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 JUNE 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. Yes ý  No o




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 o
            Accelerated filer
      o
            Non-accelerated
      filer o
            Smaller
      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
August 12, 2008 there were 14,783,090 shares of the registrant’s common stock
outstanding.















ST.
BERNARD SOFTWARE, INC.


For the
Quarter Ended June 30, 2008


Form
10-Q


INDEX




PART I – Financial Information
            3Item 1.
            Consolidated Financial Statements
            3Item 2.
            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
            13Item 3.
            Quantitative and Qualitative Disclosures About Market
      Risk
            28Item 4(T).
            Controls and Procedures
            28PART II – Other Information
            29Item 1.
            Legal Proceedings
            29Item 1A.
            Risk Factors
            29Item 4.
            Submission of Matters to a Vote of Security
      Holders
            29Item 6.
            Exhibits
            30Signatures
            32









PART I – FINANCIAL INFORMATION




Item 1. Consolidated
Financial Statements


St.
Bernard Software, Inc.




Consolidated
Balance Sheets


June
      30, 2008
            
            
            December
      31, 2007(Unaudited)AssetsCurrent
      AssetsCash
      and cash equivalents
            
            $
            376,000
            
            
            $
            1,297,000Accounts
      receivable - net of allowance for doubtfulaccounts
      of $70,000 and $59,000 at June 30, 2008 and
            
            
            3,769,000
            
            
            
            3,255,000December
      31, 2007, respectivelyInventories
      - net
            
            
            345,000
            
            
            
            158,000Prepaid
      expenses and other current assets
            
            
            405,000
            
            
            
            440,000Total
      current assets
            
            
            4,895,000
            
            
            
            5,150,000Fixed
      Assets - Net
            
            
            1,016,000
            
            
            
            1,301,000Other
      Assets
            
            
            180,000
            
            
            
            215,000Goodwill
            
            
            7,568,000
            
            
            
            7,568,000Total
      Assets
            
            $
            13,659,000
            
            
            $
            14,234,000Liabilities
      and Stockholders’ DeficitCurrent
      LiabilitiesShort-term
      borrowings
            
            $
            2,462,000
            
            
            $
            1,566,000Accounts
      payable
            
            
            2,115,000
            
            
            
            3,026,000Accrued
      compensation expenses
            
            
            885,000
            
            
            
            1,188,000Accrued
      expenses and other current liabilities
            
            
            506,000
            
            
            
            406,000Current
      portion of capitalized lease obligations
            
            
            161,000
            
            
            
            153,000Deferred
      revenue
            
            
            9,885,000
            
            
            
            9,589,000Total
      current liabilities
            
            
            16,014,000
            
            
            
            15,928,000Deferred
      Rent
            
            
            157,000
            
            
            
            232,000Capitalized
      Lease Obligations, Less Current Portion
            
            
            88,000
            
            
            
            170,000Deferred
      Revenue
            
            
            6,146,000
            
            
            
            5,860,000Total
      liabilities
            
            
            22,405,000
            
            
            
            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;
      14,772,367 and 14,760,052 shares issuedand
      outstanding at June 30, 2008 and December 31, 2007,respectively
            
            
            148,000
            
            
            
            148,000Additional
      paid-in capital
            
            
            39,628,000
            
            
            
            39,079,000Accumulated
      deficit
            
            
            (48,522,000
            )
            
            
            (47,183,000
            )Total
      stockholders’ deficit
            
            
            (8,746,000
            )
            
            
            (7,956,000
            )Total
      Liabilities and Stockholders’ Deficit
            
            $
            13,659,000
            
            
            $
            14,234,000


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


3


St.
Bernard Software, Inc.
  Unaudited
Consolidated Statements of Operations
 Three
      months ended June 30,
                
                
                Six
      months ended June 30,2008
                
                
                2007
                
                
                2008
                
                
                2007RevenuesSubscription
                
                $
                3,427,000
                
                
                $
                3,600,000
                
                
                $
                6,731,000
                
                
                $
                7,372,000Appliance
                
                
                1,161,000
                
                
                
                882,000
                
                
                
                1,762,000
                
                
                
                1,627,000License
                
                
                12,000
                
                
                
                559,000
                
                
                
                16,000
                
                
                
                1,415,000Total
      Revenues
                
                
                4,600,000
                
                
                
                5,041,000
                
                
                
                8,509,000
                
                
                
                10,414,000Cost
      of RevenuesSubscription
                
                
                557,000
                
                
                
                1,023,000
                
                
                
                1,113,000
                
                
                
                2,099,000Appliance
                
                
                811,000
                
                
                
                779,000
                
                
                
                1,236,000
                
                
                
                1,337,000License
                
                
                4,000
                
                
                
                18,000
                
                
                
                5,000
                
                
                
                50,000Total
      Cost of Revenues
                
                
                1,372,000
                
                
                
                1,820,000
                
                
                
                2,354,000
                
                
                
                3,486,000Gross
      Profit
                
                
                3,228,000
                
                
                
                3,221,000
                
                
                
                6,155,000
                
                
                
                6,928,000Sales
      and marketing expenses
                
                
                2,065,000
                
                
                
                3,414,000
                
                
                
                3,881,000
                
                
                
                7,474,000Research
      and development expenses
                
                
                746,000
                
                
                
                1,789,000
                
                
                
                1,499,000
                
                
                
                3,647,000General
      and administrative expenses
                
                
                1,377,000
                
                
                
                2,441,000
                
                
                
                2,575,000
                
                
                
                4,870,000Total
      Operating Expenses
                
                
                4,188,000
                
                
                
                7,644,000
                
                
                
                7,955,000
                
                
                
                15,991,000Loss
      from Operations
                
                
                (960,000
                )
                
                
                (4,423,000
                )
                
                
                (1,800,000
                )
                
