
II, LP (“PFG”).
  In
connection with the execution of the Agility Loan Agreement, St. Bernard issued
warrants to Agility (the "Agility Warrants"), which allows Agility to purchase
up to 463,500 shares of St. Bernard common stock at an exercise price equal to
$0.57 per share. The Agility Warrants expire on the seventh anniversary of their
issue date. The Company estimated the fair value of the warrants to be $190,000
using the following assumptions; 75.35% volatility, risk free interest rate of
3.61%, an expected life of seven years and no dividends.  In
accordance with Accounting Principles Board Opinion No. 14, the relative fair
value of the warrants, estimated to be approximately $151,000, was recorded as
debt discount.   Amortization of the debt discount for three and
nine months ended September 30, 2008, which is being recorded as interest
expense, was approximately $89,000 and $151,000, respectively. The Agility
Warrants contains anti-dilution protection in the event of a debt or equity
financing, with respect to the exercise price and number of shares. Furthermore,
St. Bernard granted Agility piggyback registration rights with respect to the
shares of common stock underlying the Agility Warrants. In July 2008, the
remaining unamortized balance of the previously recorded debt discount was
amortized to interest expense in connection with the full repayment of the
Agility Loan.
  On July
21, 2008, the Company entered into a Loan Agreement with PFG, which became
effective on July 23, 2008. Pursuant to the terms of the PFG Loan Agreement, PFG
provided St. Bernard with a revolving line of credit in an amount not to exceed
the lesser of (a) $1,500,000 at any one time outstanding or (b) up to 30% of the
amount of St. Bernard’s aggregate Eligible Billings (as defined in the PFG Loan
Agreement) over a rolling three month period calculated
monthly.
  12
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
(Continued)
    The
annual interest rate on the PFG Loan is set at the Prime Rate, quoted by SVB as
its Prime Rate from time to time, plus 3% (the “Applicable Rate”).  At
September 30, 2008, the effective interest rate was 8%. St. Bernard is required
to maintain a minimum borrowing amount of at least $750,000 (the “Minimum
Borrowing Amount”) or pay PFG a minimum interest amount (the “Minimum Interest
Amount”) equal to $750,000, multiplied by the Applicable Rate, and further
multiplied by the number of days (based on a 360-day year) from the date of such
failure to maintain the Minimum Borrowing Amount to the Maturity Date (as
defined in the PFG Loan Agreement).  Pursuant to the terms of the PFG
Loan Agreement, St. Bernard paid PFG a one-time commitment fee of $30,000 and
agreed to reimburse PFG for PFG’s reasonable attorneys’ fees in connection with
the negotiation of the PFG Loan Agreement.
  Subject
to the requirement to maintain the Minimum Borrowing Amount or pay the Minimum
Interest Amount, St. Bernard may borrow, repay and reborrow from time to time
until the Maturity Date. Proceeds of the initial loan amount were used to pay
all indebtedness owing to Agility, with the remaining amount to be used for
working capital.
  The PFG
Loan Agreement will terminate on July 20, 2010, on which date all principal,
interest and other outstanding monetary obligations must be repaid to PFG. The
obligations under the PFG Loan Agreement are secured by a security interest in
collateral comprised of substantially all of St. Bernard’s assets, subordinated
by the SVB Loan Agreement.
  The PFG
Loan Agreement contains affirmative, negative and financial covenants customary
for credit facilities of this type, including, among other things, limitations
on indebtedness, liens, sales of assets, mergers, investments, and
dividends.  The PFG Loan Agreement also requires that St. Bernard
maintain a Modified Net Income (as defined in the PFG Loan Agreement) greater
than zero. The PFG Loan Agreement contains events of default customary for
credit facilities of this type (with customary grace or cure periods, as
applicable) and provides that upon the occurrence and during the continuance of
an event of default, among other things, the interest rate on all borrowings
will be increased, the payment of all borrowings may be accelerated, PFG’s
commitments may be terminated and PFG shall be entitled to exercise all of its
rights and remedies, including remedies against collateral.  At
September 30, 2008, the Company was in compliance with the above stated
covenants.
  In
connection with the execution of the PFG Loan Agreement, St. Bernard issued a
warrant to PFG on July 21, 2008 (the “Warrant”), which allows PFG to purchase up
to 450,000 shares of St. Bernard common stock at an exercise price equal to
$0.46 per share. The Warrant expires on July 20, 2013.  The Company
recorded deferred debt issue costs in the amount of $125,000, based on the
estimated fair value allocated to the warrants using the following assumptions;
69.07% volatility, risk free interest rate of 4.09%, an expected life of five
years and no dividends. Amortization of the debt issuance costs for three months
ended September 30, 2008, which is being recorded as interest expense, was
approximately $12,000. As of September 30, 2008, the balance on the PFG Loan
Agreement was $750,000.
  4.
Stockholders’ Deficit
  Warrants
  As of
September 30, 2008 and December 31, 2007, a total of 9,803,954 and 8,750,104
shares of common stock, respectively, were reserved for issuance for the
exercise of warrants at exercise prices ranging from $0.46 to $5.00 per
share.  During the nine months ended September 30, 2008, warrants to
purchase an aggregate of 1,053,850 shares of common stock at exercise prices of
$0.46 to $0.57 per share were granted in connection with the loan agreements
described above. There were no warrants that were exercised or expired during
this period.
  13
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
(Continued)
   5.
Related Party Transactions
  During
2007, a stockholder and former member of the Board of Directors provided legal
services to the Company in the ordinary course of business. Billings for such
services totaled approximately $4,000 for the three months ended September 30,
2007 and $641,000 for the nine months ended September 30, 2007. Amounts due at
December 31, 2007 were approximately $400,000.  The Company settled
the amounts due with this related party for approximately $179,000 resulting in
a gain of $246,000 during the three months ended March 31, 2008. No such
services were rendered in 2008.
  The
Company previously occupied office space provided by an affiliate of certain
officers and directors of the Company. The Company paid this affiliate $7,500
per month to lease 2,000 square feet of office space in Amsterdam. The lease was
terminated on February 15, 2008.
  6.
Sales and Revenue Concentration
  The
Company considers itself to operate within one business segment, Secure Content
Management (“SCM”). For the nine months ended September 30, 2008 and 2007,
approximately 92% and 94%, respectively, of the Company’s revenue was in North
America, the remaining 8% and 6%, respectively, were disbursed over the rest of
the world.
   14


Item 2.
            Management’sDiscussion and Analysis of Financial Condition
      and Results of Operations




This Form
10-Q contains forward-looking statements concerning our anticipated future
revenues and earnings, adequacy of future cash flow, and related matters. These
forward-looking statements include, but are not limited to, statements or
phrases such as “believe,” “will,” “expect,” “anticipate,” “estimate,” “intend,”
“plan,”  “would” and similar expressions, and the negative thereof.
Forward-looking statements are not guarantees of performance. These statements
involve risks and uncertainties that could cause actual results to differ
materially from those in the forward-looking statements.  We assume no
obligation to update any such forward-looking statements. For a summary of such
risks and uncertainties, please see Risk Factors located in our Annual Report on
Form 10-KSB for the year ended December 31, 2007 filed with the Securities
and Exchange Commission on March 20, 2008.




