**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

** **

**FORM 10-Q**

 
| **(Mark One)** | ** **                                                                                         |
|---------------------|----------------------------------------------------------------------------------------------------|
| **ý**          | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**       |
| ** **          | ** **                                                                                         | ** ** |
| ** **          | ** **                                                                                         | **For the quarterly period ended  August 31, 2005** |
| ** **          | ** **                                                                                         | ** ** |
| **Or**              |
| **o**               | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **          | ** **                                                                                         | ** ** |
| ** **          | ** **                                                                                         | **For the transition period from                     to                      ** |

 

**Commission filenumber:** 000-25249

**INTRAWARE, INC.**

**(Exact name of registrant as specified in its charter)**

 

| **Delaware**                                                        | **68-0389976**                               |
|---------------------------------------------------------------------|----------------------------------------------|
| **(State or other jurisdiction of  incorporation or organization)** | **(I.R.S. Employer Identification  Number)** |
| ** **                                                          | ** **                                   |
| **25 Orinda Way Orinda, CA**                                        | **94563**                                    |
| **(Address of principal executive  offices)**                       | **(Zip Code))**                              |

 

**Registrant’s telephone number,including area code:**(925) 253-4500

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes ý  No o

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

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

As of September 30, 2005 there were 6,069,011 shares of theregistrant’s common stock outstanding.

 

 

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**PART I—FINANCIAL INFORMATION**

 

**ITEM 1. CONSOLIDATED FINANCIALSTATEMENTS**

 

 

**INTRAWARE,INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(inthousands, except per share amounts)**

**(unaudited)**

** **
| ** **                                                                                                                                                   | ** ** | **August 31, 2005** | ** ** | **February 28, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|
| **ASSETS**                                                                                                                                                   |       |                |       |                  |       |
| Current assets:                                                                                                                                              |       |                |       |                  |       |
| Cash and cash equivalents                                                                                                                                    |       | $                   | 9,031      |                  | $          | 9,463 |   |
| Accounts receivable, net                                                                                                                                     |       | 930                 |       | 1,765                 |       |
| Costs of deferred revenue                                                                                                                                    |       | 418                 |       | 404                   |       |
| Other current assets                                                                                                                                         |       | 310                 |       | 321                   |       |
| Total current assets                                                                                                                                         |       | 10,689              |       | 11,953                |       |
| Cost of deferred revenue,  less current portion                                                                                                              |       | 68                  |       | 70                    |       |
| Property and equipment,  net                                                                                                                                 |       | 666                 |       | 863                   |       |
| Other assets                                                                                                                                                 |       | 113                 |       | 80                    |       |
| Total assets                                                                                                                                                 |       | $                   | 11,536     |                  | $          | 12,966 |   |
| **LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED  STOCK & STOCKHOLDERS’ EQUITY**                                                                     |       |                |       |                  |       |
| Current liabilities:                                                                                                                                         |       |                |       |                  |       |
| Notes payable                                                                                                                                                |       | $                   | 510        |                  | $          | 823 |   |
| Accounts payable                                                                                                                                             |       | 484                 |       | 464                   |       |
| Accrued expenses                                                                                                                                             |       | 894                 |       | 967                   |       |
| Deferred revenue                                                                                                                                             |       | 2,262               |       | 2,450                 |       |
| Related party deferred revenue                                                                                                                               |       | —              |       | 2                     |       |
| Total current liabilities                                                                                                                                    |       | 4,150               |       | 4,706                 |       |
| Deferred revenue, less  current portion                                                                                                                      |       | 32                  |       | 164                   |       |
| Notes payable, less  current portion                                                                                                                         |       | 247                 |       | 342                   |       |
| Total liabilities                                                                                                                                            |       | 4,429               |       | 5,212                 |       |
| Contingencies (Note 4)                                                                                                                                       |       |                |       |                  |       |
| Redeemable convertible  preferred stock; $0.0001 par value; 10,000 shares authorized:                                                                        |       |                |       |                  |       |
| Series A; 552 at August 31 and February 28, 2005 (aggregate  liquidation preference of $1,000 at August 31 and February 28, 2005)                            |       | 897                 |       | 897                   |       |
| Total redeemable  convertible preferred stock                                                                                                                |       | 897                 |       | 897                   |       |
| Stockholders’ equity:                                                                                                                                   |       |                |       |                  |       |
| Common stock; $0.0001 par value; 250,000 shares authorized; 6,069 and  6,045 shares issued and outstanding at August 31 and February 28, 2005,  respectively |       | 1                   |       | 1                     |       |
| Additional paid-in-capital                                                                                                                                   |       | 163,238             |       | 163,173               |       |
| Shareholder receivable                                                                                                                                       |       | (1                  | )          | —                |       |
| Accumulated deficit                                                                                                                                          |       | (157,028            | )          | (156,317              | )          |
| Total stockholders’ equity                                                                                                                              |       | 6,210               |       | 6,857                 |       |
| Total liabilities, redeemable convertible preferred stock and  stockholders’ equity                                                                     |       | $                   | 11,536     |                  | $          | 12,966 |   |

 

 

See notes to unauditedinterim consolidated financial statements.

 

 

2

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**INTRAWARE,INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(inthousands, except per share amounts)**

**(unaudited)**

 
| ** **                                   | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **August 31,  2005**           | ** ** | **August 31,  2004**         | ** ** | **August 31,  2005** | ** ** | **August 31,  2004** | ** ** |
|                                         |       |                           |       |                         |       |   |   |   |   |
| Revenues:                                    |       |                           |       |                         |       |   |   |   |   |
| Online services and technology               |       | $                              | 2,464      |                         | $          | 1,900 |   | $ | 4,804 |   | $ | 3,595 |   |
| Alliance and reimbursement                   |       | 602                            |       | 690                          |       | 1,105 |   | 1,266 |   |
| Related party online services and technology |       | 1                              |       | 4                            |       | 4 |   | 538 |   |
| Software product sales                       |       | —                         |       | —                       |       | — |   | 42 |   |
| Total revenues                               |       | 3,067                          |       | 2,594                        |       | 5,913 |   | 5,441 |   |
| Cost of revenues:                            |       |                           |       |                         |       |   |   |   |   |
| Online services and technology               |       | 1,055                          |       | 699                          |       | 2,177 |   | 1,266 |   |
| Alliance and reimbursement                   |       | 417                            |       | 421                          |       | 818 |   | 812 |   |
| Software product sales                       |       | —                         |       | —                       |       | — |   | 37 |   |
| Total cost of revenues                       |       | 1,472                          |       | 1,120                        |       | 2,995 |   | 2,115 |   |
| Gross profit                                 |       | 1,595                          |       | 1,474                        |       | 2,918 |   | 3,326 |   |
| Operating expenses:                          |       |                           |       |                         |       |   |   |   |   |
| Sales and marketing                          |       | 595                            |       | 822                          |       | 1,277 |   | 1,574 |   |
| Product development                          |       | 335                            |       | 409                          |       | 585 |   | 812 |   |
| General and administrative                   |       | 902                            |       | 902                          |       | 1,846 |   | 1,691 |   |
| Total operating expenses                     |       | 1,832                          |       | 2,133                        |       | 3,708 |   | 4,077 |   |
| Loss from operations                         |       | (237                           | )          | (659                         | )          | (790 | ) | (751 | ) |
| Interest expense                             |       | (16                            | )          | (26                          | )          | (35 | ) | (55 | ) |
| Interest and other income  and expenses, net |       | 61                             |       | 26                           |       | 114 |   | 42 |   |
| Net loss                                     |       | $                              | (192       | )                            | $          | (659 | ) | $ | (711 | ) | $ | (764 | ) |
| Basic  and diluted net loss per share        |       | $                              | (0.03      | )                            | $          | (0.11 | ) | $ | (0.12 | ) | $ | (0.13 | ) |
| Weighted average shares -  basic and diluted |       | 6,058                          |       | 6,012                        |       | 6,055 |   | 5,987 |   |
|                                         |       |                           |       |                         |       |   |   |   |   |
|                                              |            |                                |            |                              |            |  |  |  |  |  |  |  |  |  |

** **

 

See notes to unauditedinterim consolidated financial statements.

