**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM10-Q**

 

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED MAY 31, 2004**

 

o**TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**FOR THE TRANSITION PERIODFROM          TO**

 

**Commission file number 000-25249**

 

**INTRAWARE,INC.**

(Exactname of Registrant as specified in its charter)

 

**DELAWARE**

(Stateor other jurisdiction of incorporation or organization)

 

**68-0389976**

(I.R.S.Employer Identification Number)

 

**25 ORINDA WAY**

**ORINDA, CA 94563**

(Addressof principal executive offices)

 

**(925) 253-4500**

(Registrant’stelephone number, including area code)

 

Indicate by check (X)whether the registrant: (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes ý   No o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). Yes  o No  ý

 

As of July 8, 2004 therewere 60,233,639 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)**

 
|                                                                                                                                                        |   | **May 31,  2004** |   | **February  29, 2004** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|------------------------|--------|
|                                                                                                                                                        |   | **(unaudited)**   |   |                   |   |
| **ASSETS**                                                                                                                                                  |   |              |   |                   |   |
| Current assets:                                                                                                                                             |   |              |   |                   |   |
| Cash and cash equivalents                                                                                                                                   |   | $                 | 10,855 |                   | $      | 11,804 |   |
| Accounts receivable, net                                                                                                                                    |   | 1,195             |   | 1,462                  |   |
| Costs of deferred revenue and prepaid  licenses and services                                                                                                |   | 246               |   | 214                    |   |
| Other current assets                                                                                                                                        |   | 653               |   | 317                    |   |
| Total current assets                                                                                                                                        |   | 12,949            |   | 13,797                 |   |
| Cost of deferred revenue, less current  portion                                                                                                             |   | 60                |   | 43                     |   |
| Property and equipment, net                                                                                                                                 |   | 907               |   | 897                    |   |
| Other assets, less current portion                                                                                                                          |   | 48                |   | 33                     |   |
| Total assets                                                                                                                                                |   | $                 | 13,964 |                   | $      | 14,770 |   |
|                                                                                                                                                        |   |              |   |                   |   |
| **LIABILITIES, REDEEMABLE CONVERTIBLE  PREFERRED STOCK & STOCKHOLDERS’ EQUITY**                                                                    |   |              |   |                   |   |
| Current liabilities:                                                                                                                                        |   |              |   |                   |   |
| Notes payable                                                                                                                                               |   | $                 | 1,071  |                   | $      | 1,034 |   |
| Accounts payable                                                                                                                                            |   | 710               |   | 577                    |   |
| Accrued expenses                                                                                                                                            |   | 758               |   | 928                    |   |
| Deferred revenue                                                                                                                                            |   | 2,051             |   | 2,035                  |   |
| Related party deferred revenue                                                                                                                              |   | 14                |   | 648                    |   |
| Total current liabilities                                                                                                                                   |   | 4,604             |   | 5,222                  |   |
| Deferred revenue, less current portion                                                                                                                      |   | 226               |   | 295                    |   |
| Notes payable, less current portion                                                                                                                         |   | 489               |   | 766                    |   |
| Total liabilities                                                                                                                                           |   | 5,319             |   | 6,283                  |   |
| Contingencies (Note 4)                                                                                                                                      |   |              |   |                   |   |
| Redeemable convertible preferred stock;  $0.0001 par value; 10,000 shares authorized:                                                                       |   |              |   |                   |   |
| Series A; 552 at May 31 and February 29,  2004 (aggregate liquidation preference of $1,000 at May 31 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; 59,726 and 59,504 shares issued and outstanding at May 31  and February 29, 2004, respectively |   | 6                 |   | 6                      |   |
| Additional paid-in-capital                                                                                                                                  |   | 162,306           |   | 162,043                |   |
| Accumulated deficit                                                                                                                                         |   | (154,564          | )      | (154,459               | )      |
| Total stockholders’ equity                                                                                                                             |   | 7,748             |   | 7,590                  |   |
| Total liabilities, redeemable convertible  preferred stock and stockholders’ equity                                                                    |   | $                 | 13,964 |                   | $      | 14,770 |   |

 

Seenotes 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** |   |
|----------------------------------------------|--------|---------------------------------|--------|
|                                         |   | **May 31,  2004**               |   | **May 31,  2003** |   |
|                                         |   |                            |   |   |   |
| Revenues:                                    |   |                            |   |   |   |
| Online services and technology               |   | $                               | 1,695  |   | $ | 1,720 |   |
| Alliance and reimbursement                   |   | 576                             |   | 862 |   |
| Related party online services and technology |   | 534                             |   | 117 |   |
| Software product sales                       |   | 42                              |   | 114 |   |
| Total revenues                               |   | 2,847                           |   | 2,813 |   |
| Cost of revenues:                            |   |                            |   |   |   |
| Online services and technology               |   | 567                             |   | 623 |   |
| Alliance and reimbursement                   |   | 391                             |   | 490 |   |
| Software product sales                       |   | 37                              |   | 100 |   |
| Total cost of revenues                       |   | 995                             |   | 1,213 |   |
| Gross profit                                 |   | 1,852                           |   | 1,600 |   |
| Operating expenses:                          |   |                            |   |   |   |
| Sales and marketing                          |   | 752                             |   | 769 |   |
| Product development                          |   | 403                             |   | 919 |   |
| General and administrative                   |   | 789                             |   | 766 |   |
| Total operating expenses                     |   | 1,944                           |   | 2,454 |   |
| Loss from operations                         |   | (92                             | )      | (854 | ) |
| Interest expense                             |   | (29                             | )      | (69 | ) |
| Interest and other income and expenses, net  |   | 16                              |   | 14 |   |
| Net loss                                     |   | $                               | (105   | ) | $ | (909 | ) |
| Basic and diluted net loss per share         |   | $                               | (0.00  | ) | $ | (0.02 | ) |
| Weighted average shares - basic and diluted  |   | 59,617                          |   | 52,202 |   |

 

Seenotes to unaudited interim consolidated financial information.

 

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**INTRAWARE, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

** **
|                                                                         |   | **For the  three months ended** |   |
|------------------------------------------------------------------------------|--------|---------------------------------|--------|
|                                                                         |   | **May 31, 2004**                |   | **May 31, 2003** |   |
| Cash flows from operating activities:                                        |   |                            |   |   |   |
| Net loss                                                                     |   | $                               | (105   | ) | $ | (909 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |   |                            |   |   |   |
| Depreciation and amortization                                                |   | 161                             |   | 685 |   |
| Amortization of unearned compensation                                        |   | —                          |   | 12 |   |
| Provision for (recovery of) doubtful accounts                                |   | (1                              | )      | 2 |   |
| Gain on sale of fixed assets                                                 |   | (2                              | )      | — |   |
| Amortization of discount on note payable                                     |   | 7                               |   | — |   |
| Changes in assets and liabilities:                                           |   |                            |   |   |   |
| Accounts receivable                                                          |   | 268                             |   | 229 |   |
| Costs of deferred revenue and prepaid licenses and services                  |   | (49                             | )      | 58 |   |
| Other assets                                                                 |   | (351                            | )      | (256 | ) |
| Accounts payable                                                             |   | 51                              |   | 112 |   |
| Accrued expenses                                                             |   | (170                            | )      | (107 | ) |
| Deferred revenue                                                             |   | (52                             | )      | (419 | ) |
| Related party deferred revenue                                               |   | (634                            | )      | (125 | ) |
| Net cash used in operating activities                                        |   | (877                            | )      | (718 | ) |
| Cash flows from investing activities:                                        |   |                            |   |   |   |
| Purchases of property and equipment                                          |   | (89                             | )      | (3 | ) |
| Proceeds from sale of fixed assets                                           |   | 2                               |   | — |   |
| Net cash used in investment activities                                       |   | (87                             | )      | (3 | ) |
|                                                                         |   |                            |   |   |   |
| Cash flows from financing activities:                                        |   |                            |   |   |   |
| Principal payments on note payable                                           |   | (248                            | )      | — |   |
| Proceeds from common stock                                                   |   | 263                             |   | 86 |   |
| Principal payments on capital lease obligations                              |   | —                          |   | (394 | ) |
| Net cash provided by (used in) financing activities                          |   | 15                              |   | (308 | ) |
| Net decrease in cash and cash equivalents                                    |   | (949                            | )      | (1,029 | ) |
| Cash and cash equivalents at beginning of the period                         |   | 11,804                          |   | 6,841 |   |
| Cash and cash equivalents at end of the period                               |   | $                               | 10,855 |   | $ | 5,812 |   |
|                                                                         |   |                            |   |   |   |
| Supplemental disclosure of cash flow information:                            |   |                            |   |   |   |
| Cash paid for interest                                                       |   | $                               | 23     |   | $ | 70 |   |
| Supplemental non-cash activity:                                              |   |                            |   |   |   |
| Common stock issued for preferred stock conversion                           |   | $                               | — |   | $ | 51 |   |
| Purchases of property and equipment in accounts payable                      |   | $                               | 82     |   | $ | 130 |   |

 

Seenotes to unaudited interim consolidated financial information.

 

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**INTRAWARE, INC.**

 

**NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL INFORMATION**

 

**NOTE 1.BASIS OF PRESENTATION**

 

**INTRAWARE**

 

The accompanying unauditedconsolidated financial statements have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to these rulesand regulations.  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 auditedfinancial statements, but does not include all disclosures required bygenerally accepted accounting principles.  These unaudited consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and notes thereto included in our annualreport on Form 10-K for the fiscal year ended February 29, 2004.

 

In the opinion ofmanagement, all adjustments, consisting only of normal recurring items,considered necessary for a fair presentation have been included in theaccompanying unaudited consolidated financial statements.  The results ofoperations for the interim periods presented are not necessarily indicative ofthe operating results to be expected for any subsequent interim period or forthe fiscal year ending February 28, 2005.  Certain prior periodbalances have been reclassified to conform to the current period presentation.

 

We have incurred losses andnegative cash flow from operations during each fiscal year since inception. Forthe three months ended May 31, 2004, we narrowed our net loss to approximately$0.1 million and negative cash flows to approximately $0.9 million. Our cashbalances may decline further, although we believe that the effects of ourcapital financing, strategic actions implemented to improve revenue, and costcontrols will be adequate to generate sufficient cash resources to fund ourfuture operations.  If we fail togenerate sufficient revenues or control spending, we may be unable to achievekey business objectives.

 

**NOTE 2.SIGNIFICANT ACCOUNTING POLICIES**

 

**Revenuerecognition**

 

We derive online servicesand technology revenues primarily from ESDM services (our SubscribeNetservice), from professional services, and from the sale of proprietary softwarelicenses and related maintenance. In the past, the proprietary softwarelicenses we sold were primarily licenses to use our asset management software;however, we may recognize future revenues from any sale of licenses andmaintenance for our proprietary software underlying our SubscribeNet service.

 

We derive alliance andreimbursement revenue from our alliance agreement with Software Spectrum, Inc.(“Software Spectrum”) (see Note 7). This revenue consists of a percentage ofthe gross profit derived from sales of Sun Java System and Sun ONE software(collectively “Sun software”) and related maintenance, as well as Websensesoftware licenses and maintenance, and reimbursement for the costs ofmaintaining a sales team dedicated to selling Sun and Websense softwarelicenses and maintenance, for Software Spectrum. This revenue is recognized aswe provide the services to Software Spectrum. The reimbursement revenue isrecognized in accordance with Emerging Issues Task Force (“EITF”) No. 01-14,“Income Statement Characterization of Reimbursements Received for Out-of-PocketExpenses Incurred,” which generally requires that a company recognize asrevenue travel expenses and other reimbursable expenses billed to customers.