OVERVIEW




Our
Business




We
design, develop, and market Secure Content Management, SCM, and policy
compliance solutions to small, medium, and enterprise class
customers.  These SCM solutions enable our customers to efficiently
filter and manage employee usage of internet, e-mail and instant messaging, or
IM. We also provide an on-demand archiving solution for internet usage, e-mail
and IM that supports our customers’ policy requirements for message retention
and discovery.  Our solutions are delivered as appliances and as
on-demand software as a service, or SaaS.




Our
customers include more than 5,000 business, education, and government
institutions. Our customers purchase our solutions directly from us, through our
1-tier and 2-tier reseller network, and through OEMs. Appliance purchases
consist of an initial hardware purchase and software subscription, with
recurring fees for data and maintenance.  SaaS purchases consist of a
single or multi-year subscription to the hosted services. Our primary customers
are IT managers, directors, and administrators.




We have
invested significantly in research and development activities, and for the nine
months ended September 30, 2008 and 2007 spent $2.1 million and $4.8 million,
respectively, on research and development. Our research and development efforts
have focused on network based secure content management solutions and expanding
our product portfolio into new delivery models, such as SaaS, and additional
secure content management markets, such as messaging security.  We
anticipate research and development expenses to increase for the remainder of
2008 and to an even greater extent in 2009 as we extend the core functionality
and features within our core products.




Our
Strategy




During
the first half of 2008, we started to deliver a “hybrid” secure content
management family of products. We believe that this “hybrid” product strategy
differentiates us from our competitors enabling us to grow faster than our
competition.  We have also realigned our sales and marketing efforts
to allow us to better serve medium-sized and enterprise class customers in
conjunction with this strategy.




Our
Financial Results




We
reported revenues of $4.4 million for the three months ended September 30, 2008,
compared to $4.5 million in the same period in 2007, a decrease of 2.2%; a net
loss for the three months ended September 30, 2008 of $0.5 million, compared to
a net income of $2.2 million in the same period in 2007; and net basic and
diluted loss per share for the three months ended September 30, 2008 of $0.03,
compared to a net basic and diluted income per share of $0.15 reported in the
same period in 2007. The decrease in the basic and diluted loss per share was
primarily attributable to a decrease in operating expenses of $5.2 million,
offset by a quarter over quarter decrease in the gain on the sale of assets for
the three months ended September 30, 2008 of $0.2 million compared to $8.0
million for the same period in 2007.  (See section below titled “Gain
on Sale of Assets”.)




We
reported revenues of $12.9 million for the first nine months of 2008 compared to
$14.9 million in the same period in 2007, a decrease of 13.4%; a net loss for
the first nine months of 2008 of $1.8 million, compared to a net loss of $3.5
million in the same period in 2007; and net basic loss per share for the first
nine months of 2008 of $0.12, compared to $0.24 reported in the same period in
2007.





15







Cash used
in operations was $1.9 million and  $9.7 million for the nine months
ended September 30, 2008 and 2007, respectively. The net decrease in use of cash
was due primarily to lower operating losses and substantial changes to the cost
structure of our business.




On
January 25, 2008, we amended our line of credit agreement with SVB which was
established on May 15, 2007. See section below titled, “Credit Facility” for the
terms of the original and amended agreement with SVB. The outstanding balance on
the line of credit with SVB was $1.7 million as of September 30,
2008.




On July
21, 2008, we entered into a Loan Agreement with PFG, which became effective on
July 23, 2008. Pursuant to the terms of the Loan Agreement, PFG provided us with
a revolving line of credit in the amount not to exceed the lesser of (a)
$1,500,000 at any one time outstanding or (b) 30% of the amount of St. Bernard’s
aggregate Eligible Billings over a rolling three month period calculated
monthly. The line of credit was used to pay off approximately $562,000, which
was the remaining outstanding balance on the bridge loan with
Agility.  See Note 7.




During
the nine months ended September 30, 2008, we continued to invest in product
development. Our efforts have been directed toward continual improvement of our
secure content management appliances and system protection products. In
addition, we have developed the next generation of Hybrid Solutions and the
integration of our iPrism and LivePrism products.




Critical
Accounting Policies and Estimates




There are
several accounting policies that are critical to understanding our historical
and future performance.  These policies affect the reported amounts of
revenue and other significant areas in our reported financial statements and
involve management’s judgments and estimates. These critical accounting policies
and estimates include:




•
            revenue
      recognition;




•
            warranty
      liability;




•
            allowance
      for doubtful accounts;




•
            impairment
      of goodwill and long-lived assets;




•
            accounting
      for income taxes; and




•
            accounting
      for stock options.




Please
refer to the” Management’s Discussion and Analysis of Financial Condition and
Results of Operation” located within our 10-KSB filed on March 20, 2008 for the
year ended December 31, 2007 for further discussion of our  “Summary
of Significant Accounting Policies and Estimates”. There have been no material
changes to these accounting policies during the nine months ended September 30,
2008.




Results
of Operations of St. Bernard







Comparisons
of the Three Months Ended September 30, 2008 and 2007 (in millions, except
percentages)




Revenues




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      revenues
            
            $
            4.4
            
            
            $
            4.5
            
            
            
            (2.2
            )%










16












Revenues
decreased $0.1 million for the three months ended September 30, 2008, compared
to the same period in 2007, primarily due to an increase of $0.5 million in our
core product line revenue, which includes iPrism, offset by a decrease of $0.6
million in our UpdateEXPERT and Open File Manager revenue. We sold the
UpdateEXPERT product line to Shavlik Technologies, LLC, (“Shavlik”) in January
2007, and we sold the Open File Manager product line to EVault, Inc., a wholly
owned subsidiary of Seagate Technology, Inc., (“EVault”) in August 2007. See
discussion of changes in subscription revenues, appliance revenues, and license
revenues below.




