**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM10-Q**

 

**ý****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED NOVEMBER 30, 2004**

 

**o****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE TRANSITION PERIOD FROM       TO       **

 

**Commission file number 000-25249**

 

**INTRAWARE,INC.**

(Exact name of Registrant as specified in its charter)

 

**DELAWARE**

(State or other jurisdiction of incorporation or organization)

 

**68-0389976**

(I.R.S. Employer Identification Number)

 

**25 ORINDA WAYORINDA, CA 94563**

(Address of principal executive offices)

 

**(925) 253-4500**

(Registrant’s telephone number, including area code)

 

Indicate by check (X)whether the registrant: (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or forsuch 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 markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). Yes o  No ý 

 

As of January 7, 2005there were 60,417,331 shares of the registrant’s common stock outstanding.

 

 

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**PARTI—FINANCIAL INFORMATION**

**ITEM 1.CONSOLIDATED FINANCIAL STATEMENTS**

 

**INTRAWARE, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(in thousands, except per share amounts)**

**(unaudited)**

 
| ** **                                                                                                                                                                  | ** ** | **November 30, 2004** | ** ** | **February 29, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                  |       |                       |       |                       |       |
| Current  assets:                                                                                                                                                            |       |                       |       |                       |       |
| Cash and  cash equivalents                                                                                                                                                  |       | $                          | 10,145     |                       | $          | 11,804 |   |
| Accounts  receivable, net                                                                                                                                                   |       | 1,470                      |       | 1,462                      |       |
| Costs of  deferred revenue and prepaid licenses and services                                                                                                                |       | 335                        |       | 214                        |       |
| Other  current assets                                                                                                                                                       |       | 543                        |       | 317                        |       |
| Total  current assets                                                                                                                                                       |       | 12,493                     |       | 13,797                     |       |
| Cost of  deferred revenue, less current portion                                                                                                                             |       | 72                         |       | 43                         |       |
| Property and  equipment, net                                                                                                                                                |       | 906                        |       | 897                        |       |
| Other  assets, less current portion                                                                                                                                         |       | 52                         |       | 33                         |       |
| Total assets                                                                                                                                                                |       | $                          | 13,523     |                       | $          | 14,770 |   |
|                                                                                                                                                                        |       |                       |       |                       |       |
| **LIABILITIES,  REDEEMABLE CONVERTIBLE PREFERRED STOCK & STOCKHOLDERS’ EQUITY**                                                                                    |       |                       |       |                       |       |
| Current  liabilities:                                                                                                                                                       |       |                       |       |                       |       |
| Notes  payable                                                                                                                                                              |       | $                          | 1,018      |                       | $          | 1,034 |   |
| Accounts  payable                                                                                                                                                           |       | 786                        |       | 577                        |       |
| Accrued  expenses                                                                                                                                                           |       | 826                        |       | 928                        |       |
| Deferred  revenue                                                                                                                                                           |       | 2,302                      |       | 2,035                      |       |
| Related  party deferred revenue                                                                                                                                             |       | 6                          |       | 648                        |       |
| Total current  liabilities                                                                                                                                                  |       | 4,938                      |       | 5,222                      |       |
| Deferred  revenue, less current portion                                                                                                                                     |       | 208                        |       | 295                        |       |
| Notes  payable, less current portion                                                                                                                                        |       | 319                        |       | 766                        |       |
| Total  liabilities                                                                                                                                                          |       | 5,465                      |       | 6,283                      |       |
| Contingencies  (Note 4)                                                                                                                                                     |       |                       |       |                       |       |
| Redeemable  convertible preferred stock; $0.0001 par value; 10,000 shares authorized:                                                                                       |       |                       |       |                       |       |
| Series A;  552 at November 30 and February 29, 2004 (aggregate liquidation preference  of $1,000 at November 30 and February 29, 2004)                  |       | 897                        |       | 897                        |       |
| Total  redeemable convertible preferred stock                                                                                                                               |       | 897                        |       | 897                        |       |
| Stockholders’  equity:                                                                                                                                                 |       |                       |       |                       |       |
| Common  stock; $0.0001 par value; 250,000 shares authorized; 60,417 and 59,504 shares  issued and outstanding at November 30 and February 29, 2004,  respectively |       | 6                          |       | 6                          |       |
| Additional  paid-in-capital                                                                                                                                                 |       | 163,145                    |       | 162,043                    |       |
| Accumulated  deficit                                                                                                                                                        |       | (155,990                   | )          | (154,459                   | )          |
| Total  stockholders’ equity                                                                                                                                            |       | 7,161                      |       | 7,590                      |       |
| Total  liabilities, redeemable convertible preferred stock and stockholders’ equity                                                                                    |       | $                          | 13,523     |                       | $          | 14,770 |   |

 

See notes to unaudited interim consolidated financial information.

 

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**INTRAWARE, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except per share amounts)**

**(unaudited)**

 
| ** **                                    | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                    | ** ** | **November 30, 2004**     | ** ** | **November 30, 2003**    | ** ** | **November 30, 2004** | ** ** | **November 30, 2003** | ** ** |
|                                          |       |                           |       |                          |       |   |   |   |   |
| Revenues:                                     |       |                           |       |                          |       |   |   |   |   |
| Online  services and technology               |       | $                              | 2,032      |                          | $          | 1,661 |   | $ | 5,627 |   | $ | 4,901 |   |
| Alliance and  reimbursement                   |       | 493                            |       | 662                           |       | 1,759 |   | 2,326 |   |
| Related  party online services and technology |       | 4                              |       | 114                           |       | 542 |   | 346 |   |
| Software  product sales                       |       | —                         |       | 89                            |       | 42 |   | 291 |   |
| Total  revenues                               |       | 2,529                          |       | 2,526                         |       | 7,970 |   | 7,864 |   |
| Cost of  revenues:                            |       |                           |       |                          |       |   |   |   |   |
| Online  services and technology               |       | 820                            |       | 545                           |       | 2,086 |   | 1,804 |   |
| Alliance and  reimbursement                   |       | 331                            |       | 405                           |       | 1,143 |   | 1,317 |   |
| Software  product sales                       |       | —                         |       | 77                            |       | 37 |   | 244 |   |
| Total cost  of revenues                       |       | 1,151                          |       | 1,027                         |       | 3,266 |   | 3,365 |   |
| Gross profit                                  |       | 1,378                          |       | 1,499                         |       | 4,704 |   | 4,499 |   |
| Operating  expenses:                          |       |                           |       |                          |       |   |   |   |   |
| Sales and  marketing                          |       | 756                            |       | 573                           |       | 2,330 |   | 2,037 |   |
| Product  development                          |       | 383                            |       | 560                           |       | 1,195 |   | 2,236 |   |
| General and  administrative                   |       | 1,107                          |       | 845                           |       | 2,798 |   | 2,502 |   |
| Restructuring                                 |       | (75                            | )          | —                        |       | (75 | ) | — |   |
| Total  operating expenses                     |       | 2,171                          |       | 1,978                         |       | 6,248 |   | 6,775 |   |
| Loss from  operations                         |       | (793                           | )          | (479                          | )          | (1,544 | ) | (2,276 | ) |
| Interest  expense                             |       | (24                            | )          | (40                           | )          | (79 | ) | (170 | ) |
| Interest and  other income and expenses, net  |       | 50                             |       | 21                            |       | 92 |   | 47 |   |
| Net loss                                      |       | $                              | (767       | )                             | $          | (498 | ) | $ | (1,531 | ) | $ | (2,399 | ) |
| Basic and  diluted net loss per share         |       | $                              | (0.01      | )                             | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.04 | ) |
| Weighted  average shares - basic and diluted  |       | 60,361                         |       | 58,491                        |       | 60,032 |   | 54,726 |   |

 

See notes to unaudited interim consolidated financial information.

 

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**INTRAWARE, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                   | ** ** | **For the nine months ended** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                   | ** ** | **November 30, 2004**    | ** ** | **November 30, 2003** | ** ** |
| Cash flows  from operating activities:                                       |       |                          |       |   |   |
| Net loss                                                                     |       | $                             | (1,531     | ) | $ | (2,399 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                          |       |   |   |
| Depreciation  and amortization                                               |       | 441                           |       | 1,438 |   |
| Amortization  of unearned compensation                                       |       | —                        |       | 28 |   |
| Provision  for doubtful accounts                                             |       | 13                            |       | 13 |   |
| Gain on sale  of fixed assets                                                |       | (2                            | )          | — |   |
| Amortization  of discount on note payable                                    |       | 17                            |       | 14 |   |
| Changes in  assets and liabilities:                                          |       |                          |       |   |   |
| Accounts  receivable                                                         |       | (20                           | )          | 170 |   |
| Costs of  deferred revenue and prepaid licenses and services                 |       | (150                          | )          | 55 |   |
| Other assets                                                                 |       | (245                          | )          | (122 | ) |
| Accounts  payable                                                            |       | 113                           |       | (114 | ) |
| Accrued  expenses                                                            |       | (102                          | )          | 103 |   |
| Deferred  revenue                                                            |       | 180                           |       | (476 | ) |
| Related  party deferred revenue                                              |       | (642                          | )          | 25 |   |
| Net cash  used in operating activities                                       |       | (1,928                        | )          | (1,265 | ) |
| Cash flows  from investing activities:                                       |       |                          |       |   |   |
| Purchases of  property and equipment                                         |       | (354                          | )          | (379 | ) |
| Proceeds  from sale of fixed assets                                          |       | 2                             |       | — |   |
| Net cash  used in investment activities                                      |       | (352                          | )          | (379 | ) |
| Cash flows  from financing activities:                                       |       |                          |       |   |   |
| Principal  payments on note payable                                          |       | (789                          | )          | (165 | ) |
| Proceeds  from notes payable                                                 |       | 308                           |       | 2,165 |   |
| Proceeds  from common stock and warrants                                     |       | 1,102                         |       | 7,528 |   |
| Principal  payments on capital lease obligations                             |       | —                        |       | (2,401 | ) |
| Net cash  provided by financing activities                                   |       | 621                           |       | 7,127 |   |
| Net increase  (decrease) in cash and cash equivalents                        |       | (1,659                        | )          | 5,483 |   |
| Cash and  cash equivalents at beginning of the period                        |       | 11,804                        |       | 6,841 |   |
| Cash and  cash equivalents at end of the period                              |       | $                             | 10,145     |   | $ | 12,324 |   |
|                                                                         |       |                          |       |   |   |
| Supplemental  disclosure of cash flow information:                           |       |                          |       |   |   |
| Cash paid  for interest                                                      |       | $                             | 63         |   | $ | 148 |   |
| Supplemental  non-cash activity:                                             |       |                          |       |   |   |
| Common stock  issued for preferred stock conversion                          |       | $                             | —     |   | $ | 1,584 |   |
| Purchases of  property and equipment included in accounts payable            |       | $                             | 96         |   | $ | 155 |   |
| Issuance of  warrant to purchase common stock                                |       | $                             | —     |   | $ | 46 |   |
|                                                                         |       |                          |       |   |   |

 

See notes to unaudited interim consolidated financial information.

 

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**INTRAWARE, INC.**

 

**NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIALINFORMATION**

 

**NOTE 1. BASIS OF PRESENTATION**

 

**INTRAWARE**

 

The accompanying unaudited interim consolidatedfinancial information has been prepared pursuant to the rules and regulationsof the Securities and Exchange Commission (“SEC”).  Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to these rules andregulations.  However, management believes that the disclosures areadequate to ensure the information presented is not misleading.  Thebalance sheet at February 29, 2004, has been derived from the audited financialstatements, but does not include all disclosures required by generally acceptedaccounting principles.  This unaudited interim consolidated financialinformation should be read in conjunction with the audited consolidatedfinancial statements and notes thereto included in our annual report on Form10-K for the fiscal year ended February 29, 2004, filed with the SEC onMay 5, 2004.

 

In the opinion of management, all adjustments,consisting only of normal recurring items, considered necessary for a fairstatement have been included in the accompanying unaudited interim consolidatedfinancial information.  The results of operations for the interim periodspresented are not necessarily indicative of the operating results to beexpected for any subsequent interim period or for the fiscal year ending February 28,2005.

 

We have incurred losses and negative cash flow fromoperations during each fiscal year since inception. For the nine months ended November 30,2004, we reduced our net loss to approximately $1.5 million and negative cashflows to approximately $1.7 million. Our cash balances may decline further,although we believe that the effects of our capital financing, strategicactions implemented to improve revenue, and cost controls will be adequate togenerate sufficient cash resources to fund our future operations.  If wefail to generate sufficient revenues or adequately control spending, we may beunable to achieve key business objectives.

 

**NOTE 2. SIGNIFICANT ACCOUNTING POLICIES**

 

**Revenue recognition**

 

We derive online services and technology revenuesprimarily from our SubscribeNet digital delivery service, and from relatedprofessional services. Through our fiscal year ended February 28, 2003, wealso derived online services and technology revenue from the sale ofproprietary software licenses and related maintenance, primarily for our assetmanagement software. We may recognize future revenues from any sale of licensesand maintenance for our proprietary software underlying our SubscribeNet service.

 

We derive alliance and reimbursement revenue fromour alliance agreement with Software Spectrum, Inc. (“Software Spectrum”) (seeNote 7). This revenue consists of a percentage of the gross profit derived fromsales of Sun Java System and Sun ONE software (collectively “Sun software”) andrelated maintenance, as well as Websense software licenses and maintenance, andreimbursement for the costs of maintaining a sales team dedicated to sellingthose third-party software licenses and maintenance, for Software Spectrum.This revenue is recognized as we provide the services to Software Spectrum. Thereimbursement revenue is recognized in accordance with Emerging Issues TaskForce (“EITF”) No. 01-14, “Income Statement Characterization of ReimbursementsReceived for Out-of-Pocket Expenses Incurred,” which generally requires that acompany recognize as revenue travel expenses and other reimbursable expensesbilled to customers.

 

We derive software product revenues from our pastresale of licenses and maintenance for multiple business software productlines.

 

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We defer online services and technology revenuesrelated to our SubscribeNet digital delivery service, and generally recognizethem ratably over the term of the service arrangement. Some SubscribeNetservices provided to new customers involve significant implementation orcustomization essential to the functionality of our SubscribeNet services. Inthose cases, we defer revenue recognition until the services go-live date andrecognize the revenue on a ratable basis over the remaining contract term. Thego-live date is the date on which the essential functionality has beendelivered or the point at which no additional customization is required,whichever is later. We also sell additional professional services related toexisting SubscribeNet agreements. Generally, those services do not provide stand-alone value to acustomer, and accordingly, revenue for those services is recognized ratablyover the longer of the remaining estimated duration of the customerrelationship or the remaining contract term, commencing with the delivery ofthe additional services. Such revenue is included in online services andtechnology.  Related implementationcosts, principally labor costs, are deferred and recognized over the sameperiod that the revenue is recognized.