 

We derive software productrevenues from our past resale of licenses and maintenance for multiple businesssoftware product lines.

 

We defer online services andtechnology revenues related to ESDM, and generally recognize them ratably overthe term of the service arrangement. Some SubscribeNet services provided to newcustomers involve significant implementation or customization essential to thefunctionality of our SubscribeNet services. In those cases, we defer revenuerecognition until the services go-live date and recognize the revenue on aratable basis over the remaining contract term. The go-live date is the date onwhich the essential functionality has been delivered or on which the websitethrough which the service is provided enters the production environment, or thepoint at which no additional customization is required, whichever is later.When we sell additional professional services related to an existingSubscribeNet agreement, revenue is recognized ratably over the longer of theremaining estimated

 

5

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duration of the customerrelationship or the remaining contract term, commencing with the delivery ofthe additional services. Such revenue is included in online services andtechnology.

 

We recognize revenue whenall of the following conditions are met:

 

•              There is persuasive evidence of anarrangement;

 

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

 

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

 

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

 

When we resold third-partyor sold our proprietary software licenses and maintenance, we obtained vendorspecific objective evidence of fair value for the maintenance element of theresold and proprietary software arrangements based on historical andcontractual renewal rates for maintenance.  In such cases, we deferred themaintenance revenue at the outset of the arrangement and recognized it ratablyover the period during which the maintenance was to be provided (generally 12months), which normally commenced on the date the software was delivered.

 

**Stock-BasedCompensation**

 

We account for stock-basedemployee compensation arrangements in accordance with provisions of AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees,”(“APB No. 25”) and its related interpretations and comply with the disclosureprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 123,“Accounting for Stock-Based Compensation” and related SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure.”  Under APBNo. 25, compensation expense is based on the difference, if any, on thedate of the grant between the fair value of our stock and the exercise price ofthe option.  We account for equity instruments issued to non-employees inaccordance with the provisions of SFAS No. 123 and EITF No. 96-18,“Accounting for Equity Instruments That Are Issued to Other Than Employees forAcquiring, or in conjunction with Selling Goods or Services.”

 

The following tableillustrates the effect on net loss and net loss per share if we had applied thefair value recognition provisions of SFAS No. 123, to stock-based employeecompensation (in thousands, except per share data):

 
|                                                                                                                    |   | **For the  three months ended,** |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                                                    |   | **May 31,  2004**                |   | **May 31,  2003** |   |
| Net loss                                                                                                                |   | $                                | (105   | ) | $ | (909 | ) |
| Add:   Stock-based compensation expense included in reported net loss                                              |   | —                           |   | 12 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based method for all awards |   | (870                             | )      | (1,038 | ) |
| Pro forma                                                                                                               |   | $                                | (975   | ) | $ | (1,935 | ) |
| Net loss per share — basic and diluted                                                                             |   |                             |   |   |   |
| As reported                                                                                                             |   | $                                | (0.00  | ) | $ | (0.02 | ) |
| Pro forma                                                                                                               |   | $                                | (0.02  | ) | $ | (0.04 | ) |

 

We calculated the fair valueof each option grant on the date of grant, using the Black-Scholes option

 

6

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pricing model as prescribed bySFAS No. 123 using the following assumptions:

 

|                      |   | **For the  three months ended,** |   |
|---------------------------|--------|----------------------------------|--------|
|                      |   | **May 31,  2004**                |   | **May 31,  2003** |   |
| Risk-free interest rates  |   | 2.00 - 3.85                      | %      | 1.56 - 2.85 | % |
| Expected lives (in years) |   | 4                                |   | 4 |   |
| Dividend yield            |   | 0                                | %      | 0 | % |
| Expected volatility       |   | 121                              | %      | 138 | % |

 

We calculated the fair valueof the stock issued under the employee stock purchase plan using theBlack-Scholes option pricing model as prescribed by SFAS No. 123 using thefollowing assumptions:

 

|                       |   | **For the  three months ended,** |   |
|----------------------------|--------|----------------------------------|--------|
|                       |   | **May 31,  2004**                |   | **May 31,  2003** |   |
| Risk-free interest rates   |   | 1.12                             | %      | 1.22 | % |
| Expected lives (in months) |   | 6                                |   | 6 |   |
| Dividend yield             |   | 0                                | %      | 0 | % |
| Expected volatility        |   | 79                               | %      | 102 | % |

 

**Net LossPer Share**

 

Basic net loss per commonshare is computed by dividing the net loss attributable to common stockholdersfor the period by the weighted average number of common shares outstandingduring the period excluding shares subject to repurchase. If dilutive, theparticipation right of the redeemable convertible preferred stock is reflectedin the calculation of basic income per share using the two class method.Diluted net loss per share is computed by dividing the net loss attributable tocommon stockholders for the period by the weighted average number of common andpotential common shares outstanding during the period if the effect isdilutive. Potential common shares are composed of common stock subject torepurchase rights and incremental shares of common stock issuable upon theexercise of stock options and warrants and upon the conversion of preferredstock.

 

The following table setsforth the computation of basic and diluted net loss per share as well assecurities that are not included in the diluted net loss per share calculationbecause to do so would be antidilutive (in thousands, except per shareamounts):

 
|                                   |   | **For the  three months ended** |   |
|----------------------------------------|--------|---------------------------------|--------|
|                                   |   | **May 31,  2004**               |   | **May 31,  2003** |   |
|                                   |   |                            |   |   |   |
| Numerator:                             |   |                            |   |   |   |
| Net loss                               |   | $                               | (105   | ) | $ | (909 | ) |
| Denominator:                           |   |                            |   |   |   |
| Weighted average shares                |   | 59,617                          |   | 52,202 |   |
|                                   |   |                            |   |   |   |
| Basic and diluted net loss per share   |   | $                               | (0.00  | ) | $ | (0.02 | ) |
|                                   |   |                            |   |   |   |
| Effect of antidilutive securities:     |   |                            |   |   |   |
| Redeemable convertible preferred stock |   | 552                             |   | 1,802 |   |
| Warrants to purchase common stock      |   | 2,215                           |   | 3,556 |   |
| Employee stock options                 |   | 9,131                           |   | 9,056 |   |
|                                   |   |                            |   |   |   |
|                                   |   | 11,898                          |   | 14,414 |   |

 

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**RecentAccounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 46,“Consolidation of Variable Interest Entities (“VIE”), an Interpretation of ARBNo. 51” (“FIN 46”) and in December 2003, issued a revisedinterpretation (“FIN 46-R”). FIN No. 46, as revised, requires certainvariable interest entities to be consolidated by the primary beneficiary of theentity if the equity investors in the entity do not have the characteristics ofa controlling financial interest or do not have sufficient equity at risk forthe entity to finance its activities without additional subordinated financialsupport from other parties. The provisions of FIN 46-R are effectiveimmediately for all arrangements entered into after January 31, 2003. Forarrangements entered into prior to February 1, 2003, we are required toadopt the provisions of FIN 46-R in the first quarter of our fiscal year 2005.The adoption of FIN 46-R did not have a significant effect on ourfinancial position or results of operations.

 

In May 2003, the FASBissued SFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity” (“SFAS No. 150”). SFASNo. 150 establishes standards for the classification and measurement offinancial instruments with characteristics of both liabilities and equity. Theprovisions of SFAS No. 150 apply to the first interim period beginningafter June 15, 2003. During our three months ended November 30, 2003, weadopted the relevant provisions of SFAS No. 150.  While the effective date of certain elements of SFAS No. 150 havebeen deferred, the adoption of SFAS No. 150 when finalized is not expectedto have a material impact on our financial position, results of operations orcash flows.

 

In April 2004, the EITFissued Statement No. 03-06 “Participating Securities and the Two-ClassMethod Under 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. We are currently evaluating theeffect of adopting EITF 03-06.

 

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

 

Duringthe three months ended May 31, 2004, our stockholders’ equity changed asfollows (in thousands):

 
|                                                          |   |              |   |        |   | **Additional**  |   |                   |   |              |     |     |   |
|---------------------------------------------------------------|--------|-------------------|--------|-------------|--------|-----------------|--------|------------------------|--------|-------------------|----------|----------|--------|
|                                                          |   | **Common  Stock** |   | **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                                     |   | 136               |   | —      |   | 133             |   | —                 |   | 133               |     |     |   |
| Issuance of common stock for employee stock  purchase program |   | 86                |   | —      |   | 130             |   | —                 |   | 130               |     |     |   |
| Net loss                                                      |   | —            |   | —      |   | —          |   | (105                   | )      | (105              | )        | $        | (105   | ) |
| Other comprehensive loss                                      |   | —            |   | —      |   | —          |   | —                 |   | —            |     | —   |   |
| Comprehensive loss                                            |   | —            |   | —      |   | —          |   | —                 |   | —            |     | $        | (105   | ) |
| Balance at May 31, 2004                                       |   | 59,726            |   | $           | 6      |            | $      | 162,306                |   | $                 | (154,564 | )        | $      | 7,748 |   |   |   |

 

**NOTE 4.CONTINGENCIES**

 

**Indemnifications**

 

       Inthe course of our business, we have given indemnities and made commitments andguarantees under which we may be required to make payments. These indemnitiesinclude:

 

•    *Intellectual Property Indemnities to Customers.*Our service agreements with our customerstypically contain provisions that indemnify our customers for damages and costsresulting from claims alleging that our services infringe the intellectualproperty rights of a third party. We have also entered into software

 

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license agreementsindemnifying the licensees for damages and costs resulting from claims allegingthat the software infringes third-party intellectual property rights. Theduration of these indemnities is typically unlimited. Our potential paymentsunder these indemnities are in some cases limited (e.g., to the fees paid to usunder the contract or to another amount) and are in other cases unlimited.Where we have given such indemnities for third-party software licenses that weresold, we have typically received similar indemnities from the softwarepublishers. We plan to continue to license software and provideindustry-standard indemnities to our licensees and our service customers.

 

•    *Intellectual PropertyIndemnity to Acquiror of Asset Management Business.*In the May 2002 sale of our Asset Managementsoftware business to Computer Associates International, Inc., we agreed toindemnify 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 Private Investors.*In our private placements of stock, we havemade representations and warranties to the investors and placement agents, andhave agreed to indemnify them for any damages and costs they incur as a resultof our breach of those representations and warranties. We also have signedregistration rights agreements with private investors under which we indemnifythem for damages they incur as a result of any material misstatements oromissions in our registration statements, and pay penalties in the event wefail to maintain the effectiveness of registration statements. The duration ofour indemnities to our investors under the respective stock and warrantpurchase agreements ranges from one to two years from the respective closingdates, other than the purchase agreements for our June 2000 warrants andour January 2001 Series A Preferred Stock and warrants, which providefor indemnities of unlimited duration. Our indemnities to our investors underthe respective registration rights agreements expire upon termination of ourregistration 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 Directors and Officers.*We indemnify our directors and officers fordamages and costs incurred in the performance of their duties, to the extentpermitted by Delaware law. The duration of, and our potential payments under,these indemnities are unlimited, subject to Delaware law.

 

We have historicallyreceived only a very limited number of requests for indemnification under theseagreements and have not been required to make material payments under them.Accordingly, we have not recorded a liability related to these indemnificationprovisions.