Subscription
Revenues




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeSubscription
      revenues
            
            $
            3.5
            
            
            $
            3.6
            
            
            
            (2.8
            )%As
      a percentage of revenues
            
            
            79.5
            %
            
            
            80.0
            %




For the
three months ended September 30, 2008, our subscription revenues decreased $0.1
million compared to the same period in 2007 primarily due to an increase of $0.2
million in our core product line revenue, which includes iPrism, offset by a
decrease of $0.3 million in revenue resulting from the sale in January 2007 and
August 2007, respectively, of our UpdateEXPERT and Open File Manager product
lines. We expect our subscription revenues to increase in future periods through
increases to the customer base of our core product lines. The subscription
renewal rates for our products traditionally range from 75% to 95%.




Appliance
Revenues




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeAppliance
      revenues
            
            $
            0.9
            
            
            $
            0.6
            
            
            
            50.0
            %As
      a percentage of revenues
            
            
            20.5
            %
            
            
            13.3
            %




For the
three months ended September 30, 2008, appliance revenue increased approximately
$0.3 million compared to the same period in 2007. This increase is the result of
additional units shipped, as well as the higher selling price of our h-series
appliances. We have seen a noticeable shift in customer demand toward the
higher-end models during 2008. We expect appliance revenue to continue to
increase in future periods due to the increased efforts of our sales team to
upsell our customers these appliances which are designed to enhance the iPrism
web filtering capabilities.




License
Revenues




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeLicense
      revenues
            
            $
            0.0
            
            
            $
            0.3
            
            
            
            (100.0
            )%As
      a percentage of revenues
            
            
            0.0
            %
            
            
            6.7
            %










17












For the
three months ended September 30, 2008 our net license revenues were almost
non-existent decreasing  approximately $0.3 million compared to the
same period in 2007.  This decrease was due primarily to the loss of
UpdateEXPERT and Open File Manager license revenues resulting from the sale of
these product lines in 2007. We do not anticipate significant license revenues
in future periods.




Cost
of Revenues




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      cost of revenues
            
            $
            1.2
            
            
            $
            1.3
            
            
            
            (7.7
            )%Gross
      margin percent
            
            
            72.7
            %
            
            
            71.1
            %




Cost of
revenues consist primarily of the cost of contract manufactured hardware,
royalties paid to third parties under technology licensing agreements, packaging
costs, fee-based technical support costs and freight. Cost of revenues decreased
$0.1 million for the three months ended September 30, 2008 compared to the same
period in 2007 while gross margin increased 1.6%.  This is primarily
due to a decrease in the costs associated with subscription revenue, which
includes direct subscription and payroll costs for the technical operations
group that maintains the various databases and the technical support group,
offset by an increase in the costs of appliance revenues. See the discussion of
changes in the cost of subscription and appliance revenue below.




Cost
of Subscription Revenues




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      cost of subscription revenues
            
            $
            0.5
            
            
            $
            0.9
            
            
            
            (44.4
            )%Gross
      margin percent
            
            
            85.7
            %
            
            
            75.0
            %




The cost
of subscription revenues includes the technical operations group that maintains
the various databases and the technical support group. Due to the sale of
UpdateEXPERT and Open File Manager in January and August 2007, respectively,
costs related to these two product lines were non-existent for the three months
ended September 30, 2008. In addition, payroll and other direct expenses related
to our core product line, which includes iPrism, decreased in the three months
ended September 30, 2008 compared to the same period in 2007 due primarily to a
reduction in workforce.




Cost
of Appliance Revenues




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      cost of appliance revenues
            
            $
            0.6
            
            
            $
            0.4
            
            
            
            50.0
            %Gross
      margin percent
            
            
            33.3
            %
            
            
            33.3
            %










18












The cost
of appliance revenues, which includes contract manufactured equipment,
packaging, and freight, increased $0.2 million for the three months ended
September 30, 2008 compared to the same period in 2007. This increase is due to
the fact that we shipped out more appliance units during the period ended
2008.




Sales
and Marketing




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      sales and marketing
            
            $
            1.8
            
            
            $
            2.8
            
            
            
            (35.7
            )%As
      a percentage of revenues
            
            
            40.9
            %
            
            
            62.2
            %




Sales and
marketing expenses consist primarily of salaries and related benefits,
commissions, consultant fees, advertising, lead generation and other costs
associated with our sales and marketing efforts. For the three months ended
September 30, 2008, the sales and marketing expenses decreased 35.7%, or $1.0
million, over the same period in 2007. The decrease was attributable to our cost
reduction efforts and the closure of our sales offices in Europe and Australia
during the fourth quarter of 2007. The most significant decreases include
compensation and consulting expenses of $0.5 million and advertising expenses of
$0.5 million.




Research
and Development




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      research and development
            
            $
            0.6
            
            
            $
            1.2
            
            
            
            (50.0
            )%As
      a percentage of revenues
            
            
            13.6
            %
            
            
            26.7
            %




Research
and development expense consists primarily of salaries and related benefits,
third-party consultant fees and other engineering related costs. The decrease of
$0.6 million for the three months ended September 30, 2008 compared to the same
period in 2007 was primarily the result of a decrease in compensation expenses
related to layoffs and the sale of UpdateExpert and Open File Manager. In total,
we hade 18 fewer research and development employees for the period ended
September 30, 2008 versus the same period in 2007.




We
anticipate research and development expenses to increase for the remainder of
2008 and to an even greater extent in 2009 as we extend the core functionality
and features within our core products.





19







General
and Administrative




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      general and administrative
            
            $
            1.3
            
            
            $
            1.7
            
            
            
            (23.5
            )%As
      a percentage of revenues
            
            
            29.5
            %
            
            
            37.8
            %




General
and administrative expenses, which consist primarily of salaries, related
benefits, and fees for professional services, such as legal and accounting
services, decreased $0.4 million for the three months ended September 30, 2008,
compared to the same period in 2007, due to our extensive cost cutting efforts.
The most significant decreases in the third quarter of 2008 included decreases
in compensation expenses of $0.1 million, lease and rent expenses of $0.1
million, and legal and insurance costs of $0.1 million.




Impairment




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      impairment
            
            $
            0.0
            
            
            $
            3.3
            
            
            
            (100.0
            )%As
      a percentage of revenues
            
            
            0.0
            %
            
            
            73.3
            %




An
impairment charge of $3.3 million was recorded at September 30, 2007 to
write-down the intangible assets related to the acquisition of AgaveOne to
zero.  No such write-downs occurred during the quarter ended September
30, 2008.




Interest
and Other Income, Net




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007Total
      interest and other income, net
            
            $
            0.2
            
            
            $
            0.0As
      a percentage of revenues
            
            
            4.5
            %
            
            
            0.0
            %




Interest
and other income, net, includes interest expense, interest income, and other
income. The increase for the three months ended September 30, 2008 over the same
period in 2007 was due to the gain on the settlement of trade payables, offset
by an increase in interest expense due to the increase in short-term
borrowings.