                
                (9,063,000
                )Other
      (Income) ExpenseInterest
      expense - net
                
                
                157,000
                
                
                
                59,000
                
                
                
                300,000
                
                
                
                72,000(Gain)
      loss on sale of assets
                
                
                -
                
                
                
                251,000
                
                
                
                (320,000
                )
                
                
                (3,463,000
                )Other
      income
                
                
                (180,000
                )
                
                
                -
                
                
                
                (444,000
                )
                
                
                (9,000
                )Total
      Other (Income) Expense
                
                
                (23,000
                )
                
                
                310,000
                
                
                
                (464,000
                )
                
                
                (3,400,000
                )Loss
      Before Income Taxes
                
                
                (937,000
                )
                
                
                (4,733,000
                )
                
                
                (1,336,000
                )
                
                
                (5,663,000
                )Income
      tax expense
                
                
                3,000
                
                
                
                -
                
                
                
                3,000
                
                
                
                4,000Net
      Loss
                
                $
                (940,000
                )
                
                $
                (4,733,000
                )
                
                $
                (1,339,000
                )
                
                $
                (5,667,000
                )Net
      Loss Per Common Share - Basic and Diluted
                
                $
                (0.06
                )
                
                $
                (0.32
                )
                
                $
                (0.09
                )
                
                $
                (0.38
                )Weighted
      Average Shares Outstanding - Basic and Diluted
                
                
                14,772,367
                
                
                
                14,764,512
                
                
                
                14,772,096
                
                
                
                14,779,434
  The accompanying notes are an
integral part of these consolidated financial statements.
  4
  St.
Bernard Software, Inc.
  Unaudited
Consolidated Statement of Stockholders' Deficit
 AdditionalCommon 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
                
                
                12,315
                
                
                
                -
                
                
                
                6,000
                
                
                
                -
                
                
                
                6,000Stock-based
      compensation expense
                
                
                -
                
                
                
                -
                
                
                
                334,000
                
                
                
                -
                
                
                
                334,000Value
      of warrants issued
                
                
                -
                
                
                
                -
                
                
                
                209,000
                
                
                
                -
                
                
                
                209,000Net
      loss
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (1,339,000
                )
                
                
                (1,339,000
                )Balance
      at June 30, 2008
                
                
                14,772,367
                
                
                $
                148,000
                
                
                $
                39,628,000
                
                
                $
                (48,522,000
                )
                
                $
                (8,746,000
                )
 The
accompanying notes are an integral part of these consolidated financial
statements.
 5
  St.
Bernard Software, Inc.
  Unaudited
Consolidated Statements of Cash Flows
 Six
      months ended June 30,2008
                
                
                2007Cash
      Flows From Operating ActivitiesNet
      loss
                
                $
                (1,339,000
                )
                
                $
                (5,667,000
                )Adjustments
      to reconcile net loss to net cashused
      in operating activities:Depreciation
      and amortization
                
                
                321,000
                
                
                
                740,000Allowance
      for doubtful accounts
                
                
                11,000
                
                
                
                (32,000
                )Gain
      on sale of assets
                
                
                (320,000
                )
                
                
                (3,463,000
                )Stock-based
      compensation expense
                
                
                334,000
                
                
                
                581,000Increase
      (decrease) in cash resulting from changes in:Accounts
      receivable
                
                
                (525,000
                )
                
                
                (92,000
                )Inventories
                
                
                (187,000
                )
                
                
                4,000Prepaid
      expenses and other assets
                
                
                38,000
                
                
                
                (24,000
                )Accounts
      payable
                
                
                (911,000
                )
                
                
                (564,000
                )Accrued
      expenses and other current liabilities
                
                
                (242,000
                )
                
                
                72,000Deferred
      rent
                
                
                51,000
                
                
                
                -Deferred
      revenue
                
                
                582,000
                
                
                
                1,031,000Net
      cash used in operating activities
                
                
                (2,065,000
                )
                
                
                (7,412,000
                )Cash
      Flows From Investing ActivitiesAdditional
      costs related to purchase of business
                
                
                -
                
                
                
                (83,000
                )Purchases
      of fixed assets
                
                
                (4,000
                )
                
                
                (231,000
                )Proceeds
      from the sale of assets
                
                
                320,000
                
                
                
                1,200,000Net
      cash provided by investing activities
                
                
                316,000
                
                
                
                886,000Cash
      Flows From Financing ActivitiesProceeds
      from stock option and warrant exercises
                
                
                -
                
                
                
                30,000Proceeds
      from the sales of stock under the employee stock purchase
    plan
                
                
                6,000
                
                
                
                -Principal
      payments on capitalized lease obligations
                
                
                (74,000
                )
                
                
                (51,000
                )Net
      increase in short-term borrowings
                
                
                896,000
                
                
                
                2,042,000Net
      cash provided by financing activities
                
                
                828,000
                
                
                
                2,021,000Net
      Decrease in Cash and Cash Equivalents
                
                
                (921,000
                )
                
                
                (4,505,000
                )Cash
      and Cash Equivalents at Beginning of Period
                
                
                1,297,000
                
                
                
                4,842,000Cash
      and Cash Equivalents at End of Period
                
                $
                376,000
                
                
                $
                337,000Supplemental
      Disclosures of Cash Flow Information:Cash
      paid during the period for:Interest
                
                $
                190,000
                
                
                $
                125,000Income
      taxes
                
                $
                -
                
                
                $
                2,000
 Non Cash Investing and Financing
Activities:
  In
January 2008, the Company amended its loan agreement with a bank. As a result,
the Company issued warrants which allows the bank to purchase up to 140,350
shares of the Company's common stock at an exercise price of $0.57 a share. Debt
issuance costs of $58,000 were recorded in connection with the issuance of the
warrants. See Note 3.
 