 

3

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**INTRAWARE,INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 

 
| ** **                                                                                      | ** ** | **For the six months ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                      | ** ** | **August 31,  2005**         | ** ** | **August 31,  2004** | ** ** |
| Cash flows from operating  activities:                                                          |       |                         |       |   |   |
| Net loss                                                                                        |       | $                            | (711       | ) | $ | (764 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                         |       |   |   |
| Depreciation and amortization                                                                   |       | 299                          |       | 295 |   |
| Provision for (recovery of) doubtful accounts                                                   |       | (5                           | )          | 3 |   |
| Gain on sale of fixed assets                                                                    |       | —                       |       | (2 | ) |
| Amortization of discount on note payable                                                        |       | 3                            |       | 13 |   |
| Changes in assets and liabilities:                                                              |       |                         |       |   |   |
| Accounts receivable                                                                             |       | 840                          |       | 249 |   |
| Costs of deferred revenue                                                                       |       | (12                          | )          | (112 | ) |
| Other assets                                                                                    |       | (22                          | )          | (70 | ) |
| Accounts payable                                                                                |       | 108                          |       | (185 | ) |
| Accrued expenses                                                                                |       | (73                          | )          | (125 | ) |
| Deferred revenue                                                                                |       | (320                         | )          | 19 |   |
| Related party deferred revenue                                                                  |       | (2                           | )          | (638 | ) |
| Net provided by (cash  used) in operating activities                                            |       | 105                          |       | (1,317 | ) |
| Cash flows from investing  activities:                                                          |       |                         |       |   |   |
| Purchases of property and equipment                                                             |       | (190                         | )          | (153 | ) |
| Proceeds from sale of fixed assets                                                              |       | —                       |       | 2 |   |
| Net cash used in  investment activities                                                         |       | (190                         | )          | (151 | ) |
| Cash flows from financing  activities:                                                          |       |                         |       |   |   |
| Principal payments on notes payable                                                             |       | (587                         | )          | (496 | ) |
| Proceeds from notes payable                                                                     |       | 176                          |       | 109 |   |
| Proceeds from common stock and warrants                                                         |       | 64                           |       | 995 |   |
| Net cash provided by (used  in) financing activities                                            |       | (347                         | )          | 608 |   |
| Net decrease in cash and  cash equivalents                                                      |       | (432                         | )          | (860 | ) |
| Cash and cash equivalents  at beginning of the period                                           |       | 9,463                        |       | 11,804 |   |
| Cash and cash equivalents  at end of the period                                                 |       | $                            | 9,031      |   | $ | 10,944 |   |
|                                                                                            |       |                         |       |   |   |
| Supplemental disclosure of  cash flow information:                                              |       |                         |       |   |   |
| Cash paid for interest                                                                          |       | $                            | 32         |   | $ | 43 |   |
| Supplemental non-cash  activity:                                                                |       |                         |       |   |   |
| Purchases of property and equipment in accounts payable                                         |       | $                            | 3          |   | $ | 142 |   |
|                                                                                            |       |                         |       |   |   |

 

See notes to unauditedinterim consolidated financial statements.

 

 

4

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**INTRAWARE,INC.**

 

**NOTES TOUNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1. BASIS OF PRESENTATION**

 

**INTRAWARE**

 

The accompanying unaudited interim consolidatedfinancial statements have been prepared pursuant to the rules and regulationsof the Securities and Exchange Commission (“SEC”).  Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to these rules andregulations.  However, management believes that the disclosures areadequate to ensure the information presented is not misleading.  Thebalance sheet at February 28, 2005, has been derived from the audited financialstatements, but does not include all disclosures required by generally acceptedaccounting principles.  These unaudited interim consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and notes thereto included in our annual report on Form 10-K for thefiscal year ended February 28, 2005, filed with the SEC on April 22, 2005.

 

In the opinion of management, all adjustments,consisting only of normal recurring items, considered necessary for a fairstatement have been included in the accompanying unaudited interim consolidatedfinancial statements.  The results of operations for the interim periodspresented are not necessarily indicative of the operating results to beexpected for any subsequent interim period or for the fiscal year endingFebruary 28, 2006.

 

We have incurred losses and negative cash flow fromoperations during each fiscal year since inception. Although our net loss forthe three and six months ended August 31, 2005 improved from the respectiveprior year periods and we recorded cash provided by operations for the sixmonths ended August 31, 2005, we expect to report an overall cash usage for thefull fiscal year and our cash balances could decline further.  We believe that the effects of our pastcapital financings, of our past and current strategic actions to improverevenue, and of our ongoing cost controls, will be adequate to generate the cashresources we will need to fund our future operations.  If we fail togenerate sufficient revenues or fail to adequately control spending, we may beunable to achieve key business objectives.

 

Certain prior year amounts have been reclassified toconform to the current period presentation. The reclassifications did notchange previously reported net loss, stockholders’ equity or cash flow.

 

**NOTE 2. SIGNIFICANT ACCOUNTINGPOLICIES**

 

**Revenue recognition**

 

Online services and technology revenue resultsprimarily from four types of arrangements.  First, it results from salesof our SubscribeNet digital delivery service to software vendors and othercompanies that distribute software as part of their business.  Second, itresults from professional services that we provide to customize ourSubscribeNet service for customers, to convert data for customers, and tointegrate our proprietary software.  Third, it results from our resale ofthird-party services or software licenses complementary to our SubscribeNetservice. Fourth, it results from the sale of our proprietary software licensesand related maintenance to companies using those products internally or usingthose products to provide web-based services to their customers. As a result ofthe sale of our Asset Management software business in May 2002, we are notcurrently deriving revenue from licenses, maintenance or integration servicesfor our proprietary software; however, we may recognize such revenues in thefuture if opportunities arise to sell licenses for our proprietary softwareunderlying our SubscribeNet service and related maintenance. We sell ourSubscribeNet service, and will sell proprietary software licenses ifopportunities present themselves, primarily through our direct sales force andauthorized resellers.

 

Alliance and reimbursement revenue primarily relatesto our alliance agreement with Software Spectrum for sales and marketingservices. This revenue consists of a percentage of the gross profit derivedfrom Software Spectrum’s sales of the third-party software and maintenance forwhich we provide sales and marketing services, and, prior to August 1, 2005,reimbursement for the costs of maintaining a sales team dedicated to providingsales and marketing 

 

 

5

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services to Software Spectrum for that third-partysoftware and maintenance. This revenue is recognized as we provide the servicesto Software Spectrum.  On August 1, 2005,we signed a new agreement with Software Spectrum that extends for two years ourcurrent arrangement, with some changes. Under the new agreement, Software Spectrum no longer reimburses us forour direct costs in maintaining a team dedicated to sales of Sun softwarelicenses and maintenance.  SoftwareSpectrum continues to pay us a percentage of the gross profit derived from itssales of Sun software licenses and maintenance; this percentage has increasedin the new agreement.  Also, under thenew agreement gross profit is no longer impacted by charges related to SoftwareSpectrum’s commission and back-office costs. However, these benefits to us under the new agreement are unlikely tofully offset the elimination of Spectrum’s reimbursement of our direct costs.

 

We defer online services and technology revenuesrelated to our SubscribeNet digital delivery service and generally recognizethem ratably over the term of the service arrangement. Some SubscribeNetservice implementations for new customers involve customization essential tothe functionality of the service.  In those cases, we defer revenuerecognition until the service go-live date is reached and recognize the revenueon a ratable basis over the remaining contract term.  The go-live date isthe later of the date on which the essential functionality is delivered or thepoint at which no additional customization is required.  Our SubscribeNetcontracts with customers typically give the customer a period of time(generally five days) to evaluate a SubscribeNet implementation after we havecompleted it, and provide that the customer is deemed to have accepted theimplementation if it has not affirmatively rejected it within thatperiod.  We typically rely on such non-rejections by customers to indicatetheir acceptance of implementations.  Any subsequent indications by our customersthat their implementations have not been properly completed could have amaterial adverse impact on our financial condition or results of operations.

 

We also sell additional professional services relatedto SubscribeNet agreements.  Generally, these services do not providestand-alone value to a customer, and accordingly, we defer recognition of thatrevenue until the go-live date for the professional services, similar to themanner in which we treat SubscribeNet service revenues as discussed above. Such professional services revenues are recognized ratably over the longer ofthe remaining estimated customer life or the remaining contract term,commencing with the completion of the professional services. Estimated customerlife requires that we periodically estimate the projected life of our existingcustomers, based on historical information, such as customer renewal rates.  A 10% increase in our estimated customer lifeduring the three and six months ended August 31, 2005, would have caused a net increasein our net loss of $4,000 and $7,000, respectively.

 

Online services and technology revenues related to ourresale of third-party services or software licenses complimentary to ourSubscribeNet service are generally recognized as the service or license isprovided.  If the service or license resold involves customizationessential to the functionality of the underlying SubscribeNet service, the feescharged for the customization are recognized as revenue in the same manner inwhich we treat the professional services discussed above. Revenue related tothese resold services or licenses are recognized as revenue based on the feecharged to the customer as we bear the credit risk for resold services orlicenses, have the latitude to establish pricing at our discretion, and areprimarily responsible for acceptability of the services or licensesdelivered.  In addition, costs paid to the third-party providers arerecorded as cost of revenues and recognized in the same manner as the relatedrevenue.