Gain
on Sale of Assets




For
      theThree
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeGain
      on sale of assets
            
            $
            0.2
            
            
            $
            8.0
            
            
            
            (97.5
            )%As
      a percentage of revenues
            
            
            4.5
            %
            
            
            177.8
            %










20










The gain
on the sale of assets for the three months ended September 30, 2008 was $0.2
million as compared to approximately $8.0 million for the same period in 2007.
During the first and third quarter of fiscal year 2007, we sold our UpdateExpert
product line to Shavlik and Open File Manager product line to EVault and
recognized a gain of approximately $ 3.6 million and $7.9 million, respectively.
The gain for the three months ended September 30, 2008 consisted of the release
of funds from an indemnification escrow as a result of the sale of the Open File
Manager product.




Comparisons
of the Nine Months Ended September 30, 2008 and 2007 (in millions, except
percentages)




Revenues




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      revenues
            
            $
            12.9
            
            
            $
            14.9
            
            
            
            (13.4
            )%




Revenues
decreased $2.0 million for the nine months ended September 30, 2008, compared to
the same period in 2007 primarily due to an increase of $1.6 million in our core
product line revenue, which includes iPrism, offset by a decrease of $3.6
million in our UpdateEXPERT and Open File Manager revenues. We sold the
UpdateEXPERT product line to Shavlik in January 2007, and we sold the Open File
Manager product line to EVault in August 2007. See discussion of changes in
subscription revenues, appliance revenues, and license revenues
below.




Subscription
Revenues




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeSubscription
      revenues
            
            $
            10.3
            
            
            $
            11.0
            
            
            
            (6.4
            )%As
      a percentage of revenues
            
            
            79.8
            %
            
            
            73.8
            %




For the
nine months ended September 30, 2008, our subscription revenues decreased $0.7
million compared to the same period in 2007 primarily due to an increase of $1.3
million in our core product line revenue, which includes iPrism, offset by a
decrease of $2.0 million in revenue resulting from the sale in January 2007 and
August 2007, respectively, of our UpdateEXPERT and Open File Manager product
lines. We expect our subscription revenues to increase in future periods through
increases to our customer base in our core product lines. The subscription
renewal rates for our products traditionally range from 75% to 95%.




Appliance
Revenues




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeAppliance
      revenues
            
            $
            2.7
            
            
            $
            2.2
            
            
            
            22.7
            %As
      a percentage of revenues
            
            
            20.9
            %
            
            
            14.8
            %










21







For the
nine months ended September 30, 2008, appliance revenues increased approximately
$0.5 million compared to the same period in 2007.  Although we shipped
slightly fewer appliance units during the nine months ended September 30, 2008
compared to the same period in 2007, the increase in revenue is attributed to
the higher selling price of our h-series appliances. We have seen a noticeable
shift in customer demand toward the higher-end models during 2008. We expect
appliance revenue to continue to increase in future periods due to the increased
efforts of our sales team to upsell our customers these appliances, which are
designed to enhance the iPrism web filtering capabilities.




License
Revenues




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeLicense
      revenues
            
            $
            0.0
            
            
            $
            1.7
            
            
            
            (100.0
            )%As
      a percentage of revenues
            
            
            0.0
            %
            
            
            11.4
            %




For the
nine months ended September 30, 2008 our net license revenues were almost
non-existent decreasing approximately $1.7 million compared to the same period
in 2007.  This decrease was due primarily to the loss of UpdateEXPERT
and Open File Manager license revenues resulting from the sale of these product
lines in 2007. We do not anticipate significant license revenue in future
periods.




Cost
of Revenues






For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      cost of revenues
            
            $
            3.5
            
            
            $
            4.8
            
            
            
            (27.1
            )%Gross
      margin percent
            
            
            72.9
            %
            
            
            67.8
            %




Cost of
revenues consist primarily of the cost of contract manufactured hardware,
royalties paid to third parties under technology licensing agreements, packaging
costs, fee-based technical support costs and freight. Cost of revenues decreased
$1.3 million for the nine months ended September 30, 2008 compared to the same
period in 2007. Gross margin increased 5.1% for the nine months ended September
30, 2008 compared to the same period in 2007, primarily due to a decrease in the
costs associated with subscription revenues, which includes direct subscription
costs and payroll costs for the technical operations group that maintains the
various databases and the technical support group, offset by an increase in the
costs of appliance revenues. See the discussion of changes in the cost of
subscription and appliance revenues below.





22







Cost
of Subscription Revenues




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      cost of subscription revenues
            
            $
            1.7
            
            
            $
            3.0
            
            
            
            (43.3
            )%Gross
      margin percent
            
            
            83.5
            %
            
            
            72.7
            %




The cost
of subscription revenues includes the technical operations group that maintains
the various databases and the technical support group. Due to the sale of
UpdateEXPERT and Open File Manager in January and August 2007, respectively,
costs related to these two product lines were non-existent for the nine months
ended September 30, 2008. In addition, payroll and other direct expenses related
to our core product line, which includes iPrism, decreased in the nine months
ended September 30, 2008 compared to the same period in 2007 due primarily to a
reduction in workforce.




Cost
of Appliance Revenues




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      cost of appliance revenues
            
            $
            1.8
            
            
            $
            1.7
            
            
            
            5.9
            %Gross
      margin percent
            
            
            33.3
            %
            
            
            22.7
            %




The cost
of appliance revenues, which includes contract manufactured equipment, packaging
and freight, increased $0.1 million  for the nine months ended
September 30, 2008 compared to the same period in 2007.  While the
increase is attributed to the higher cost of our new, higher-end h-series
appliances, the increase of 10.6% in our gross margin percentage is due to the
higher gross margin earned on these same appliances.




Sales
and Marketing




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      sales and marketing
            
            $
            5.7
            
            
            $
            10.3
            
            
            
            (44.7
            )%As
      a percentage of revenues
            
            
            44.2
            %
            
            
            69.1
            %




Sales and
marketing expenses consist primarily of salaries, related benefits, commissions,
consultant fees, advertising, lead generation and other costs associated with
our sales and marketing efforts. For the nine months ended September 30, 2008,
the sales and marketing expenses decreased 44.7%, or $4.6 million, over the same
period in 2007. The decrease was attributable to our cost reduction efforts and
the closure of our sales offices in Europe and Australia during the fourth
quarter of 2007. The most significant decreases include compensation and
consulting expenses of $3.1 million and advertising expenses of $1.5
million.