 

**LegalProceedings**

 

InOctober 2001, we were served with a summons and complaint in a purportedsecurities class action lawsuit. On or about April 19, 2002, we wereserved with an amended complaint 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 Public OfferingSecurities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The amended complaint isbrought purportedly on behalf of all persons who purchased our common stockfrom February 25, 1999 (the date of our initial public offering) throughDecember 6, 2000. It names as defendants Intraware, three of our presentand former officers and directors, and several investment banking firms thatserved as underwriters of our initial public offering. The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 and Sections10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that theregistration statement for the offerings did not disclose that: (1) theunderwriters had agreed to allow certain customers to purchase shares in theofferings in exchange for excess commissions paid to the underwriters; and(2) the underwriters had arranged for certain customers to purchaseadditional shares in the aftermarket at predetermined prices. The amendedcomplaint also alleges that the underwriters misused their securities analyststo manipulate the price of our stock. No specific damages are claimed.

 

Lawsuitscontaining similar allegations have been filed in the Southern District of New Yorkchallenging over 300 other initial public offerings and secondary offeringsconducted in 1999 and 2000. All of these lawsuits have been consolidated forpretrial purposes before United States District Court Judge Shira Scheindlin ofthe

 

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Southern District of New York.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. OnFebruary 19, 2003, the Court entered an order denying in part the issuerdefendants’ omnibus motion to dismiss, including those portions of the motionto dismiss relating to Intraware. No discovery has been served on us to date.

 

InJune and July 2003, nearly all of the issuers named as defendants in theIn re Initial Public Offering Securities Litigation (collectively, the“issuer-defendants”), including us, approved a tentative settlement proposalthat is reflected in a memorandum of understanding. A special committee of ourBoard of Directors approved the memorandum of understanding in June 2003.The memorandum of understanding is not a legally binding agreement. Further,any final settlement agreement would be subject to a number of conditions, mostof which would be outside of the Company’s control, including approval by theCourt. The underwriter-defendants in the In re Initial Public OfferingSecurities Litigation (collectively, the “underwriter-defendants”), includingthe underwriters of our initial public offering, are not parties to thememorandum of understanding.

 

Thememorandum of understanding provides that, in exchange for a release of claimsagainst the settling 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 settlementagreement, including the number of issuer-defendants that ultimately approvethe final settlement agreement, and the amounts, if any, recovered by theplaintiffs from the underwriter-defendants and other non-settling defendants.If all or substantially all of the issuer-defendants approve the finalsettlement agreement, the amount our insurers would be required to pay to theplaintiffs could range from zero to approximately $3.5 million, dependingon plaintiffs’ 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.  Management estimates that itsrange of loss relative to this matter is zero to $3.5 million. Presentlythere is no more likely point estimate of loss within this range. As aconsequence of the uncertainties described above regarding the amount we willultimately be required to pay, if any, as of May 31, 2004, we have not accrueda liability for this matter.

 

In July 2004, a complaintwas filed in the United 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 thanIntraware were members of a “group” under Sections 13(d)(3)  16(b) of the Securities Exchange Act of 1934(the “1934 Act”).  The complaint furtheralleges that ComVest Venture Partners, LP and Mr. Priddy, while they andthe other alleged group members collectively owned more than 10% of a class ofour equity securities, bought and sold our equity securities within a 6-monthperiod and failed to disgorge to us the profits allegedly realized in thosetrades, thereby violating Section 16(b) of the 1934 Act.  Mr. Falk was a member of our Board ofDirectors from April 2001 to May 2002 and Mr. Provow was a member of our Boardof Directors from October 2001 to 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 complaint suggests that amount may be approximately $1.3 million.The complaint does not seek damages 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.

 

Weare also subject to legal proceedings, claims and litigation arising in theordinary course of business. We do not expect that the ultimate costs toresolve these matters will have a material adverse effect on our consolidatedfinancial position, results of operations, or cash flows.

 

**NOTE5.  REDEEMABLE CONVERTIBLE PREFERRED STOCK**

 

We are authorized, subjectto limitations prescribed by Delaware law, to provide for the issuance ofpreferred stock in one or more series, to establish from time to time thenumber of shares included within each series, to fix the rights, preferencesand privileges of the shares of each wholly unissued series and anyqualifications, limitations or restrictions thereon, and to increase ordecrease the number of shares of any such series (but not below the number ofshares of such series then outstanding) without any further vote or action bythe stockholders.

 

During the three monthsended May 31, 2004 there was no activity in our redeemable convertiblepreferred stock.

 

**NOTE6.  NOTES PAYABLE**

 

In August 2003, weissued a note payable to a bank for proceeds of approximately $2.0million.  The note bears an annual interest rate of the greater of 1% inexcess of the bank’s prime rate (4.00% at May 31, 2004) or 5.25%.  Theinterest rate on the note payable at May 31, 2004, was 5.25%.  The notepayable is payable in fixed monthly principal installments plus interestthrough September 2005.  In connection with the note payable, we

 

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issued a warrant to purchase41,730 shares of our common stock at an exercise price of $1.19 pershare.  The warrant was immediately exercisable and expires inAugust 2010.  We estimated the allocated fair value of such warrantat approximately $46,000, using the Black-Scholes valuation model with thefollowing assumptions: expected volatility of 136%, risk-free interest rate of4.01%, expected life of seven years and no dividends.  The value of thewarrant was recorded as a debt discount and is being amortized as interestexpense using the effective interest method over the life of the notepayable.  For the three months ended May 31, 2004, interest expenserelated to such warrant amounted to approximately $7,000.  The unamortizedbalance is presented as a discount against the principal balance of the notepayable outstanding.  At May 31, 2004, the warrants had not beenexercised.

 

In August 2003, we alsoentered into a line of credit with the same bank. The line of credit bearsannual interest at the greater of the bank’s prime rate plus 1% or 5.25%. The agreement provides for borrowings of up to $500,000 throughAugust 2004 and is limited to equipment purchases.  As of May 31,2004, we had borrowed approximately $254,000 under this agreement and theinterest rate at that date was 5.25%.  Monthly payments of interest onlyare payable through August 2004, after which fixed monthly principalinstallments plus interest will be made through August 2006.

 

All of this debt iscollateralized by a senior security interest in substantially all of ourassets.  We are also required to maintain compliance with certainfinancial covenants, with all of which we were in compliance at May 31, 2004.

 

Scheduled maturities of debtat May 31, 2004, are as follows (in thousands):

 
| Years ending:     |   |   |   |   |
|-------------------|--------|--------|--------|--------|
| February 28, 2005 |   | $      | 807    |   |
| February 28, 2006 |   | 705    |   |
| February 28, 2007 |   | 64     |   |
|              |   | $      | 1,576  |   |

 

**NOTE 7.ALLIANCES**

 

**Resale ofSun and Websense Software by Intraware and Software Spectrum**

 

In October 1998, we enteredinto an agreement with Netscape Communications Corporation for our resale andelectronic distribution of Netscape software to end-users in North America. Theagreement also allowed us to use Netscape products internally. In 1999, AmericaOnline, Inc. acquired Netscape and formed an alliance with Sun Microsystems,Inc. to manage Netscape’s business software division. In September 1999, wesigned an agreement with Sun for our resale and electronic distribution ofNetscape business software (marketed by Sun under the brands “Sun/NetscapeAlliance,” “iPlanet” and ultimately “Sun ONE” and “Java Enterprise System”) andrelated maintenance services to end-users in North America. In July 2001, thisagreement was replaced by a new agreement between Intraware and Sun for ourresale and electronic distribution of Sun ONE software and maintenance servicesin North America. Concurrently with entering into this July 2001 softwareresale agreement with Sun, we assigned the agreement to CorpSoft, Inc., asdetailed below. (CorpSoft later merged with Software Spectrum, Inc., and werefer to the combined entity as Software Spectrum below.)

 

In June 2001, we signed anagreement with Software Spectrum under which we transferred to SoftwareSpectrum our Sun software resale business, including our agreement with Sun forresale of Sun software and maintenance services.  Software Spectrum assumed primary responsibility for resale ofSun software and related maintenance under its agreement with Sun (which hassince been replaced by an agreement between Software Spectrum and Sun’sdistributor).  However, we continue toassist Software Spectrum in its sales and marketing of Sun software andmaintenance, and also provide our SubscribeNet service to Software Spectrum toenable it to deliver Sun software to its customers electronically. As part ofthis arrangement, Software Spectrum pays us a percentage of the gross profitderived from its sales of Sun software licenses and maintenance services, andreimburses us for our cost in maintaining a team dedicated to sales of Sunsoftware licenses and maintenance (included in alliance and reimbursementrevenue line item on the consolidated statement of operations).  The June 2001 agreement with SoftwareSpectrum was part of our transition out of the business of resellingthird-party

 

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software. At the time weannounced this agreement, we also ceased reselling all other third-partysoftware except in a limited manner in connection with our proprietary productsand services.

 

In December 2003, we amendedour June 2001 agreement with Software Spectrum to add Websense software to theset of products that Software Spectrum and Intraware jointly resell under thatagreement. As part of this arrangement, Software Spectrum pays us a percentageof the gross profit derived from our joint sales of Websense software licensesand maintenance services (included in alliance and reimbursement revenue lineitem on the consolidated statement of operations).

 

In June 2004, we amended theJune 2001 agreement with Software Spectrum to extend the term of the agreementthrough June 30, 2005.  We also amendedthe agreement to enable either party to terminate the agreement without causeon 90 days’ prior written notice.

 

**Resale ofSubscribeNet Service by Zomax Incorporated**

 

On August 12, 2002, weentered into a strategic alliance agreement with Zomax Incorporated (“Zomax”),an international outsource provider of process management services.  Theagreement provided for Zomax’ marketing and resale of our SubscribeNet ESDMservice to its global customer base.  Under the agreement, Zomax wasrequired to pay a minimum license fee totaling $15 million to us over 10 years,subject to some conditions, including Zomax’ right to cancel the agreement atany time with one year’s notice.  The annual minimum license fee was basedon a graduated scale, beginning with $0.5 million in the first year of theagreement and escalating to $2.2 million in the final year of the agreement. The agreement also provided for Zomax’ payment to us of non-refundablequarterly service fees, based on sales of the SubscribeNet service by Zomax,over the term of the agreement.  Under the agreement, our SubscribeNetservice was the only ESDM 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 beapplied against future fees.  The agreement also provided for Zomax’payment to us of fees for any referrals by us to Zomax of potential customersfor Zomax’ services which resulted in completed sales.  Lastly, we reimbursed Zomax for one-half of thebase salary of a product sales manager, up to a maximum amount.  On theday we entered into that strategic alliance agreement with Zomax, we alsocompleted a private placement of approximately 6.1 million shares of our commonstock to Zomax for gross proceeds of approximately $5.0 million.  Uponcompletion of that private placement, Zomax held approximately 12% of ouroutstanding common stock.  On September 18, 2003, we filed an amendedregistration statement to register the resale of the common stock issued toZomax.  The SEC declared that registration statement effective onSeptember 25, 2003.

 

On August 29, 2003, weamended our strategic alliance agreement with Zomax to: (1) allow Zomax toterminate the agreement as of August 12, 2004, or as of any datethereafter, with or without cause, by delivery of 30 days prior written notice;(2) accelerate the due date of the payment of $0.4 million by Zomax to us forthe second year of the agreement; and (3) reduce the minimum license fee forthe third year of the agreement, which was to begin August 12, 2004, from$1.0 million to $0.6 million if Zomax has not terminated the agreement. During the three months ended November 30, 2003, and in accordance withthat amendment, we received $0.4 million from Zomax, all of which was recordedas deferred revenue at February 29, 2004, and was subject to be applied tofuture services.