 

We recognize revenue when all of the followingconditions are met:

 

•                  There is persuasive evidence of anarrangement;

 

•                  We have provided the service to thecustomer, made the software available for customer download through ourwebsite, or shipped the software to the customer;

 

•                  We believe that collection of these feesis reasonably assured; and

 

•                  The amount of fees to be paid by thecustomer is fixed or determinable.

 

 

6

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**Costs of deferred revenue**

 

We capitalize direct costs of revenues related tosignificant SubscribeNet service implementations and established professionalservices contracts associated with our SubscribeNet services. Direct costsinclude compensation and payroll-related fringe benefits directly related tothe time spent on significant implementation and professional servicesactivities. These costs are recognized over the longer of the remainingestimated customer life or the remaining contract term (see “RevenueRecognition” above). Costs associated with professional services involvingsignificant new functionality for the SubscribeNet service that are partiallyor fully funded by customers but do not qualify as funded research anddevelopment activities are expensed as cost of revenues as incurred until aworking model is delivered to the customer. Once a working model has beendelivered, all additional direct costs are capitalized in the same mannerdiscussed above. Any change in our revenue recognition estimates could resultin corresponding changes to our recognition of costs of deferred revenues. AtAugust 31, 2005, we had approximately $0.5 million in capitalized costsrelating to deferred revenues. We expense customer acquisition costs, includingsales commissions, as incurred.

 

**Stock-based compensation**

 

We account for stock-based employee compensationarrangements in accordance with provisions of Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” (“APBNo. 25”) and its related interpretations and comply with the disclosureprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” andrelated SFAS No. 148, “Accounting for Stock-Based Compensation—Transitionand Disclosure.” Under APB No. 25, compensation expense is based on thedifference, if any, on the date of the grant between the fair value of ourstock and the exercise price of the option. We account for equity instrumentsissued to non-employees in accordance with the provisions of SFAS No. 123and Emerging Issues Task Force (“EITF”) 96-18, “Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring, or inconjunction with Selling Goods or Services.”

 

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

 
| ** **                                                                                                       | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                       | ** ** | **August 31,  2005**           | ** ** | **August 31,  2004**         | ** ** | **August 31,  2005** | ** ** | **August 31,  2004** | ** ** |
| Net loss                                                                                                         |       | $                              | (192       | )                            | $          | (659 | ) | $ | (711 | ) | $ | (764 | ) |
| Deduct: Total stock-based employee compensation expense determined  under fair value based method for all awards |       | (608                           | )          | (821                         | )          | (1,196 | ) | (1,619 | ) |
| Pro forma                                                                                                        |       | $                              | (800       | )                            | $          | (1,480 | ) | $ | (1,907 | ) | $ | (2,383 | ) |
| Net loss per share — basic and diluted                                                                      |       |                           |       |                         |       |   |   |   |   |
| As reported                                                                                                      |       | $                              | (0.03      | )                            | $          | (0.11 | ) | $ | (0.12 | ) | $ | (0.13 | ) |
| Pro forma                                                                                                        |       | $                              | (0.13      | )                            | $          | (0.25 | ) | $ | (0.31 | ) | $ | (0.40 | ) |

 

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

 
| ** **                | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|---------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                | ** ** | **August 31,  2005**           | ** ** | **August 31,  2004**         | ** ** | **August 31,  2005** | ** ** | **August 31,  2004** | ** ** |
| Risk-free interest rates  |       | 3.69  - 4.17                   | %          | 2.00  - 3.93                 | %          | 3.69  - 4.17 | % | 2.00-3.93 | % |
| Expected lives (in years) |       | 3-4                            |       | 4                            |       | 3-4 |   | 4 |   |
| Dividend yield            |       | 0                              | %          | 0                            | %          | 0 | % | 0 | % |
| Expected volatility       |       | 67  - 86                       | %          | 115                          | %          | 67  - 86 | % | 115 | % |

 

We calculated the fair value of the stock issued underthe employee stock purchase plan using the Black-Scholes option pricing modelas prescribed by SFAS No. 123 using the following assumptions:

 

 

7

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| ** **                 | ** ** | **For the three and  six months ended** | ** ** |
|----------------------------|------------|-----------------------------------------|------------|
| ** **                 | ** ** | **August 31,  2005**                    | ** ** | **August 31,  2004** | ** ** |
| Risk-free interest rates   |       | 3.12                                    | %          | 1.12 | % |
| Expected lives (in months) |       | 6                                       |       | 6 |   |
| Dividend yield             |       | 0                                       | %          | 0 | % |
| Expected volatility        |       | 52                                      | %          | 79 | % |

 

**Net loss per share**

 

Basic net loss per common share is computed bydividing the net loss for the period by the weighted average number of commonshares outstanding during the period excluding shares subject to repurchase.The terms of our redeemable convertible preferred stock include the right toparticipate in dividends declared to common stockholders. Our redeemableconvertible preferred stock does not have a contractual obligation to share inthe losses in any given period. As a result, this participating security willnot be allocated any losses in the periods of net losses, but will be allocatedin the periods of net income using the two-class method. The two-class methodis an earnings allocation formula that determines earnings per share for eachclass of common stock and participating securities according to dividendsdeclared or accumulated and participation rights in undistributed earnings.Under the two-class method, net income is reduced by the amount of dividendsdeclared in the current period for each class of stock and by the contractualamounts of dividends that must be paid for the current period. The remainingearnings are then allocated to common stock and participating securities to theextent that each security may share in earnings as if all of the earnings forthe period had been distributed. The total earnings allocated to each securityare determined by adding together the amounts allocated for dividends and theamounts allocated for a participation feature. The total earnings allocated toeach security are then divided by the number of outstanding shares of thesecurity to which the earnings are allocated to determine the earnings per share.

 

Diluted net loss per share is computed by dividing thenet loss for the period by the weighted average number of common and potentialcommon shares outstanding during the period if the effect is dilutive.Potential common shares are composed of common stock subject to repurchaserights and incremental shares of common stock issuable upon the exercise ofstock options and warrants and upon the conversion of preferred stock. Thedilutive effect of outstanding stock options and warrants is computed using thetreasury stock method.

 

The following table sets forth the computation ofbasic and diluted net loss per share as well as securities not included in thediluted net loss per share calculation because to do so would be antidilutive(in thousands, except per share amounts):

** **
| ** **                                                                      | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                      | ** ** | **August 31,  2005**           | ** ** | **August 31,  2004**         | ** ** | **August 31,  2005** | ** ** | **August 31,  2004** | ** ** |
| Numerator:                                                                      |       |                           |       |                         |       |   |   |   |   |
| Net loss                                                                        |       | $                              | (192       | )                            | $          | (659 | ) | $ | (711 | ) | $ | (764 | ) |
| Denominator:                                                                    |       |                           |       |                         |       |   |   |   |   |
| Weighted average shares                                                         |       | 6,058                          |       | 6,012                        |       | 6,055 |   | 5,987 |   |
| Basic  and diluted net loss per share                                           |       | $                              | (0.03      | )                            | $          | (0.11 | ) | $ | (0.12 | ) | $ | (0.13 | ) |
| Antidilutive securities not included in the computation of net loss  per share: |       |                           |       |                         |       |   |   |   |   |
| Redeemable convertible preferred stock                                          |       | 55                             |       | 55                           |       | 55 |   | 55 |   |
| Warrants to purchase common stock                                               |       | 159                            |       | 187                          |       | 159 |   | 187 |   |
| Employee stock options                                                          |       | 1,221                          |       | 1,124                        |       | 1,221 |   | 1,124 |   |
|                                                                            |       | 1,435                          |       | 1,366                        |       | 1,435 |   | 1,366 |   |

 

 

8

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**Recent Accounting Pronouncements**

 

In December 2004, the FASB issued SFAS No. 123(Revised 2004) “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R addressesall forms of share-based payment (“SBP”) awards, including shares issued underemployee stock purchase plans, stock options, restricted stock and stockappreciation rights. SFAS No. 123R will require us to expense SBP awards withcompensation cost for SBP transactions measured at fair value. The FASBoriginally stated a preference for a lattice model because it believed that alattice model more fully captures the unique characteristics of employee stockoptions in the estimate of fair value, as compared to the Black-Scholes modelwhich we currently use for our pro forma disclosure. The FASB decided to removeits explicit preference for a lattice model and not require a specificvaluation methodology. In April 2005, the SEC issued a release which amends thecompliance dates for SFAS No. 123R.  Accordingly, we will be required toadopt the new accounting provisions beginning in the first quarter of ourfiscal year ending February 28, 2007.