 In
January 2008, the Company entered into a  loan agreement with a
lender. As a result, the Company issued a warrant which allows the lender to
purchase up to 460,526 shares of the Company's common stock at an exercise price
of $0.57 a share. Debt discount of $151,000 was recorded in connection with the
issuance of the warrants. See Note 3.
 
 During  the
six months ended June 30, 2007, the Company entered into capitalized lease
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.
 6
  St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
 1.
Summary of Significant Accounting Policies
  St. Bernard Software, Inc., a
Delaware corporation (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 June 30, 2008, the consolidated statements of
operations for the three and six months ended June 30, 2008 and 2007, the
consolidated statement of stockholders’ deficit for the six months ended June
30, 2008, and the consolidated statements of cash flows for the six months ended
June 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; such entities
were dissolved 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 assumptions used to determine the
fair value of stock options under Statement of Financial Accounting Standards,
or SFAS, No. 123R (revised 2004), “Share-based Payment”(“SFAS
123R”).
  Liquidity
  As of
June 30, 2008, the Company had approximately $0.4 million of cash and cash
equivalents and a working capital deficit of $11.1
million.  Approximately $9.9 million of our current liability balance
at June 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 $8.7 million at June 30,
2008.
  The
Company has a history of losses and has not been able to achieve profitability.
For the three and six months ended June 30, 2008, the Company incurred net
losses of $0.9 million and $1.3 million, respectively, and through June 30, 2008
has recorded a cumulative net loss of $48.5 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 within Europe, 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 the changes described above, 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
7.
  7
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
 The
Company believes that its existing cash resources, combined with projected
billings for 2008, cost reductions implemented in the fourth quarter of 2007 and
through the second quarter of 2008, and its 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 net loss by the weighted-average
number of shares of common stock outstanding. 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 and six months ended June 30, 2008 and 2007, respectively, as the Company
reported a net loss in each period and the effect would have been
anti-dilutive.
  New
accounting standards
  In
May 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS
No. 162, “The Hierarchy
of Generally Accepted Accounting Principle”.  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.
  On
February 15, 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities”. 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.” 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 current practice. The
Company adopted SFAS 157 on January 1, 2008.  The adoption of SFAS 157
did not have a material impact on its financial position, cash flows, or results
of operations.
  Reclassifications
  Certain
amounts in the 2007 financial statements have been reclassified to conform to
the 2008 classifications. These reclassifications have no effect on previously
reported net income.
  8
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
 2.
Stock-based Compensation Expense
  Effective
January 1, 2006, the Company adopted the fair value recognition provisions
of 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 to five years, and expiration dates not to exceed ten years from 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,
expected stock price volatility factor, and the pre-vesting option forfeiture
rate. The weighted average fair value of options granted during the six months
ended June 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.
  Six
      Months Ended
              
              Six
      Months EndedJune
      30, 2008
              
              June
      30, 2007Average
      expected life (years)
              
              
              6.5
              
              
              
              6.5Average
      expected volatility factor
              
              
              73.3
              %
              
              
              74.0
              %Average
      risk-free interest rate
              
              
              3.8
              %
              
              
              4.8
              %Average
      expected dividend yield
              
              
              0
              
              
              
              0
  Total
stock-based compensation expense was approximately $277,000 and $321,000 for the
three months ended June 30, 2008 and 2007, respectively, and $334,000 and
$581,000 for the six months ended June 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 for the three and six months ended June 30, 2008. The
tax effect was immaterial.
  The
following is a summary of stock option activity under the Plans as of June 30,
2008 and changes during the six months ended June 30, 2008:
  Number
      of
                Shares
                Outstanding
              
              
              Weighted
                Average
                Exercise
                PriceOptions
      outstanding at December 31, 2007
              
              2,074,861
              
              
              $
              1.77Granted
              
              472,000
              
              
              $
              0.58Exercised
              
              —
              
              
              $
              —Forfeited
              
              (509,857
              )
              
              $
              1.64Options
      outstanding at June 30, 2008
              
              2,037,004
              
              
              $
              1.60
  9
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
 Additional
information regarding options outstanding as of June 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
      $0.54
              52,500
              