 

On April 30, 2004,Zomax and Intraware mutually terminated our August 12, 2002 strategic allianceagreement (“Strategic Agreement”) and entered into a new reseller agreement.The new reseller agreement allows Zomax to resell our SubscribeNet ESDMservice. Zomax will pay us fees, to be determined on a case-by-case basis, foreach resale of the SubscribeNet service to a customer. Under the new agreement,Zomax will no longer pay minimum annual license fees to us. The term of the newagreement is one year, subject to automatic annual renewal for one-yearperiods. Each party has the right to terminate the agreement without cause upon60 days’ notice.

 

As part of the terminationof the Strategic Agreement, Zomax and Intraware will no longer be subject toexclusivity requirements or restrictions on sales to other companies. Inaddition, in consideration for Zomax’ termination of the Strategic Agreement,we refunded $115,000 of the $400,000 prepayment for future services paid byZomax to us in October 2003.  Theremaining deferred revenue balance of $383,000 at April 30, 2004, wasrecognized as revenue given that we no longer have any obligations under theStrategic Agreement.

 

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

 

The following discussion ofour financial condition and results of operations should be read in conjunctionwith our consolidated financial statements and related notes included in ourAnnual Report on Form 10-K for the fiscal year ended February 29,2004.  This discussion contains forward-looking statements that involve risksand uncertainties. Forward-looking statements include statements regarding ourfuture cash and liquidity position, the extent and timing of future revenuesand expenses and customer demand, the deployment of our products and services,and our reliance on third parties.  All forward-looking statementsincluded in this document are based on information available to us as of thedate hereof, and we assume no obligation to update any forward-lookingstatement.  Our actual results could differ materially from those anticipatedin these forward-looking statements as a result of certain factors, includingbut not limited to, those discussed in “Risk Factors” below and elsewhere inthis Quarterly Report on Form 10-Q.

 

**INTRAWAREOVERVIEW**

 

Our goal is to be thepreeminent digital entitlement and delivery services provider. We are pursuinga three-pronged strategy to achieve this goal. First, we are seeking tosolidify and strengthen our technological advantage by further improving ourESDM technology solutions through internal research and development and throughalliances with adjacent technology providers. Second, we are seeking to extendour customer base by strengthening our sales force, implementing new marketingprograms focused on lead generation, offering new functional capabilities andpricing packages, and providing exceptional customer service. Third, we areworking to become a profitable, cash-generating company by growing ourSubscribeNet business and practicing stringent fiscal responsibility.

 

We currently see a number oftrends in the marketplace that are potentially important for our business.First, the macroeconomy and the technology sector have improved in the pastyear. However, the improvement seems tentative, apparently due in part toconcerns about geopolitical instability and potential terrorist attacks, andspending by technology companies remains cautious. Second, in the past yearthere have been a number of mergers and acquisitions in the enterprise softwaresector. These consolidations pose both opportunities and risks for us,potentially leading either to growth in our contracts with those customers orto cancellation of customer contracts. Third, technology companies areincreasingly outsourcing operational functions to reduce costs. Our services enableenterprise software companies to outsource key operational functions in amanner that we believe is financially compelling. Therefore, we may benefitfrom this outsourcing trend. Fourth, the use of hosted web-based applications,which in the past has been limited by concerns about speed, reliability andsecurity, is now becoming more accepted among mainstream businesses, largelybecause of a desire for cost savings. This trend may benefit us because ourSubscribeNet service is a hosted web-based application.

 

Our management is focused onfour key opportunities. The first is what appears to be growing demand forelectronic delivery and management of enterprise software applications. Thesecond opportunity is to further penetrate the enterprise software providermarket by better integrating and cross-selling our suite of services, includingour SubscribeNet ESDM service, our outsourced sales and marketing services, andthe digital rights management and desktop update management and deploymentservices that we provide through strategic alliances. The third opportunity isto continue expanding into vertical markets other than enterprise software, andinto other untapped markets. The fourth is to continue forging alliances withadjacent technology providers to build our market position and develop newrevenue streams.

 

We also face a number of keyrisks, which are described in the “Risk Factors” beginning on page 23 below.

 

We earn revenues andgenerate cash principally through recurring service fees charged for ourSubscribeNet service, professional services fees charged for customization ofour SubscribeNet service, and profit-sharing and cost reimbursement receivedfor our sales and marketing services. We have also raised substantial amountsof cash through private stock placements. In our most recent private stockplacement, in September 2003, we raised gross proceeds of approximately$6.2 million through a sale of common stock to investment funds andaccounts managed by Apex Capital, LLC.

 

Despite our revenue- andcash-generating activities, we have incurred losses and negative cash flow fromoperations during each fiscal year since inception. For the three months endedMay 31, 2004, we narrowed our net loss to approximately $0.1 million andnegative cash flows to approximately $0.9 million. Our cash balances maydecline further, although we believe that the effects of our capital financing,strategic actions implemented to improve revenue, and cost controls will beadequate to generate sufficient cash resources to fund our futureoperations.  If we fail to generatesufficient revenues or control spending, we may be unable to achieve keybusiness objectives.

 

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**CriticalAccounting Policies and Estimates**

 

This MD&A discusses ourconsolidated financial statements, which have been prepared in accordance withgenerally accepted accounting principles in the United States of America. Inpreparing these financial statements, we are required to make estimates andassumptions affecting the reported amounts of assets and liabilities and thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. On an ongoing basis, we evaluate our estimates and judgments.We base our estimates and judgments on historical experience and on variousother factors believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assetsand liabilities not readily apparent from other sources. Actual results maydiffer from these estimates under different assumptions or conditions.

 

We consider accountingpolicies related to revenue recognition, prepaid licenses, services and costsof deferred revenue, allowance for doubtful accounts, stock-based compensation,goodwill and intangibles, and income taxes to be critical accounting policiesdue to the estimation process involved in each.

 

*RevenueRecognition*

 

Online services andtechnology revenue results primarily from three types of arrangements.  First, it results from sales of ourSubscribeNet electronic software delivery and management service to softwarevendors and other companies that distribute software as part of theirbusiness.  Second, it results fromprofessional services that we provide to integrate our proprietary software, toconvert data for customers, and to customize our SubscribeNet service forcustomers.  Third, it results from thesale of our proprietary software licenses and related maintenance to companiesusing those products internally or using those products to provide web-basedservices to their customers. As a result of the sale of our Asset Managementsoftware business in May 2002, we are not currently deriving revenue fromlicenses for our proprietary software; however, we may recognize futurerevenues if opportunities arise to sell licenses for our proprietary softwareunderlying our SubscribeNet service and related maintenance. We sell our SubscribeNetservice, and will sell proprietary software licenses if opportunities presentthemselves, primarily through our direct sales force and authorized resellers.

 

Alliance and reimbursementrevenue primarily relates to our alliance agreement with Software Spectrum forsales of Sun and Websense software licenses and maintenance. This revenueconsists of a percentage of the gross profit derived from the sales of Sun andWebsense software licenses and maintenance services, and reimbursement for thecosts of maintaining a sales team dedicated to selling Sun and Websensesoftware for Software Spectrum. This revenue is recognized as we provide theservices to Software Spectrum.

 

We derive software productrevenues from our past resale of licenses and maintenance for multiple businesssoftware product lines. As of July 1, 2001, we generally no longer resellthird party software licenses and maintenance, though we still resell licensesfor third party products complementary to our SubscribeNet service. Since July1, 2001, we have continued to recognize revenue from third party softwarelicenses and related maintenance contracts over the life of the arrangementsmade prior to July 1, 2001. Vendor specific objective evidence of fairvalue for the maintenance element of the resold software arrangements has beenbased on historical and contractual renewal rates for maintenance. We havedeferred the maintenance revenue at the outset of the arrangement andrecognized it ratably over the period during which the maintenance was to beprovided (generally 12 months), which normally commenced on the date thesoftware was delivered.  At May 31,2004, we do not have any deferred revenue relating to software productrevenues.

 

We defer online services andtechnology revenues related to ESDM and generally recognize them ratably overthe term of the service arrangement. Some SubscribeNet services provided to newcustomers involve implementation or customization essential to thefunctionality of our SubscribeNet services. In those cases, we defer revenue recognition until the services go-livedate is reached and recognize the revenue on a ratable basis over the remainingcontract term.  The go-live date is thedate on which the essential functionality is delivered or on which the websitethrough which the service is provided enters the production environment, or thepoint at which no additional customization is required, whichever islater.  Our SubscribeNet contracts withcustomers typically give the customer a period of time to evaluate aSubscribeNet implementation after we have completed it, and provide that thecustomer is deemed to have accepted the implementation if it has not rejectedit within that period.  We typicallyrely on such non-rejections by customers to indicate their acceptance ofimplementations.  Any subsequent

 

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indications by our customersthat their implementations have not been properly completed could have amaterial adverse impact on our financial condition and results of operations.

 

When we sell additionalprofessional services related to a SubscribeNet agreement, we defer revenuerecognition until the go-live date for the professional services, similar tothe manner in which we treat SubscribeNet service revenues as discussedabove.  Such professional servicesrevenues are recognized ratably over the longer of the remaining estimatedcustomer life or the remaining contract term, commencing with the completion ofthe professional services. Estimated customer life requires that weperiodically estimate the projected life of our existing customers, based onhistorical information, such as customer renewal rates. Since revenuesgenerated from additional professional services represent less than 6% of ouroverall revenues for the year ended February 29, 2004, any change to ourestimated customer life is unlikely to have a material adverse impact on ourfinancial condition or results of operations.

 

We recognize revenue whenall 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 isprobable; and

 

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

 

Revenue from transactionsthrough authorized resellers has been recognized when the licenses andmaintenance have been resold or utilized by the reseller or when our relatedobligations have been satisfied. These transactions primarily related to AssetManagement software licenses and maintenance resold.  During the year ended February 28, 2003, we sold our AssetManagement software business to Computer Associates International, Inc.  We based vendor specific objective evidenceof fair value for the maintenance element of the proprietary softwarearrangements on historical and contractual renewal rates for maintenance. Wedeferred the maintenance revenue at the outset of the arrangement andrecognized it ratably over the period during which the maintenance was to beprovided (generally 12 months), which normally commenced on the date thesoftware was delivered.

 

As mentioned above, adetermination that the collection of fees is probable is a precursor torecognizing revenue. Determination of collectability of payments requiresjudgment on the part of management and includes periodically evaluatingcustomers’ credit (see “Allowance for Doubtful Accounts” below).

 

*Costs ofDeferred Revenue and Prepaid Licenses and Services*

 

We capitalize deferred costsof revenues related to significant implementation and professional servicescontracts associated with our SubscribeNet services.  These costs are recognized over the same term as the associatedrevenue from those contracts (see “Revenue Recognition” above). Any change inour revenue recognition estimates could result in corresponding changes to ourrecognition of costs of deferred revenues. At May 31, 2004, we had approximately$0.3 million in capitalized costs of deferred revenues.  We recognize customer acquisition costs,including sales commissions, as incurred.