 

We recognize revenue when all of the followingconditions are met:

 

•                  Thereis persuasive evidence of an arrangement;

 

•                  Wehave provided the service to the customer, made the software available forcustomer download through our website, or shipped the software to the customer;

 

•                  Webelieve that collection of these fees is reasonably assured; and

 

•                  Theamount of fees to be paid by the customer is fixed or determinable.

 

When we resold third-party software license andmaintenance directly to our customers, or sold our proprietary asset managementsoftware licenses and maintenance, we obtained vendor-specific objectiveevidence of fair value for the maintenance element of the resold andproprietary software arrangements based on historical and contractual renewalrates for maintenance.  In such cases, we deferred the maintenance revenueat the outset of the arrangement and recognized it ratably over the period duringwhich the maintenance was to be provided (generally 12 months), which normallycommenced on the date the software was delivered.

 

**Costsof Deferred Revenue**

 

Wecapitalize direct costs of revenues related to significant implementation andprofessional services contracts associated with our SubscribeNetservices.  Direct costs include compensation and payroll-related fringebenefits directly related to the time spent on significant implementation andprofessional services activities.  These costs are recognized over thesame term as the associated revenue from those contracts (see “RevenueRecognition” above). Any change in our revenue recognition estimates couldresult in corresponding changes to our recognition of costs of deferredrevenues. At November 30, 2004, we had approximately $0.4 million incapitalized costs of deferred revenues.  We expense customer acquisitioncosts, including sales commissions, as incurred.

 

**Stock-Based Compensation**

 

We account for stock-based employee compensationarrangements in accordance with provisions of Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” (“APB No. 25”) andits related interpretations and comply with the disclosure provisions ofStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting forStock-Based Compensation” and related SFAS No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure.”  Under APB No. 25,compensation expense is based on the difference, if any, between the fair valueof our stock and the exercise price of the option on the date of thegrant.  We account for equity instruments issued to non-employees inaccordance with the provisions of SFAS No. 123 and EITF No. 96-18, “Accountingfor

 

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EquityInstruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling Goods or Services.”

 

The following table illustrates the effect on netloss and net loss per share if we had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based employee compensation (in thousands,except per share data):

 
| ** **                                                                                                        | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                        | ** ** | **November 30, 2004**     | ** ** | **November 30, 2003**    | ** ** | **November 30, 2004** | ** ** | **November 30, 2003** | ** ** |
| Net loss                                                                                                          |       | $                              | (767       | )                             | $          | (498 | ) | $ | (1,531 | ) | $ | (2,399 | ) |
| Add:  Stock-based compensation expense included in reported net loss                                              |       | —                         |       | 4                             |       | — |   | 28 |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards |       | (836                           | )          | (851                          | )          | (2,427 | ) | (2,760 | ) |
| Pro forma                                                                                                         |       | $                              | (1,603     | )                             | $          | (1,345 | ) | $ | (3,958 | ) | $ | (5,131 | ) |
| Net loss per  share — basic and diluted                                                                      |       |                           |       |                          |       |   |   |   |   |
| As reported                                                                                                       |       | $                              | (0.01      | )                             | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.04 | ) |
| Pro forma                                                                                                         |       | $                              | (0.03      | )                             | $          | (0.02 | ) | $ | (0.07 | ) | $ | (0.09 | ) |

 

We calculated the fair value of each option grant onthe date of grant, using the Black-Scholes option pricing model as prescribedby SFAS No. 123 using the following assumptions:

 
| ** **                | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|---------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                | ** ** | **November 30, 2004**     | ** ** | **November 30, 2003**    | ** ** | **November 30, 2004** | ** ** | **November 30, 2003** | ** ** |
| Risk-free interest rates  |       | 2.83-3.53                      | %          | 1.51-3.37                     | %          | 2.00-3.53 | % | 1.51-3.37 | % |
| Expected lives (in years) |       | 4                              |       | 4                             |       | 4 |   | 4 |   |
| Dividend yield            |       | 0                              | %          | 0                             | %          | 0 | % | 0 | % |
| Expected volatility       |       | 110                            | %          | 134                           | %          | 110 | % | 134 | % |

 

We calculated the fair value of the stock issuedunder the employee stock purchase plan using the Black-Scholes option pricingmodel as prescribed by SFAS No. 123 using the following assumptions:

 

| ** **                 | ** ** | **For the three and nine months ended** | ** ** |
|----------------------------|------------|-----------------------------------------|------------|
| ** **                 | ** ** | **November 30, 2004**              | ** ** | **November 30, 2003** | ** ** |
| Risk-free  interest rates  |       | 1.12 - 1.99                             | %          | 1.22 - 1.96 | % |
| Expected  lives (in years) |       | 6                                       |       | 6 |   |
| Dividend  yield            |       | 0                                       | %          | 0 | % |
| Expected  volatility       |       | 64 - 79                                 | %          | 102 - 151 | % |

 

**Net Loss Per Share**

 

Basic net loss per common share is computed bydividing the net loss attributable to common stockholders for the period by theweighted average number of common shares outstanding during the period,excluding shares subject to repurchase. If dilutive, any participation right ofredeemable convertible preferred stock is reflected in the calculation of basicincome per share using the two-class method. Diluted net loss per share iscomputed by dividing the net loss attributable to common stockholders for theperiod by the weighted average number of common and potential common sharesoutstanding during the period if the effect is dilutive. Potential commonshares are composed of common stock subject to repurchase rights andincremental shares of common stock issuable upon the exercise of stock optionsand warrants and upon the conversion of preferred stock.

 

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The following table sets forth the computation ofbasic and diluted net loss per share as well as securities that are notincluded in the diluted net loss per share calculation because to do so wouldbe antidilutive (in thousands, except per share amounts): 

 
| ** **                                                        | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                        | ** ** | **November 30, 2004**     | ** ** | **November 30, 2003**    | ** ** | **November 30, 2004** | ** ** | **November 30, 2003** | ** ** |
| Numerator:                                                        |       |                           |       |                          |       |   |   |   |   |
| Net loss                                                          |       | $                              | (767       | )                             | $          | (498 | ) | $ | (1,531 | ) | $ | (2,399 | ) |
| Denominator:                                                      |       |                           |       |                          |       |   |   |   |   |
| Weighted  average shares                                          |       | 60,361                         |       | 58,491                        |       | 60,032 |   | 54,726 |   |
| Basic and  diluted net loss per share                             |       | $                              | (0.01      | )                             | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.04 | ) |
| Antidilutive  securities not included in weighted average shares: |       |                           |       |                          |       |   |   |   |   |
| Redeemable  convertible preferred stock                           |       | 552                            |       | 556                           |       | 552 |   | 556 |   |
| Warrants to  purchase common stock                                |       | 1,868                          |       | 2,215                         |       | 1,868 |   | 2,215 |   |
| Employee  stock options                                           |       | 11,199                         |       | 8,633                         |       | 11,199 |   | 8,633 |   |
|                                                              |       | 13,619                         |       | 11,404                        |       | 13,619 |   | 11,404 |   |

 

Our outstanding redeemable convertible preferredstock is a participating security accounted for under the two-class method forearnings per share purposes.  However, because we have reported a netloss, there is no impact to the basic and diluted loss per share calculation.

 

**Recent Accounting Pronouncements**

 

In January 2003, the Financial AccountingStandards Board (“FASB”) issued Interpretation No. 46, “Consolidation ofVariable Interest Entities (“VIE”), an Interpretation of ARB No. 51” (“FIN46”) and in December 2003, issued a revised interpretation (“FIN 46-R”).FIN No. 46, as revised, requires certain VIEs to be consolidated by theprimary beneficiary of the entity if the equity investors in the entity do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. The provisions ofFIN 46-R are effective immediately for all arrangements entered into after January 31,2003. For arrangements entered into prior to February 1, 2003, we wererequired to adopt the provisions of FIN 46-R in the first quarter of our fiscalyear 2005. The adoption of FIN 46-R did not have a significant effect onour financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity” (“SFAS No. 150”). SFAS No. 150 establishesstandards for the classification and measurement of financial instruments withcharacteristics of both liabilities and equity. The provisions of SFASNo. 150 apply to the first interim period beginning after June 15,2003. During our three months ended November 30, 2003, we adopted theprovisions of SFAS No. 150.  The adoption of SFAS No. 150 did nothave a material impact on our financial position, results of operations or cashflows.

 

In April 2004, the EITFissued Statement No. 03-06 “Participating Securities and the Two-Class MethodUnder FASB Statement No. 128, *EarningsPer Share*“ (“EITF 03-06”). EITF 03-06 addresses a number ofquestions regarding the computation of earnings per share by companies thathave issued securities other than common stock that contractually entitle theholder to participate in dividends and earnings of a company when, and if, itdeclares dividends on its common stock. The issue also provides furtherguidance in applying the two-class method of computing earnings per share onceit is determined that a security is participating, including how to allocateundistributed earnings to such a security. EITF 03-06 is effective for fiscalperiods beginning after March 31, 2004. The adoption of EITF 03-06 did nothave a significant effect on our financial position or results of operations.

 

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In December 2004, the FASB issued SFAS No. 123(Revised 2004) “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R addressesall forms of share-based payment (“SBP”) awards, including shares issued underemployee stock purchase plans, stock options, restricted stock and stockappreciation rights. SFAS No. 123R will require us to expense SBP awards withcompensation cost for SBP transactions measured at fair value. The FASB originallystated a preference for a lattice model because it believed that a latticemodel more fully captures the unique characteristics of employee stock optionsin the estimate of fair value, as compared to the Black-Scholes model which wecurrently use for our footnote disclosure. The FASB decided to remove itsexplicit preference for a lattice model and not require a specific valuationmethodology. SFAS No. 123R requires us to adopt the new accountingprovisions beginning in our third quarter of our fiscal year ending February 28,2006. We have not yet determined the impact of applying the various provisionsof SFAS No. 123R.

 

**NOTE 3. CHANGES IN STOCKHOLDERS’ EQUITY**

 

During the nine months ended November 30, 2004,our stockholders’ equity changed as follows (in thousands): 

 
| ** **                                                    | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
|---------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|-----------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                    | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**     | ** ** | **Deficit**            | ** ** | **Equity**        | ** ** | **Loss** | ** ** |
|                                                          |       |             |       |                    |       |            |       |                   |       |              |       |   |   |
| Balance at February 29,  2004                            |       | 59,504           |       | $                       | 6          |            | $          | 162,043                |       | $                 | (154,459   | ) | $ | 7,590 |   |   |   |
| Exercise of  stock options                                    |       | 371              |       | —                  |       | 381             |       | —                 |       | 381               |       |   |   |
| Issuance of  common stock for employee stock purchase program |       | 195              |       | —                  |       | 230             |       | —                 |       | 230               |       |   |   |
| Conversions  of warrants into common stock                    |       | 347              |       | —                  |       | 491             |       | —                 |       | 491               |       |   |   |
| Net loss                                                      |       | —           |       | —                  |       | —          |       | (1,531                 | )          | (1,531            | )          | $ | (1,531 | ) |
| Other  comprehensive loss                                     |       | —           |       | —                  |       | —          |       | —                 |       | —            |       | — |   |
| Comprehensive  loss                                           |       | —           |       | —                  |       | —          |       | —                 |       | —            |       | $ | (1,531 | ) |
| Balance at November 30,  2004                            |       | 60,417           |       | $                       | 6          |            | $          | 163,145                |       | $                 | (155,990   | ) | $ | 7,161 |   |   |   |

 

**NOTE 4. CONTINGENCIES**

 

**Indemnifications**

 

In the course of our business, we have givenindemnities and made commitments and guarantees under which we may be requiredto make payments. These indemnities include:

 

*•**                 **Intellectual PropertyIndemnities to Customers and Resellers.*Our customer and reseller agreements for our SubscribeNet servicetypically contain provisions that indemnify our customers or resellers fordamages and costs resulting from claims alleging that our services infringe theintellectual property rights of a third party. We have also entered intosoftware license agreements indemnifying the licensees for damages and costsresulting from claims alleging that the software infringes third-partyintellectual property rights. The duration of these indemnities is typicallyunlimited. Our potential payments under these indemnities are in some caseslimited (e.g., to the fees paid to us under the contract or to another amount)and are in other cases unlimited. Where we have given such indemnities forthird-party software licenses that we resold, we have typically receivedsimilar indemnities from the software publishers. We plan to continue to enterinto SubscribeNet service agreements with customers and resellers, to continueto license software, and to continue to provide industry-standard indemnitiesto our service customers, resellers and licensees.

 

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*•**                 **Intellectual PropertyIndemnity to Acquiror of Asset Management Business.*In the May 2002 sale of our AssetManagement software business to Computer Associates International, Inc., weagreed to indemnify Computer Associates for damages and costs incurred by it inconnection with claims alleging that the software and technology we sold tothem infringes the intellectual property rights of third parties. Thisindemnity will remain in effect until May 2007. Our maximum potentialpayment under this indemnity is $9.5 million.

 

*•**                 **Indemnities to PrivateInvestors.*In our privateplacements of stock, we have made representations and warranties to the investorsand placement agents, and have agreed to indemnify them for any damages andcosts they incur as a result of our breach of those representations andwarranties. We also have signed registration rights agreements with privateinvestors under which we indemnify them for damages they incur as a result ofany material misstatements or omissions in our registration statements, and paypenalties in the event we fail to maintain the effectiveness of registrationstatements. The duration of our indemnities to our investors under therespective stock and warrant purchase agreements ranges from one to two yearsfrom the respective closing dates, other than the purchase agreements for our June 2000warrants and our January 2001 Series A Preferred Stock and warrants, whichprovide for indemnities of unlimited duration. Our indemnities to our investorsunder the respective registration rights agreements expire upon termination ofour registration obligations, which is typically the date the securities may besold under Rule 144(k) under the Securities Act of 1933. Our potentialpayments under these indemnities are unlimited.

 

*•**                 **Indemnities to Directorsand Officers.*We indemnifyour directors and officers for damages and costs incurred in the performance oftheir duties, to the extent permitted by Delaware law. The duration of, and ourpotential payments under, these indemnities are unlimited, subject to Delawarelaw.

 

We have historically received only a very limitednumber of requests for indemnification under these agreements and have not beenrequired to make material payments under them. Accordingly, we have notrecorded a liability related to these indemnification provisions.