23







Research
and Development




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      research and development
            
            $
            2.1
            
            
            $
            4.8
            
            
            
            (56.3
            )%As
      a percentage of revenues
            
            
            16.3
            %
            
            
            32.2
            %




Research
and development expense consists primarily of salaries, related benefits,
third-party consultant fees and other engineering related costs. The decrease of
$2.7 million for the nine months ended September 30, 2008 compared to the same
period in 2007 was primarily the result of a decrease in compensation expenses
related to layoffs and the sale of UpdateExpert and Open File Manager. In total,
we had 18 fewer research and development employees for the period ended
September 30, 2008 versus the same period in 2007. Management believes that a
significant investment in research and development is required to remain
competitive and we expect to continue to invest in research and development
activities.




We
anticipate research and development expenses to increase for the remainder of
2008 and to an even greater extent in 2009 as we extend the core functionality
and features within our core products.




General
and Administrative




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      general and administrative
            
            $
            3.9
            
            
            $
            6.6
            
            
            
            (40.9
            )%As
      a percentage of revenues
            
            
            30.2
            %
            
            
            44.3
            %




General
and administrative expenses, which consist primarily of salaries and related
benefits, and fees for professional services, such as legal and accounting
services, decreased $2.7 million for the nine months ended September 30, 2008,
compared to the same period in 2007, mainly due to our extensive cost cutting
efforts. The most significant decreases in 2008 included decreases in
compensation and consulting expenses of $1.0 million, accounting, legal, and
insurance costs of $0.7 million, lease and rent expenses of $0.3 million, and
utilities expense of $0.2 million.




Impairment




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeTotal
      impairment
            
            $
            0.0
            
            
            $
            3.3
            
            
            
            (100.0
            )%As
      a percentage of revenues
            
            
            0.0
            %
            
            
            22.1
            %










24







An
impairment charge of $3.3 million was recorded at September 30, 2007 to
write-down the intangible assets related to the acquisition of AgaveOne to
zero.  No such write-downs occurred during the nine months ended
September 30, 2008.




Interest
and Other Income, Net




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007Total
      interest and other income, net
            
            $
            0.1
            
            
            $
            0.0As
      a percentage of revenues
            
            
            0.8
            %
            
            
            0.0
            %




Interest
and other income, net, includes interest expense, interest income, and other
income. The increase for the nine months ended September 30, 2008 over the same
period in 2007 was due to the gain on the settlement of trade payables, offset
by an increase in interest expense due to the increase in short-term
borrowings.




Gain
on Sale of Assets




For
      theNine
      Months EndedSeptember
      30,2008
            
            
            2007
            
            
            % ChangeGain
      on sale of assets
            
            $
            0.6
            
            
            $
            11.4
            
            
            
            (94.7
            )%As
      a percentage of revenues
            
            
            4.7
            %
            
            
            76.5
            %




The gain
on the sale of assets for the nine months ended September 30, 2008 was $0.6
million as compared to approximately $11.4 million for the same period in 2007.
During the first and third quarter of fiscal year 2007, we sold our UpdateExpert
product line to Shavlik and our Open File Manager product line to EVault
recognizing a gain of approximately $ 3.6 million and $7.8 million,
respectively. The gain for the nine months ended September 30, 2008 consisted
primarily of funds released from an indemnification escrow as a result of the
sale of the Open File Manager product.







Recent
Accounting Pronouncements




In
May 2008, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 162, “The Hierarchy of Generally Accepted
Accounting Principle”(“SFAS 162”).  SFAS 162 will provide
framework for selecting accounting principles to be used in preparing financial
statements that are presented in conformity with U.S. GAAP for nongovernmental
entities.  SFAS 162 will be effective 60 days following the Securities
and Exchange Commission's approval of the Public Company Accounting Oversight
Board (PCAOB) amendments to AU Section 411.  We are currently
evaluating the impact, if any, this statement will have on our financial
position, cash flows, or results of operations.




In April
2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of Useful Life of
Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors
that should be considered in developing the renewal or extension assumptions
used to determine the useful life of a recognized intangible asset under FAS
142, “Goodwill and Other
Intangible Assets.” FSP FAS 142-3 also requires expanded disclosure
related to the determination of intangible asset useful lives. FSP FAS 142-3 is
effective for fiscal years beginning after December 15, 2008. Earlier adoption
is not permitted. We do not expect FSP FAS 142-3 to have a material impact on
our financial statements.





25







On
February 15, 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities” (“SFAS 159”). SFAS No. 159 permits
all entities to choose, at specified election dates, to measure eligible items
at fair value (the “fair value option”). A business entity shall report
unrealized gains and losses on items for which the fair value option has been
elected in earnings (or another performance indicator if the business entity
does not report earnings) at each subsequent reporting date. Upfront costs and
fees related to items for which the fair value option is elected shall be
recognized in earnings as incurred and not deferred. We adopted SFAS 159 on
January 1, 2008.  The adoption of SFAS 159 did not have a material
impact on our financial position, cash flows, or results of
operations.




In
September 2006, FASB issuedSFAS No. 157,
“Fair Value Measurements”(“SFAS 157”). This Statement defines fair value, establishes a framework
for measuring fair value in U.S. GAAP, and expands disclosures about fair value
measurements. This statement applies in those instances where other
accounting pronouncements require or permit fair value measurements and the
board of directors has previously concluded in those accounting pronouncements
that fair value is the relevant measurement attribute. Accordingly, this
statement does not require any new fair value measurements. However, for some
entities, the application of this Statement will change the current practice. In
February 2008, the FASB issued FSP FAS 157-2 which defers the effective date of
SFAS 157 for all non-financial assets and liabilities, except those items
recognized or disclosed at fair value on an annual or more frequent recurring
basis, until years beginning after November 15, 2008.  Our adoption of
SFAS 157 for our financial assets and liabilities on January 1, 2008 did not
have a material impact on our financial position, cash flows, or results of
operations. We are currently reviewing the adoption requirements related to our
non-financial assets and liabilities and have not yet determined the impact, if
any, this will have on our financial position, cash flows, or results of
operations.




Liquidity
and Capital Resources




Cash
Flows




Our
largest source of operating cash flows is cash collections from our customers
for purchases of products, subscription, maintenance and technical support. Our
standard payment terms for both subscription and support invoices are net 30
days from the date of invoice. The recurring revenue subscription portion of our
business is a mainstay of the cash flow we generate. Our primary uses of cash
for operating activities include personnel and facilities, related expenditures
and technology costs, as well as costs associated with outside support and
services.




Cash used
in operations for the nine months ended September 30, 2008 was $1.9 million
compared to cash used during the nine months ended September 30, 2007 of $9.7
million. The net decrease in use of cash was due primarily to lower operating
losses and substantial changes to the cost structure of our
business.





Cash
flows provided by investing activities for the nine months ended September 30,
2008 and 2007 was $0.6 million and $7.0 million, respectively. The cash provided
by investing activities as of September 30, 2008 included the $500,000 payment
for the “Holdback Amount” by EVault in satisfaction of the signed agreement
between EVault and the Company for the sale of the Open File Manager product
line.