 

On March 29, 2005, the SEC issued Staff AccountingBulletin (SAB) 107 which expresses the views of the SEC regarding theinteraction between SFAS No. 123R and certain SEC rules and regulations andprovides the SEC’s views regarding the valuation of share-based paymentarrangements for public companies. In particular, SAB 107 provides guidancerelated to share-based payment transactions with nonemployees, the transitionfrom nonpublic to public entity status, valuation methods (includingassumptions such as expected volatility and expected term), the accounting forcertain redeemable financial instrument issues under share-based paymentarrangements, the classification of compensation expense, non-GAAP financialmeasures, first-time adoption of SFAS No. 123R in an interim period,capitalization of compensation costs related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentsarrangements upon adoption of SFAS No. 123R, the modification of employee shareoptions prior to adoption of SFAS No. 123R, and disclosures in Management’sDiscussion and Analysis of Financial Condition and Results of Operationssubsequent to adoption of SFAS No. 123R. We expect the adoption of SFAS No.123R and SAB 107 will have a material adverse impact on our results ofoperations and loss per share. We are currently in the process of evaluatingthe extent of such impact.

 

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections”. SFAS No. 154 replaces APB Opinion No. 20, “AccountingChanges” and SFAS No. 3, “Reporting Accounting Changes in Interim FinancialStatements”. SFAS No. 154 requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. We do not expect the adoption of SFAS No. 154 to have amaterial impact on our consolidated financial statements.

** **

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

 

During the six months ended August 31, 2005, ourstockholders’ equity changed as follows (in thousands):

 

 

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| ** **                                                   | ** ** | **Common Stock** | ** ** | **Additional Paid-In** | ** ** | **Shareholder** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
|--------------------------------------------------------------|------------|------------------|------------|------------------------|------------|-----------------|------------|-----------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                   | ** ** | **Shares**       | ** ** | **Amount**             | ** ** | **Capital**     | ** ** | **Receivable**  | ** ** | **Deficit**            | ** ** | **Equity**        | ** ** | **Loss** | ** ** |
| Balance at February 28, 2005                                 |       | 6,045            |       | $                      | 1          |            | $          | 163,173         |       | $                      | —     |              | $          | (156,317 | ) | $ | 6,857 |   |   |   |
| Exercise of stock options                                    |       | 11               |       | —                 |       | 7               |       | (1              | )          | —                 |       | 6                 |       |   |   |
| Issuance of common stock for employee stock purchase program |       | 13               |       | —                 |       | 58              |       | —          |       | —                 |       | 58                |       |   |   |
| Net loss                                                     |       | —           |       | —                 |       | —          |       | —          |       | (711                   | )          | (711              | )          | $ | (711 | ) |
| Other comprehensive loss                                     |       |             |       |                   |       |            |       |            |       |                   |       |              |       | — |   |
| Comprehensive loss                                           |       |             |       |                   |       |            |       |            |       |                   |       |              |       | $ | (711 | ) |
| Balance at August 31, 2005                                   |       | 6,069            |       | $                      | 1          |            | $          | 163,238         |       | $                      | (1         | )                 | $          | (157,028 | ) | $ | 6,210 |   |   |   |

 

**NOTE 4. CONTINGENCIES**

** **

**Indemnifications**

 

In the course of ourbusiness, we have given indemnities and made commitments and guarantees underwhich we may be required to make payments. These indemnities include:

 

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

 

•                  *Intellectual Property Indemnity toAcquiror 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, wehave made representations and warranties to the investors and placement agents,and have agreed to indemnify them for any damages and costs they incur as aresult of our breach of those representations and warranties. We also havesigned registration rights agreements with private investors under which weindemnify them for damages they incur as a result of any material misstatementsor omissions 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.

 

 

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•                  *Indemnities to Directors andOfficers.*Weindemnify our directors and officers for damages and costs incurred in theperformance of their duties, to the extent permitted by Delaware law. Theduration 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.

 

**Legal Proceedings**

 

*In reIntraware, Inc. Initial Public Offering Securities Litigation*

* *

In October 2001, wewere served with a summons and complaint in a purported securities class actionlawsuit.  On or about April 19, 2002, we were served with an amendedcomplaint in this action, which is now titled *Inre Intraware, Inc. Initial Public Offering Securities Litigation*,Civ. No. 01-9349 (SAS) (S.D.N.Y.), related to *In re Initial Public Offering Securities Litigation*, 21 MC92 (SAS) (S.D.N.Y.).  The amended complaint is brought purportedly onbehalf of all persons who purchased our common stock from February 25,1999 (the date of our initial public offering) through December 6,2000.  It names as defendants Intraware, three of our present and formerofficers and directors, and several investment banking firms that served asunderwriters of our initial public offering.  The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 andSections 10(b) and 20(a) of the Securities Exchange Act of 1934,on the grounds that the registration statement for the offerings did notdisclose that: (1) the underwriters had agreed to allow certain customersto purchase shares in the offerings in exchange for excess commissions paid tothe underwriters; and (2) the underwriters had arranged for certaincustomers to purchase additional shares in the aftermarket at predeterminedprices.  The amended complaint also alleges that the underwriters misusedtheir securities analysts to manipulate the price of our stock.  Nospecific damages are claimed.

 

Lawsuits containingsimilar 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 consolidatedfor pretrial purposes before United States District Court Judge ShiraScheindlin of the Southern District of New York.  On July 15, 2002,an omnibus motion to dismiss was filed in the coordinated litigation on behalfof the issuer defendants, of which Intraware and its three named current andformer officers and directors are a part, on common pleadings issues.  Onor about October 9, 2002, the Court entered and ordered a Stipulation ofDismissal, which dismissed the three named current and former officers anddirectors from the litigation without prejudice.  On February 19,2003, the Court entered an order denying in part the issuer-defendants’ omnibusmotion to dismiss, including those portions of the motion to dismiss relatingto Intraware.

 

In June 2004, astipulation of settlement for the claims against the issuer-defendants,including us, was submitted to the Court.  The underwriter-defendants inthe *In re Initial Public Offering SecuritiesLitigation* (collectively, the “underwriter-defendants”), includingthe underwriters of our initial public offering, are not parties to thestipulation of settlement.

 

The settlement providesthat, in exchange for a release of claims against the settlingissuer-defendants, the insurers of all of the settling issuer-defendants willprovide a surety undertaking to guarantee plaintiffs a $1 billion recoveryfrom the non-settling defendants, including the underwriter-defendants. The amount our insurers would be required to pay to the plaintiffs could rangefrom zero to approximately $3.5 million, depending on plaintiffs’ recoveryfrom the underwriter-defendants and from other non-settling parties.  Ifthe plaintiffs recover at least $1 billion from theunderwriter-defendants, our insurers would have no liability for settlementpayments under the terms of the settlement.  If the plaintiffs recoverless than $1 billion, we believe our insurance will likely cover our shareof any payments towards satisfying plaintiffs’ $1 billion recoverydeficit.  Management estimates that its range of loss relative to thismatter is zero to $3.5 million.  Presently there is no more likelypoint estimate of loss within this range.  As a consequence of theuncertainties described above regarding the amount we will ultimately berequired to pay, if any, as of August 31, 2005, we have not accrued aliability for this matter.

 

 

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On August 31, 2005, thecourt granted preliminary approval of the settlement.  A fairness hearingfor the settlement is scheduled for April 2006. There is no guarantee the settlement will become final as it is subjectto a number of conditions, including the final approval of the court.

 

*LeonSegen v. ComVest Venture Partners. LP. et al.*

* *

In July 2004, acomplaint was filed in the United States District Court for the District ofDelaware, Civ. No. 04-822, against ComVest Venture Partners, LP; ComVestManagement, LLC; Commonwealth Associates Management Company, Inc.;Commonwealth Associates, LP; RMC Capital, LLC; Michael S. Falk; RobertPriddy; Travis L. Provow; Keith Rosenbloom; and Intraware.  The complaintdescribes Intraware as a nominal defendant.  The complaint alleges that,between August 2001 and January 2002, all of the defendants otherthan Intraware were members of a group, and therefore should be treated as asingle “person,” for purposes of Sections 13(d)(3) and 16(b) ofthe Securities Exchange Act of 1934 (the “1934 Act”).  The complaintfurther alleges that ComVest Venture Partners, LP and Mr. Priddy, whilethey and the other alleged group members collectively owned more man 10% of aclass of our equity securities, bought and sold our equity securities within a6-month period 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 of Directors from April 2001 toMay 2002 and Mr. Provow was a member of our Board of Directors fromOctober 2001 to May 2002.  The complaint demands that ComVestVenture Partners, LP and Mr. Priddy pay over to Intraware the profits theyallegedly realized and retained in violation of Section 16(b) of the1934 Act, together with interest and legal costs.  According to thecomplaint, 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 damagesagainst 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.  In June 2005, thecourt denied motions filed by the defendants other than Intraware to dismissthe plaintiff’s claims.  The parties, including Intraware, are currentlyengaged in discovery.  A trial in thiscase is currently scheduled to begin in July 2006.