 

**Legal Proceedings**

 

*In re Intraware, Inc. Initial Public OfferingSecurities Litigation*

 

In October 2001, we were served with a summonsand complaint in a purported securities class action lawsuit. On or about April 19,2002, we were served with an amended complaint in this action, which is nowtitled *In re Intraware, Inc. Initial Public OfferingSecurities Litigation*, Civ. No. 01-9349 (SAS) (S.D.N.Y.),related to *In re Initial Public Offering Securities Litigation*,21 MC 92 (SAS) (S.D.N.Y.). The amended complaint is brought purportedly onbehalf of all persons who purchased our common stock from February 25,1999 (the date of our initial public offering) through December 6, 2000.It names as defendants Intraware, three of our present and former officers anddirectors, and several investment banking firms that served as underwriters ofour initial public offering. The complaint alleges liability under Sections 11and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934, on the grounds that the registration statementfor the offerings did not disclose that: (1) the underwriters had agreedto allow certain customers to purchase shares in the offerings in exchange forexcess commissions paid to the underwriters; and (2) the underwriters hadarranged for certain customers to purchase additional shares in the aftermarketat predetermined prices. The amended complaint also alleges that theunderwriters misused their securities analysts to manipulate the price of ourstock. No specific damages are claimed.

 

Lawsuits containing similar allegations have beenfiled in the Southern District of New York challenging over 300 other initialpublic offerings and secondary offerings conducted in 1999 and 2000. All

 

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ofthese lawsuits have been consolidated for pretrial purposes before UnitedStates District Court Judge Shira Scheindlin of the Southern District of NewYork. On July 15, 2002, an omnibus motion to dismiss was filed in thecoordinated litigation on behalf of the issuer defendants, of which Intrawareand its three named current and former officers and directors are a part, oncommon pleadings issues. On or about October 9, 2002, the Court enteredand ordered a Stipulation of Dismissal, which dismissed the three named currentand former officers and directors from the litigation without prejudice. On February 19,2003, the Court entered an order denying in part the issuer defendants’ omnibusmotion to dismiss, including those portions of the motion to dismiss relatingto Intraware. No discovery has been served on us to date.

 

In June and July 2003, nearly all of theissuers named as defendants in the *In re Initial PublicOffering Securities Litigation* (collectively, the “issuer-defendants”),including us, approved a tentative settlement proposal that is reflected in amemorandum of understanding. A special committee of our Board of Directorsapproved the memorandum of understanding in June 2003. The memorandum ofunderstanding is not a legally binding agreement. Further, any final settlementagreement would be subject to a number of conditions, most of which would beoutside of our control, including approval by the Court. Theunderwriter-defendants in the *In re Initial PublicOffering Securities Litigation* (collectively, the “underwriter-defendants”),including the underwriters of our initial public offering, are not parties tothe memorandum of understanding.

 

The memorandum of understanding provides that, inexchange for a release of claims against the settling issuer-defendants, theinsurers of all of the settling issuer-defendants will provide a suretyundertaking to guarantee plaintiffs a $1 billion recovery from thenon-settling defendants, including the underwriter-defendants. The ultimateamount, if any, that may be paid on behalf of Intraware will therefore dependon the final terms of the settlement agreement, including the number ofissuer-defendants that ultimately approve the final settlement agreement, andthe amounts, if any, recovered by the plaintiffs from theunderwriter-defendants and other non-settling defendants. If all orsubstantially all of the issuer-defendants approve the final settlementagreement, the amount our insurers would be required to pay to the plaintiffscould range from zero to approximately $3.5 million, depending on plaintiffs’recovery from the underwriter-defendants and from other non-settling parties.If the plaintiffs recover at least $1 billion from theunderwriter-defendants, our insurers would have no liability for settlementpayments under the proposed terms of the settlement. If the plaintiffs recoverless than $1 billion, we believe our insurance will likely cover our shareof any payments towards satisfying plaintiffs’ $1 billion recoverydeficit.  Management estimates that its range of loss relative to thismatter is zero to $3.5 million. Presently there is no more likely pointestimate of loss within this range. As a consequence of the uncertaintiesdescribed above regarding the amount we will ultimately be required to pay, ifany, as of November 30, 2004, we have not accrued a liability for thismatter.

 

*Leon Segen v. ComVest Venture Partners, LP, et al.*

 

In July 2004, a complaint was filed in theUnited States District Court for the District of Delaware, Civ.No. 04-822, against ComVest Venture Partners, LP; ComVest Management, LLC;Commonwealth Associates Management Company, Inc.; Commonwealth Associates, LP;RMC Capital, LLC; Michael S. Falk; Robert Priddy; Travis L. Provow; KeithRosenbloom; and Intraware. The complaint describes Intraware as a nominaldefendant. The complaint alleges that, between August 2001 and January 2002,all of the defendants other than Intraware were members of a group, andtherefore should be treated as a single “person,” for purposes of Sections13(d)(3) and 16(b) of the Securities Exchange Act of 1934 (the “1934 Act”). The complaint further alleges that ComVest Venture Partners, LP andMr. Priddy, while they and the other alleged group members collectivelyowned more than 10% of a class of our equity securities, bought and sold ourequity securities within a 6-month period and failed to disgorge to us theprofits allegedly realized in those trades, thereby violating Section 16(b)of the 1934 Act.  Mr. Falk was a member of our Board of Directors from April 2001to May 2002 and Mr. Provow was a member of our Board of Directors from October 2001to May 2002.  The complaint demands that ComVest Venture Partners, LP andMr. Priddy pay over to Intraware the profits they allegedly realized andretained in violation of Section 16(b) of the 1934 Act, together withinterest and legal costs. According to the compliant, the amount of thosealleged profits is unknown to the plaintiff, however, the information allegedin the

 

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complaintsuggests that amount may be approximately $1.3 million. The complaint doesnot seek damages against us.  After the complaint was filed, the plaintiffand Intraware signed a stipulation acknowledging that Intraware takes noposition with respect to the claims in the action, and providing that Intrawareaccepts service of the complaint, that Intraware is not required to file ananswer or other response to the complaint, and that Intraware will otherwisehave the rights and responsibilities of a party to the action.

 

We are also subject to legal proceedings, claims andlitigation arising in the ordinary course of business. We do not expect thatthe ultimate costs to resolve these matters will have a material adverse effecton our consolidated financial position, results of operations, or cash flows.

 

**NOTE 5.  REDEEMABLE CONVERTIBLE PREFERRED STOCK**

 

We are authorized, subject to limitations prescribedby Delaware law, to provide for the issuance of preferred stock in one or moreseries, to establish from time to time the number of shares included withineach series, to fix the rights, preferences and privileges of the shares ofeach wholly unissued series and any qualifications, limitations or restrictionsthereon, and to increase or decrease the number of shares of any such series (butnot below the number of shares of such series then outstanding) without anyfurther vote or action by the stockholders.

 

During the nine months ended November 30, 2004there was no activity in our redeemable convertible preferred stock.

 

**NOTE 6.  NOTES PAYABLE**

 

In August 2003, we issued a note payable toSilicon Valley Bank for proceeds of approximately $2.0 million.  The notebears an annual interest rate of the greater of 5.25% or 1.00% above the bank’sprime rate (5.00% at November 30, 2004).  The interest rate on thenote payable at November 30, 2004, was 6.00%.  The note is payable infixed monthly principal installments plus interest through September 2005. In connection with the note payable, we issued a warrant to purchase 41,730shares of our common stock at an exercise price of $1.19 per share.  Thewarrant was immediately exercisable and expires in August 2010.  Weestimated the allocated fair value of such warrant at approximately $46,000,using the Black-Scholes valuation model with the following assumptions:expected volatility of 136%, risk-free interest rate of 4.01%, expected life ofseven years and no dividends.  The value of the warrant was recorded as adebt discount and is being amortized as interest expense using the effective interestmethod over the life of the note payable.  For the nine months ended November 30,2004, interest expense related to such warrant amounted to approximately$17,000.  The unamortized balance of approximately $6,000 at November 30,2004, is presented as a discount against the principal balance of the notepayable outstanding.  At November 30, 2004, the warrants had not beenexercised.

 

In August 2003, we also entered into a line ofcredit with Silicon Valley Bank. The line of credit bears annual interest at thegreater of 5.50% or 1.00% above the bank’s prime rate.  The agreementprovided for borrowings of up to $500,000 through August 2004 and waslimited to equipment purchases.  As of November 30, 2004, we hadborrowed approximately $363,000 under this agreement and the interest rate atthat date was 6%.  Monthly payments of interest only were payable through August 1,2004, after which fixed monthly principal installments plus interest will bemade through August 2006.

 

In September 2004, we entered into another lineof credit with Silicon Valley Bank.  This new line of credit bears annualinterest at the greater of 5.50% or 1.00% above the bank’s prime rate. This line of credit allows us to borrow up to $500,000 through August 1, 2005,solely to finance equipment purchases.   As of November 30, 2004, wehad borrowed approximately $200,000 under this agreement and the interest rateat that date was 6.00%.  Monthly payments of interest only arepayable through August 2005, after which fixed monthly principal installmentsplus interest will be made through August 2007.

 

All of this debt is collateralized by a seniorsecurity interest in substantially all of our assets.  We are alsorequired to maintain compliance with certain financial covenants, with all ofwhich we were in compliance at November 30, 2004.

 

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Scheduled maturities of debt at November 30,2004, are as follows (in thousands): 

 
| Years  ending:          |   |   |   |
|-------------------------|--------|--------|--------|
| February 28,  2005 |   | $      | 293    |   |
| February 28,  2006 |   | 801    |   |
| February 28,  2007 |   | 191    |   |
| February 28,  2008 |   | 58     |   |
|                    |   | $      | 1,343  |   |

 

**NOTE 7. ALLIANCES**

 

**Provision of Sales and Marketing Services to SoftwareSpectrum for Resale of Third-Party Software**

 

Prior to June 2001, we resold Sun Microsystems,Inc. Internet-related application software (marketed under the brands “Sun/NetscapeAlliance” and “iPlanet”) and related maintenance services to end-users in NorthAmerica under an agreement between us and Sun.  In June 2001, wesigned an agreement with Software Spectrum under which we transferred toSoftware Spectrum our Sun software resale business, including our agreementwith Sun for resale of Sun software and maintenance services.  SoftwareSpectrum assumed primary responsibility for resale of Sun software and related maintenanceunder its agreement with Sun (which has since been replaced by an agreementbetween Software Spectrum and Sun’s distributor).  We continue to assistSoftware Spectrum in its sales and marketing of the Sun software currentlymarketed under the brands “Sun ONE” and “Java Enterprise System,” as well asrelated maintenance, and also provide our SubscribeNet service to SoftwareSpectrum to enable it to deliver that Sun software to its customerselectronically. As part of this arrangement, Software Spectrum pays us apercentage of the gross profit derived from its sales of Sun software licensesand maintenance services, and reimburses us for up to a set amount of our costsin maintaining a team dedicated to sales of Sun software licenses andmaintenance (included in the Alliance and reimbursement revenue line item onour consolidated statements of operations).  The June 2001 agreementwith Software Spectrum was part of our transition out of the business ofgenerally reselling third-party software. At the time we announced thisagreement, we also ceased reselling all third-party software except a limitednumber of products that were complementary to our SubscribeNet service.

 

In December 2003, we amended our June 2001agreement with Software Spectrum to add Websense software to the set ofproducts that Software Spectrum and Intraware jointly resell under thatagreement. Under these arrangements, Software Spectrum pays us a percentage ofthe gross profit derived from our joint sales of Websense software licenses andmaintenance services (included in the Alliance and reimbursement revenue lineitem on our consolidated statements of operations).

 

The current term of this agreement with SoftwareSpectrum runs until June 30, 2005.  Either party may terminate theagreement without cause on 90 days’ prior written notice.  Any terminationof our relationship with Software Spectrum without an adequate replacementwould cause a substantial and immediate decrease in our revenues.

 

**Resale of SubscribeNet Service by Zomax Incorporated**

 

On August 12, 2002, we entered into a strategicalliance agreement (the “Strategic Alliance Agreement”) with Zomax Incorporated(“Zomax”), an international outsource provider of process managementservices.  The Strategic Alliance Agreement provided for Zomax’ marketingand resale of our SubscribeNet digital delivery service to its global customerbase.  Under the Strategic Alliance Agreement, Zomax was required to pay aminimum license fee totaling $15 million to us over 10 years, subject to some conditions,including Zomax’ right to cancel the agreement at any time with one year’snotice.  The annual minimum license fee was based on a graduated scale,beginning with $0.5 million in the first year of the agreement and escalatingto $2.2 million in the final year of the agreement.  The agreement alsoprovided for Zomax’ payment to us of non-refundable quarterly service fees,based on sales of the SubscribeNet service by Zomax, over the term of theagreement.  Under the agreement, our SubscribeNet service was the

 

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onlyelectronic software delivery solution Zomax was permitted to sell and Zomax wasthe only supply chain management outsourcing industry company we couldauthorize to resell our SubscribeNet service.  In accordance with theagreement, Zomax made a $1 million prepayment to us on September 3, 2002,to be applied against future fees.  The Strategic Alliance Agreement alsoprovided for Zomax’ payment to us of fees for any referrals by us to Zomax ofpotential customers for Zomax’ services which resulted in completedsales.  Lastly, we reimbursed Zomax for one-half of the base salary of aproduct sales manager, up to a maximum amount.

 

On the day we entered into the Strategic AllianceAgreement, we also completed a private placement of approximately 6.1 millionshares of our common stock to Zomax for gross proceeds of approximately $5.0million.  Upon completion of that private placement, Zomax heldapproximately 12% of our outstanding common stock.  On September 18,2003, we filed an amended registration statement to register the resale of thecommon stock issued to Zomax.  The SEC declared that registrationstatement effective on September 25, 2003.

 

On August 29, 2003, Intraware and Zomax amendedthe Strategic Alliance Agreement to: (1) allow Zomax to terminate the agreementas of August 12, 2004, or as of any date thereafter, with or withoutcause, by delivery of 30 days prior written notice; (2) accelerate the due dateof the payment of $0.4 million by Zomax to us for the second year of theagreement; and (3) reduce the minimum license fee for the third year of theagreement, which was to begin August 12, 2004, from $1.0 million to $0.6million if Zomax had not terminated the agreement before then.  During thethree months ended November 30, 2003, and in accordance with thatamendment, we received $0.4 million from Zomax, all of which was recorded asdeferred revenue at February 29, 2004, and was to be applied to futureservices.