Cash
flows provided by financing activities for the nine months ended September 30,
2008 and 2007 was $0.8 million and $0.7 million, respectively. The increase in
cash provided by financing activities in the third quarter of 2008 was primarily
from the net increase in short-term borrowings.




As a
result of the foregoing, the net decrease in cash and cash equivalents was $0.6
million for the nine months ended September 30, 2008 as compared to a net
decrease in cash of approximately $2.0 million for the comparable period in
2007.





26







Losses
from Operations – Liquidity




As of
September 30, 2008, we had approximately $0.7 million of cash and cash
equivalents and a working capital deficit of $10.7 million.  Operating
losses for the three and nine months ended September 30, 2008 were $0.5 million
and $2.3 million, respectively. During the nine months ended September 30, 2008,
we reported a realized gain of $0.5 million from the release of funds from an
indemnification escrow resulting from the sale of the Open File Manager product
in the third quarter of 2007. As a result, we had a net loss of $0.5 million and
$1.8 million for the three and nine months ended September 30,
2008.




At
September 30, 2008, we had a stockholders’ deficit of approximately $8.8
million. Our expenses consist primarily of expenses that can be modified to meet
our operating needs should management deem that changes are necessary. In
addition, approximately $10.4 million of our current liability balance at
September 30, 2008 consists of deferred revenues, which represents amounts that
will be amortized into revenue as they are earned.




The
Company has a history of losses and has yet not been able to achieve
profitability.  For the three and nine months ended September 30,
2008, we incurred net losses of $0.5 million and $1.8 million, respectively, and
through September 30, 2008 recorded a cumulative net loss of $49.0 million.
During the fourth quarter of 2007 and through the second quarter of 2008, we
made substantial changes to the cost structure of its business. These changes
included the closure of its sales and marketing offices within Europe and
Australia, reducing headcount to be in line with the current size of its
business, renegotiating vendor contracts, and refocusing its marketing strategy
around its core business. In addition to these changes, the Company also entered
into a Loan Agreement with PFG in July 2008. See Note 3.




The
Company believes that its existing cash resources, combined with projected
billings, implemented cost reductions, and borrowing availability under existing
credit facilities, will provide sufficient liquidity for us to meet our
continuing obligations for the next twelve months. However, there can be no
assurances that projected revenue will be achieved or the improvement in
operating results will occur. In the event cash flow from operations is not
sufficient, we may require additional sources of financing in order to maintain
our current operations. These additional sources of financing may include public
or private offerings of equity or debt securities. Whereas management believes
it will have access to these financing sources, no assurance can be given that
additional sources of financing will be available on acceptable terms, on a
timely basis, or at all.




Credit
Facility




On
May 15, 2007, the Company entered into a Loan and Security Agreement with
Silicon Valley Bank, a California corporation (“SVB”) which was subsequently
amendedon
January 25, 2008.  Pursuant to the terms of the amendment, among
other things, SVB (i) refinanced the existing term loan with the proceeds
of an advance under the revolving line of credit (and terminated the term loan
facility), (ii) reduced the revolving line of credit provided to St.
Bernard to an amount not to exceed $2,000,000, (iii) increased the interest
rate on the revolving line of credit to 3% (from 2%) over the greater of the
prime rate or 7.5%, (iv) modified the tangible net worth covenant, and
(v) took a security interest in St. Bernard’s intellectual property. At
September 30, 2008, the effective interest rate was 10.5%. At September 30, 2008
the Company was in compliance with the above stated covenants and
restrictions.




In
connection with the execution of the SVB Loan Amendment, St. Bernard issued
warrants to SVB which allows SVB to purchase up to 140,350 shares of our common
stock at an exercise price of $0.57 per share. The warrants expire on the
seventh anniversary of their issue date. We recorded deferred debt issue costs
in the amount of $58,000, based on the estimated fair value allocated to the
warrants using the following assumptions; 75.35% volatility, risk free interest
rate of 3.61%, an expected life of seven years and no
dividends.  Amortization of the debt issuance costs, including amounts
recorded as a debt discount for warrants previously issued for three and nine
months ended September 30, 2008, which is being recorded as interest expense,
was approximately $23,000 and $81,000, respectively. Furthermore, St. Bernard
agreed to grant SVB certain piggyback registration rights with respect to the
shares of common stock underlying the warrants. As of September 30, 2008, the
balance on the line of credit with SVB was $1.7 million.





27







Bridge
Loan




On
January 25, 2008, St. Bernard Software, Inc. entered into a Loan Agreement (the
"Agility Loan Agreement") with Agility. Pursuant to the terms of the Agility
Loan Agreement, Agility provided St. Bernard with a non-revolving term loan in
the amount of $750,000, at a 15% fixed interest rate (the “Agility Loan”).
Beginning March 1, 2008, and on the first day of each month thereafter until
July 1, 2008, St. Bernard was required to pay to Agility $25,000 plus accrued
but unpaid interest. Beginning July 1, 2008, and on the first day of each month
thereafter, St. Bernard was required to pay Agility $50,000 plus accrued
interest.  The obligations under the Agility Loan Agreement were
secured by substantially all of St. Bernard's assets subordinated by the SVB
Loan Amendment.




In July
2008, the entire outstanding balance on the Agility Loan was paid using the
proceeds from a new loan (See Note 3).




In
connection with the execution of the Agility Loan Agreement, St. Bernard issued
warrants to Agility (the "Agility Warrants"), which allows Agility to purchase
up to 463,500 shares of our common stock at an exercise price equal to $0.57 per
share. The Agility Warrants expire on the seventh anniversary of their issue
date. The Company estimated the fair value of the warrants to be $189,000 using
the following assumptions; 75.35% volatility, risk free interest rate of 3.61%,
an expected life of seven years and no dividends.  In accordance with
Accounting Principles Board Opinion No. 14, the relative fair value of the
warrants, estimated to be approximately $151,000, was recorded as debt
discount.   Amortization of the debt discount for three and nine
months ended September 30, 2008, which is being recorded as interest expense,
was approximately $89,000 and $151,000, respectively. The Agility Warrants
contains anti-dilution protection in the event of a debt or equity financing,
with respect to the exercise price and number of shares. Furthermore, St.
Bernard granted Agility piggyback registration rights with respect to the shares
of common stock underlying the Agility Warrants.




On July
21, 2008, we entered into a Loan Agreement with Partners for Growth II, LP
(“PFG”), which became effective on July 23, 2008. Pursuant to the terms of the
PFG Loan Agreement, PFG provided St. Bernard with a revolving line of credit in
an amount not to exceed the lesser of (a) $1,500,000 at any one time outstanding
or (b) up to 30% of the amount of St. Bernard’s aggregate Eligible Billings (as
defined in the PFG Loan Agreement) over a rolling three month period calculated
monthly.