 

We are also subject to legal proceedings, claims andlitigation arising in the ordinary 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.

** **

**NOTE 5.  NOTES PAYABLE**

 

In August 2003, we issued a note payable toSilicon Valley Bank for proceeds of approximately $2.0 million.  The notebears an annual interest rate of the greater of 1.00% in excess of the bank’sprime rate (6.50% at August 31, 2005) or 5.25%.  The interest rate on thenote payable at August 31, 2005, was 7.50%.  The note is payable in fixedmonthly principal installments plus interest through September 2005. In connection with the note payable, we issued a warrant to purchase 4,173shares of our common stock at an exercise price of $11.90 per share.  Thewarrant was immediately exercisable and expires in August 2010.  Weestimated the allocated fair value of such warrant at approximately $46,000,using the Black-Scholes valuation model with the following assumptions:expected volatility of 136%, risk-free interest rate of 4.01%, expected life ofseven years and no dividends.  The value of the warrant was recorded as adebt discount and was amortized as interest expense using the effectiveinterest method over the life of the note payable.  For the three monthsended August 31, 2005, interest expense related to such warrant amounted toapproximately $1,000.  The debt discount related to the warrant was fullyamortized as of August 31, 2005.  As of August 31, 2005, the warrant hadnot been exercised.

 

In August 2003, we also entered into an equipmentadvance agreement with Silicon Valley Bank. The equipment advance agreementbears an annual interest at the greater of the bank’s prime rate plus 1.00% or5.50%.  The agreement provided for borrowings of up to $500,000 throughAugust 2004 and was limited to equipment purchases.  As of August 31,2005, we had borrowed approximately $363,000 under this agreement and theinterest rate at that date was 7.50%.  Monthly payments of interest onlywere payable through August 1, 2004, after which fixed monthly principal installmentsplus interest will be made through August 2006.

 

In September 2004, we entered into a second equipmentadvance agreement with Silicon Valley Bank.  This new equipment advanceagreement bears an annual interest at the greater of 5.50% or the bank’s primerate plus 1.00%.  

 

 

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This second equipment advance allowed us to borrow upto $500,000 through August 1, 2005, solely to finance equipment purchases.As of August 31, 2005, we had borrowed approximately $493,000 under thisagreement and the interest rate at that date was 7.50%.  Monthly payments of interest only werepayable through August 2005, after which fixed monthly principalinstallments plus interest will be made through August 2007.

 

All of this debt is collateralized by a seniorsecurity interest in substantially all of our assets.  We are alsorequired to maintain compliance with certain financial covenants, with all ofwhich we were in compliance at August 31, 2005.

 

Scheduled maturities of debt at August 31, 2005, areas follows (in thousands):

  

| Years ending:     |   |   |   |
|-------------------|--------|--------|--------|
| February 28, 2006 |   | $      | 297    |   |
| February 28, 2007 |   | 337    |   |
| February 29, 2008 |   | 123    |   |
|              |   | $      | 757    |   |
|                   |        |        |        |  |  |

** **

 

**NOTE 6. ALLIANCES**

 

**Provision of Sales and MarketingServices to Software Spectrum for Resale of Third-Party Software**

 

Prior to June 2001, we resold Sun Microsystems, Inc.Internet-related application software (marketed under the brands “Sun/NetscapeAlliance” and “iPlanet”) and related maintenance services to end-users in NorthAmerica under an agreement between us and Sun.  In June 2001, 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 Spectrumassumed primary responsibility for resale of Sun software and relatedmaintenance under its agreement with Sun (which has since been replaced by anagreement between Software Spectrum and Sun’s distributor).  Under theJune 2001 agreement, we continued to assist Software Spectrum in its sales andmarketing of the Sun software marketed under the brands “Sun ONE” and “JavaEnterprise System,” as well as related maintenance, and also provided ourSubscribeNet service to Software Spectrum to enable it to deliver that Sunsoftware to its customers electronically. As part of this arrangement, SoftwareSpectrum paid us a percentage of the gross profit derived from its sales of Sunsoftware licenses and maintenance services, and reimbursed us for our cost inmaintaining a team dedicated to sales of Sun software licenses and maintenance(included in the Alliance and reimbursement revenue line item on ourconsolidated statements of operations).  The June 2001 agreement withSoftware Spectrum was part of our transition out of the business of generallyreselling third-party software. At the time we announced this agreement, wealso ceased reselling all third-party software except for a limited number ofproducts that were complementary to our SubscribeNet service.

 

In December 2003 and August 2004, we amended our June2001 agreement with Software Spectrum to add Websense software to the set ofproducts that Software Spectrum and Intraware jointly resold under thatagreement. Under these arrangements, Software Spectrum paid us a percentage ofthe gross profit derived from our joint sales of Websense software licenses andmaintenance services (included in the Alliance and reimbursement revenue lineitem on our consolidated statements of operations).

 

This contract accounted for more than 10% of our totalrevenues in our 2005 fiscal year and during the three and six months endedAugust 31, 2005.

 

On August 1, 2005, we signed a new agreement withSoftware Spectrum that extends our sales and marketing services arrangement fortwo years, subject to some changes. Under the August 2005 agreement, we continue to provide outsourced salesservices and our SubscribeNet digital delivery service to Software Spectrum forSun Java System and Sun ONE software. Software Spectrum continues to pay us a percentage of the gross profitderived from its sales of Sun software licenses and maintenance.  However, under the new agreement SoftwareSpectrum no longer reimburses us for our direct costs in maintaining a teamdedicated to sales of Sun software licenses and maintenance.  Though the 

 

 

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percentage of gross profit that Software Spectrum paysus has increased in the new agreement, and gross profit is no longer impactedby charges related to Software Spectrum’s commission and back-office costs,these benefits to Intraware under the new agreement are unlikely to fullyoffset the elimination of Spectrum’s reimbursement of our direct costs.  Also, the notice period for termination byeither party without cause was changed from 90 days in the June 2001 agreementto 60 days in the August 2005 agreement.

 

Overall, we expect to receive lower margins on theresale of Sun software and maintenance, thereby decreasing the revenueattributed to future shared gross profit and SubscribeNet fees associated withour Software Spectrum alliance.

 

**NOTE 7. SUBSEQUENT EVENT**

 

**Reverse Stock Split**

 

At the close of business on September 26, 2005, weeffected a one-for-ten reverse stock split of our common stock.  All share and per share information includedin these unaudited condensed consolidated financial statements has beenretroactively adjusted to reflect the reverse stock split.  Shares authorized and par value were notadjusted as they were not affected by the reverse stock split.

 

 

 

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** **

**ITEM 2. MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussion of our financial conditionand results of operations should be read in conjunction with our consolidatedfinancial statements and related notes included in our annual report on Form10-K for the fiscal year ended February 28, 2005, which was filed with theSecurities and Exchange Commission (“SEC”) on April 22, 2005, and the unauditedconsolidated financial statements and related notes contained in this quarterlyreport on Form 10-Q.  This discussion contains forward-looking statementsthat involve risks and uncertainties. Forward-looking statements includestatements regarding trends in the marketplace, our future cash and liquidityposition, the extent and timing of future revenues and expenses and customerdemand, the deployment of our products and services or the anticipatedperformance of products or services, gross margin expectations for Sun softwareand maintenance resold through Software Spectrum, statements regarding thefinancial statement impact of SFAS 123R, statements regarding future economicconditions or performance, and our reliance on third parties.  Allforward-looking statements included in this document are based on informationavailable to us as of the date hereof, and we assume no obligation to updateany forward-looking statement.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofcertain factors, including but not limited to, those discussed in “Risk Factors”below and elsewhere in this quarterly report on Form 10-Q.