 

On April 30, 2004, Zomax and Intraware mutuallyterminated the Strategic Alliance Agreement and entered into a new reselleragreement (the “Zomax Reseller Agreement”). The Zomax Reseller Agreement allowsZomax to resell our SubscribeNet service. Zomax will pay us fees, to bedetermined on a case-by-case basis, for each resale of the SubscribeNetservice.  Under the Zomax Reseller Agreement, Zomax will no longer payminimum annual license fees to us. The term of the Zomax Reseller Agreement isone year, subject to automatic annual renewal for one-year periods. Each partyhas the right to terminate the Zomax Reseller Agreement without cause upon60 days’ notice.

 

As part of the termination of the Strategic AllianceAgreement, Zomax and Intraware will no longer be subject to exclusivityrequirements or restrictions on sales to other companies. In addition, inconsideration for Zomax’ termination of the Strategic Alliance Agreement, werefunded approximately $0.1 million of the $0.4 million prepayment for futureservices paid by Zomax to us during the three months ended November 30,2003.  The remaining deferred revenue balance of approximately $0.4million at April 30, 2004, was recognized as revenue during the threemonths ended May 31, 2004, given that we no longer had any obligations underthe Strategic Alliance Agreement.

 

**Resale of SubscribeNet Service by Hewlett-PackardCompany**

 

In September 2004, we entered into an agreementwith Hewlett-Packard Company (“HP”) for its resale of our SubscribeNet servicethrough HP’s Software Publisher Services division (the “HP Reseller Agreement”). Under the HP Reseller Agreement, HP will pay us service fees based on itsresales of the SubscribeNet service.  The term of the HP ResellerAgreement is one year, subject to automatic annual renewal for one-yearperiods. Each party has the right to terminate the HP Reseller Agreementwithout cause upon 120 days’ notice.

 

**NOTE 8. RESTRUCTURING**

 

During the three months ended November 30,2004, we realized a payroll tax refund for overpaid payroll taxes ofapproximately $75,000.  These overpaidpayroll taxes related to supplemental unemployment compensation benefits forinvoluntarily terminated employees during our restructuring events in December 2000,August 2001 and May 2002.  As of November 30,2004 we believe all transactions relating to past restructuring events havebeen recognized.

 

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**ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

Thefollowing discussion of our financial condition and results of operationsshould be read in conjunction with our consolidated financial information andrelated notes included in our annual report on Form 10-K for the fiscal yearended February 29, 2004, which was filed with the Securities and ExchangeCommission (“SEC”) on May 5, 2004.  This discussion containsforward-looking statements that involve risks and uncertainties.Forward-looking statements include, but are not limited to, statements aboutour future cash and liquidity position, the amount and timing of futurerevenues and expenses and customer demand, our deployment of products andservices, and activities of third parties on which we rely.  Allforward-looking statements included in this document are based on informationavailable to us as of the date hereof, and we assume no obligation to updateany forward-looking statement.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofcertain factors, including but not limited to, those discussed in “Risk Factors”below and elsewhere in this Form 10-Q.

 

**INTRAWAREOVERVIEW**

 

Ourgoal is to be the preeminent digital delivery and entitlement servicesprovider. We are pursuing a three-pronged strategy to achieve this goal. First,we are seeking to solidify and strengthen our technological advantage byfurther improving our digital delivery solutions through internal research anddevelopment and through alliances with adjacent technology providers. Second, weare seeking to extend our customer base by strengthening our sales force,implementing new marketing programs focused on lead generation, offering newfunctional capabilities and pricing packages, and providing exceptionalcustomer service. Third, we are working to become a profitable, cash-generatingcompany by growing our SubscribeNet business and practicing stringent fiscalresponsibility.

 

Wecurrently see a number of trends in the marketplace that are potentiallyimportant for our business. First, growth in the macroeconomy and thetechnology sector seem to have been uncertain over the past year, apparentlydue in part to concerns about geopolitical issues, potential terrorist attacksand petroleum costs.  In the current climate, spending by technologycompanies is cautious. Second, in the past year there have been a number ofmergers and acquisitions in the enterprise software sector. Theseconsolidations pose both opportunities and risks for us, potentially leadingeither to growth in our contracts with those customers or to cancellation ofcustomer contracts. Third, technology companies are increasingly outsourcingoperational functions to reduce costs. Our services enable enterprise softwarecompanies to outsource key operational functions in a manner that we believe isfinancially compelling. Therefore, we may benefit from this outsourcing trend.Fourth, the use of hosted web-based applications, which in the past has beenlimited by concerns about speed, reliability and security, is now becoming moreaccepted among mainstream businesses, largely because of a desire for costsavings. This trend may benefit us because our SubscribeNet service is a hostedweb-based application.

 

Ourmanagement is focused on four key opportunities. The first opportunity is whatappears to be growing demand for electronic delivery and management ofenterprise software applications. The second opportunity is to furtherpenetrate the enterprise software provider market by better integrating andcross-selling our suite of services, including our SubscribeNet digitaldelivery service, our outsourced sales and marketing services, and thee-commerce services and software licensing integration that we provide throughstrategic alliances. The third opportunity is to continue expanding intovertical markets other than enterprise software, and into other untappedmarkets. The fourth opportunity is to continue forging alliances with adjacenttechnology providers to build our market position and develop new revenuestreams.

 

Wealso face a number of key risks, which are described in the “Risk Factors”beginning on page 27 below.

 

Weearn revenues and generate cash principally through recurring service feescharged for our

 

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SubscribeNet service,professional services fees charged for customization of our SubscribeNetservice, and profit-sharing and cost reimbursement received for our sales andmarketing services. Historically, we have also raised substantial amounts ofcash through private and public stock placements.

 

Despiteour revenue- and cash-generating activities, we have incurred losses andnegative cash flows from operations during each fiscal year since inception.For the nine months ended November 30, 2004, our net loss was approximately$1.5 million and we had negative cash flows from operations of approximately$1.7 million.  Our cash balances may decline further, although we believethat the effects of our capital financing, strategic actions implemented toimprove revenue, and cost controls will be adequate to generate sufficient cashresources to fund our future operations.  If we fail to generatesufficient revenues or adequately control spending, we may be unable to achievekey business objectives.

 

**CriticalAccounting Policies and Estimates**

 

ThisMD&A discusses our unaudited interim consolidated financial information,which has been prepared in accordance with generally accepted accountingprinciples in the United States of America. In preparing this financialinformation, we are required to make estimates and assumptions affecting thereported amounts of assets and liabilities and the disclosure of contingentassets and liabilities at the date of the financial information and thereported amounts of revenues and expenses during the reporting period. On anongoing basis, we evaluate our estimates and judgments. We base our estimatesand judgments on historical experience and on various other factors believed tobe reasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities notreadily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

 

Weconsider accounting policies related to revenue recognition, costs of deferredrevenue, stock-based compensation, allowance for doubtful accounts, goodwilland intangibles, and income taxes to be critical accounting policies due to theestimation process involved in each.

 

*RevenueRecognition*

 

Onlineservices and technology revenue results primarily from three types ofarrangements.  First, it results from sales of our SubscribeNet digitaldelivery service to software vendors and other companies that distributesoftware as part of their business.  Second, it results from professionalservices that we provide to customize our SubscribeNet service for customers,to convert data for customers, and to integrate our proprietary software. Third, it results from the sale of our proprietary software licenses andrelated maintenance to companies using those products internally or using thoseproducts to provide web-based services to their customers. As a result of thesale of our Asset Management software business in May 2002, we are notcurrently deriving revenue from licenses, maintenance or integration servicesfor our proprietary software; however, we may recognize such revenues in thefuture if opportunities arise to sell licenses for our proprietary softwareunderlying our SubscribeNet service and related maintenance. We sell ourSubscribeNet service, and will sell proprietary software licenses ifopportunities present themselves, primarily through our direct sales force andauthorized resellers.

 

Allianceand reimbursement revenue primarily relates to our alliance agreement withSoftware Spectrum for sales and marketing services. This revenue consists of apercentage of the gross profit derived from Software Spectrum’s sales of thethird-party software and maintenance for which we provide sales and marketingservices, and reimbursement for the costs of maintaining a sales team dedicatedto providing sales and marketing services to Software Spectrum for thatthird-party software and maintenance. This revenue is recognized as we providethe services to Software Spectrum.

 

Wederive software product revenues from our past resales of licenses andmaintenance for multiple business software product lines. As of July 1,2001, we generally no longer resell third-party software licenses andmaintenance, though we still resell licenses for third-party productscomplementary to our SubscribeNet service. Since July 1, 2001, we havecontinued to recognize revenue from our resale of third-party software licensesand related maintenance contracts over the life of the arrangements made prior

 

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to July 1, 2001. Vendorspecific objective evidence of fair value for the maintenance element of theresold software arrangements has been based on historical and contractual renewalrates for maintenance. We deferred the maintenance revenue at the outset of thearrangement and recognized it ratably over the period during which themaintenance was to be provided.  This period normally commenced on thedate the software was delivered and generally continued for 12 months, althoughcertain maintenance contracts continued for longer periods.  At November 30,2004, we did not have any deferred revenue relating to software productrevenues.

 

Wedefer online services and technology revenues related to our SubscribeNet digitaldelivery service and generally recognize them ratably over the term of theservice arrangement. Some SubscribeNet service implementations for newcustomers involve customization essential to the functionality of the service. In those cases, we defer revenue recognition until the service go-live date isreached and recognize the revenue on a ratable basis over the remainingcontract term.  The go-live date is the later of the date on which theessential functionality is delivered or the point at which no additionalcustomization is required.  Our SubscribeNet contracts with customerstypically give the customer a period of time (generally five days) to evaluatea SubscribeNet implementation after we have completed it, and provide that thecustomer is deemed to have accepted the implementation if it has notaffirmatively rejected it within that period.  We typically rely on suchnon-rejections by customers to indicate their acceptance ofimplementations.  Any subsequent indications by our customers that theirimplementations have not been properly completed could have a material adverseimpact on our financial condition or results of operations.

 

Wealso sell additional professional services related to SubscribeNet agreements.  Generally, these services do not providestand-alone value to a customer, and accordingly, we defer recognition of thatrevenue until the go-live date for the professional services, similar to themanner in which we treat SubscribeNet service revenues as discussedabove.  Such professional services revenues are recognized ratably overthe longer of the remaining estimated customer life or the remaining contractterm, commencing with the completion of the professional services. Estimatedcustomer life requires that we periodically estimate the projected life of ourexisting customers, based on historical information, such as customer renewalrates. Since revenues generated from additional professional services representless than 6% of our overall revenues for the year ended February 29, 2004,any change to our estimated customer life is unlikely to have a materialadverse impact on our financial condition or results of operations.

 

Werecognize revenue when all of the following conditions are met:

 

•                  There is persuasive evidence of anarrangement;

•                  We have provided the service to the customer,made the software available for customer download through our website, orshipped the software to the customer;

•                  We believe that collection of these fees isreasonably assured; and

•                  The amount of fees to be paid by the customeris fixed or determinable.

 

Revenuefrom transactions through authorized resellers has been recognized when thelicenses and maintenance have been resold or utilized by the reseller or whenour related obligations have been satisfied. Those transactions primarilyconsisted of resales, through our authorized resellers, of our proprietaryAsset Management software licenses and maintenance (we sold our AssetManagement software business to Computer Associates International, Inc. duringour fiscal year ended February 28, 2003).  For those transactions, webased vendor specific objective evidence of fair value for the maintenanceelement of the proprietary software arrangements on historical and contractualrenewal rates for maintenance. We deferred the maintenance revenue at theoutset of the arrangement and recognized it ratably over the period duringwhich the maintenance was to be provided (generally 12 months), whichnormally commenced on the date the software was delivered.

 

Asmentioned above, a determination that the collection of fees is reasonablyassured is a precursor to recognizing revenue. Determination of collectabilityof payments requires judgment on the part of management and includesperiodically evaluating customers’ credit (see “Allowance for Doubtful Accounts”below).

 

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*Costs ofDeferred Revenue*

 

Wecapitalize direct costs of revenues related to significant implementation and professionalservices contracts associated with our SubscribeNet services.  Directcosts include compensation and payroll-related fringe benefits directly relatedto the time spent on significant implementation and professional servicesactivities.  These costs are recognized over the same term as theassociated revenue from those contracts (see “Revenue Recognition” above). Anychange in our revenue recognition estimates could result in correspondingchanges to our recognition of costs of deferred revenues. At November 30,2004, we had approximately $0.4 million in capitalized costs of deferredrevenues.  We expense customer acquisition costs, including salescommissions, as incurred.

 

*Stock-basedCompensation*

 

Weaccount for stock-based compensation for our employees using the intrinsicvalue method presented in Accounting Principles Board (APB) No. 25, ”Accountingfor Stock Issued to Employees,” and related interpretations, and comply withthe disclosure provisions of Statement of Financial Accounting Standard (SFAS)No. 123, ”Accounting for Stock-Based Compensation,” and with thedisclosure provisions of SFAS No. 148, ”Accounting for Stock-BasedCompensation—Transition and Disclosure Amendment of SFAS No. 123.” Under APBNo. 25, compensation expense is based on the difference, as of the date of thegrant, between the fair value of our stock and the exercise price. For ourfiscal quarter ended November 30, 2004, no stock-based compensation wasrecorded for stock options granted to our employees because the exercise priceof all stock options granted to our employees was equal to the market price ofthe underlying stock on the date of grant.

 

InOctober 2004, the Financial Accounting Standards Board (FASB) issued SFASNo. 123 (Revised) “Share Based Payment” (SFAS No. 123R). The standard requirescompanies to value employee stock options and stock issued under employee stockpurchase plans using the fair value based method on the grant date and recordstock-based compensation expense. The fair value based models that companiesare allowed to use can be different from the Black-Scholes option-pricingmodel, which we currently use to calculate the pro forma effect on net incomeand earnings per share if we had applied SFAS No. 123 to employee optiongrants. Note 2 to our unaudited interim consolidated financial informationshows what the pro forma net loss and loss per share for the three months endedNovember 30, 2004 and 2003 would have been if we had applied SFAS No.123.  However, the actual impact to our results of operations uponadoption of the standard could materially differ from the pro forma informationincluded in Note 2 to our unaudited interim consolidated financial informationdue to differences in the option-pricing model used, estimates and assumptionsrequired, and options to be included in the calculation upon adoption. The fairvalue based models require the input of highly subjective assumptions and donot necessarily provide a reliable single measure of the fair value of ourstock options. SFAS No. 123R requires us to adopt the new accounting provisionsbeginning in our third quarter of our fiscal year ending February 28,2006.