The
annual interest rate on the PFG Loan is set at the Prime Rate, quoted by SVB as
its Prime Rate from time to time, plus 3% (the “Applicable Rate”).  At
September 30, 2008, the effective interest rate was 8%. St. Bernard is required
to maintain a minimum borrowing amount of at least $750,000 (the “Minimum
Borrowing Amount”) or pay PFG a minimum interest amount (the “Minimum Interest
Amount”) equal to $750,000, multiplied by the Applicable Rate, and further
multiplied by the number of days (based on a 360-day year) from the date of such
failure to maintain the Minimum Borrowing Amount to the Maturity Date (as
defined in the PFG Loan Agreement).  Pursuant to the terms of the PFG
Loan Agreement, St. Bernard paid PFG a one-time commitment fee of $30,000 and
agreed to reimburse PFG for PFG’s reasonable attorneys’ fees in connection with
the negotiation of the PFG Loan Agreement.




Subject
to the requirement to maintain the Minimum Borrowing Amount or pay the Minimum
Interest Amount, St. Bernard may borrow, repay and reborrow from time to time
until the Maturity Date. Proceeds of the initial loan amount were used to pay
all indebtedness owing to Agility, with the remaining amount to be used for
working capital.




The PFG
Loan Agreement will terminate on July 20, 2010, on which date all principal,
interest and other outstanding monetary obligations must be repaid to PFG. The
obligations under the PFG Loan Agreement are secured by a security interest in
collateral comprised of substantially all of St. Bernard’s assets, subordinated
by the SVB Loan Agreement.




The PFG
Loan Agreement contains affirmative, negative and financial covenants customary
for credit facilities of this type, including, among other things, limitations
on indebtedness, liens, sales of assets, mergers, investments, and
dividends.  The PFG Loan Agreement also requires that St. Bernard
maintain a Modified Net Income (as defined in the PFG Loan Agreement) greater
than zero. The PFG Loan Agreement contains events of default customary for
credit facilities of this type (with customary grace or cure periods, as
applicable) and provides that upon the occurrence and during the continuance of
an event of default, among other things, the interest rate on all borrowings
will be increased, the payment of all borrowings may be accelerated, PFG’s
commitments may be terminated and PFG shall be entitled to exercise all of its
rights and remedies, including remedies against collateral.  At
September 30, 2008, the Company was in compliance with the above stated
covenants.





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In
connection with the execution of the PFG Loan Agreement, St. Bernard issued a
warrant to PFG on July 21, 2008 (the “Warrant”), which allows PFG to purchase up
to 450,000 shares of St. Bernard common stock at an exercise price equal to
$0.46 per share. The Warrant expires on July 20, 2013.  We recorded
deferred debt issue costs in the amount of $125,000, based on the estimated fair
value allocated to the warrants using the following assumptions; 69.07%
volatility, risk free interest rate of 4.09%, an expected life of five years and
no dividends. Amortization of the debt issuance costs for three months ended
September 30, 2008, which is being recorded as interest expense, was
approximately $12,000. As of September 30, 2008, the balance on the PFG Loan
Agreement was $750,000.




Off-Balance
Sheet Arrangements




Except
for the commitments arising from our operating lease arrangements, we have no
other off-balance sheet arrangements that are reasonably likely to have a
material effect on our financial statements.




Asset
Sale/Purchase and License Agreements




On
January 29, 2007, pursuant to the terms of an Asset Sale and License
Agreement signed and effective as of January 4, 2007, by and between the
Company and Shavlik, we assigned and sold to Shavlik our UpdateEXPERT and
UpdateEXPERT Premium software applications and related customer and end user
license agreements, software, programming interfaces and other intellectual
property rights and contracts for an aggregate purchase price of $1.2 million
plus 45% of any maintenance renewal fees collected by Shavlik in excess of $1.2
million for renewals invoiced by Shavlik between February 1, 2007 and
January 31, 2008 (the “Asset Sale”). As result, we realized a gain of
approximately $70,000 during the nine months ended September 30,
2008.




On August
14, 2007, pursuant to the terms of a Purchase Agreement signed and effective as
of August 13, 2007 , by and between the Company and EVault, we assigned and
sold to EVault our Open File Manager (the “Product”) software applications,
which included all of our rights, title, and interest worldwide in and to (i)
the Product, (ii) the assumed contracts, (iii) the Company Materials (as defined
in the agreement), (iv) all the Company Intellectual Property Rights, (v) all
claims of the Company against third parties relating to the Purchased Assets,
(vi) all data and information collected from, or on behalf of, customers of the
Company who were party to the assumed contracts (the “Customer Base”), the OEM
Partners and any Lead, including to the extent that receipt of such information
would not violate any applicable Law, (vii) all routing and billing information
and components used in connection with the Assumed Contracts, and (viii) all
other tangible or intangible assets of the Company used in the Business and
necessary for the operation or use of the Product for an aggregate purchase
price of $6.9 million. During the nine months ended September 30, 2008, we
realized a gain of $500,000 as payment of the “Holdback Amount” by EVault in
satisfaction of Article 8 of the signed agreement between EVault and the
Company.




Item 3.  Quantitativeand Qualitative Disclosures About Market
Risk




As a
Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in
item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations and therefore are not required to provide the information requested
by this Item.




Item 4(T).  Controlsand Procedures




Evaluation
of Disclosure Controls




We
maintain "disclosure controls and procedures," as such term is defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), that are designed to ensure that information
required to be disclosed by us in reports that we file or submit under the
Exchange Act is recorded, processed, summarized, and reported within the time
periods specified in Securities and Exchange Commission rules and forms, and
that such information is accumulated and communicated to our management,
including our Chief Executive Officer (and Acting Chief Financial Officer), as
appropriate, to allow timely decisions regarding required disclosure. In
designing and evaluating our disclosure controls and procedures, management
recognizes that disclosure controls and procedures, no matter how well conceived
and operated, can provide only reasonable, not absolute, assurance that the
objectives of the disclosure controls and procedures are met. Additionally, in
designing disclosure controls and procedures, our management was required to
apply its judgment in evaluating the cost-benefit relationship of possible
disclosure controls and procedures. The design of any disclosure controls and
procedures is also based in part upon 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.





29







Based on
his evaluation as of the end of the period covered by this Quarterly Report on
Form 10-Q and subject to the foregoing, our Chief Executive Officer (and
Acting Chief Financial Officer) has concluded that our disclosure controls and
procedures were effective.