              9.69
              
              $
              0.52
              
              —
              
              $
              —$
              0.57
              
              to
      $0.57
              375,000
              
              9.41
              
              $
              0.57
              
              —
              
              $
              —$
              0.58
              
              to
      $0.58
              3,000
              
              9.76
              
              $
              0.58
              
              —
              
              $
              —$
              0.59
              
              to
      $0.59
              331,977
              
              8.81
              
              $
              0.59
              
              35,977
              
              $
              0.59$
              0.60
              
              to
      $1.80
              192,728
              
              6.77
              
              $
              1.03
              
              133,856
              
              $
              1.04$
              1.90
              
              to
      $1.90
              275,000
              
              8.47
              
              $
              1.90
              
              136,812
              
              $
              1.90$
              1.95
              
              to
      $1.95
              552,347
              
              8.02
              
              $
              1.95
              
              204,912
              
              $
              1.95$
              3.71
              
              to
      $3.71
              177,666
              
              6.94
              
              $
              3.71
              
              114,852
              
              $
              3.71$
              4.75
              
              to
      $4.75
              60,000
              
              1.54
              
              $
              4.75
              
              60,000
              
              $
              4.75$
              5.20
              
              to
      $5.20
              16,786
              
              4.10
              
              $
              5.20
              
              16,786
              
              $
              5.20$
              0.36
              
              to
      $5.20
              2,037,004
              
              8.08
              
              $
              1.60
              
              703,195
              
              $
              2.30
  The
aggregate intrinsic value of options outstanding and exercisable at June 30,
2008 was $0. The aggregate intrinsic value of options outstanding and
exercisable at June 30, 2007 was $39,000. The aggregate intrinsic value
represents the total intrinsic value based upon the stock price of $0.51 at June
30, 2008.
  As of
June 30, 2008, there was approximately $1.5 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 1.93 years.
  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”).  The Loan and
Security Agreement with SVB was later amended during the first quarter of 2008
as discussed below.
  On
January 25, 2008, St. Bernard entered into an Amendment to the Loan and
Security Agreement (the “SVB Loan Amendment”) with SVB, amending the Loan and
Security Agreement entered into between St. Bernard and SVB on May 15,
2007. 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 it will provide 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 June 30, 2008, the
effective interest rate was 10.5%. At June 30, 2008 the Company was in
compliance with the above stated covenants and restrictions.
  10
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
 In
connection with the execution of the SVB Loan Amendment, St. Bernard issued
warrants to SVB on January 25, 2008, 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 the issue date of the warrants.
Accordingly, the Company recorded 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 for three and six months ended June 30, 2008, which is being
recorded as interest expense, was approximately $11,000 and $19,000,
respectively. Furthermore, St. Bernard has agreed to grant SVB certain piggyback
registration rights with respect to the shares of common stock underlying the
warrants. As of June 30, 2008, the balance on the line of credit with SVB was
$1.9 million.
  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 is 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 is required to pay Agility
$50,000 plus accrued interest.  The obligations under the Agility Loan
Agreement are secured by substantially all of St. Bernard's assets subordinated
by the SVB Loan Amendment.
  The
Agility Loan Agreement contains customary affirmative and negative covenants and
other restrictions.  At June 30, 2008, the Company was in compliance
with the above stated covenants.
  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 460,526 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 $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
six months ended June 30, 2008, which is being recorded as interest expense, was
approximately $38,000 and $63,000, 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. As of June 30, 2008, the balance
on the Agility loan was approximately $650,000.
  In July
2008, the entire outstanding balance on the Agility Loan was paid using the
proceeds from a new loan (See Note 7).
  4.
Stockholders’ Deficit
  Warrants
  As of
June 30, 2008 and December 31, 2007, a total of 9,350,980 and 8,750,104 shares
of common stock, respectively, were reserved for issuance for the exercise of
warrants at exercise prices of $0.57, $1.60, $1.85, $2.98, and $5.00 per
share.  During the six months ended June 30, 2008, warrants to purchase an
aggregate of 600,876 shares of common stock at an exercise price of $0.57 per
share were granted resulting in $209,000 in compensation costs. There were no
warrants that were exercised or expired during this period.
  11
 St.
Bernard Software, Inc.
 
 Notes
to Consolidated Financial Statements
 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 $14,000 for the three months ended June 30, 2007
and $636,000 for the six months ended June 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.
Concentrations
  Sales
and revenue
  The
Company considers itself to operate within one business segment, Secure Content
Management (“SCM”). For the six months ended June 30, 2008 and 2007,
approximately 97% and 92%, respectively, of the Company’s revenue was in North
America, the remaining 3% and 8%, respectively, were disbursed over the rest of
the world.
  7.
Subsequent Events
  On July
21, 2008, the Company 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 the 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 Silicon
Valley Bank as its Prime Rate from time to time, plus 3% (the “Applicable
Rate”).  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 the collateral.
  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.
  12




Item 2. Management’s
Discussion 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 their employee usage policy for the 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
invested significantly in research and development activities, and for the six
months ended June 30, 2008 and 2007 we spent $1.5 million and $3.6 million,
respectively, on research and development. Our research and development efforts
have been 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.




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
will differentiate us from our competitors and enable us to grow faster than our
competition.  We have also started to realign our sales and marketing
efforts to allow us to better serve medium-sized and enterprise class customers
in conjunction with the above mentioned product strategy.  As we move
through 2008, we intend to finalize the Company’s transformation and continue to
expand our product portfolio to create additional leverage across our customer
base.




Our
Business Growth




We have
historically grown through internal organic growth and through
acquisitions.  In 2006 we completed a merger with Sand Hill IT
Security and Acquisition Corp. (“Sand Hill”), a publicly held Delaware
Corporation.




The
shares of common stock held by the former stockholders of the private company in
the merger were converted into a total of 9,733,771 shares of our stock, or
approximately 69.2% of our outstanding common stock following the
merger.




For
accounting purposes the merger was accounted for as a reverse acquisition. Under
this method of accounting, Sand Hill was treated as the “acquired” company.
Accordingly, for accounting purposes, the merger was treated as the equivalent
of the private company in the merger issuing stock for the net monetary assets
of Sand Hill. Our historical financial statements prior to July 27, 2006,
are those of the private company in the merger. All historical share and per
share amounts have been retroactively adjusted, using a conversion factor of
0.419612277 to give effect to the reverse acquisition of Sand Hill.




13




Effective
October 17, 2006, we acquired AgaveOne, Inc., a Nevada corporation doing
business as Singlefin. Singlefin provided on-demand security and business
services to small and medium sized companies, including email filtering, web
filtering and instant messaging management as a hosted or on demand service. In
connection with the Singlefin acquisition, we paid Singlefin stockholders and
option holders $0.47 million in cash, issued 471,288 shares of common stock and
assumed certain stock options granted by Singlefin and converted them into
options to acquire 47,423 shares of our common stock. We also paid off $5.5
million in Singlefin indebtedness and certain Singlefin employees received
bonuses totaling $0.25 million. The aggregate value of the transaction initially
recorded was approximately $8.0 million. During 2007, 66,667 shares, valued at
$250,000, issued in conjunction with the purchase were cancelled as a result of
indemnification claims.




Our
Financial Results




We
reported revenues of $4.6 million for the three months ended June 30, 2008,
compared to $5.0 million in the same period in 2007, a decrease of 8.0%; a net
loss for the three months ended June 30, 2008 of $0.9 million, compared to a net
loss of $4.7 million in the same period in 2007; and net basic and diluted loss
per share for the three months ended June 30, 2008 of $0.06, compared to $0.32
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 $3.5
million, offset by a quarter over quarter decrease in the gain on the sale of
assets for the three months ended June 30, 2008 compared to the same period in
2007.