 

*Allowancefor Doubtful Accounts*

 

Wemaintain an allowance for doubtful accounts for estimated losses from ourinability to collect required payments from our customers. When evaluating theadequacy of this allowance, we analyze specific accounts receivable, historicalbad debts, customer credit-worthiness, current economic trends and changes inour customer payment history.  We may need to record increases to ourallowance balances in the future.  At November 30, 2004, we have manyaccounts receivable balances and one large unbilled receivable balance. Any dispute, early contract termination or other collection issue related tothese receivable balances could have a material adverse impact on our financialcondition or result of operations. At November 30, 2004, our unbilledreceivable balance was $0.3 million. This balance relates to our SoftwareSpectrum agreement (see “Revenue Recognition” above). There are no allowancesfor doubtful accounts related to this balance. This estimate involvesmanagement’s judgment, which takes into account Software Spectrum’s priorpayment history, current credit-worthiness and overall business condition.Changes in the above factors could have a material impact on actual bad debtsincurred.

 

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*Goodwilland Intangibles*

 

Weare required to regularly review all of our long-lived assets, including goodwilland other intangible assets, for impairment whenever events or changes incircumstances indicate that the carrying value may not be recoverable.  Wereview goodwill balances for impairment at least once annually and havedetermined that we have one reporting unit.  Factors we consider importantwhich could trigger an impairment review include, but are not limited to,significant underperformance relative to historical or projected futureoperating results, significant changes in the manner of use of the acquiredassets or the strategy for our overall business, significant negative industryor economic trends, a significant decline in our stock price for a sustainedperiod, and our market capitalization relative to net book value. When wedetermine that an impairment review for intangible and long-lived assets isnecessary based upon the existence of one or more of the above indicators ofimpairment, we compare the book value of such assets to the future undiscountedcash flows attributable to those assets. If the book value is greater than thefuture undiscounted cash flows, we measure any impairment based on a projecteddiscounted cash flow method using a discount rate commensurate with the riskinherent in our current business model. When we determine an impairment reviewof goodwill is necessary based on an impairment indicator or based on ourannual testing requirements, we compare the fair value of the reporting unit tothe carrying value of the reporting unit. If the carrying value of the reportingunit is greater than the fair value of the reporting unit, an impairment may benecessary. Significant judgment is required in the development of projectedcash flows for these purposes, including assumptions regarding the appropriatelevel of aggregation of cash flows, their term and discount rate as well as theunderlying forecasts of expected future revenue and expense.

 

*IncomeTaxes*

 

Inconjunction with preparing our financial statements, we must estimate ourincome taxes in each of the jurisdictions in which we operate. This processinvolves estimating our actual current tax expense together with assessingtemporary differences resulting from differing treatment of items for tax andaccounting purposes. These differences result in deferred tax assets andliabilities. We must then assess the likelihood that our deferred tax assetswill be recovered from future taxable income and to the extent we believe thatrecovery is not likely, we must establish a valuation allowance. Given that wehave incurred losses since inception and therefore have not been required topay income taxes, we have fully reserved our deferred tax assets at February 29,2004.  In the event that we are able to realize our deferred tax assets inthe future, an adjustment to the deferred tax asset would increase income inthe period that this is determined.

 

**Results ofOperations**

 

*TotalRevenue*

 

Thefollowing table sets forth the revenue, changes in revenue and percentage oftotal revenue for the periods indicated (in thousands, except percentageamounts):

 
| ** **                                   | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **November 30, 2004**     | ** ** | **November 30, 2003**    | ** ** | **November 30, 2004** | ** ** | **November 30, 2003** | ** ** |
| ** **                                   | ** ** | **Total**                      | ** ** | **Change**                    | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **Change** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** |
| Revenues:                                    |       |                           |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Online services and technology               |       | $                              | 2,032      |                          | $          |  371 |   | 80 | % | $ | 1,661 |   | 66 | % | $ | 5,627 |   | $ | 726 |   | 70 | % | $ | 4,901 |   | 62 | % |
| Alliance and reimbursement                   |       | 493                            |       | (169                          | )          | 20 | % | 662 |   | 26 | % | 1,759 |   | (567 | ) | 22 | % | 2,326 |   | 30 | % |
| Related party online services and technology |       | 4                              |       | (110                          | )          | 0 | % | 114 |   | 5 | % | 542 |   | 196 |   | 7 | % | 346 |   | 4 | % |
| Software product sales                       |       | —                         |       | (89                           | )          | 0 | % | 89 |   | 3 | % | 42 |   | (249 | ) | 1 | % | 291 |   | 4 | % |
| Total revenues                               |       | $                              | 2,529      |                          | $          |  3 |   | 100 | % | $ | 2,526 |   | 100 | % | $ | 7,970 |   | $ | 106 |   | 100 | % | $ | 7,864 |   | 100 | % |

 

Combinedonline services and technology revenue results primarily from sales of ourSubscribeNet service.  Revenues for combined online services andtechnology for the three and nine

 

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months ended November 30,2004, increased from the three and nine months ended November 30, 2003,respectively.  The year-over-year online services and technology increaseduring the three and nine months ended November 30, 2004, is mainly due toa net increase of approximately $0.3 million and $0.7 million, respectively, inrevenue recognized primarily from four of our existing customers.  Therelated party online services and technology revenue increase for the ninemonths ended November 30, 2004, resulted from our recognition of theremaining deferred revenue under our strategic alliance agreement with Zomax,upon termination of that agreement in April 2004.   The relatedparty online services and technology revenue decrease for the three monthsended November 30, 2004, resulted from our termination of that strategicalliance agreement.  We expect our onlineservices and technology revenue and related party online services andtechnology revenues for our fiscal quarter ending February 28, 2005, to beslightly higher than those for the three months ended November 30,2004.  The previous sentence is a forward-looking statement that issubject to risks and uncertainties, and actual results could differ materiallyfrom those anticipated (see “Risk Factors” beginning on page 27 below).

 

Allianceand reimbursement revenue primarily relates to our alliance agreement withSoftware Spectrum for sales and marketing services. This revenue consists of apercentage of the gross profit derived from Software Spectrum’s sales of Sun andWebsense software and maintenance for which we provide sales and marketingservices, and reimbursement for the costs of maintaining a team dedicated toproviding sales and marketing services to Software Spectrum for thatthird-party software and maintenance.  This alliance agreement withSoftware Spectrum accounted for more than 10% of our total revenue during thethree months ended November 30, 2004 (see Note 7 of our “Notes toUnaudited Interim Consolidated Financial Information” in Item 1 above and “RiskFactors” beginning on page 27 below). The decrease in alliance andreimbursement revenue for the three and nine months ended November 30,2004, was primarily due to a reduction of the shared gross profit derived fromthe sales of Sun software licenses and maintenance services, of $0.1 millionand $0.4 million, respectively.  This reduction in shared gross profit wasdue to lower sales of Sun software through our alliance with Software Spectrumduring the three and nine months ended November 30, 2004.  We expectour alliance and reimbursement revenues in our fiscal quarter ending February 28,2005, to be slightly higher than those in our fiscal quarter ended November 30,2004, in accordance with past seasonality we have experienced with theserevenues.  More generally, the Sun software we resell through our alliancewith Software Spectrum has experienced a decrease in market share over the pastseveral quarters, which has contributed to a reduction in our alliance andreimbursement revenues, and we expect this product line to experience continuedpressure in the marketplace over the longer term.

 

Thedecline in software product revenue for the three and nine months ended November 30,2004, was due to our transition out of the business of directly reselling third-partysoftware products and related maintenance.  We do not expect to recognizefuture revenues from our exited third-party resale business.  However, wemay recognize future revenues from resales of software licenses and relatedservices that are complementary to our SubscribeNet service and which we resellas part of a comprehensive digital delivery solution.  The previous twosentences are forward-looking statements that are subject to risks anduncertainties, and actual results could differ materially from thoseanticipated (see “Risk Factors” beginning on page 27 below).

 

*Costs andExpenses*

 

Thefollowing table sets forth the costs and expenses, changes in costs andexpenses and percentage of total revenue for the periods indicated (inthousands, except percentage amounts):

 

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| ** **                 | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|----------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                 | ** ** | **November 30, 2004**     | ** ** | **November 30, 2003**    | ** ** | **November 30, 2004** | ** ** | **November 30, 2003** | ** ** |
| ** **                 | ** ** | **Total**                      | ** ** | **Change**                    | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **Change** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** |
|                       |       |                           |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total cost of revenues     |       | $                              | 1,151      |                          | $          | 124 |   | 46 | % | $ | 1,027 |   | 41 | % | $ | 3,266 |   | $ | (99 | ) | 41 | % | $ | 3,365 |   | 43 | % |
| Gross margin               |       | 1,378                          |       | (121                          | )          | 54 | % | 1,499 |   | 59 | % | 4,704 |   | 205 |   | 59 | % | 4,499 |   | 57 | % |
| Operating expenses:        |       |                           |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing        |       | 756                            |       | 183                           |       | 30 | % | 573 |   | 23 | % | 2,330 |   | 293 |   | 29 | % | 2,037 |   | 26 | % |
| Product development        |       | 383                            |       | (177                          | )          | 15 | % | 560 |   | 22 | % | 1,195 |   | (1,041 | ) | 15 | % | 2,236 |   | 28 | % |
| General and administrative |       | 1,107                          |       | 262                           |       | 44 | % | 845 |   | 33 | % | 2,798 |   | 296 |   | 35 | % | 2,502 |   | 32 | % |
| Restructuring              |       | (75                            | )          | (75                           | )          | -3 | % | — |   | 0 | % | (75 | ) | (75 | ) | -1 | % | — |   | 0 | % |
| Total operating expenses   |       | $                              | 2,171      |                          | $          | 193 |   | 86 | % | $ | 1,978 |   | 78 | % | $ | 6,248 |   | $ | (527 | ) | 78 | % | $ | 6,775 |   | 86 | % |
|                            |            |                                |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Cost of Revenues*

 

Ourcost of revenues increase and margin percentage decrease for the three monthsended November 30, 2004, is primarily due to incremental investments madeto support a larger support organization and infrastructure for theSubscribeNet service and variable support costs for higher bandwidthutilization rates.

 

Thedecrease in cost of revenues for the nine months ended November 30, 2004,is primarily due to the $0.2 million decrease in alliance and reimbursementcost of revenue and to the phasing out of our direct software resellerbusiness, which resulted in a $0.2 million reduction in cost ofrevenues.   These decreases werepartially offset by investments in our SubscribeNet service as described above.The margin percentage increase for the nine months ended November 30,2004, primarily reflects our focus on the sale of our own online services andtechnology, which generate higher margins than either our earlier resale ofthird-party products directly to customers or our alliance and reimbursementrevenue.

 

Costof revenues primarily consists of certain allocated costs related to ourInternet connectivity, assets supporting cost of revenues, and customersupport, as well as the costs associated with maintaining our team dedicated tohelping Software Spectrum sell Sun and Websense software, for which we arereimbursed by Software Spectrum. Cost of revenues also consists of professionalservices personnel costs and the cost of third-party products sold.  Whenwe were in the business of directly reselling third-party software products, wepurchased those products at a discount from the third-parties’ established listprices according to standard reseller terms.  We expect total cost ofrevenues and gross profit margin percentages for the current fiscal year to beapproximately the same as for our fiscal year 2004.  The previous sentenceis a forward-looking statement that is subject to risks and uncertainties. Theactual mix of sales transactions and the timing of the transactions may causeour cost of revenues and gross profit margins to fluctuate materially fromthose anticipated (see “Risk Factors” beginning on page 27 below).

 

*Sales andMarketing Expenses*

 

Salesand marketing expenses consist primarily of employee salaries, benefits andcommissions, advertising, consulting, promotional materials, trade showexpenses and certain allocated overhead costs.

 

Theincrease in the dollar amount of our sales and marketing expenses for the threemonths ended November 30, 2004, is primarily due to an increase ofapproximately $0.1 million in outside services related to marketing andadvertising which were part of our planned increase in sales and marketingexpenditures. The increase is also attributable to an increase ofapproximately $0.1 million in related payroll expense resulting from greatercommissions during the period.

 

Theincrease in the dollar amount of our sales and marketing expenses for the ninemonths ended November 30, 2004, is primarily due to an increase ofapproximately $0.5 million in outside services related to marketing andadvertising which were part of our planned growth in sales and marketingexpenditures. This increase was partially offset by a reduction in payrollrelated expenses of approximately $0.1 million during the nine months ended November 30,2004.

 

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Weplan to continue to increase our expenditures on sales and marketing in fiscalyear 2005 over those in fiscal year 2004, both in dollar amounts and as apercentage of revenue. We plan to continue to market and sell our services, andmay market and sell proprietary software licenses, directly to customers usingour existing sales force and through resellers. We also plan to continue todevelop alliances with other companies to sell our services to a broadercustomer base. The previous three sentences are forward-looking statements thatare subject to risks and uncertainties, and actual results could differmaterially from those anticipated (see “Risk Factors” beginning on page 27 below).

 

*ProductDevelopment Expenses*

 

Productdevelopment expenses primarily consist of personnel, consulting, software andrelated maintenance, equipment depreciation expenses and allocated overheadcosts.  Costs related to research, design and development of products andservices have been charged to product development expense as incurred.

 

Thedecrease in the dollar amount and percentage of revenue of our productdevelopment expenses for the three months ended November 30, 2004,compared to the three months ended November 30, 2003, is due primarily to anincrease in the portion of our product development resources applied to costsof sales activities during the three months ended November 30, 2004, whichresulted in a decrease in overall product development expenses of approximately$0.2 million.

 

Thedecrease in the dollar amount and percentage of revenue of our productdevelopment expenses for the nine months ended November 30, 2004, comparedto the nine months ended November 30, 2003, is due primarily to a decreasein software and equipment depreciation expense of approximately $0.8 million,as many fixed assets have become fully depreciated during the past severalquarters.  The decrease is also due to a one-time expense of approximately$0.2 million related to lease buyouts that occurred during the nine monthsended November 30, 2003.

 

Weanticipate continuing to invest in additional functionality for ourSubscribeNet service and underlying proprietary software. However, we expectthose investments to fluctuate over time, and expect our product developmentexpenses to fluctuate accordingly. We expect total product developmentexpenditures to be lower in fiscal year 2005 than in fiscal year 2004, both indollar amounts and as a percentage of revenue, primarily due to expected lowerdepreciation of equipment. The previous sentences are forward-lookingstatements that are subject to risks and uncertainties, and actual resultscould differ materially from those anticipated (see “Risk Factors” beginning onpage 27 below). We cannot give assurance that our product development effortswill result in new or improved products, features or functionality or that themarket will accept the improvements to existing or new products, features orfunctionality developed.

 

*Generaland Administrative Expenses*

 

Generaland administrative expenses consist primarily of compensation foradministrative and executive personnel, fees for professional services andcertain overhead costs.