 

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*Stock-based Compensation*

 

Weaccount for stock-based compensation for our employees using the intrinsicvalue method presented in Accounting Principles Board (APB) No.25, ”Accounting for Stock Issued to Employees,” and relatedinterpretations, and comply with the disclosure provisions of Statement ofFinancial Accounting Standard (SFAS) No. 123, ”Accounting for Stock-BasedCompensation,” and with the disclosure provisions of SFAS No.148, ”Accounting for Stock-Based Compensation—Transition and DisclosureAmendment of SFAS No. 123. Under APB No. 25,” compensation expense is based onthe difference, as of the date of the grant, between the fair value of ourstock and the exercise price. No stock-based compensation was recorded forstock options granted to our employees because we have granted stock options toour employees equal to the market price of the underlying stock on the date ofgrant.

 

OnMarch 31, 2004, the Financial Accounting Standards Board (FASB) issued anexposure draft on a proposed standard for the accounting of stock options. Theproposed standard requires companies to value employee stock options and stockissued under employee stock purchase plans using the fair value based method onthe grant date and record stock-based compensation expense. The fair valuebased models that companies are allowed to use could be different from theBlack-Scholes option-pricing model, which is currently used by us to calculatethe pro forma effect on net income and earnings per share if we had appliedSFAS No. 123 to employee option grants. (See Note 1 to our consolidatedfinancial statements for the disclosure of the pro forma net loss and loss pershare for the three months ended May 31, 2004 and 2003 if we had applied SFASNo. 123.) However, the actual impact to our results of operations upon adoptionof the proposed standard could materially differ from the pro forma informationincluded in Note 1 to our consolidated financial statements due to differencesin the option-pricing model used, estimates and assumptions required, andoptions to be included in the calculation upon adoption. The fair value basedmodels require the input of highly subjective assumptions and do notnecessarily provide a reliable single measure of the fair value of our stockoptions. We closely monitor the status of this proposed standard and willevaluate the impact to our financial position and results of operations at suchtime when the final standard is issued.

 

*Allowancefor Doubtful Accounts*

 

We maintain an allowance fordoubtful accounts for estimated losses from our inability to collect requiredpayments from our customers. When evaluating the adequacy of this allowance, weanalyze specific accounts receivable, historical bad debts, customercredit-worthiness, current economic trends and changes in our customer paymenthistory.  We may need to recordincreases to our allowance balances in the future.  At May 31, 2004, we have many accounts receivable balances andone large unbilled receivable balance. Any dispute, early contract termination or other collection issues couldhave a material adverse impact on our financial condition and result ofoperations. At May 31, 2004, our unbilled receivable balance was$0.3 million. This balance relates to our Software Spectrum agreement (see“Revenue Recognition” above). There are no allowances for doubtful accountsrelated to this balance. This estimate involves management’s judgment, whichtakes into account Software Spectrum’s prior payment history, currentcredit-worthiness and overall business condition. Changes in the above factorscould have a material impact on actual bad debts incurred.

 

*Goodwilland Intangibles*

 

We are required to regularlyreview all of our long-lived assets, including goodwill and other intangibleassets, for impairment whenever events or changes in circumstances indicate thatthe carrying value may not be recoverable. We have reviewed goodwill balances for impairment at least onceannually.  Factors we consider importantwhich could trigger an impairment review include, but are not limited to,significant underperformance

 

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relative to historical orprojected future operating results, significant changes in the manner of use ofthe acquired assets or the strategy for our overall business, significantnegative industry or economic trends, a significant decline in our stock pricefor a sustained period, and our market capitalization relative to net bookvalue. When we determine that an impairment review for intangible andlong-lived assets is necessary based upon the existence of one or more of theabove indicators of impairment, we compare the book value of such assets to thefuture undiscounted cash flows attributable to those assets. If the book valueis greater than the future undiscounted cash flows, we measure any impairmentbased on a projected discounted cash flow method using a discount ratecommensurate with the risk inherent in our current business model. When wedetermine an impairment review of goodwill is necessary based on an impairmentindicator or based on our annual testing requirements, we compare the fairvalue of the reporting unit to the carrying value of the reporting unit. If thecarrying value of the reporting unit is greater than the fair value of thereporting unit, an impairment may be necessary. Significant judgment isrequired in the development of projected cash flows for these purposes,including assumptions regarding the appropriate level of aggregation of cashflows, their term and discount rate as well as the underlying forecasts ofexpected future revenue and expense.

 

*IncomeTaxes*

 

In conjunction withpreparing our financial statements, we must estimate our income taxes in eachof the jurisdictions in which we operate. This process involves estimating ouractual current tax expense together with assessing temporary differencesresulting from differing treatment of items for tax and accounting purposes.These differences result in deferred tax assets and liabilities. We must thenassess the likelihood that our deferred tax assets will be recovered fromfuture taxable income and to the extent we believe that recovery is not likely,we must establish a valuation allowance. Given that we have incurred lossessince inception and therefore have not been required to pay income taxes, wehave fully reserved our deferred tax assets at February 29, 2004.  In the event that we are able to realize ourdeferred tax assets in the future, an adjustment to the deferred tax assetwould increase income in the period that this is determined.

 

**Results ofOperations**

 

*Total Revenue*

 

The following table setsforth the revenue, changes in revenue and percentage of total revenue for theperiods indicated (in thousands):

 
|                                          |   | **For the  three months ended** |   |
|-----------------------------------------------|--------|---------------------------------|--------|
|                                          |   | **May 31,  2004**               |   | **May 31,  2003** |   |
|                                          |   | **Total**                       |   | **Change  ($)** |   | **% of  Revenue** |   | **Total** |   | **% of  Revenue** |   |
| Revenues:                                     |   |                            |   |   |   |   |   |   |   |   |   |
| Online services and technology                |   | $                               | 1,695  |   | $ | (25 | ) | 60 | % | $ | 1,720 |   | 61 | % |
| Alliance and reimbursement                    |   | 576                             |   | (286 | ) | 20 | % | 862 |   | 31 | % |
| Related party online services and  technology |   | 534                             |   | 417 |   | 19 | % | 117 |   | 4 | % |
| Software product sales                        |   | 42                              |   | (72 | ) | 1 | % | 114 |   | 4 | % |
| Total revenues                                |   | $                               | 2,847  |   | $ | 34 |   | 100 | % | $ | 2,813 |   | 100 | % |

 

Revenues for combined onlineservices and technology and related party online services and technology forthe three months ended May 31, 2004, increased from the same quarter in theprior year.  This increase is primarily due to a $0.4 million increase inrelated party online services and technology revenue.  This increase resulted from our recognition of the remainingdeferred revenue under our strategic alliance agreement with Zomax Incorporatedupon the termination of that agreement. We expect our combined online services and technology revenue andrelated party online services and technology revenues for our fiscal quarterending August 31, 2004, to be lower than those in our fiscal quarter ended May31, 2004, as we will no longer be recognizing annual license fee revenue fromour alliance with Zomax.  The previous sentence is a forward-lookingstatement that is subject to risks and uncertainties, and actual results coulddiffer materially from those anticipated (see “Risk Factors” beginning on page23 below).

 

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Alliance and reimbursementrevenue primarily relates to our alliance agreement with Software Spectrum forsales of Sun Java Enterprise System and Sun ONE (collectively “Sun Software)and Websense software licenses and maintenance.  This revenue consists ofa percentage of the gross profit derived from the sales of Sun and Websensesoftware licenses and maintenance services, and reimbursement for the costs ofmaintaining a sales team dedicated to selling Sun and Websense software forSoftware Spectrum.  On June 29, 2004, we extended our agreement withSoftware Spectrum through June 30, 2005, and amended it to enable either partyto terminate the agreement without cause on 90 days’ written notice.  The decrease in alliance and reimbursementrevenue for the three months ended May 31, 2004, was primarily due to a reductionof the shared gross profit derived from the sales of Sun software licenses andmaintenance services, of $0.2 million.  This reduction in shared grossprofit was due to lower sales of Sun software during the three months ended May31, 2004.  We expect our alliance andreimbursement revenues in our fiscal quarter ending August 31, 2004, to beconsistent with or slightly higher than those in our fiscal quarter ended May31, 2004.  However, the Sun software weresell has experienced a decrease in market share over the past severalquarters, 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.  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 23 below).

 

The decline in softwareproduct revenue for the three months ended May 31, 2004, was due to ourtransition out of the business of reselling third-party software products andrelated maintenance.  We do not expect to recognize future revenues fromour exited third-party resale business. However, we may recognize future revenues from product licenses andrelated services complementary to our SubscribeNet service, which originatewith other companies and which we resell as part of a comprehensive ESDMbusiness solution.  The previous two sentences are forward-lookingstatements that are subject to risks and uncertainties, and actual resultscould differ materially from those anticipated (see “Risk Factors” beginning onpage 23 below).

 

*Costs and Expenses*

 

The following table setsforth the costs and expenses, changes in costs and expenses and percentage oftotal revenue for the periods indicated (in thousands):

 
|                                        |   | **For the  three months ended** |   |
|---------------------------------------------|--------|---------------------------------|--------|
|                                        |   | **May 31,  2004**               |   | **May 31,  2003** |   |
|                                        |   | **Total**                       |   | **Change  ($)** |   | **% of  Revenue** |   | **Total** |   | **% of  Revenue** |   |
|                                        |   |                            |   |   |   |   |   |   |   |   |   |
| Total cost of revenues                      |   | $                               | 995    |   | $ | (218 | ) | 35 | % | $ | 1,213 |   | 43 | % |
| Gross margin                                |   | 1,852                           |   | 252 |   | 65 | % | 1,600 |   | 57 | % |
| Operating expenses:                         |   |                            |   |   |   |   |   |   |   |   |   |
| Sales and marketing                         |   | 752                             |   | (17 | ) | 26 | % | 769 |   | 27 | % |
| Product development                         |   | 403                             |   | (516 | ) | 14 | % | 919 |   | 33 | % |
| General and administrative                  |   | 789                             |   | 23 |   | 28 | % | 766 |   | 27 | % |
| Total operating expenses                    |   | 1,944                           |   | (510 | ) | 68 | % | 2,454 |   | 87 | % |
| Loss from operations                        |   | (92                             | )      | 762 |   | -3 | % | (854 | ) | -30 | % |
| Interest expense                            |   | (29                             | )      | 40 |   | -1 | % | (69 | ) | -2 | % |
| Interest and other income and expenses, net |   | 16                              |   | 2 |   | 1 | % | 14 |   | 0 | % |
| Net loss                                    |   | $                               | (105   | ) | $ | 804 |   | -4 | % | $ | (909 | ) | -32 | % |

 

*Cost of Revenues*

 

The decrease in cost ofrevenues for the three months ended May 31, 2004, is primarily due to the $0.1million decrease in alliance and reimbursement revenue and to the phasing outof our software reseller business, which resulted in a $0.1 million reductionin cost of revenues.  The margin percentage increase for the three monthsended May 31, 2004, primarily reflects our focus on the sale of our own onlineservices and technology, which generate higher margins than third-partyproducts we resold and alliance and reimbursement revenue.

 

Cost of revenues primarilyconsists of certain allocated costs related to our Internet connectivity,assets supporting cost of revenues, and customer support, as well as the costsassociated with maintaining our sales team dedicated to selling Sun andWebsense software for which we are reimbursed by Software Spectrum. Cost of

 

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revenues also consists ofprofessional services personnel costs and the cost of third-party productssold.  When we were in the business of reselling third-party softwareproducts, we purchased those products at a discount from the third-parties’established list prices according to standard reseller terms.  We expectthe overall cost of revenues in the current fiscal year to be lower than, andgross profit margin percentage to be greater than, in our fiscal year2004.  The previous sentence is a forward-looking statement that issubject to risks and uncertainties.  The actual mix of sales transactionsand the timing of the transactions may cause our cost of revenues and grossprofit margins to fluctuate materially from those anticipated (see “RiskFactors” beginning on page 23 below).