 

**INTRAWARE OVERVIEW**

 

Our goal is to become the de facto standard amongdigital delivery solution providers. We are pursuing a four-pronged strategy toachieve this goal. First, we are working to become a profitable,cash-generating company by growing our SubscribeNet business and practicingstringent fiscal responsibility. Second, we are seeking to strengthen ourtechnological advantage and extend the breadth of our functionality in theelectronic software delivery and management (“ESDM”) area by further improvingour ESDM solutions through internal research and development and throughalliances with adjacent technology providers.  Third, we are preparing aproduction release of a new service called Digital Fastball, which willleverage our digital delivery expertise to enable small and medium-sizedbusinesses, as well as consumers, to send, receive and manage virtually alltypes and sizes of digital files over the Internet quickly, easily andsecurely. Fourth, we are seeking to extend and strengthen our customer base byexecuting on our sales and marketing plan and by providing exceptional customerservice.

 

We currently see a number of trends in the marketplacethat are potentially important for our business. First, growth in thetechnology sector has improved in the last year, but remains uneven. In thecurrent climate, which includes volatile energy prices, spending by technologycompanies remains cautious. Second, there appears to be an increasing pace ofmergers and acquisitions in the enterprise software sector. Theseconsolidations pose both opportunities and risks for us, potentially leadingeither to growth in our contracts with those customers or to cancellation ofcustomer contracts. Third, technology companies are increasingly outsourcingoperational functions to reduce costs. Our services enable enterprise softwarecompanies to outsource key operational functions in a manner that we believe isfinancially compelling. Therefore, we may benefit from this outsourcing trend.Fourth, the use of hosted web-based applications, which in the past has beenlimited by concerns about speed, reliability and security, is now becoming moreaccepted among mainstream businesses, largely because of a desire for costsavings. This trend may benefit us because our SubscribeNet service and plannedDigital Fastball service are hosted web-based applications.  Thisparagraph contains forward-looking statements that are subject to risks anduncertainties, and actual results could differ materially from thoseanticipated (see “Risk Factors” beginning on page 26 below).

 

Our management is focused on five key areas. The firstis broadening our SubscribeNet service to meet expanding and more sophisticatedrequirements of the enterprise software industry for digital deliverymanagement systems, including requirements for license management and delivery,management of channel partner relationships, and electronic commerce.  Thesecond is taking advantage, through our planned Digital Fastball service, ofthe growing acceptance by non-technology businesses and individual consumers ofthe Internet as a medium for exchanging all types of digital files.  Thethird is leveraging our relationships with our strategic allies to reach newand larger customers for our SubscribeNet service. The fourth is to takeadvantage of the drive toward greater efficiency among large informationtechnology companies, as evidenced by the increasing consolidation in thatsector, by emphasizing the cost savings that can be realized through broadadoption of electronic software delivery and management. The fifth area is thedevelopment of new pricing packages for our services that emphasize shortersales cycles and strong profit margins.

 

 

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We also face a number of key risks, which aredescribed in the “Risk Factors” beginning on page 26 below.

 

We earn revenues and generate cash principally throughrecurring service fees charged for our SubscribeNet service, professionalservices fees charged for customization of our SubscribeNet service, andprofit-sharing and, prior to August 1, 2005, cost reimbursement received forour sales and marketing services. Historically, we have also raised substantialamounts of cash through private stock placements.

 

We have incurred losses and negative cash flows duringeach fiscal year since inception.  Although our net loss for the three andsix months ended August 31, 2005 improved from the respective prior yearperiods, our cash balances could nonetheless decline further.  Under our June 2001 agreement with SoftwareSpectrum, and the August 2005 agreement that replaced it, we provide Sales andMarketing Services to Software Spectrum to assist in its resale and marketingof Sun software licenses and maintenance. This contract has accounted for morethan 10% of our total revenues in the six months ended August 31, 2005. Weexpect to earn lower margins on the resale of Sun software and maintenance,thereby decreasing future shared gross profit and SubscribeNet fees fromSoftware Spectrum.  The precedingparagraph contains forward-looking statements that are subject to risks anduncertainties, and actual results could differ materially from thoseanticipated (see “Risk Factors” beginning on page 26 below).

 

We believe that the effects of our past capitalfinancings, of our past and current strategic actions to improve revenue, andof our ongoing cost controls, will be adequate to generate the cash resourceswe will need to fund our future operations.  However, if we fail tosufficiently increase our revenues or control spending, our business could bematerially adversely affected.  The preceding paragraph contains forward-lookingstatements that are subject to risks and uncertainties, and actual resultscould differ materially from those anticipated (see “Risk Factors” beginning onpage 26 below).

 

At our annual meeting of stockholders on September 8,2005, our stockholders authorized our Board of Directors to effect aone-for-ten reverse split of our common stock. On September 26, 2005, we filed a Certificate of Amendment to ourAmended and Restated Certificate of Incorporation with the Delaware Secretaryof State to effect the reverse stock split. The reverse stock split became effective at the close of business onSeptember 26, 2005.

 

**Critical Accounting Policies andEstimates**

 

This MD&A discusses our consolidated financialstatements, which have been prepared in accordance with generally acceptedaccounting principles in the United States. In preparing these financialstatements, we are required to make estimates and assumptions affecting thereported amounts of assets and liabilities and the disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. On an ongoingbasis, we evaluate our estimates and judgments. We base our estimates andjudgments on historical experience and on various other factors believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities notreadily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

 

We consider accounting policies related to revenuerecognition, costs of deferred revenue, stock-based compensation, allowance fordoubtful accounts, and income taxes to be critical accounting policies due tothe estimation process involved in each.

 

*Revenue Recognition*

 

We recognize revenue when all of the followingconditions are met:

 

•                  There is persuasive evidence of anarrangement;

 

•                  We have provided the service to thecustomer, made the software available for customer download through ourwebsite, or shipped the software to the customer;

 

 

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•                  We believe that collection of these feesis reasonably assured; and

 

•                  The amount of fees to be paid by thecustomer is fixed or determinable.

 

Online services and technology revenue resultsprimarily from four types of arrangements.  First, it results from salesof our SubscribeNet digital delivery service to software vendors and other companiesthat distribute software as part of their business.  Second, it resultsfrom professional services that we provide to customize our SubscribeNetservice for customers, to convert data for customers, and to integrate ourproprietary software.  Third, it results from our resale of third-partyservices or software licenses complementary to our SubscribeNet service.Fourth, it results from the sale of our proprietary software licenses andrelated maintenance to companies using those products internally or using thoseproducts to provide web-based services to their customers. As a result of thesale of our Asset Management software business in May 2002, we are notcurrently deriving revenue from licenses, maintenance or integration servicesfor our proprietary software; however, we may recognize such revenues in thefuture if opportunities arise to sell licenses for our proprietary softwareunderlying our SubscribeNet service and related maintenance. We sell ourSubscribeNet service, and will sell proprietary software licenses ifopportunities present themselves, primarily through our direct sales force andauthorized resellers.

 

Alliance and reimbursement revenue primarily relatesto our alliance agreement with Software Spectrum for sales and marketing services.This revenue consists of a percentage of the gross profit derived from SoftwareSpectrum’s sales of the third-party software and maintenance for which weprovide sales and marketing services, and, prior to August 1, 2005,reimbursement for the costs of maintaining a sales team dedicated to providingsales and marketing services to Software Spectrum for that third-party softwareand maintenance. This revenue is recognized as we provide the services toSoftware Spectrum.  On August 1, 2005, wesigned a new agreement with Software Spectrum that extends our currentarrangement for two years, with some changes. Under the new agreement, Software Spectrum no longer reimburses us forour direct costs in maintaining a team dedicated to sales of Sun software licensesand maintenance.  Software Spectrumcontinues to pay us a percentage of the gross profit derived from its sales ofSun software licenses and maintenance; this percentage has increased in the newagreement.  In addition, gross profit isno longer impacted by charges related to Software Spectrum’s commission andback-office costs.  Also, we are nowpermitted to use our sales and marketing services team for activities outsideour agreement with Software Spectrum.  However,these benefits to us under the new agreement are unlikely to fully offset theelimination of Spectrum’s reimbursement of our direct costs.  Also, the notice period for termination byeither party without cause was changed from 90 days in the June 2001 agreementto 60 days in the August 2005 agreement. We continue to evaluate implementing a comparable relationship withanother provider or transitioning to becoming an authorized Sun softwarereseller ourselves.