 

Theincrease in the dollar amount of our general and administrative expenses forthe three and nine months ended November 30, 2004, is primarily due to anincrease of approximately $0.2 million in outside consulting services andtemporary costs associated with preparation for evaluation of our internalcontrols to enable management to report on, and our auditors attest to, ourinternal control over financial reporting as required by Section 404 ofthe Sarbanes-Oxley Act of 2002.

 

Weexpect total general and administrative expenses in fiscal year 2005 to beslightly higher than our fiscal year 2004 levels. The previous sentence is aforward-looking statement that is subject to risks and uncertainties, andactual results could differ materially from those anticipated (see “RiskFactors” beginning on page 27 below).

 

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*Restructuring*

 

Duringthe three months ended November 30, 2004, we realized a payroll tax refundfor overpaid payroll taxes of approximately $75,000.  These overpaid payroll taxes related tosupplemental unemployment compensation benefits for involuntarily terminatedemployees during our restructuring events in December 2000, August 2001and May 2002.  As of November 30,2004 we believe all transactions relating to past restructuring events havebeen recognized.

 

*InterestExpense*

 

Forthe three months ended November 30, 2004, interest expense wasapproximately $24,000, a decrease from $40,000 for the three months ended November 30,2003.  For the nine months ended November 30, 2004, interest expensewas approximately $79,000, a decrease from $170,000 for the nine months ended November 30,2003.

 

Interestexpense primarily relates to obligations under capital leases and notespayable.  The decrease in interest expense for the three and nine monthsended November 30, 2004, is primarily due to the reduction of the principalbalance on our capital lease obligations.  In August 2003, wereplaced certain capital leases with a note payable bearing a lower interestrate (see Note 6 of our “Notes to Unaudited Interim Consolidated FinancialInformation” in Item 1 above, and  “Liquidityand Capital Resources” below).

 

*Interestand Other Income and Expenses, Net*

 

Forthe three months ended November 30, 2004, interest and other income andexpenses, net was approximately a $50,000 credit, an increase from a $21,000credit for the three months ended November 30, 2003.   For thenine months ended November 30, 2004, interest and other income andexpenses, net was approximately a $92,000 credit, an increase from a $47,000credit for the nine months ended November 30, 2003.

 

Interestand other income and expenses, net primarily relates to interest earned on ourinvestment balances.  The increase in interest and other income andexpenses, net for the three and nine months ended November 30, 2004, isprimarily the result of our increased average cash balance from the prior year.The increase for the three and nine months ended November 30, 2004 alsoincludes approximately $10,000 related to a payroll tax refund for overpaidpayroll taxes (See “Restructuring” above).

 

*IncomeTaxes*

 

Frominception through February 29, 2004, we incurred net losses for federaland state tax purposes and have not recognized any tax provision or benefit. Asof February 29, 2004, we had approximately $129 million of federal and $59million of state net operating loss carryforwards available to offset futuretaxable income, which expire in varying amounts between 2004 and 2025. Becauseof cumulative ownership changes, federal loss carryforwards totalingapproximately $90 million and state loss carryforwards totalingapproximately $39 million are subject to limitation. At February 29,2004, $39 million and $20 million of federal and state net operating losses,respectively, are available, without limitation to offset future taxableincome. Should there be a change of ownership in the future; the available netoperating losses may be further limited. Given our limited operating history,losses incurred to date and the difficulty in accurately forecasting our futureresults, management does not believe that the realization of the relateddeferred income tax asset meets the criteria required by generally acceptedaccounting principles. Accordingly, we have recorded a 100% valuationallowance.

 

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**Liquidity and Capital Resources**

 

Thefollowing table presents our liquidity position at November 30, 2004 and2003 (in thousands): 

 
| ** **                                 | ** ** | **For the nine months ended** | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|
| ** **                                 | ** ** | **November 30, 2004**    | ** ** | **November 30, 2003** | ** ** |
|                                       |       |                          |       |   |   |
| Cash and  cash equivalents                 |       | $                             | 10,145     |   | $ | 5,279 |   |
| Working  capital                           |       | $                             | 7,555      |   | $ | 1,838 |   |
| Net cash  used in operating activities     |       | $                             | (1,928     | ) | $ | (1,265 | ) |
| Net cash  provided by financing activities |       | $                             | 621        |   | $ | 7,127 |   |
| Net cash  used in investing activities     |       | $                             | (352       | ) | $ | (379 | ) |

 

Ournet cash used in operations was $1.9 million for the nine months ended November 30,2004, up from $1.3 million net cash used in operations in the nine monthsended November 30, 2003. This increase was primarily due to approximately$0.5 million in additional marketing related activities as described above. Ouroverall net cash used in operating activities primarily resulted from our netloss for the year and the timing of our payments to vendors and receipts fromcustomers. The majority of our operating costs continue to relate to employeepayroll and related expenditures.  The net cash used in operations for thenine months ended November 30, 2004 came from our existing cash and cashequivalents, and from our issuance of common stock in connection with warrantexercises, our employee stock purchase plan and our employee stock optionplans.  We expect to continue to improve our cash used in operations byincreasing our billings to customers as more end-users are added to ourSubscribeNet service. We plan to use part of those expected increased cash receiptsin additional sales and marketing expenditures to expand our market reach. Theprevious two sentences are forward-looking statements that are subject to risksand uncertainties, and actual results could differ materially from thoseanticipated (see “Risk Factors” beginning on page 27 below).  Our abilityto improve our uses of cash and generate positive cash flows in future periodswill largely depend on our ability to increase the number of customers of ourSubscribeNet service while increasing existing subscriptions through strongcontract renewals. It is also important for us to increase our current level ofsales through our Software Spectrum sales alliance, and continue to control ouroperational and customer support costs in future periods.

 

Ournet cash provided by financing activities was approximately $0.6million for the nine months ended November 30, 2004.  Most ofthis amount came from the issuance of approximately 0.9 million shares ofcommon stock pursuant to warrant and stock option exercises and employee stockpurchases for approximately $1.1 million.  The proceeds from these stockissuances were offset by payments on our notes payable of approximately $0.8million (see below).

 

InAugust 2003, we entered into an agreement with Silicon Valley Bank underwhich we issued a note payable for proceeds of approximately $2.0 millionand obtained access to a $500,000 line of credit. The note payable and line ofcredit both bear an annual interest rate of the greater of 1% in excess of thebank’s prime rate (5.00% at November 30, 2004) or 5.25%, and are bothpayable in fixed monthly installments through September 2005.  At November 30,2004, the interest rate was 6.00%.  We used the proceeds from the notepayable to settle our remaining liability under a capital lease bearing aninterest rate of approximately 12%. This refinancing enabled us tosignificantly reduce our monthly capital financing and interest expenditures.The line of credit allowed us to draw for equipment purchases through August 1,2004.   In September 2004, we entered into an additional$500,000 line of credit at the same interest rate that applies to the notepayable and the first line of credit.  The new line of credit allows us todraw for equipment purchases through August 1, 2005.

 

Underthe agreement for the note payable and lines of credit, all borrowings arecollateralized by a senior security interest in substantially all of ourassets. The agreement also requires us to comply with financial covenants, withwhich we were in compliance as of November 30, 2004. The agreement furtherrestricts us from incurring or assuming additional indebtedness outside of thenote payable and lines of credit, excluding trade payables and certain otherliabilities incurred in the ordinary course of business.

 

Ournet cash used in investing activities during the nine months ended November 30,2004 was $0.4 million. This amount was primarily comprised of purchases offixed assets. We paid for these equipment purchases from our cash and cashequivalents, but later drew down approximately $0.3 million

 

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under the above-mentionedlines of credit to finance these purchases. We used these fixed asset purchasesprimarily to upgrade and expand our SubscribeNet infrastructure and corporateinformation systems. We expect to continue to use and renew our line of creditto finance additional fixed asset purchases at levels that approximate or areslightly higher than our prior year levels. The previous sentence is aforward-looking statement that is subject to risks and uncertainties, andactual results could differ materially from those anticipated (see “RiskFactors” beginning on page 27 below).

 

Webelieve our existing cash and cash equivalents, together with any cashgenerated from operations, will be sufficient to fund our operating activities,capital expenditures and financing arrangements for the foreseeable future.However, if our SubscribeNet business fails to grow significantly or declinesfrom its current level, we could be forced to seek additional capital.

 

AtNovember 30, 2004, we did not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. As such, we are not materiallyexposed to any financing, liquidity, market or credit risk that could arise ifwe had engaged in such relationships.

 

Thefollowing table summarizes our debt and lease obligations at November 30,2004, and the effect such obligations are expected to have on our liquidity andcash flow in future periods (in thousands). This table provides informationthrough our year ending February 28, 2008, as we do not have any debt orlease obligations beyond that point.

 
| ** **        | ** ** | **Payments due by period** | ** ** |
|-------------------|------------|----------------------------|------------|
| ** **        | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Total** | ** ** |
| Long term  debt   |       | $                          | 311        |   | $ | 836 |   | $ | 199 |   | $ | 60 |   | $ | 1,406 | (a) |
| Operating  leases |       | 144                        |       | 287 |   | 2 |   | 1 |   | 434 | (b) |
|              |       | $                          | 455        |   | $ | 1,123 |   | $ | 201 |   | $ | 61 |   | $ | 1,840 |   |
|                   |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(a)                      This amount includes approximately $62,000 ininterest.

 

(b)                     This amount excludes approximately $281,000,$569,000, $579,000, $597,000, and $300,000 per year for the periods of 2006through 2010, which will become due and payable as monthly rent payments if wedo not exercise our right to exit our operating lease for our Orinda office. Inaddition, this amount excludes potential sublease receipts.

 

Asof November 30, 2004, our Series A redeemable convertible preferredstock entitled its holders to a liquidation preference of $1.0 million inthe event of Intraware’s liquidation.

 

**RecentAccounting Pronouncements**

 

InJanuary 2003, the Financial Accounting Standards Board (“FASB”) issuedInterpretation No. 46, “Consolidation of Variable Interest Entities (“VIE”), anInterpretation of ARB No. 51” (“FIN 46”) and in December 2003, issueda revised interpretation (“FIN 46-R”). FIN No. 46, as revised, requirescertain VIEs to be consolidated by the primary beneficiary of the entity if theequity investors in the entity do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. The provisions of FIN 46-R are effective immediately for allarrangements entered into after January 31, 2003. For arrangements enteredinto prior to February 1, 2003, we were required to adopt the provisionsof FIN 46-R in the first quarter of our fiscal year 2005. The adoption of FIN46-R did not have a significant effect on our financial position or results ofoperations.

 

InMay 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity” (“SFASNo. 150”). SFAS No. 150 establishes standards for the classificationand measurement of financial instruments with characteristics of bothliabilities and

 

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equity. The provisions ofSFAS No. 150 apply to the first interim period beginning after June 15,2003.  During the three months ended November 30, 2003, we adoptedthe provisions of SFAS No. 150.  The adoption of SFAS No. 150 did nothave a material impact on our financial position, results of operations or cashflows.

 

InApril 2004, the EITF issued Statement No. 03-06 “ParticipatingSecurities and the Two-Class Method Under FASB Statement No. 128, *Earnings Per Share*“ (“EITF 03-06”). EITF03-06 addresses a number of questions regarding the computation of earnings pershare by companies that have issued securities other than common stock thatcontractually entitle the holder to participate in dividends and earnings of acompany when, and if, it declares dividends on its common stock. The issue alsoprovides further guidance in applying the two-class method of computingearnings per share once it is determined that a security is participating,including how to allocate undistributed earnings to such a security. EITF 03-06is effective for fiscal periods beginning after March 31, 2004. Theadoption of EITF 03-06 did not have a significant effect on our financialposition or results of operations.

 

InDecember 2004, the FASB issued SFAS No. 123 (Revised 2004) “Share-BasedPayment” (“SFAS No. 123R”). SFAS No. 123R addresses all forms of share-basedpayment (“SBP”) awards, including shares issued under employee stock purchaseplans, stock options, restricted stock and stock appreciation rights. SFAS No.123R will require us to expense SBP awards with compensation cost for SBPtransactions measured at fair value. The FASB originally stated a preferencefor a lattice model because it believed that a lattice model more fullycaptures the unique characteristics of employee stock options in the estimateof fair value, as compared to the Black-Scholes model which we currently usefor our footnote disclosure. The FASB decided to remove its explicit preferencefor a lattice model and not require a specific valuation methodology. SFASNo. 123R requires us to adopt the new accounting provisions beginning inour third quarter of our fiscal year ending February 28, 2006. We have notyet determined the impact of applying the various provisions of SFAS No. 123R.

 

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**RISKFACTORS**

 

You should carefullyconsider the risks described below before making a decision to invest in ourcommon stock. The risks and uncertainties described below are not the only onesfacing Intraware. Additional risks and uncertainties not presently known to usor that we do not currently believe are important to an investor may also harmour business operations. If any of the events, contingencies, circumstances orconditions described in the following risks actually occur, our business,financial condition or our results of operations could be seriously harmed. Ifthat occurs, the trading price of our common stock could decline, and you maylose part or all of your investment.

 

**Revenues to us under our Sales andMarketing Services arrangement with Software Spectrum are likely to declineover the long term. Also, any termination of our relationship with SoftwareSpectrum in the near term, without an adequate replacement, would cause a substantialdecrease in our revenues.**

 

Under our June 2001agreement with Software Spectrum, we provide Sales and Marketing Services toSoftware Spectrum to assist in its resale and marketing of Sun and Websensesoftware licenses and maintenance. Software Spectrum shares with us a portionof its gross profit from resales of Sun and Websense software licenses andmaintenance, and reimburses us for a substantial portion of our cost ofmaintaining a team dedicated to sales and marketing of that software and maintenance.This contract accounted for substantially all of our Alliance and reimbursementrevenues, a significant portion of our Online services and technology revenues,and more than 10% of our total revenues in our 2004 fiscal year and our quarterended November 30, 2004. While this agreement covers resales of Sun andWebsense software and maintenance, most of the sales under the agreement are ofSun software and maintenance.  In recentyears, sales and market share of those Sun software product lines havegenerally declined.  If this trendcontinues, revenues to us under this contract are likely to decrease over thelong term. In addition, the term of this agreement will expire in June 2005,is renewable for subsequent one-year terms, and may be terminated without causeby either party on 90 days’ notice. It is possible that Software Spectrum willterminate this agreement without cause or will choose not to renew theagreement at any renewal point. It is also possible that Sun and/or Websensewill choose to stop permitting Software Spectrum to resell their software. Anytermination or non-renewal of our agreement with Software Spectrum, ortermination of Software Spectrum’s rights to resell Sun software, would likelycause a substantial and immediate decrease in our revenues.