 

*Sales and Marketing Expenses*

 

Sales and marketing expensesconsist primarily of employee salaries, benefits and commissions, advertising,promotional materials, trade show expenses and certain allocated overheadcosts.

 

The decrease in the dollaramount of our sales and marketing expenses for the three months ended May 31,2004, compared to the three months ended May 31, 2003, is primarily due to adecrease in the number of our sales and marketing personnel, which resulted ina reduction in payroll related expenses of approximately $128,000. Thisreduction was partially offset by an increase in consulting expenditures ofapproximately $123,000. This increase in consulting expenditures was part ofour planned increase in sales and marketing expenditures, as discussed below.

 

We plan to increase ourexpenditures on sales and marketing in fiscal year 2005 over those in fiscalyear 2004, both in dollar amounts and as a percentage of revenue. We plan tocontinue to market and sell our services, and may market and sell proprietarysoftware licenses, directly to customers using our existing sales force. Wealso plan to continue to develop additional business relationships to sell ourservices to a broader customer base. The previous three sentences areforward-looking statements that are subject to risks and uncertainties, andactual results could differ materially from those anticipated (see “RiskFactors” beginning on page 23 below).

 

*Product Development Expenses*

 

Product development expensesprimarily consist of personnel, consulting, software and related maintenance, equipmentdepreciation expenses and allocated overhead costs.  Costs related toresearch, design and development of products and services have been charged toproduct development expense as incurred.

 

The decrease in the dollaramount and percentage of revenue of our product development expenses for thethree months ended May 31, 2004, compared to the three months ended May 31,2003, is due primarily to a decrease in software and equipment depreciationexpense of approximately $409,000, as many fixed assets have become fullydepreciated during the past several quarters, as well as to a reduction inpayroll related expenses of approximately $49,000.

 

We anticipate continuing toinvest in additional functionality for our SubscribeNet service and underlyingproprietary software. However, we expect those investments to fluctuate overtime, and expect our product development expenses to fluctuate accordingly. Weexpect total product development expenditures to be lower in fiscal year 2005than in fiscal year 2004, both in dollar amounts and as a percentage ofrevenue, primarily due to expected lower depreciation of equipment and expectedgrowth in revenue. 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 23 below). Wecannot give assurance that our product development efforts will result in newor improved products, features or functionality or that the market will acceptthe improvements to existing or new products, features or functionalitydeveloped.

 

*General and AdministrativeExpenses*

 

General and administrativeexpenses consist primarily of compensation for administrative and executivepersonnel, fees for professional services and certain overhead costs.

 

Our change in general andadministrative expenses for the three months ended May 31, 2004, is primarilydue to the reduction in recovery of accounts previously written off, ascompared to our higher recovery of such accounts during the three months endedMay 31, 2003. During our 2001 fiscal year, we wrote off accounts that weredeemed to be uncollectible at that time. However, we continued to pursuecollection efforts and ultimately succeeded in recovering amounts from thattime period. During the three months ended May 31, 2004, we recoveredapproximately $159,000 less than in the three months ended May 31, 2003. Thislower recovery of accounts previously written off were partially offset byreductions in legal expenses of $153,000.

 

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We expect total expendituresin fiscal year 2005 to approximate fiscal year 2004 levels. The previoussentence is a forward-looking statement that is subject to risks and uncertainties,and actual results could differ materially from those anticipated (see “RiskFactors” beginning on page 23 below).

 

*Interest Expense*

 

For the three months endedMay 31, 2004, interest expense was approximately $29,000, a decrease from$69,000 for the three months ended May 31, 2003

 

Interest expense relates toobligations under capital leases and notes payable.  The decrease ininterest expense for the three months ended May 31, 2004, is primarily due tothe reduction of the principal balance on our capital lease obligations. We also replaced certain capital leases with a note payable bearing a lowerinterest rate See Note 6 of our “Notes to Consolidated FinancialStatements” in Item 1 above.

 

*Interest and Other Income andExpenses, Net*

 

For the three months endedMay 31, 2004, interest and other income and expenses, net was approximately a$16,000 credit, an increase from a $14,000 credit for the three months endedMay 31, 2003.

 

Interest and other incomeand expenses, net primarily relates to interest earned on our investmentbalances.  The increase in interest and other income and expenses, net forthe three months ended May 31, 2004, is primarily the result of our increasedcash balance from the prior year.

 

*Income Taxes*

 

From inception through February29, 2004, we incurred net losses for federal and state tax purposes and havenot recognized any tax provision or benefit. As of February 29, 2004, we hadapproximately $129 million of federal and $59 million of state net operatingloss carryforwards available to offset future taxable income, which expire invarying amounts between 2004 and 2025. Because of cumulative ownership changes,federal loss carryforwards totaling approximately $90 million and stateloss carryforwards totaling approximately $39 million are subject tolimitation. At February 29, 2004, $39 million and $20 million of federal andstate net operating losses, respectively, are available, without limitation tooffset future taxable income. Should there be a change of ownership in the future,the available net operating losses may be further limited. Given our limitedoperating history, losses incurred to date and the difficulty in accuratelyforecasting our future results, management does not believe that therealization of the related deferred income tax asset meets the criteriarequired by generally accepted accounting principles. Accordingly, we haverecorded a 100% valuation allowance.

 

**Liquidityand Capital Resources**

 

The following table presentsour liquidity position at May 31, 2004 and 2003 (in thousands):

 
|                                                |   | **For the  three months ended** |   |
|-----------------------------------------------------|--------|---------------------------------|--------|
|                                                |   | **May 31,  2004**               |   | **May 31,  2003** |   |
|                                                |   |                            |   |   |   |
| Cash and cash equivalents                           |   | $                               | 10,855 |   | $ | 5,812 |   |
| Working capital                                     |   | $                               | 8,345  |   | $ | 2,082 |   |
| Net cash used in operating activities               |   | $                               | (877   | ) | $ | (718 | ) |
| Net cash used in investing activities               |   | $                               | (87    | ) | $ | (3 | ) |
| Net cash provided by (used in) financing activities |   | $                               | 15     |   | $ | (308 | ) |

 

Our net cash used inoperations was $0.9 million for the three months ended May 31, 2004, upfrom $0.7 million net cash used in operations in the three months endedMay 31, 2003. This increase was primarily due to approximately$0.2 million in incremental payments for insurance policies that werefinanced in the prior year. Our overall net cash used in operating activitiesprimarily resulted from our net loss for the year and the timing of ourpayments to vendors and receipts from customers. The majority of our operating

 

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costs continue to relate toemployee payroll and related expenditures. The net cash used in operations for the three months ended May 31, 2004came from our existing cash and cash equivalents, and from our issuance ofcommon stock in connection with our employee stock purchase and employee optionplans.  We expect to continue to improveour cash used in operations by increasing our billings to customers as moresubscribers are added to our ESDM service. We plan to use part of thoseexpected increased cash receipts in additional sales and marketing expendituresto expand our market reach. The previous sentence is a forward-lookingstatement that is subject to risks and uncertainties, and actual results coulddiffer materially from those anticipated (see “Risk Factors” beginning on page23 below).  Our ability to improve ouruses of cash and generate positive cash flows in future periods will largelydepend on our ability to increase the number of customers of our SubscribeNetservice while increasing existing subscriptions through strong contractrenewals. It is also important for us to increase our current level of salesthrough our Software Spectrum sales alliance, and continue to control ouroperational and customer support costs in future periods.

 

Our net cash provided byfinancing activities was approximately $15,000 for the three months endedMay 31, 2004.  Most of this amount camefrom the issuance of approximately 222,000 shares of common stock in connectionwith our stock option and employee stock purchase plan for approximately $263,000.  The proceeds from these stock issuances wereoffset by payments on our notes payable of approximately $248,000 (see below).

 

                In August 2003, we entered into anagreement with a bank under which we issued a note payable for proceeds ofapproximately $2.0 million and obtained access to a $500,000 line ofcredit. The note payable bears an annual interest rate of the greater of 1% inexcess of the bank’s prime rate (4.00% at May 31, 2004) or 5.25%. We used theproceeds from the note payable to settle our remaining liability under a capitallease bearing an interest rate of approximately 12%. This refinancing enabledus to significantly reduce our monthly capital financing and interestexpenditures. The line of credit allows us to draw, through August 2004,for equipment purchases at the same interest rate that applies to the notepayable.

 

                Under the agreement for the notepayable and line of credit, all borrowings are collateralized by a seniorsecurity interest in substantially all of our assets. The agreement alsorequires us to comply with financial covenants, with which we complied as ofMay 31, 2004. The agreement further restricts us from incurring or assumingadditional indebtedness outside of this note payable and line of credit,excluding trade payables and certain other liabilities incurred in the ordinarycourse of business.

 

                Our net cash used in investingactivities during the three months ended May 31, 2004 was $87,000. This amountwas primarily comprised of approximately $89,000 for our purchase of fixedassets. We paid for these equipment purchases from our cash and cashequivalents, however, we plan to continue to utilize our above-mentioned lineof credit to finance these type 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.

 

                We believe our existing cash and cashequivalents, together with any cash generated from operations, will besufficient to fund our operating activities, capital expenditures and financingarrangements for the foreseeable future. However, if our SubscribeNet businessfails to grow significantly or declines from its current level, we could beforced to seek additional capital.

 

                At May 31, 2004, we did not have anyrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in such relationships.

 

                The following table summarizes our debtand lease obligations at May 31, 2004, and the effect such obligations areexpected to have on our liquidity and cash flow in future periods (inthousands). This table provides information through our year endingFebruary 28, 2007, as we do not have any debt or lease obligations beyondthat point.

 

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|             |   | **Payments  due by period** |   |
|------------------|--------|-----------------------------|--------|
|             |   | **2005**                    |   | **2006** |   | **2007** |   | **Total** |   |
| Long-term debt   |   | $                           | 855    |   | $ | 722 |   | $ | 65 |   | $ | 1,642 | (a) |
| Operating leases |   | 434                         |   | 284 |   | — |   | 718 | (b) |
|             |   | $                           | 1,289  |   | $ | 1,006 |   | $ | 65 |   | $ | 2,360 |   |

 

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(a)      This amountincludes approximately $66,000 in interest.

 

(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 if we do not exercise our rightto exit our operating lease for our Orinda office. In addition, this amountexcludes potential sublease receipts.

 

 As of May 31, 2004,our Series A redeemable convertible preferred stock entitled its holdersto a liquidation preference of $1.0 million in the event of Intraware’sliquidation.

 

**RecentAccounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 46,“Consolidation of Variable Interest Entities (“VIE”), an Interpretation of ARBNo. 51” (“FIN 46”) and in December 2003, issued a revised interpretation(“FIN 46-R”). FIN No. 46, as revised, requires certain variable interestentities 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 are required to adopt the provisions ofFIN 46-R in the first quarter of our fiscal year 2005. The adoption of FIN 46-Rdid not have a significant effect on our financial position or results ofoperations.