We
reported revenues of $8.5 million for the first six months of 2008 compared to
$10.4 million in the same period in 2007, a decrease of 18.3%; a net loss for
the first six months of 2008 of $1.3 million, compared to a net loss of $5.7
million in the same period in 2007; and net basic loss per share for the first
six months of 2008 of $0.09, compared to $0.38 reported in the same period in
2007.




Cash used
in operations for the six months ended June 30, 2008 was $2.1 million compared
to cash used during the six months ended June 30, 2007 of $7.4 million. The net
decrease in use of cash was due primarily to lower operating
losses.




On
May 15, 2007, we established a line of credit with SVB, terminating our
line of credit with Camel Financial. On January 25, 2008, we amended our line of
credit agreement with SVB. 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 $1.9 million as of June 30, 2008. In addition,
we secured a bridge loan with Agility Capital, LLC for $750,000 on January 25,
2008. See section below titled, “Bridge Loan” for the terms of the agreement
with Agility Capital, LLC. The outstanding balance on the bridge loan with
Agility was approximately $650,000 as of June 30, 2008.




On July
21, 2008, we entered into a Loan Agreement with Partners for 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) up to 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 the entire
amount of the outstanding balance on the bridge loan with
Agility.  See Note 7.




During
the six months ended June 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, because 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:




14




•
            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-K 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 six months ended June 30,
2008.




Results
of Operations of St. Bernard




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




Revenues




For
      theThree
      Months EndedJune
      30,2008
              
              
              2007
              
              
              % ChangeTotal
      revenues
              
              $
              4.6
              
              
              $
              5.0
              
              
              
              (8.0%
              )




Revenues
decreased $0.4 million for the three months ended June 30, 2008, compared to the
same period in 2007, primarily due to an increase of $0.8 million in our core
product line revenue, which includes iPrism, offset by a decrease of $1.2
million in our UpdateEXPERT and Open File Manager revenue. We sold the
UpdateEXPERT product line to Shavlik Technologies in January 2007, and we sold
the Open File Manager product line to EVault, Inc. in August 2007. See
discussion of changes in subscription revenues, appliance revenues, and license
revenues below.




Subscription
Revenues




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeSubscription
      revenues
              
              $
              3.4
              
              
              $
              3.6
              
              
              
              (5.6%
              )As
      a percentage of revenues
              
              
              73.9
              %
              
              
              72.0
              %




For the
three months ended June 30, 2008, our subscription revenues decreased $0.2
million 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 $0.7 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%.




15




Appliance
Revenues




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeAppliance
      revenues
              
              $
              1.2
              
              
              $
              0.9
              
              
              
              33.3%As
      a percentage of revenues
              
              
              26.1
              %
              
              
              18.0
              %




For the
three months ended June 30, 2008, appliance hardware sales increased
approximately $0.3 million compared to the same period in 2007. Total units
shipped for the three months ended June 30, 2008 were 661 compared with 713 for
the same period in 2007. Though we shipped fewer appliance units, the increase
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 increase in future periods due to the
increased efforts of our sales team to upsell our customers to our new,
higher-end h-series appliances, which are designed to enhance the iPrism web
filtering capabilities.




License
Revenues




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeLicense
      revenues
              
              $
              0.0
              
              
              $
              0.6
              
              
              
              (100.0%
              )As
      a percentage of revenues
              
              
              0.0
              %
              
              
              12.0
              %




For the
three months ended June 30, 2008 our net license revenues were almost
non-existent and as a result decreased approximately $0.6 million compared to
the same period in 2007 due primarily to a loss in UpdateEXPERT and Open File
Manager license revenues resulting from the sale of these product lines in 2007.
We do not expect significant license revenues in future periods due to the sale
of these two products lines.




Cost
of Revenues




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      cost of revenues
              
              $
              1.4
              
              
              $
              1.8
              
              
              
              (22.2%
              )Gross
      margin percent
              
              
              69.6
              %
              
              
              64.0
              %




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
$0.4 million for the three months ended June 30, 2008 compared to the same
period in 2007. Gross margin increased 5.6% for the three months ended June 30,
2008 compared to the same period in 2007, 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. See the discussion of changes in the
cost of subscription and appliance revenue below.




16




Cost
of Subscription Revenues




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      cost of subscription revenues
              
              $
              0.6
              
              
              $
              1.0
              
              
              
              (40.0%
              )Gross
      margin percent
              
              
              82.4
              %
              
              
              72.2
              %




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 June 30, 2008. In addition, payroll and other direct expenses related to
our core product line, which includes iPrism, decreased in the three months
ended June 30, 2008 compared to the same period in 2007 due primarily to a
reduction in our workforce for the comparable periods mentioned
above.




Cost
of Appliance Revenues




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      cost of appliance revenues
              
              $
              0.8
              
              
              $
              0.8
              
              
              
              0.0%Gross
      margin percent
              
              
              33.3
              %
              
              
              11.1
              %




The cost
of appliance revenues includes contract manufactured equipment, packaging, and
freight. The cost of hardware for the three months ended June 30, 2008 remained
virtually unchanged for the same period in 2007, even though we shipped out 52
fewer appliance units during the comparable periods. The increase in the cost
can be attributed to the increased costs for the new, higher-end h-series
appliances and the increased cost of freight.




Sales
and Marketing




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      sales and marketing
              
              $
              2.1
              
              
              $
              3.4
              
              
              
              (38.2%
              )As
      a percentage of revenues
              
              
              45.7
              %
              
              
              68.0
              %




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 three months ended June 30, 2008, the
sales and marketing expenses decreased 38.2%, or $1.3 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 during the fourth quarter of 2007.
The most significant decreases include compensation and consulting expenses of
$1.1 million and advertising expenses of $0.2 million.