 

**The loss of one or more of our keycustomers or partners could cause our revenue growth to slow or cause ourrevenues to decline.**

 

A substantial amount of therevenues from our SubscribeNet service come from a relatively small number ofcompanies. These include software providers to whom we provide our SubscribeNetservice, as well as Software Spectrum, to whom we provide both our SubscribeNetservice and sales and marketing services. Our contracts with most of thesecompanies are subject to renewal or cancellation annually. If any of thesecompanies elected to cancel their agreements with us, our revenue growth wouldlikely slow or our revenues might decline.

 

**Our prospective customers may delaypurchasing, and our new customers may delay implementing, our SubscribeNetservice while they assess their internal controls in preparation for compliancewith Section 404 of the Sarbanes-Oxley Act of 2002.  This may delay our revenue growth.**

 

Section 404 of theSarbanes-Oxley Act of 2002 requires most publicly traded companies to includein their annual reports an assessment by management of the companies’ internalcontrol structures and procedures for financial reporting, and an attestationby the companies’ registered public accounting firms of that managementassessment. To comply with this new requirement, many public companies arepreparing detailed documentation of their information technology (“IT”) systemssupporting their internal control structures and procedures.  To minimizetheir risk of error, these companies may be reluctant to add new IT systemsuntil their Section 404 assessments are complete and have been filed withthe SEC as part of their annual reports.  As a result, prospectivepurchasers of our SubscribeNet service may delay

 

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completing their purchases of the service, and newSubscribeNet customers may delay implementing the service, while they completethe Section 404 assessments over the next several months.  Thiscould, in turn, cause delays in new sales of our SubscribeNet service and/ordelays in recognition of revenue from recent sales of our service.

 

**We have a history of losses andnegative cash flow, and we have yet to achieve sustained profitability orpositive cash flow. We have recently increased spending on sales and marketing,which could limit or prevent any near-term improvement in our net income andcash flow.**

 

We have incurred significantlosses since we were formed in 1996, and have yet to achieve sustained profitabilityor positive cash flow. As of November 30, 2004, we had an accumulateddeficit of approximately $156 million. Also, with the exception of ourquarter ended November 30, 2002, we have not achieved positive cash flowfrom operations since our formation in 1996. Our operating history makes itdifficult to evaluate whether or when we will be able to achieve sustainedprofitability or positive cash flow in the future.

 

We have recently increased,and plan to increase further, our spending on sales and marketing activitiesand programs. We believe these investments will contribute to improvedfinancial performance over the longer term, although we cannot assure you thatthese investments will be successful.  In the near term this increase inour costs may limit or prevent any improvement in our net loss or cash flows.

 

**Competition from other digitaldelivery service providers, and potential customers’ development of their own digitaldelivery systems, could limit our revenue growth and reduce our gross margins.**

 

The market for selling digitaldelivery services is highly competitive.  Some of our competitors havelonger operating histories, greater financial, technical, marketing and otherresources, broader product and service offerings, better name recognition, anda larger installed base of customers than we do. Some of our competitors alsohave well-established relationships with our potential customers and withthird-party information technology or consulting firms that help market ourcompetitors’ services. We expect competition to intensify as currentcompetitors expand and improve their service offerings and new competitorsenter the market. Mergers and consolidation in the information technologyindustry may also increase competition by enlarging our competitors and theirproduct and service offerings, and/or by reducing the pool of potentialcustomers. In addition, our current and potential customers are primarilyinformation technology companies with strong software development expertise.When considering their alternatives for implementing a system for electronicdelivery of software or license keys, these companies sometimes elect todevelop such systems in-house. While we believe our competitive position isstrong against both external competitors and in-house development, we have attimes experienced reduced prices, reduced gross margins and lost sales as aresult of such competitive factors. Such competition is likely to intensify,which could limit the growth of our revenues or gross margins.

 

**Although our subscription-basedsales model for our SubscribeNet service limits the volatility of our Onlineservices and technology revenue, other factors may cause our operating results,and therefore our stock price, to fluctuate.**

 

Our SubscribeNet servicefees, which comprise most of our Online services and technology revenues, arerecognized ratably over contract terms of generally one year, thereby limitingthe quarter-to-quarter volatility of those revenues.  Nevertheless, certain factors may cause ourOnline services and technology revenues to fluctuate.  In addition, ourAlliance and reimbursement revenues and overall operating results are subjectto substantial quarterly and annual fluctuation.  In addition to the otherrisk factors described in this section, factors that could cause suchfluctuation include:

 

•                  Fluctuations in demand for the software weresell jointly with Software Spectrum, which is the basis for most of ourAlliance and reimbursement revenue;

 

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•                  Deferral of SubscribeNet revenue recognitiondue to delays by customers in implementing the SubscribeNet service, due to newsales involving extensive implementations, or due to contract modificationsadding future deliverables;

 

•                  Lengthening of the sales cycle for ourSubscribeNet service due to macroeconomic or other factors;

 

•                  Corporate mergers involving one or more ofour customers;

 

•                  Actual events, circumstances, outcomes, andamounts differing from judgments, assumptions, and estimates used indetermining the values of certain assets (including the amounts of relatedvaluation allowances), liabilities and other items reflected in ourconsolidated financial statements or unaudited interim consolidated financialinformation; and

 

•                  Changes in accounting rules, such asrecording expenses for employee stock option grants.

 

As a consequence, operatingresults for a particular future period are difficult to predict, and priorresults are not necessarily indicative of results to be expected in futureperiods. Any of the foregoing factors, or any other factors discussed elsewhereherein, could have a material adverse effect on our business, results ofoperations, or financial condition that could adversely affect our stock price.

 

**The market for our technologydelivery model and hosted digital delivery services is immature and volatile,and if it does not develop or develops more slowly than we expect, our businesswill be harmed.**

 

The market for hosted digitaldelivery services is relatively new and unproven, and it is uncertain whetherthese services will achieve and sustain high levels of demand and marketacceptance. Our success will depend to a substantial extent on the willingnessof software companies, large and small, to increase their use of hosted digitaldelivery services. Many software companies have invested substantial personneland financial resources to develop their own digital delivery systems andtherefore may be reluctant or unwilling to migrate to a remotely hostedservice. In addition, some software companies have adopted automatic update, or“phone home,” technology for delivering software updates, whereby an end-user’scomputer automatically contacts the software company’s server to check whetherupdates are available and, if so, downloads and installs those updates. This method for delivering software updates could be viewed by our potentialand existing customers as an alternative to our digital delivery technology,and therefore any increased adoption of this automatic update technology couldhurt our business and results of operations. Further, some software companiesmay be reluctant to use hosted digital delivery services because they areconcerned about the security capabilities of these services. If software companiesdo not perceive the benefits of hosted digital delivery services, then themarket for these services may develop more slowly than we expect, which wouldsignificantly adversely affect our operating results. In addition, in thisunproven market, we have limited insight into trends that may develop andaffect our business. We may make errors in predicting and reacting to relevantbusiness trends, which could harm our business.

 

**The technological and functionalrequirements we must meet to stay competitive are subject to rapid change. Ifwe are unable to quickly adapt to these changes and meet the demands of ourcurrent and potential customers, we will likely lose sales and market share andour revenue growth will be limited.**

 

We market primarily tosoftware providers, who generally demand that a service like ours meet hightechnological and functional standards. To remain competitive in this marketand meet the demands of current and prospective customers, we must continuallyadapt and upgrade our technology and functionality. If we do not respondquickly enough to changing industry standards or the demands of customers andpotential customers, we will likely lose sales and market share to competitorsand our growth prospects will be limited. In addition, we could incursubstantial costs to modify our services or infrastructure in order to adapt tochanging standards and demands. If we incur such costs but our sales fail

 

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to increase commensurately, we may not be able toachieve sustained profitability and positive operating cash flow.

 

**Defects in our SubscribeNet servicecould diminish demand for the service and subject us to substantial liability.**

 

Because our service iscomplex, it may have errors or defects that users identify after they beginusing it, which could harm our reputation and our business. Internet-basedservices frequently contain undetected errors when first introduced or when newversions or enhancements are released. Despite taking precautions to avoiderrors, we have from time to time found defects in our service and new errorsin our existing service may be detected in the future. Since our customers useour service for important aspects of their business, any errors, defects orother performance problems with our service could hurt our reputation and maydamage our customers’ businesses. If that occurs, customers could elect not torenew their agreements with us, could be eligible for credits under our servicelevel agreements, and could delay or withhold payment to us.  We couldalso lose future sales, or customers may make warranty claims against us, whichcould result in an increase in our provision for doubtful accounts, an increasein collection cycles for accounts receivable or the expense and risk oflitigation.

 

**Interruptions or delays in servicefrom our third-party Web hosting facilities could impair the delivery of ourservice and harm our business.**

 

We provide our servicethrough computer hardware that is currently located in a third-party Webhosting facilities in Santa Clara, California operated by SAVVISCommunications, and in Ireland operated by Data Electronics. We do not controlthe operation of these facilities, and they are subject to damage orinterruption from earthquakes, floods, fires, power loss, telecommunicationsfailures and similar events. While physical security measures are in place,they are also subject to break-ins, sabotage, intentional acts of vandalism andsimilarmisconduct.Despite precautions taken at the facilities, the occurrence of a naturaldisaster, a decision to close a facility without adequate notice or otherunanticipated problems at a facility could result in lengthy interruptions inour service. In addition, the failure by either facility to provide ourrequired data communications capacity could result in interruptions in ourservice. We have an agreement with SBC E-Services, an affiliate of SBCCommunications, Inc., to provide access to a geographically remote disasterrecovery facility that would provide us access to hardware, software andInternet connectivity in the event the SAVVIS facility becomes unavailable.Even with this disaster recovery arrangement, however, our service would beinterrupted during the transition. Any damage to, or failure of, our systemscould result in interruptions in our service. Interruptions in our service mayreduce our revenue, cause us to issue credits or pay penalties, cause customersto terminate their subscriptions and adversely affect our renewal rates. Ourbusiness will be harmed if our customers and potential customers believe ourservice is unreliable.

 

**Viruses may hinder acceptance ofInternet-based digital delivery, which could in turn limit our revenue growth.**

 

The proliferation ofsoftware viruses is a key risk that could inhibit acceptance by informationtechnology professionals of Web-based delivery of digital goods.  Any well-publicized transmission of a computervirus by us or another company using digital delivery could deter informationtechnology professionals from using and deter software providers fromoutsourcing digital delivery, thereby adversely affecting our business. OurSubscribeNet service enables our customers to upload their software productsdirectly onto our systems for downloading by their end-users. Our systemsautomatically scan our customers’ software products for known computer viruseson an ongoing basis while they are on our systems. However, it is possiblethat, in spite of those periodic virus scans, our system could transmit thevirus to one or more end-users. Any such virus transmission could result indisputes, litigation and negative publicity that could adversely affect ourbusiness.

 

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**If our security measures are breachedand unauthorized access is obtained to a customer’s data, our service may beperceived as not being secure and customers may curtail or stop using ourservice.**

 

Our service involves thestorage and transmission of customers’ proprietary information, and securitybreaches could expose us to a risk of loss of this information, litigation andpossible liability. If our security measures are breached as a result ofthird-party action, employee error, malfeasance or otherwise, and, as a result,someone obtains unauthorized access to one of our customers’ data, ourreputation will be damaged, our business may suffer and we could incursignificant liability. Because techniques used to obtain unauthorized access orto sabotage systems change frequently and generally are not recognized untillaunched against a target, we may be unable to anticipate these techniques orto implement adequate preventative measures. If an actual or perceived breachof our security occurs, the market perception of the effectiveness of oursecurity measures could be harmed and we could lose sales and customers.

 

**We may raise additional capital tofund acquisitions, product development or general operations. Any such capitalfinancing would dilute our shareholders’ investments.**

 

We may raise additionalcapital in the future through private or public offerings of stock, or throughother means. The purposes of any such financing would be to increase our cashreserves for potential use in acquiring other businesses, product developmentactivities, funding our operations and generally strengthening our balancesheet. Any such additional financing would likely dilute the investments of ourcurrent shareholders.

 

**Additional government regulationsmay harm demand for our services and increase our costs of doing business.**

 

Our business has benefitedfrom the tax laws of states in which purchases of software licenses are nottaxable if the software is received only electronically. Some states currentlyexperiencing revenue shortfalls are considering whether to change their laws tobroaden the taxability of transactions executed over the Internet. Any newimposition of taxes on sales of software licenses, where the software isreceived electronically, could substantially harm demand for our services andthereby materially adversely affect our business, operating results andfinancial condition. We have also benefited from implementing our services inIreland, which offers taxadvantagesto software companies distributing their software from Ireland to otherEuropean countries. Any regulatory change in Ireland or elsewhere thatdiminishes those advantages could harm our business. Other changes ingovernment regulations, in areas such as privacy and export compliance, couldalso require us to implement changes in our services or operations thatincrease our cost of doing business and thereby hurt our financial performance.

 

**Claims by third parties forintellectual property infringement could force us to stop selling our services,force us to pay royalties, and force us to indemnify our customers.**

 

Our business involves a highrisk that we will be the target of intellectual property infringementclaims.  These claims could take a number of forms, including:

 

•                  Claims by other technology companies allegingthat current or future components of our digital delivery service or relatedservices infringe their intellectual property rights;

 

•                  Claims by our customers’ competitors allegingthat our customers’ software, which we store and electronically deliver for ourcustomers, infringes those competitors’ intellectual property rights (ourcustomers would typically be required to defend and indemnify us against suchclaims, but the claims could nevertheless disrupt our business); or

 

•                  Claims by our customers that we deliveredtheir software to unauthorized third parties, thereby infringing our customers’intellectual property rights.

 

Industry consolidation is increasingthe risk that we will become a target of the types of claims described in thefirst two bullets above.  Consolidationamong companies providing digital delivery, licensing, e-commerce and relatedtechnologies is resulting in more direct competition among the surviving companiesin that segment, heightening the risk of intellectual property infringementclaims among those

 

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companies, including us.  Similarly, consolidation in the enterprisesoftware industry heightens the risk of intellectual property infringementclaims among the companies remaining in that industry, including most of ourcustomers.

 

These intellectual property claimscould be made for patent, copyright or trademark infringement or formisappropriation of trade secrets.  They could be made directly againstus, or indirectly through our contractual indemnification obligations to ourcustomers and channel partners.  Any claims could result in costlylitigation and be time-consuming to defend, divert management’s attention andresources, or cause delays in releasing new or upgrading existing services.Royalty or licensing agreements, if required, may be available only on onerousterms, if at all.  Although we carry general liability insurance, ourinsurance may not cover all potential claims or may not be adequate to protectus from all liability that may be imposed.