 

We derive software product revenues from our pastresales of licenses and maintenance for multiple business software productlines. As of July 1, 2001, we generally no longer resell third-partysoftware licenses and maintenance. Since July 1, 2001, we have continuedto recognize revenue from our resale of third-party software licenses andrelated maintenance contracts over the life of the arrangements made prior toJuly 1, 2001. Vendor specific objective evidence of fair value for themaintenance element of the resold software arrangements has been based onhistorical and contractual renewal rates for maintenance. We deferred themaintenance revenue at the outset of each respective arrangement and recognizedit ratably over the period during which the maintenance was to beprovided.  This period normally commenced on the date the software wasdelivered and generally continued for 12 months, although certain maintenancecontracts continued for longer periods.  Since the three months ended May31, 2004, we have no longer recognized any revenue relating to software productsales.

 

We defer online services and technology revenuesrelated to our SubscribeNet digital delivery service and generally recognizethem ratably over the term of the service arrangement. Some SubscribeNetservice implementations for new customers involve customization essential tothe functionality of the service.  In those cases, we defer revenuerecognition until the service go-live date is reached and recognize the revenueon a ratable basis over the remaining contract term.  The go-live date isthe later of the date on which the essential functionality is delivered or thepoint at which no additional customization is required.  Our SubscribeNetcontracts with customers typically give the customer a period of time(generally five days) to evaluate a SubscribeNet implementation after we havecompleted it, and provide that the customer is deemed to have accepted theimplementation if it has not affirmatively rejected it within thatperiod.  We typically rely on such non-rejections by customers to indicatetheir acceptance of implementations.  Any subsequent indications by ourcustomers that their implementations have not been properly completed couldhave a material adverse impact on our financial condition or results ofoperations.

 

 

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We also sell additional professional services relatedto SubscribeNet agreements.  Generally, these services do not providestand-alone value to a customer, and accordingly, we defer recognition of thatrevenue until the go-live date for the professional services, similar to themanner in which we treat SubscribeNet service revenues as discussedabove.  Such professional services revenues are recognized ratably overthe longer of the remaining estimated customer life or the remaining contractterm, commencing with the completion of the professional services. Estimatedcustomer life requires that we periodically estimate the projected life of ourexisting customers, based on historical information, such as customer renewalrates. A 10% increase in our estimated customer life during the three and sixmonths ended August 31, 2005, would have caused a net increase in our net lossof $4,000 and $7,000, respectively.

 

Online services and technology revenues related to ourresale of third-party services or software licenses complementary to ourSubscribeNet service are generally recognized as the service is provided. If the service or license resold involves customization essential to thefunctionality of the underlying SubscribeNet service, the fees charged for thecustomization is recognized as revenue in the same manner in which we treat theprofessional services discussed above. Revenue related to these resold servicesor licenses is recognized as revenue based on the fee charged to the customer,since we bear the credit risk for resold services or licenses, have thelatitude to establish pricing at our discretion, and are primarily responsiblefor acceptability of the services or licenses delivered.  In addition,costs paid to the third-party providers are recorded as cost of revenues andrecognized in the same manner as the related revenue. As mentioned above, adetermination that the collection of fees is reasonably assured is a precursorto recognizing revenue. Determination of collectability of payments requiresjudgment on the part of management and includes periodically evaluatingcustomers’ credit-worthiness (see “Allowance for Doubtful Accounts” below).

 

*Costs of Deferred Revenue*

 

We capitalize direct costs of revenues related tosignificant SubscribeNet service implementations and established professionalservices contracts associated with our SubscribeNet services.  Directcosts include compensation and payroll-related fringe benefits directly relatedto the time spent on significant implementation and professional servicesactivities.  These costs are recognized over the longer of the remainingestimated customer life or the remaining contract term (see “RevenueRecognition” above). Costs associated with professional services involving significantnew functionality for the SubscribeNet service that are partially or fullyfunded by customers but do not qualify as funded research and developmentactivities are expensed as cost of revenues as incurred until a working modelis delivered to the customer. Once a working model has been delivered, alladditional direct costs are capitalized in the same manner discussed above. Anychange in our revenue recognition estimates could result in correspondingchanges to our recognition of costs of deferred revenues.  A 10% increase in our estimated customer lifeduring the three and six months ended August 31, 2005, would have caused a netincrease in our net loss of $4,000 and $7,000, respectively.  At August 31, 2005, we had approximately$0.5 million in capitalized costs relating to deferred revenues.  Weexpense customer acquisition costs, including sales commissions, as incurred.

 

*Stock-based Compensation*

 

We account for stock-based compensation for ouremployees using the intrinsic value method presented in Accounting PrinciplesBoard (APB) No. 25, ”Accounting for Stock Issued to Employees,” andrelated interpretations, and comply with the disclosure provisions of Statementof Financial Accounting Standard (SFAS) No. 123, ”Accounting forStock-Based Compensation,” 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. For our fiscal quarter ended August 31, 2005, nostock-based compensation was recorded for stock options granted to ouremployees because the exercise price of all stock options granted to our employeeswas equal to the market price of the underlying stock on the date of grant.

 

In December 2004, the Financial AccountingStandards Board (FASB) issued SFAS No. 123 (Revised) “Share Based Payment”(SFAS No. 123R). The standard requires companies to value employee stockoptions and stock issued under employee stock purchase plans using the fairvalue based method on the grant date and record stock-based compensationexpense. The fair value based models that companies are allowed to use can bedifferent from the 

 

 

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Black-Scholes option-pricing model, which we currentlyuse to calculate the pro forma effect on net income and earnings per share ifwe had applied SFAS No. 123 to employee option grants. Note 2 to our unauditedinterim consolidated financial statements shows what the pro forma net loss andloss per share for the fiscal quarter ended August 31, 2005 andAugust 31, 2004, would have been if we had applied SFAS No. 123. However, the actual impact to our results of operations upon adoption of thestandard could materially differ from the pro forma information included inNote 2 to our unaudited interim consolidated financial statements due todifferences in the option-pricing model used, estimates and assumptionsrequired, and options to be included in the calculation upon adoption. The fairvalue based models require the input of highly subjective assumptions and donot necessarily provide a reliable single measure of the fair value of ourstock options. In April 2005, the SEC issued a release which amends thecompliance dates for SFAS No. 123R.  Accordingly, we will be required toadopt the new accounting provisions beginning in our first quarter of ourfiscal year ending February 28, 2007.

 

*Allowance for Doubtful Accounts*

 

We maintain an allowance for doubtful accounts forestimated losses from our inability to collect required payments from ourcustomers. When evaluating the adequacy of this allowance, we analyze specificaccounts receivable, historical bad debts, customer credit-worthiness, currenteconomic trends and changes in our customers’ payment history.  We mayneed to record increases to our allowance balances in the future.  AtAugust 31, 2005, we have many accounts receivable balances and one largeunbilled receivable balance.  Any dispute, early contract termination orother collection issue related to these receivable balances could have amaterial adverse impact on our financial condition or result of operations. AtAugust 31, 2005, our unbilled receivable balance was $0.2 million. This balancerelates to our Software Spectrum agreement (see “Revenue Recognition” above).There are no allowances for doubtful accounts related to this balance. Thisestimate involves management’s judgment, which takes into account SoftwareSpectrum’s prior payment history, current credit-worthiness and overallbusiness condition. Changes in the above factors could have a material impacton actual bad debts incurred.

 

*Income Taxes*

 

In conjunction with preparing our financialstatements, we must estimate our income taxes in each of the jurisdictions inwhich we operate. This process involves estimating our actual current taxexpense together with assessing temporary differences resulting from differingtreatment of items for tax and accounting purposes. These differences result indeferred tax assets and liabilities. We must then assess the likelihood thatour deferred tax assets will be recovered from future taxable income and to theextent we believe that recovery is not likely, we must establish a valuationallowance. Given that we have incurred losses since inception and thereforehave not been required to pay income taxes, we have fully reserved our deferredtax assets at August 31, 2005.  In the event that we are able to realizeour deferred tax assets in the future, an adjustment to the deferred tax assetwould increase income in the period that this is determined.