17




Research
and Development




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      research and development
              
              $
              0.8
              
              
              $
              1.8
              
              
              
              (55.6%
              )As
      a percentage of revenues
              
              
              17.4
              %
              
              
              36.0
              %





Research
and development expense consists primarily of salaries, related benefits,
third-party consultant fees and other engineering related costs. The decrease of
$1.0 million for the three months ended June 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 have 39 fewer employees for the period ended June 30, 2008 versus the same
period in 2007.




We
believe that the present level of research and development costs will be
sufficient in the future to keep our existing products competitive, however,
additional development staff and other development resources will be required if
a new product development effort is undertaken.




General
and Administrative


For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      general and administrative
              
              $
              1.4
              
              
              $
              2.4
              
              
              
              (41.7%
              )As
      a percentage of revenues
              
              
              30.4
              %
              
              
              48.0
              %





General
and administrative expenses, which consist primarily of salaries, related
benefits, and fees for professional services, such as legal and accounting
services, decreased $1.0 million for the three months ended June 30, 2008,
compared to the same period in 2007, due to our extensive cost cutting efforts.
The most significant decreases in the second quarter of 2008 included
compensation and consulting expenses of $0.4 million, SFAS 123R expenses of $0.1
million, lease and rent expenses of $0.1 million, and accounting, legal, and
insurance costs of $0.3 million.




Interest
and Other Income, Net




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      interest and other income, net
              
              $
              0.0
              
              
              $
              (0.1
              )
              
              
              100.0%As
      a percentage of revenues
              
              
              0.0
              %
              
              
              2.0
              %





Interest
and other income, net, includes interest expense, interest income, and other
income. The increase for the three months ended June 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.




18




Gain
on Sale of Assets




For
      theThree
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeGain
      on sale of assets
              
              $
              0.0
              
              
              $
              0.3
              
              
              
              (100.0%
              )As
      a percentage of revenues
              
              
              0.0
              %
              
              
              6.0
              %




The gain
on the sale of assets for the three months ended June 30, 2008 was $0.0 million
as compared to approximately $0.3 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 June 30, 2007 consisted of a gain from the
excess renewal fees collected by Shavlik.




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




Revenues


For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      revenues
              
              $
              8.5
              
              
              $
              10.4
              
              
              
              (18.3%
              )




Revenues
decreased $1.9 million for the six months ended June 30, 2008, compared to the
same period in 2007 primarily due to an increase of $1.1 million in our core
product line revenue, which includes iPrism, offset by a decrease of $3.0
million in our UpdateEXPERT and Open File Manager revenues. We sold the
UpdateEXPERT product line to Shavlik Technologies in January 2007, and we sold
the Open File Manager product line to EVault, Inc. in August 2007. See
discussion of changes in subscription revenues, appliance revenues, and license
revenues below.




Subscription
Revenues




For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeSubscription
      revenues
              
              $
              6.7
              
              
              $
              7.4
              
              
              
              (9.5%
              )As
      a percentage of revenues
              
              
              78.8
              %
              
              
              71.2
              %




For the
six months ended June 30, 2008, our subscription revenues decreased $0.7 million
compared to the same period in 2007 primarily due to an increase of $1.0 million
in our core product line revenue, which includes iPrism, offset by a decrease of
$1.7 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%.




19




Appliance
Revenues




For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeAppliance
      revenues
              
              $
              1.8
              
              
              $
              1.6
              
              
              
              12.5%As
      a percentage of revenues
              
              
              21.2
              %
              
              
              15.4
              %




For the
six months ended June 30, 2008, appliance hardware sales increased approximately
$0.2 million compared to the same period in 2007. Total units shipped for the
six months ended June 30, 2008 were 1,190 as compared with 1,333 for the same
period in 2007. Though we shipped less appliance units, the increase 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 increase in future periods due to the increased
efforts of our sales team to upsell our customers to our new,
higher-end  h-series appliances, which are designed to enhance the
iPrism web filtering capabilities.




License
Revenues


For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeLicense
      revenues
              
              $
              0.0
              
              
              $
              1.4
              
              
              
              (100.0%
              )As
      a percentage of revenues
              
              
              0.0
              %
              
              
              13.5
              %





For the
six months ended June 30, 2008 our net license revenues were almost non-existent
and as a result decreased approximately $1.4 million compared to the same period
in 2007 due primarily to a loss in UpdateEXPERT and Open File Manager license
revenues resulting from the sale of these product lines in 2007. We do not
expect significant license revenue in future periods due to the sale of these
two products lines.




Cost
of Revenues


For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      cost of revenues
              
              $
              2.4
              
              
              $
              3.5
              
              
              
              (31.4%
              )Gross
      margin percent
              
              
              71.8
              %
              
              
              66.3
              %





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
$1.1 million for the six months ended June 30, 2008 compared to the same period
in 2007. Gross margin increased 5.5% for the six months ended June 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. See the discussion of changes in the
cost of subscription and appliance revenues below.




20




Cost
of Subscription Revenues




For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      cost of subscription revenues
              
              $
              1.1
              
              
              $
              2.1
              
              
              
              (47.6%
              )Gross
      margin percent
              
              
              83.6
              %
              
              
              71.6
              %





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 six months
ended June 30, 2008. In addition, payroll and other direct expenses related to
our core product line, which includes iPrism, decreased in the six months ended
June 30, 2008 compared to the same period in 2007 due primarily to a reduction
in our workforce for the comparable periods mentioned above.