 

We believe we own the rightsin, or have the required rights to use, our SubscribeNet technology. However, there can be no assurance that this technology does not infringe therights of third parties.  In addition, we take steps to verify thatend-users who download our customers’ software through our SubscribeNet serviceare entitled to deploy and use that software. However, there can be noassurance that this verification procedure will help us defend against claimsby, or protect us against liability to, our customers whose software isdownloaded.

 

We are aware that certainother companies are using the name “Intraware” as a company name or as atrademark or service mark. While we have received no notice of any claims oftrademark infringement from any of those companies, we cannot assure you thatthese companies may not claim superior rights to “Intraware” or to other markswe use.

 

**If our export compliance systemfails to prevent unauthorized exports of our customers’ software, we could besanctioned by the U.S. government.**

 

Through our SubscribeNetservice we globally distribute software containing high encryption and otherfeatures restricted by U.S. laws and regulations from exportation to certaincountries, types of recipients, and specific end-users. Our SubscribeNetsolution incorporates automated procedures to help ensure that the software wedeliver electronically is not downloaded in violation of U.S. export laws andregulations. However, these procedures may not prevent unauthorized exports ofrestricted software in every case. If an unauthorized export of software occursthrough the SubscribeNet service and the U.S. government determines that weviolated the U.S. export laws or regulations, we could be sanctioned underthose laws or regulations. Sanctions include fines, suspension or revocation ofexport privileges, and imprisonment.

 

**If our key personnel left thecompany, our product development, sales, and corporate management could suffer.**

 

Our future success dependsupon the continued service of our executive officers and other key technology,sales, marketing and support personnel. None of our officers or key employeesis bound by an employment agreement for any specific term. If we lost theservices of one or more of our key employees, or if one or more of ourexecutive officers or key employees decided to join a competitor or otherwisecompete directly or indirectly with us, this could have a significant adverseeffect on our business.

 

**Financial Accounting StandardsBoard (“FASB”)’s adoption of Statement 123 (Revised 2004) will cause, andchanges to existing accounting pronouncements or taxation rules or practicesmay cause, adverse revenue fluctuations and affect our reported results ofoperations and how we conduct our business.**

 

In October 2004,FASB adopted Statement 123 (Revised 2004), “Share-Based Payment,” which willrequire us, starting in the third quarter of fiscal year 2006, to measurecompensation costs for all stock based compensation (including stock optionsand our employee stock purchase plan) at fair value and take a compensationcharge equal to that value. Also, a change in accounting pronouncements ortaxation rules or practices can have a significant effect on our reportedresults and may even affect our reporting of

 

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transactions completedbefore the change is effective. Other new accounting pronouncements or taxationrules and varying interpretations of accounting pronouncements or taxation practicehave occurred and may occur in the future. This change to existing rules,future changes, if any, or the questioning of current practices may adverselyaffect our reported financial results or the way we conduct our business.

 

**Recent legislation, especially theSarbanes Oxley Act of 2002, requires that we evaluate our internal controls,and while we believe that we currently have adequate internal controlprocedures in place, this exercise has no precedent available by which tomeasure the adequacy of our compliance, and in addition it may also cause ouroperating expenses to increase.**

 

TheSarbanes-Oxley Act of 2002, the California Disclosure Act and newly proposed orenacted rules and regulations of the SEC and the National Association ofSecurities Dealers impose new duties on us and our executives, directors,attorneys and independent accountants. In order to comply with theSarbanes-Oxley Act and such new rules and regulations, we are evaluating ourinternal controls systems to allow management to report on, and our independentregistered public accounting firm to attest to, our internal controls. We areperforming the system and process evaluation and testing (and any necessaryremediation) required in an effort to comply with the management certificationand auditor attestation requirements of Section 404 of the Sarbanes-OxleyAct. As a result, we are incurring additional expenses and diversion ofmanagement’s time and we may be required to hire additional personnel as wellas to use additional outside legal, accounting and advisory services. Any ofthese developments could materially increase our operating expenses andaccordingly reduce our net income or increase our net losses. While weanticipate being able to fully implement the requirements relating to internalcontrols and all other aspects of Section 404 in a timely fashion, wecannot be certain as to the outcome of our testing and resulting remediationactions or the impact of the same on our operations since there is no precedentavailable by which to measure compliance adequacy. If we are not able toimplement the requirements of Section 404 in a timely manner or withadequate compliance, we may be subject to sanctions or investigation byregulatory authorities, such as the SEC or The Nasdaq Stock Market and ourreputation may be harmed. Any such action could adversely affect our financialresults and the market price of our common stock.

 

Moreover,our management, including our CEO and CFO, does not expect that our disclosurecontrols or our internal controls will prevent all error and all fraud. Acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Our disclosure controls or procedures can be circumvented by theindividual acts of some persons, by collusion of two or more people or bymanagement override of the control. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

**If we acquire any companies ortechnologies in the future, they could prove difficult to integrate, disruptour business, dilute stockholder value and adversely affect our operatingresults.**

 

We may acquire or makeinvestments in complementary companies, services and technologies in thefuture. We are considerably smaller now than we were when we made our pastacquisitions, and therefore any new acquisitions or investments could be moredisruptive to our organization than in the past. Acquisitions and investmentsinvolve numerous risks, including:

 

•                  difficulties in integrating operations,technologies, services and personnel;

 

•                  diversion of financial and managerialresources from existing operations;

 

•                  risk of entering new markets;

 

•                  potential write-offs of acquired assets;

 

•                  potential loss of key employees;

 

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•                  inability to generate sufficient revenue tooffset acquisition or investment costs; and

 

•                  delays in customer purchases due touncertainty.

 

In addition, if we financeacquisitions by issuing convertible debt or equity securities, our existingstockholders may be diluted which could affect the market price of our stock.As a result, if we fail to properly evaluate and execute acquisitions orinvestments, our business and prospects may be seriously harmed.

 

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

At November 30, 2004, we had cash and cashequivalents of $10.1 million. We have not used derivative financial instrumentsin our investment portfolio during fiscal 2004 or the nine months ended November 30,2004. We place our investments with high quality issuers, by policy, in aneffort to limit the amount of credit exposure to any one issue or issuer.

 

Ourexposure to market risk for changes in interest rates relates primarily to ourcash and cash equivalents portfolio, note payable and lines of credit. We havenot used derivative financial instruments. The effect of changes in interestrates of +/-10% over a six-month horizon would not have a material effect onthe fair value of the portfolio or our debt.

 

**ITEM 4.CONTROLS AND PROCEDURES**

 

(a) *Evaluation of Disclosure Controls and Procedures*.Our principal executive officer and principal financial officer, afterevaluating the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of1934 (the “Exchange Act”)) as of the end of the period covered by thisquarterly report, have concluded that our disclosure controls and proceduresare effective based on their evaluation of the controls and procedures requiredby paragraph (b) of the Exchange Act Rules 13a-15 or 15d-15.

 

(b) *Changes in Internal Controls over Financial Reporting*.No changes in our internal control over financial reporting identified inconnection with the evaluation required by paragraph (d) of Exchange Act Rules13a-15 or 15d-15 occurred during our last fiscal quarter that have materiallyaffected or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II**

 

**OTHER INFORMATION**

 

**ITEM 1.LEGAL PROCEEDINGS**

 

*In re Intraware, Inc. InitialPublic Offering Securities Litigation*

 

In October 2001, wewere served with a summons and complaint in a purported securities class actionlawsuit. On or about April 19, 2002, we were served with an amendedcomplaint in this action, which is now titled *In reIntraware, Inc. Initial Public Offering Securities Litigation*,Civ. No. 01-9349 (SAS) (S.D.N.Y.), related to In re Initial PublicOffering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The amendedcomplaint is brought purportedly on behalf of all persons who purchased ourcommon stock from February 25, 1999 (the date of our initial public offering)through December 6, 2000. It names as defendants Intraware, three of ourpresent and former officers and directors, and several investment banking firmsthat served as underwriters of our initial public offering. The complaintalleges liability under Sections 11 and 15 of the Securities Act of 1933 andSections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the groundsthat the registration statement for the offerings did not disclose that:(1) the underwriters had agreed to allow certain customers to purchaseshares in the offerings

 

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in exchange for excess commissions paid to theunderwriters; and (2) the underwriters had arranged for certain customersto purchase additional shares in the aftermarket at predetermined prices. Theamended complaint also alleges that the underwriters misused their securitiesanalysts to manipulate the price of our stock. No specific damages are claimed.

 

Lawsuits containing similarallegations have been filed in the Southern District of New York challengingover 300 other initial public offerings and secondary offerings conducted in1999 and 2000. All of these lawsuits have been consolidated for pretrialpurposes before United States District Court Judge Shira Scheindlin of theSouthern District of New York. On July 15, 2002, an omnibus motion todismiss was filed in the coordinated litigation on behalf of the issuerdefendants, of which Intraware and its three named current and former officersand directors are a part, on common pleadings issues. On or about October 9,2002, the Court entered and ordered a Stipulation of Dismissal, which dismissedthe three named current and former officers and directors from the litigationwithout prejudice. On February 19, 2003, the Court entered an orderdenying in part the issuer defendants’ omnibus motion to dismiss, includingthose portions of the motion to dismiss relating to Intraware. No discovery hasbeen served on us to date.

 

In June and July 2003,nearly all of the issuers named as defendants in the *In reInitial Public Offering Securities Litigation* (collectively, the “issuer-defendants”),including us, approved a tentative settlement proposal that is reflected in amemorandum of understanding. A special committee of our Board of Directorsapproved the memorandum of understanding in June 2003. The memorandum ofunderstanding is not a legally binding agreement. Further, any final settlementagreement would be subject to a number of conditions, most of which would beoutside of our control, including approval by the Court. Theunderwriter-defendants in the *In re Initial PublicOffering Securities Litigation* (collectively, the “underwriter-defendants”),including the underwriters of our initial public offering, are not parties tothe memorandum of understanding.

 

The memorandum ofunderstanding provides that, in exchange for a release of claims against thesettling issuer-defendants, the insurers of all of the settlingissuer-defendants will provide a surety undertaking to guarantee plaintiffs a$1 billion recovery from the non-settling defendants, including theunderwriter-defendants. The ultimate amount, if any, that may be paid on behalfof Intraware will therefore depend on the final terms of the settlement agreement,including the number of issuer-defendants that ultimately approve the finalsettlement agreement, and the amounts, if any, recovered by the plaintiffs fromthe underwriter-defendants and other non-settling defendants. In the event thatall or substantially all of the issuer-defendants approve the final settlementagreement, the amount our insurers would be required to pay to the plaintiffscould range from zero to approximately $3.5 million, depending onplaintiffs’ recovery from the underwriter-defendants and from othernon-settling parties. If the plaintiffs recover at least $1 billion fromthe underwriter-defendants, our insurers would have no liability for settlementpayments under the proposed terms of the settlement. If the plaintiffs recoverless than $1 billion, we believe our insurance will likely cover our shareof any payments towards satisfying plaintiffs’ $1 billion recoverydeficit.

 

*Leon Segen v. ComVest VenturePartners, LP, et al.*

 

In July 2004, acomplaint was filed in the United States District Court for the District ofDelaware, Civ. No. 04-822, against ComVest Venture Partners, LP; ComVestManagement, LLC; Commonwealth Associates Management Company, Inc.; CommonwealthAssociates, LP; RMC Capital, LLC; Michael S. Falk; Robert Priddy; Travis L.Provow; Keith Rosenbloom; and Intraware. The complaint describes Intraware as anominal defendant. The complaint alleges that, between August 2001 and January 2002,all of the defendants other than Intraware were members of a group, andtherefore should be treated as a single “person,” for purposes of Sections13(d)(3) and 16(b) of the Securities Exchange Act of 1934 (the “1934 Act”). The complaint further alleges that ComVest Venture Partners, LP andMr. Priddy, while they and the other alleged group members collectivelyowned more than 10% of a class of our equity securities, bought and sold ourequity securities within a 6-month period and failed to disgorge to us theprofits allegedly realized in those trades, thereby violating Section 16(b)of the 1934 Act.  Mr. Falk was a member of our Board of Directors from April 2001to May 2002 and Mr. Provow was a member of our Board of

 

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Directors from October 2001 to May 2002. The complaint demands that ComVest Venture Partners, LP and Mr. Priddy payover to Intraware the profits they allegedly realized and retained in violationof Section 16(b) of the 1934 Act, together with interest and legal costs.According to the compliant, the amount of those alleged profits is unknown tothe plaintiff, however, the information alleged in the complaint suggests thatamount may be approximately $1.3 million. The complaint does not seekdamages against us.  After the complaint was filed, the plaintiff and Intrawaresigned a stipulation acknowledging that Intraware takes no position withrespect to the claims in the action, and providing that Intraware acceptsservice of the complaint, that Intraware is not required to file an answer orother response to the complaint, and that Intraware will otherwise have therights and responsibilities of a party to the action.

 

We are also subject to legalproceedings, claims and litigation arising in the ordinary course of business.We do not expect that the ultimate costs to resolve these matters will have amaterial adverse effect on our consolidated financial position, results ofoperations, or cash flows.

 

**ITEM2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

None.

 

**ITEM 3.DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS**

 

None.

 

**ITEM 5.OTHER INFORMATION**

 

None.

 

**ITEM 6. EXHIBITS**

 

**Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                             |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Loan Modification Agreement, dated September 20,  2004 between Silicon Valley Bank and Intraware, Inc. |
|                |       |                                                                                                        |
| 10.2                |       | Form of Stock Option Agreement under 1996 Stock  Option Plan (Initial Grant)                                |
|                |       |                                                                                                        |
| 10.3                |       | Form of Stock Option Agreement under 1996 Stock  Option Plan (Subsequent Grant)                             |
|                |       |                                                                                                        |
| 10.4                |       | Form of Director Option Agreement under 1998  Director Option Plan (Initial Grant)                          |
|                |       |                                                                                                        |
| 10.5                |       | Form of Director Option Agreement under 1998  Director Option Plan (Subsequent Grant)                       |
|                |       |                                                                                                        |
| 31.1                |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act — Peter H. Jackson               |
|                |       |                                                                                                        |
| 31.2                |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act — Wendy A. Nieto                 |
|                |       |                                                                                                        |
| 32.1                |       | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act                                       |

 

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**SIGNATURE**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, as amended, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                               | **INTRAWARE, INC.** |                                                                                   |
|------------------------------------|---------------------|----------------------------------------------------------------------------------------|
|                               |                |                                                                                   |   |
| Dated:  January 14, 2005 | By:                 | /s/ WENDY A. NIETO                                                                     |   |
|                               |                | Wendy A. Nieto                                                                         |   |
|                               |                | *Chief  Financial Officer and  Executive Vice President of  Technology and Operations* |   |

 

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