Changes
in Internal Control over Financial Reporting




During
the period covered by this report, there were no changes in our internal control
over financial reporting that have materially affected, or are reasonably likely
to materially affect, our internal control over financial
reporting.






PART
II – OTHERINFORMATION




Item 1.
            LegalProceedings




In the
normal course of business, the Company is occasionally named as a defendant in
various lawsuits. On March 14, 2007, a stockholder filed an action against the
Company seeking money damages in the San Diego Superior Court for the County of
San Diego, asserting claims of intentional misrepresentation, negligent
misrepresentation, fraudulent concealment, and negligence. The Company has
successfully appealed the Superior Court's denial of its motion to compel
arbitration. The Company intends to vigorously defend its interests in this
matter and expects that the resolution of this matter will not have a material
adverse effect on its business, financial condition, results of operations, or
cash flows. However, due to the uncertainties in litigation, no assurance can be
given as to the outcome of these proceedings.







Item 1A.
            RiskFactors




As a
Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in
item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations and therefore are not required to provide the information requested
by this Item.





30












Item 6.
            Exhibits




3.1
            
            Amended
      and Restated Certificate of Incorporation of St. Bernard Software, Inc.
      (formerly known as Sand Hill IT Security Acquisition Corp.) (incorporated
      herein by reference to Exhibit 3.1.1 to the Company’s Registration
      Statement on Form S-4 initially filed with the Securities and Exchange
      Commission on December 16, 2005).3.2
            
            Amended
      and Restated Bylaws of St. Bernard Software, Inc. (formerly known as Sand
      Hill IT Security Acquisition Corp.) (incorporated herein by reference to
      Exhibit 3.1 to the Company’s Current Report on Form 8-K initially filed
      with the Securities and Exchange Commission on April 5,
    2007)4.1
            
            Specimen
      Unit Certificate of St. Bernard Software, Inc. (formerly known as Sand
      Hill IT Security Acquisition Corp.) (incorporated herein by reference to
      Exhibit 4.1 to the Company’s Amendment No. 2 to the Registration
      Statement on Form S-1 (File No. 333-114861) filed with the Securities and
      Exchange Commission on June 23, 2004).4.2
            
            Specimen
      Common Stock Certificate of St. Bernard Software, Inc. (formerly known as
      Sand Hill IT Security Acquisition Corp.) (incorporated herein by reference
      to Exhibit 4.2 to the Company’s Annual Report on Form 10-KSB filed with
      the Securities and Exchange Commission on March 20,
  2008).4.3
            
            Specimen
      Warrant Certificate of St. Bernard Software, Inc. (formerly known as Sand
      Hill IT Security Acquisition Corp.) (incorporated herein by reference to
      Exhibit 4.3 to the Company’s Amendment No. 2 to the Registration Statement
      on Form S-1 (File No. 333-114861) filed with the Securities and Exchange
      Commission on June 23, 2004).4.4
            
            Unit
      Purchase Option No. UPO-2 dated July 30, 2004, granted to Newbridge
      Securities Corporation (incorporated herein by reference to Exhibit 4.4.1
      to the Company’s Annual Report on Form 10-KSB filed with the Securities
      and Exchange Commission on March 31, 2005).4.5
            
            Unit
      Purchase Option No. UPO-3 dated July 30, 2004, granted to James E.
      Hosch (incorporated herein by reference to Exhibit 4.4.2 to the Company’s
      Annual Report on Form 10-KSB filed with the Securities and Exchange
      Commission on March 31, 2005).





4.6
            
            Unit
      Purchase Option No. UPO-4 dated July 30, 2004, granted to Maxim Group, LLC
      (incorporated herein by reference to Exhibit 4.4.3 to the Company’s Annual
      Report on Form 10-KSB filed with the Securities and Exchange Commission on
      March 31, 2005).4.7
            
            Unit
      Purchase Option No. UPO-5 dated July 30, 2004, granted to Broadband
      Capital Management, LLC (incorporated herein by reference to Exhibit 4.4.4
      to the Company’s Annual Report on Form 10-KSB filed with the Securities
      and Exchange Commission on March 31, 2005).4.8
            
            Unit
      Purchase Option No. UPO-6 dated July 30, 2004, granted to I-Bankers
      Securities Incorporated (incorporated herein by reference to Exhibit 4.4.5
      to the Company’s Annual Report on Form 10-KSB filed with the Securities
      and Exchange Commission on March 31, 2005).4.9
            
            Warrant
      issued by St. Bernard Software, Inc. on May 16, 2007 to Silicon Valley
      Bank (incorporated herein by reference to Exhibit 4.1 to the Company’s
      Current Report on Form 8-K filed with the Securities and Exchange
      Commission on May 23, 2007).4.10
            
            Warrant
      issued by St. Bernard Software, Inc. on January 25, 2008 to Agility
      Capital, LLC (incorporated herein by reference to Exhibit 4.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on January 31, 2008).4.11
            
            Warrant
      issued by St. Bernard Software, Inc. on January 25, 2008 to Silicon Valley
      Bank (incorporated herein by reference to Exhibit 4.2 to the Company’s
      Current Report on Form 8-K filed with the Securities and Exchange
      Commission on January 31, 2008).





31








4.12
            
            Warrant
      issued by St. Bernard Software, Inc. on July 21, 2008 to Partners for
      Growth II, L.P. (incorporated herein by reference to Exhibit 4.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on July 28, 2008).4.13
            
            Warrant
      Purchase Agreement between St. Bernard Software, Inc. and Partners for
      Growth II, L.P. dated July 21, 2008 (incorporated herein by reference to
      Exhibit 4.2 to the Company’s Current Report on Form 8-K filed with the
      Securities and Exchange Commission on July 28, 2008).10.1
            
            Loan And Security Agreement
      between St. Bernard Software, Inc. and Partners for Growth II, L.P. dated
      July 21, 2008 (incorporated herein by reference
      to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the
      Securities and Exchange Commission on July 28,
    2008).10.2
            
            Intellectual Property Security
      Agreement between St. Bernard Software, Inc. and Partners for Growth II,
      L.P. dated July 21, 2008 (incorporated herein by reference
      to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed with the
      Securities and Exchange Commission on July 28,
    2008).





31.1
            
            Certification
      of Chief Executive Officer and Acting Chief Financial Officer Pursuant to
      Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act
      of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
      of 2002.32.1
            
            Certification
      of Chief Executive Officer and Acting Chief Financial Officer Pursuant to
      18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002.





32















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.




ST.
      BERNARD SOFTWARE, INC.Date:  November
      12, 2008
            By:
            /s/
      Vincent
      RossiVincent
      Rossi
              Chief
      Executive Officer
              Acting
      Chief Financial Officer








































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