Cost
of Appliance Revenues




For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      cost of appliance revenues
              
              $
              1.2
              
              
              $
              1.3
              
              
              
              (7.7%
              )Gross
      margin percent
              
              
              33.3
              %
              
              
              18.8
              %





The cost
of appliance revenues includes contract manufactured equipment, packaging and
freight. The cost of hardware for the six months ended June 30, 2008 decreased
$0.1 million from the same period in 2007. The decrease in costs and the 14.5%
increase in gross margin percentage for the six months ended June 30, 2008, as
compared to the same period in 2007, and can be attributed to a decrease in the
net number of outstanding customer-service replacement units, 143 fewer
appliance units shipped, offset by an increase in the cost of our new,
higher-end h-series appliances and an increase in the costs of
freight.




Sales
and Marketing




For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      sales and marketing
              
              $
              3.9
              
              
              $
              7.5
              
              
              
              (48.0%
              )As
      a percentage of revenues
              
              
              45.9
              %
              
              
              72.1
              %





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 six months ended June 30, 2008, the
sales and marketing expenses decreased 48.0%, or $3.6 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 during the fourth quarter of 2007.
The most significant decreases include compensation and consulting expenses of
$2.5 million and advertising expenses of $1.0 million.




21




Research
and Development




For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      research and development
              
              $
              1.5
              
              
              $
              3.6
              
              
              
              (58.3%
              )As
      a percentage of revenues
              
              
              17.6
              %
              
              
              34.6
              %





Research
and development expense consists primarily of salaries, related benefits,
third-party consultant fees and other engineering related costs. The decrease of
$2.1 million for the six months ended June 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 have
39 fewer employees for the period ended June 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
believe that the present level of research and development costs will be
sufficient in the future to keep our existing products competitive, however,
additional development staff and other development resources will be required if
a new product development effort is undertaken.




General
and Administrative




For
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeTotal
      general and administrative
              
              $
              2.6
              
              
              $
              4.9
              
              
              
              (46.9%
              )As
      a percentage of revenues
              
              
              30.6
              %
              
              
              47.1
              %




General
and administrative expenses, which consist primarily of salaries, related
benefits, and fees for professional services, such as legal and accounting
services, decreased $2.3 million for the six months ended June 30, 2008,
compared to the same period in 2007, due to our extensive cost cutting efforts.
The most significant decreases in the second quarter of 2008 included
compensation and consulting expenses of $0.7 million, SFAS 123R expenses of $0.3
million, lease and rent expenses of $0.2 million, utilities expense of $0.1
million, and accounting, legal, and insurance costs of $0.6
million.


Interest
and Other Income, Net
  For
      theSix
      Months EndedJune
      30,2008
                
                2007
                
                % ChangeTotal
      interest and other income, net
                
                $
                0.1
                
                
                $
                (0.1
                )
                
                
                200.0%As
      a percentage of revenues
                
                
                1.2
                %
                
                
                1.0
                %


22




Interest
and other income, net, includes interest expense, interest income, and other
income. The increase for the six months ended June 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
      theSix
      Months EndedJune
      30,2008
              
              2007
              
              % ChangeGain
      on sale of assets
              
              $
              0.3
              
              
              $
              3.5
              
              
              
              (91.4%
              )As
      a percentage of revenues
              
              
              3.5
              %
              
              
              33.7
              %




The gain
on the sale of assets for the six months ended June 30, 2008 was approximately
$0.3 million as compared to approximately $3.5 million for the same period in
2007. During the first and third quarter of fiscal year 2007, the Company sold
its 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 six months ended June 30, 2008 consisted of a
gain from the excess renewal fees collected by Shavlik and from the release of
the first half of funds from an indemnification from EVault.




Recent
Accounting Pronouncements




In
May 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS
No. 162, “The Hierarchy
of Generally Accepted Accounting Principle”.  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.




On
February 15, 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities”. 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.” 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 current practice. The
Company adopted SFAS 157 on January 1, 2008.  The adoption of SFAS 157
did not have a material impact on its financial position, cash flows, or results
of operations.




23




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 six months ended June 30, 2008 was $2.1 million compared
to cash used during the six months ended June 30, 2007 of $7.4 million. The net
decrease in use of cash was due primarily to lower operating
losses.




Cash
flows provided by investing activities for the six months ended June 30, 2008
and 2007 was $0.3 million and $0.9 million, respectively. The cash provided by
investing activities as of June 30, 2008 included the $250,000 payment of the
first part of 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 three months ended June 30, 2008
and 2007 was $0.8 million and $2.0 million, respectively. The decrease in cash
provided by financing activities in the second quarter of 2008 was primarily
from the net decrease in short-term borrowings.




As a
result of the foregoing, the net decrease in cash and cash equivalents was $0.9
million for the six months ended June 30, 2008 as compared to a net decrease in
cash of approximately $4.5 million for the comparable period in
2007.




Losses
from Operations – Liquidity




As of
June 30, 2008, the Company had approximately $0.4 million of cash and cash
equivalents and a working capital deficit of $11.1 million.  Operating
losses for the three and six months ended June 30, 2008 were $1.0 million and
$1.8 million, respectively. During the three months ended March 31, 2008, the
Company reported a realized gain of $0.3 million from the release of the first
half of funds from an indemnification escrow as a result of the sale of the Open
File Manager product in third quarter of 2007. As a result, the Company had a
net loss of $0.9 million and $1.3 million for the three and six months ended
June 30, 2008.




At June
30, 2008, we had a stockholders’ deficit of approximately $8.7 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 $9.9 million of our current liability balance at June 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 not been able to achieve
profitability.  For the three and six months ended June 30,2008, the
Company incurred net losses of $0.9 million and $1.3 million, respectively, and
through June 30, 2008 has recorded a cumulative net loss of $48.5 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 within Europe,
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 the changes described above, the Company also
entered into a Loan Agreement with PFG in July 2008. See Note 7.




The
Company believes that its existing cash resources, combined with projected
billings for 2008, cost reductions implemented in the fourth quarter of 2007 and
through the second quarter of 2008, and its 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.