 

                In May 2003, the FASB issued SFASNo. 150, “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity” (“SFAS No. 150”). SFASNo. 150 establishes standards for the classification and measurement offinancial instruments with characteristics of both liabilities and equity. Theprovisions of SFAS No. 150 apply to the first interim period beginningafter June 15, 2003.  During thethree months ended November 30, 2003, we adopted the relevant provisions ofSFAS No. 150.  While the effective dateof certain elements of SFAS No. 150 have been deferred, the adoption of SFASNo. 150 when finalized is not expected to have a material impact on ourfinancial position, results of operations or cash flows.

 

               In April 2004, the EITFissued Statement No. 03-06 “Participating Securities and the Two-ClassMethod Under 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. We are currently evaluating theeffect of adopting EITF 03-06.

 

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**RISK FACTORS**

 

                You should carefully consider the risksdescribed below before making a decision to invest in our common stock. Therisks and uncertainties described below are not the only ones facing Intraware.Additional risks and uncertainties not presently known to us or that we do notcurrently believe are important to an investor may also harm our business operations.If any of the events, contingencies, circumstances or conditions described inthe following risks actually occur, our business, financial condition or ourresults of operations could be seriously harmed. If that occurs, the tradingprice of our common stock could decline, and you may lose part or all of yourinvestment.

 

**Revenues tous under our Sales and Marketing Services arrangement with Software Spectrumare likely to decline over the long term. Also, any termination of ourrelationship with Software Spectrum in the near term, without an adequatereplacement, would cause a substantial decrease in our revenues.**

 

                Under our June 2001 agreement withSoftware Spectrum, we provide Sales and Marketing Services to Software Spectrumto assist in its resale and marketing of Sun and Websense software licenses andmaintenance. Software Spectrum shares with us a portion of its gross profitfrom resales of Sun and Websense software licenses and maintenance, andreimburses us for a substantial portion of our cost of maintaining a teamdedicated to sales and marketing of that software and maintenance. Thiscontract 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 May 31, 2004. However, in recent years, sales and market share of the Sunsoftware product lines that we resell with Software Spectrum have generallydeclined. If this trend continues, revenues to us under this contract arelikely to decrease over the long term. In addition, the term of this agreementwill expire in June 2005, is renewable for subsequent one-year terms, andmay be terminated without cause by either party on 90 days’ notice. It ispossible that Software Spectrum will terminate this agreement without cause orwill choose not to renew the agreement at any renewal point. It is alsopossible that Sun and/or Websense will choose to stop permitting Software Spectrumto resell their software. Any termination or non-renewal of our agreement withSoftware Spectrum, or termination of Software Spectrum’s rights to resell Sunsoftware, would likely cause a substantial and immediate decrease in ourrevenues.

 

**The loss ofone or more of our key customers or partners could cause our revenue growth toslow or cause our revenues to decline.**

 

                A substantial amount of the revenuesfrom our SubscribeNet service come from a relatively small number of companies.These include software providers to whom we provide our SubscribeNet service,as well as Software Spectrum, to whom we provide both our SubscribeNet serviceand sales and marketing services. Our contracts with most of these companiesare subject to renewal or cancellation annually. If any of these companieselected to cancel their agreements with us, our revenue growth would likelyslow or our revenues might decline.

 

                In April 2004, Zomax and Intrawareterminated our August 2002 strategic alliance agreement, under which Zomaxpaid us an aggregate of $1.3 million in annual SubscribeNet license feesover two years. We replaced that agreement with a new reseller agreement underwhich Zomax does not pay us annual license fees, but rather pays us for servicesas they are provided.  This agreement isterminable without cause upon 60 days’ notice.

 

**We have ahistory of losses and negative cash flow, and we have yet to achieve sustainedprofitability or positive cash flow. We plan to increase spending on sales and marketing,which could limit or prevent any near-term improvement in our net income andcash flow.**

 

                We have incurred significant lossessince we were formed in 1996, and have yet to achieve sustained profitabilityor positive cash flow. As of May 31, 2004, we had an accumulated deficit ofapproximately $155 million. Also, with the exception of our quarter endedNovember 30, 2002, we have not achieved positive cash flow since ourformation in 1996. Our operating history, combined with our plans to increaseinvestments in sales and marketing programs, make it difficult to evaluatewhether or when we will be able to achieve sustained profitability or positivecash flow in the future.

 

                We plan to increase our spending onsales and marketing activities and programs. We believe these

 

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investments will contribute toimproved financial performance over the longer term, although we cannot assureyou that these investments will be successful. In the near term this increasein our costs may limit or prevent any improvement in our net income and cashflows.

 

**Competitionfrom other electronic software delivery service providers, and potentialcustomers’ development of their own electronic software delivery systems, couldlimit our revenue growth and reduce our gross margins.**

 

                The market for selling electronicsoftware delivery services is highly competitive.  Some of our competitors have longer operating histories, greaterfinancial, technical, marketing and other resources, broader product andservice offerings, better name recognition, and a larger installed base ofcustomers than we do. Some of our competitors also have well-establishedrelationships with our potential customers and with third-party informationtechnology or consulting firms that help market our competitors’ services. Weexpect competition to intensify as current competitors expand and improve theirservice offerings and new competitors enter the market. Mergers andconsolidation in the information technology industry may also increasecompetition by enlarging our competitors and their product and serviceofferings, and/or by reducing the pool of potential customers. In addition, ourcurrent and potential customers are primarily information technology companieswith strong software development expertise. When considering their alternativesfor implementing an electronic software delivery and management system, thesecompanies sometimes elect to develop such systems in-house. While we believeour competitive position is strong against both external competitors andin-house development, we have at times experienced reduced prices, reducedgross margins and lost sales as a result of such competitive factors. It ispossible that such competition will intensify and thereby limit the growth ofour revenues and gross margins.

 

**Ouroperating results may fluctuate in future periods, which may adversely affectour stock price.**

 

                Our operating results have been in thepast, and will continue to be, subject to quarterly and annual fluctuations asa result of a number of factors. In addition to the other risk factorsdescribed in this section, those factors include:

 

•                  Fluctuations in demand for the Sun softwarewe resell jointly with Software Spectrum, for which we recognize revenue basedlargely on sales during the reported period, unlike our SubscribeNet fees whichwe generally recognize ratably over the term of our customer agreements;

 

•                  Deferral of SubscribeNet revenue recognitiondue to delays by customers in implementing the SubscribeNet service, new salesinvolving extensive implementations, or contract modifications adding futuredeliverables;

 

•                  Changes in sales and implementation cyclesfor our SubscribeNet service;

 

•                  The overall trend toward industryconsolidation both among our customers and our competitors;

 

•                  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; 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 therefore,prior results are not necessarily indicative of results to be expected infuture periods. Any of the foregoing factors, or any other factors discussedelsewhere herein, could have a material adverse effect on our business, resultsof operations, and financial condition that could adversely affect our stockprice.

 

**The market for our technology delivery model and hosted electronicsoftware delivery and management services is immature and volatile, and if itdoes not develop or develops more slowly than we expect, our business will beharmed.**

 

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The market for hostedelectronic software delivery and management services is new and unproven, andit is uncertain whether these services will achieve and sustain high levels ofdemand and market acceptance. Our success will depend to a substantial extenton the willingness of software companies, large and small, to increase theiruse of hosted ESDM services. Many software companies have invested substantialpersonnel and financial resources to develop their own electronic softwaredelivery systems and therefore may be reluctant or unwilling to migrate to aremotely hosted service. In addition, some software companies have adoptedautomatic update, or “phone home,” technology for delivering software updates,whereby an end-user’s computer automatically contacts the software company’sserver to check whether updates are available and, if so, downloads andinstalls those updates.  This method fordelivering software updates could be viewed by our potential and existingcustomers as an alternative to our ESDM technology, and therefore any increasedadoption of this automatic update technology could hurt our business andresults of operations. Furthermore, some software companies may be reluctant orunwilling to use hosted ESDM services because they have concerns regarding therisks associated with security capabilities, among other things, of thetechnology delivery model associated with these services. If software companiesdo not perceive the benefits of hosted ESDM services, then the market for theseservices may develop more slowly than we expect, which would significantlyadversely affect our operating results. In addition, in this unproven market,we have limited insight into trends that may develop and affect our business.We may make errors in predicting and reacting to relevant business trends,which could harm our business.

 

**Thetechnological and functional requirements we must meet to stay competitive aresubject to rapid change. If we are unable to quickly adapt to these changes andmeet the demands of our current and potential customers, we will likely losesales and market share and our 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 toincrease commensurately, our goals of sustained profitability and positiveoperating cash flow will become more difficult to achieve.

 

**Defects in our service could diminish demand for our service andsubject 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 or otherperformance problems with our service could hurt our reputation and may damageour customers’ businesses. If that occurs, customers could elect not to renew,could be eligible for credits under our service level agreements, or delay orwithhold payment to us, we could lose future sales or customers may makewarranty claims against us, which could result in an increase in our provisionfor doubtful accounts, an increase in collection cycles for accounts receivableor the expense and risk of litigation.

 

**Interruptions or delays in service from our third-party Web hostingfacilities could impair the delivery of our service 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 andsimilar misconduct. Despite precautions taken at the facilities, the occurrenceof a natural disaster, a decision to close a facility without adequate noticeor other unanticipated problems at a facility could result in lengthyinterruptions in our service. In addition, the failure by either facility toprovide our required data communications capacity could result in interruptionsin our service. 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

 

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adversely affect our renewalrates. Our business will be harmed if our customers and potential customersbelieve our service is unreliable.

 

**Viruses mayhinder acceptance of Internet-based electronic software delivery andmanagement, which could in turn limit our revenue growth.**

 

                The proliferation of software virusesis a key risk.that could inhibit acceptance by information technologyprofessionals of Web-based electronic software delivery and management. Anywell-publicized transmission of a computer virus by us or another company usingelectronic software delivery could deter information technology professionalsfrom using and deter software providers from outsourcing electronic softwaredelivery, thereby adversely affecting our business. Our SubscribeNet serviceenables our customers to upload their software products directly onto oursystems for downloading by their end-users. Our systems automatically scan ourcustomers’ software products for known computer viruses on an ongoing basiswhile they are on our systems. However, it is possible that, in spite of thoseperiodic virus scans, our system could transmit the virus to one or moreend-users. Any such virus transmission could result in disputes, litigation andnegative publicity that could adversely affect our business.

 

**If our security measures are breached and unauthorized access isobtained to a customer’s data, our service may be perceived as not being secureand customers may curtail or stop using our service.**

 

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 mayraise additional capital to fund acquisitions, product development or generaloperations. Any such capital financing would dilute our shareholders’investments.**

 

                We may raise additional capital in thefuture through private or public offerings of stock, or through other means.The purposes of any such financing would be to increase our cash reserves forpotential use in acquiring other businesses, product development activities,funding our operations and generally strengthening our balance sheet. Any suchadditional financing would likely dilute the investments of our currentshareholders.

 

**Additionalgovernment regulations may harm demand for our services and increase our costsof doing business.**

 

                Our business has benefited from the taxlaws of states in which purchases of software licenses are not taxable if thesoftware is received only electronically. Some states currently experiencingrevenue shortfalls are considering whether to change their laws to broaden thetaxability of transactions executed over the Internet. Any new imposition oftaxes on sales of software licenses, where the software is received electronically,could substantially harm demand for our services and thereby materiallyadversely affect our business, operating results and financial condition. Wehave also benefited from implementing our services in Ireland, which offers taxadvantages to software companies distributing their software from Ireland toother European 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 negatively affect our financialperformance.