24




Credit
Facility




During
the first quarter of 2007, the Company had a $1,250,000 line of credit with a
finance company that automatically renewed every six months. The line of credit
provided for advances of up to 80% of eligible accounts receivable. Interest was
payable monthly at 1.5% per month (18% per annum).




On
May 15, 2007, the Company entered into a Loan and Security Agreement with
SVB.  The Loan and Security Agreement with SVB was later amended
during the first quarter of 2008 as discussed below.




On
January 25, 2008, St. Bernard entered into the SVB Loan Amendment with SVB,
amending the Loan and Security Agreement entered into between St. Bernard and
SVB on May 15, 2007. 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 it will provide 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
June 30, 2008, the effective interest rate was 10.5%. At June 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 on January 25, 2008, 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 the issue date of the warrants.
Accordingly, the Company recorded 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 for three and six months ended June 30, 2008, which is being
recorded as interest expense, was approximately $11,000 and $19,000,
respectively. Furthermore, St. Bernard has agreed to grant SVB certain piggyback
registration rights with respect to the shares of common stock underlying the
warrants. As of June 30, 2008, the balance on the line of credit with SVB was
$1.9 million.




Bridge
Loan




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




The
Agility Loan Agreement contains customary affirmative and negative covenants and
other restrictions.  At June 30, 2008, the Company was in compliance
with the above stated covenants.




In
connection with the execution of the Agility Loan Agreement, St. Bernard issued
Agility Warrants, which allows Agility to purchase up to 460,526 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 $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 six
months ended June 30, 2008, which is being recorded as interest expense, was
approximately $38,000 and $63,000, 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. As of June 30, 2008, the balance
on the Agility loan was approximately $650,000.




25




In July
2008, the entire outstanding balance on the Agility Loan was paid using the
proceeds from a credit facility with PFG.




On July
21, 2008, the Company 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
(the “PFG Loan”) in the 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 Silicon
Valley Bank as its Prime Rate from time to time, plus 3% (the “Applicable
Rate”).  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 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 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 the collateral.




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 Technologies, LLC, or Shavlik, the Company assigned and sold
to Shavlik the Company’s 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 a result of the sale, the Company realized a gain of approximately
$70,000 during the six months ended June 30, 2008, due to the excess renewal
fees collected by Shavlik.




26




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, Inc., a wholly owned
subsidiary of Seagate Technology, Inc., (“EVault”), the Company assigned and
sold to EVault the Company’s Open File Manager (the “Product”) software
applications, which include all of the Company’s 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 that is
collected from, or on behalf of, customers of the Company who are 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 six months ended June 30, 2008, the Company
realized a gain of $250,000 as payment of the first part of the “Holdback
Amount” by EVault in satisfaction of Article 8 of the signed agreement between
EVault and the Company.




Forward-Looking
Statements




We
believe it is important to communicate our expectations to our stockholders.
However, there may be events in the future that we are not able to predict
accurately or over which we have no control.




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 the need
for our products and of our brand, 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.  A component of our business strategy is to enter new
markets and to expand our presence in existing markets by acquiring
complementary technologies that allow us to increase our product
offerings, augment our distribution channels, expand our market
opportunities or broaden our customer base.  Acquisitions involve
a number of risks, including:




●
            diversion
      of management’s attention;●
            difficulty
      in integrating and absorbing the acquired business and its employees,
      corporate culture, managerial systems and processes, technology, products
      and services;●
            failure
      to retain key personnel and employee turnover;●
            challenges
      in retaining customers of the acquired business, and customer
      dissatisfaction or performance problems with the acquired
      firm;●
            developing
      products or services that meet our customers’ needs;●
            assumption
      of unknown liabilities;


27




●
            dilutive
      issuances of securities or use of debt or limited cash;●
            incremental
      amortization expenses related to acquired intangible assets, as well as
      potential future impairment charges to goodwill or intangible assets;
      and●
            other
      unanticipated events or circumstances.




The
foregoing discussion should be read in conjunction with our Financial Statements
and related Notes thereto included elsewhere in this report.





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.




Item 3. Quantitative and
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).        Controls
and 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
recognized 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 also is 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.




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.




28




PART II – OTHER INFORMATION




Item 1. Legal
Proceedings


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.         
Risk
Factors


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.             Submission
of Matters to a Vote of Security Holders


The
Annual Meeting of Stockholders was held on Thursday, June 5, 2008.  The
following matters were voted upon at the meeting and were adopted by the margins
indicated:




1. The
stockholders elected five Directors to hold office until the 2009 Annual Meeting
of Stockholders or until his or her successor is elected and
qualified.




Number of SharesName of Director Elected
            
            For
            
            
            WithheldHumphrey
      Polanen
            
            
            9,588,691
            
            
            
            1,463,295Scott
      Broomfield
            
            
            9,588,691
            
            
            
            1,463,295Bart
      A.M. van Hedel
            
            
            9,588,691
            
            
            
            1,463,295Louis
      Ryan
            
            
            9,588,691
            
            
            
            1,463,295Vince
      Rossi
            
            
            9,586,013
            
            
            
            1,465,973




2. The
stockholders ratified the selection by the Audit Committee of the Board of
Directors of Squar, Milner, Miranda & Williamson, LLP as independent
auditors of the Company for its fiscal year ending December 31,
2008.




For
            
            10,828,816Against
            
            67,531Abstain
            
            155,639




29




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).




30




10.1*
            
            St.
      Bernard Software, Inc. 2008 Variable (Bonus) Compensation Plan
      (incorporated herein by reference to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on April 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.





*
            Management
      contract or compensatory plan or
arrangement


31




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:  August
      12, 2008
            By:
            /s/
      Vincent
      RossiVincent Rossi
              Chief Executive Officer
              Acting Chief Financial Officer




32