 

**Claims bythird parties for intellectual property infringement could force us to stopselling our services, force us to pay royalties, and force us to indemnify ourcustomers.**

 

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                We electronically deliver third-partysoftware to end-users. This activity creates the potential for claims to bemade against us, either directly or through our contractual indemnificationobligations to our customers. Any claims could result in costly litigation andbe time-consuming to defend, divert management’s attention and resources, causedelays in releasing new or upgrading existing services or require us to enterinto royalty or licensing agreements. These claims could be made fordefamation, negligence, patent, copyright or trademark infringement, personalinjury, invasion of privacy or other legal theories based on the nature,content or copying of these materials.

 

                Litigation regarding intellectualproperty rights is common in the Internet and software industries. We expectthat Internet technologies and software products and services may beincreasingly subject to third-party infringement claims as the number ofcompetitors in our industry segment grows and the functionality of products indifferent industry segments overlaps. There can be no assurance that ourservices do not infringe the intellectual property rights of third parties. Inaddition, we may be involved in litigation involving the software ofthird-party vendors that we have electronically distributed in the past.Royalty or licensing agreements, if required, may not be available onacceptable terms, if at all. A successful claim of infringement against uscould adversely affect our business. Although we carry general liabilityinsurance, our insurance may not cover all potential claims or may not beadequate to protect us from all liability that may be imposed.

 

                We take steps to verify that end-userswho download third-party software through our SubscribeNet service are entitledto deploy and use that software. However, there can be no assurance that thisverification procedure will help us defend against claims by, or protect usagainst liability to, the owners of copyrights in that third-party software.Our success and ability to compete are substantially dependent upon ourinternally developed technology, which we protect through a combination ofpatent, copyright, trade secret and trademark law. We are aware that certainother companies are using or may have plans to use the name “Intraware” as acompany name or as a trademark or service mark. While we have received nonotice of any claims of trademark infringement from any of those companies, wecannot assure you that these companies may not claim superior rights to“Intraware” or to other marks we use. Despite our efforts to protect our proprietaryrights, unauthorized parties may attempt to copy or otherwise obtain and useour services or technology and we cannot be certain that the steps we havetaken will prevent misappropriation of our technology.

 

**If ourexport compliance system fails to prevent unauthorized exports of ourcustomers’ software, we could be sanctioned by the U.S. government.**

 

                Through our SubscribeNet service weglobally distribute software containing high encryption and other featuresrestricted by U.S. laws and regulations from exportation to certain countries,types of recipients, and specific end-users. Our SubscribeNet solutionincorporates automated procedures to help ensure that the software we deliverelectronically 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 keypersonnel left the company, our product development, sales, and corporatemanagement could suffer.**

 

                Our future success depends upon thecontinued service of our executive officers and other key technology, sales,marketing and support personnel. None of our officers or key employees is boundby an employment agreement for any specific term. If we lost the services ofone or more of our key employees, or if one or more of our executive officersor key employees decided to join a competitor or otherwise compete directly orindirectly with us, this could have a significant adverse effect on ourbusiness.

 

**Our reported financial results may be adversely affected by changes inaccounting principles generally accepted in the United States.**

 

Generally acceptedaccounting principles in the United States are subject to interpretation by theFinancial Accounting Standards Board, or FASB, the American Institute ofCertified Public Accountants, the Securities and

 

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Exchange Commission, or SEC,and various bodies formed to promulgate and interpret appropriate accountingprinciples. A change in these principles or interpretations could have asignificant effect on our reported financial results, and could affect thereporting of transactions completed before the announcement of a change.

 

For example, we currentlyare not required to record stock-based compensation charges if the employee’sstock option exercise price is equal to or exceeds the deemed fair value of ourcommon stock at the date of grant. However, several companies have recentlyelected to change their accounting policies and begun to record the fair valueof stock options as an expense. Although the standards have not been finalizedand the timing of a final statement has not been established, FASB has announcedits support for recording expense for the fair value of stock options granted.If we were required to change our accounting policy in accordance withStatement of Financial Accounting Standards (SFAS) No. 123, *Accounting for Stock-Based Compensation*andSFAS No. 148. *Accounting for Stock-BasedCompensation—Transition and Disclosure*, then our net loss and netloss per share would have increased (See Note 1 to our consolidated financialstatements for the pro forma net loss and loss per share for the three monthsended May 31, 2003 and 2004).  However,the actual impact to our results of operations upon adoption of the proposednew standard could materially differ from the pro forma information included inNote 1 to our consolidated financial statements due to differences in theoption-pricing model used, estimates and assumptions required, and options tobe included in the calculation upon adoption. The fair value based modelsrequire the input of highly subjective assumptions and do not necessarily providea reliable single measure of the fair value of our stock options.

 

**If we acquire any companies or technologies in the future, they couldprove difficult to integrate, disrupt our business, dilute stockholder valueand adversely affect our operating results.**

 

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;

 

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

 

•                  delays in customer purchases due to uncertainty.

 

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 May 31, 2004, we had cash and cashequivalents of $10.9 million. We have not used derivative financialinstruments in our investment portfolio during fiscal 2004 or the three monthsended May 31, 2004. We place our investments with high quality issuers, bypolicy, in an effort to limit the amount of credit exposure to any one issue orissuer.

 

                Our exposure to market risk for changesin interest rates relates primarily to our cash and cash equivalents portfolio.We have not used derivative financial instruments in our cash and cashequivalents portfolio. The effect of changes in interest rates of +/-10% over asix-month horizon would not have a material effect on the fair value of theportfolio.

 

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**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 reportingidentified in connection with the evaluation required by paragraph (d) ofExchange Act Rules 13a-15 or 15d-15 occurred during our last fiscal quarterthat have materially affected or are reasonably likely to materially affect,our internal control over financial reporting.

 

**PART II**

 

**OTHER INFORMATION**

 

**ITEM 1.LEGAL PROCEEDINGS**

 

                In October 2001, we were servedwith a summons and complaint in a purported securities class action lawsuit. Onor about April 19, 2002, we were served with an amended complaint in thisaction, which is now titled In re Intraware, Inc. Initial Public OfferingSecurities Litigation, Civ. No. 01-9349 (SAS) (S.D.N.Y.), related to In reInitial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). Theamended complaint is brought purportedly on behalf of all persons who purchasedour common stock from February 25, 1999 (the date of our initial publicoffering) through December 6, 2000. It names as defendants Intraware,three of our present and former officers and directors, and several investmentbanking firms that served as underwriters of our initial public offering. Thecomplaint alleges liability under Sections 11 and 15 of the Securities Act of1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, onthe grounds that the registration statement for the offerings did not disclosethat: (1) the underwriters had agreed to allow certain customers topurchase shares in the offerings 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 similar allegationshave been filed in the Southern District of New York challenging over 300 otherinitial public offerings and secondary offerings conducted in 1999 and 2000.All of these lawsuits have been consolidated for pretrial purposes beforeUnited States District Court Judge Shira Scheindlin of the Southern District ofNew York. 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. OnFebruary 19, 2003, the Court entered an order denying in part the issuerdefendants’ omnibus motion to dismiss, including those portions of the motionto dismiss relating to Intraware. No discovery has been served on us to date.

 

                In June and July 2003, nearly allof the issuers named as defendants in the In re Initial Public OfferingSecurities Litigation (collectively, the “issuer-defendants”), including us,approved a tentative settlement proposal that is reflected in a memorandum ofunderstanding. A special committee of our Board of Directors approved the memorandumof understanding in June 2003. The memorandum of understanding is not alegally binding agreement. Further, any final settlement agreement would besubject to a number of conditions, most of which would be outside of theCompany’s control, including approval by the Court. The underwriter-defendantsin the In re Initial Public Offering Securities Litigation (collectively, the“underwriter-defendants”), including the underwriters of our initial publicoffering, are not parties to the 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 ultimate

 

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amount, if any, that may bepaid on behalf of Intraware will therefore depend on the final terms of the settlementagreement, including the number of issuer-defendants that ultimately approvethe final settlement agreement, and the amounts, if any, recovered by theplaintiffs from the underwriter-defendants and other non-settling defendants.In the event that all or substantially all of the issuer-defendants approve thefinal settlement agreement, the amount our insurers would be required to pay tothe plaintiffs could range from zero to approximately $3.5 million,depending on plaintiffs’ recovery from the underwriter-defendants and fromother non-settling parties. If the plaintiffs recover at least $1 billionfrom the underwriter-defendants, our insurers would have no liability forsettlement payments under the proposed terms of the settlement. If the plaintiffsrecover less than $1 billion, we believe our insurance will likely coverour share of any payments towards satisfying plaintiffs’ $1 billionrecovery deficit.

 

                In July 2004, a complaint was filed inthe United 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; Keith Rosenbloom;and Intraware. The complaint describes Intraware as a nominal defendant.  The complaint alleges that, between August2001 and January 2002, all of the defendants other than Intraware were membersof a “group” under Sections 13(d)(3) 16(b) of the Securities Exchange Act of 1934 (the “1934 Act”).  The complaint further alleges that ComVestVenture Partners, LP and Mr. Priddy, while they and the other allegedgroup members collectively owned more than 10% of a class of our equitysecurities, bought and sold our equity securities within a 6-month period andfailed to disgorge to us the profits 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 October2001 to May 2002.  The complaint demandsthat ComVest Venture Partners, LP and Mr. Priddy pay over to Intraware theprofits they allegedly realized and retained in violation of Section 16(b)of the 1934 Act, together with interest and legal costs. According to thecompliant, the amount of those alleged profits is unknown to the plaintiff,however, the information alleged in the complaint suggests that amount may beapproximately $1.3 million. The complaint does not seek damages againstus.  After the complaint wasfiled, the plaintiff and Intraware signed a stipulation acknowledging thatIntraware takes no position with respect to the claims in the action, andproviding that Intraware accepts service of the complaint, that Intraware isnot required to file an answer or other response to the complaint, and thatIntraware will otherwise have the rights and responsibilities of a party to theaction.

 

                We are also subject to legal proceedings,claims and litigation arising in the ordinary course of business. We do notexpect that the ultimate costs to resolve these matters will have a materialadverse effect on our consolidated financial position, results of operations,or cash flows.

 

**ITEM2.  CHANGES IN 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 AND REPORT ON FORM 8-K**

 

**Exhibits**

 
| **Exhibit   Number** |   | **Description**                                                                               |
|----------------------|--------|-----------------------------------------------------------------------------------------------|
|                 |   |                                                                                          |
| 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                         |

 

**Reportson Form 8-K**

 

On March 25, 2004, we furnished a Current Report onForm 8-K reporting under Item 7–Financial Statements and Exhibits andItem 12—Results of Operations and Financial Condition in connection withour press release announcing results for our fiscal quarter and year endedFebruary 29, 2004. No financial statements were filed, although we furnishedthe financial information included in the press release we furnished with theForm 8-K.

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   | **INTRAWARE, INC.** |                                                                                   |
|--------|---------------------|----------------------------------------------------------------------------------------|
|   |                |                                                                                   |
|   | By:                 |                                                                                   |
| Dated: | July 15, 2004       |                                                                                   |   | /s/ WENDY A. NIETO |   |
|   |                |                                                                                   | Wendy A. Nieto |   |
|   |                | *Chief  Financial Officer and   Executive Vice President of Technology and Operations* |   |
|        |                     |                                                                                        |  |  |  |

 

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