 

**Results of Operations**

 

*Total Revenue*

 

The following table sets forth the revenue, changes inrevenue and percentage of total revenue for the periods indicated (inthousands, except percentage amounts):

 

| ** **                                   | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **August 31, 2005**            | ** ** | **August 31, 2004**          | ** ** | **August 31, 2005** | ** ** | **August 31, 2004** | ** ** |
| ** **                                   | ** ** | **Total**                      | ** ** | **Change**                   | ** ** | **% of Revenue** | ** ** | **Total** | ** ** | **% of Revenue** | ** ** | **Total** | ** ** | **Change** | ** ** | **% of Revenue** | ** ** | **Total** | ** ** | **% of Revenue** | ** ** |
| Revenues:                                    |       |                           |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Online services and technology               |       | $                              | 2,464      |                         | $          | 564 |   | 80 | % | $ | 1,900 |   | 73 | % | $ | 4,804 |   | $ | 1,209 |   | 81 | % | $ | 3,595 |   | 66 | % |
| Alliance and reimbursement                   |       | 602                            |       | (88                          | )          | 20 | % | 690 |   | 27 | % | 1,105 |   | (161 | ) | 19 | % | 1,266 |   | 23 | % |
| Related party online services and technology |       | 1                              |       | (3                           | )          | 0 | % | 4 |   | 0 | % | 4 |   | (534 | ) | 0 | % | 538 |   | 10 | % |
| Software product sales                       |       | —                         |       | —                       |       | 0 | % | — |   | 0 | % | — |   | (42 | ) | 0 | % | 42 |   | 1 | % |
| Total revenues                               |       | $                              | 3,067      |                         | $          | 473 |   |   |   | $ | 2,594 |   |   |   | $ | 5,913 |   | $ | 472 |   |   |   | $ | 5,441 |   |   |   |

 

 

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Combined online services and technology revenueresults primarily from sales of our SubscribeNet services.  The online services and technology revenueincrease during the three months ended August 31, 2005, as compared to thethree months ended August 31, 2004, is primarily due to two factors: first,approximately $0.3 million in revenue recognized from new SubscribeNetcustomers whose go-live date was achieved between September 1, 2004, and August31, 2005; and second, approximately $0.2 million in additional revenuerecognized from expanded contracts with existing customers.  The online services and technology revenueincrease during the six months ended August 31, 2005, as compared to the sixmonths ended August 31, 2004, is primarily due to three factors: first,approximately $0.6 million in revenue recognized from new SubscribeNetcustomers whose go-live date was achieved between September 1, 2004, and August31, 2005; second, approximately $0.5 million in additional revenue recognizedfrom expanded contracts with existing customers; and third, approximately $0.2million in additional revenue recognized from our resale of third-party servicescomplementary to our SubscribeNet service. The related party online services and technology revenue decrease duringthe six months ended August 31, 2005, resulted from our recognition of theremaining deferred revenue under our strategic alliance agreement with ZomaxIncorporated, upon termination of that agreement in the prior year.  We expect our online services and technologyrevenue for our fiscal quarter ending November 30, 2005, to be lower than thoseduring the three months ended August 31, 2005, primarily due to the expecteddecrease in SubscribeNet fees paid under our Software Spectrum alliance (seebelow).  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 26 below).

 

Alliance and reimbursement revenue primarily relatesto our alliance agreement with Software Spectrum for sales and marketingservices. This revenue consists of a percentage of the gross profit derivedfrom Software Spectrum’s sales of Sun software and maintenance for which weprovide sales and marketing services, and, prior to July 31, 2005, it alsoincluded reimbursement for the costs of maintaining a team dedicated toproviding sales and marketing services to Software Spectrum for thatthird-party software and maintenance.  This alliance agreement withSoftware Spectrum accounted for more than 10% of our total revenue during thethree and six months ended August 31, 2005. The decrease in alliance andreimbursement revenue for the three and six months ended August 31, 2005, wasprimarily due to a reduction of the cost reimbursement for maintaining our teamdedicated to providing sales and marketing services for Software Spectrum, of $0.1million and $0.2 million, respectively. The reimbursement decrease was primarily due to the elimination ofSoftware Spectrum’s reimbursement obligation under the sales alliance agreementas of August 1, 2005, as described above.   We expect our alliance andreimbursement revenues in our fiscal quarter ending November 30, 2005, to belower than those in our fiscal quarter ended August 31, 2005, primarily due tothe elimination of Software Spectrum’s reimbursement obligation, and areduction in shared gross profit under the Software Spectrum alliance due toexpected lower margins on the resale of Sun software and maintenance. More generally, the Sun software we resell through our alliance with SoftwareSpectrum has experienced a decrease in market share over the past four years,which has contributed to a reduction in our alliance and reimbursementrevenues.  We expect this product line to experience continued pressure inthe marketplace over the longer term.  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 26 below).

 

The decline in software product revenue for the threeand six months ended August 31, 2005, was due to our transition out of thebusiness of reselling third-party software products and relatedmaintenance.  We do not expect to recognize future revenues from ourexited third-party resale business.  However, we may recognize futurerevenues from third-party product licenses and related services complementaryto our SubscribeNet service, which we resell as part of a comprehensive ESDMsolution.  The previous two sentences are forward-looking statements thatare subject to risks and uncertainties, and actual results could differmaterially from those anticipated (see “Risk Factors” beginning on page 26 below).

 

*Costs and Expenses*

 

The following table sets forth the costs and expenses,changes in costs and expenses and percentage of total revenue for the periodsindicated (in thousands, except percentage amounts):

 

 

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| ** **                 | ** ** | **For the  three months ended** | ** ** | **For the  six months ended** | ** ** |
|----------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                 | ** ** | **August  31, 2005**            | ** ** | **August  31, 2004**          | ** ** | **August  31, 2005** | ** ** | **August  31, 2004** | ** ** |
| ** **                 | ** ** | **Total**                       | ** ** | **Change**                    | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **Change** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** |
| Total cost of  revenues    |       | $                               | 1,472      |                          | $          | 352 |   | 48 | % | $ | 1,120 |   | 43 | % | $ | 2,995 |   | $ | 880 |   | 51 | % | $ | 2,115 |   | 39 | % |
| Gross margin               |       | 1,595                           |       | 121                           |       | 52 | % | 1,474 |   | 57 | % | 2,918 |   | (408 | ) | 49 | % | 3,326 |   | 61 | % |
| Operating  expenses:       |       |                            |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and  marketing       |       | 595                             |       | (227                          | )          | 19 | % | 822 |   | 32 | % | 1,277 |   | (297 | ) | 21 | % | 1,574 |   | 29 | % |
| Product  development       |       | 335                             |       | (74                           | )          | 11 | % | 409 |   | 16 | % | 585 |   | (227 | ) | 10 | % | 812 |   | 15 | % |
| General and administrative |       | 902                             |       | —                        |       | 29 | % | 902 |   | 35 | % | 1,846 |   | 155 |   | 31 | % | 1,691 |   | 31 | % |
| Total operating  expenses  |       | $                               | 1,832      |                          | $          | (301 | ) | 60 | % | $ | 2,133 |   | 82 | % | $ | 3,708 |   | $ | (369 | ) | 63 | % | $ | 4,077 |   | 75 | % |

 

   *Cost of Revenues*

 

The increase in cost of revenues and decrease inmargin percentage for the three months ended August 31, 2005, is primarily dueto the $0.4 million increase in online services and technology cost ofrevenues. Approximately $0.2 million of this increase was due to variablesupport costs for higher bandwidth utilization rates and incrementalinvestments in our SubscribeNet service infrastructure. Approximately $0.1million of this increase was due to additional costs associated with revenuerecognized from our resale of third-party services complementary to our SubscribeNetservice.  In addition, approximately $0.1million of this increase was due to increased utilization of our productdevelopment teams in cost of revenues activities since August 2004.

 

The increase in cost of revenues and decrease inmargin percentage for the six months ended August 31, 2005, is primarily due tothe $0.9 million increase in online services and technology cost of revenues.Approximately $0.4 million of this increase was due to variable support costsfor higher bandwidth utilization rates and incremental investments in ourSubscribeNet service infrastructure. Approximately $0.1 million of thisincrease was due to additional costs associated with revenue recognized fromservices for third-party products complimentary to our SubscribeNet servicethat we resold.  In addition,approximately $0.3 million of this increase was due to increased utilization ofour product development teams in cost of revenues activities since August 2004.

 

Cost of revenues primarily consists of certainallocated costs related to our Internet connectivity, assets supporting cost ofrevenues, and customer support, as well as the costs associated withmaintaining our team dedicated to helping Software Spectrum sell Sun software.Cost of revenues also consists of professional services personnel costs and thecost of third-party products and services sold.  When we were in thebusiness of directly reselling third-party software products, we purchasedthose products at a discount from the third-parties’ established list pricesaccording to standard reseller terms.  We expect total cost of revenuesfor the current fiscal year to be higher than our fiscal year 2005amounts.  In addition, we expect our gross profit margin percentage forthe current fiscal year to be significantly lower than those for our fiscalyear 2005. Our quarterly cost of revenues may fluctuate based on multiplevariables including but not limited to revenue mix fluctuations, levels ofprofessional services activities, infrastructure costs, and variable externalsupport utilization rates, and expect our margins to fluctuate accordingly. Theprevious sentences are forward-looking statements that are subject to risks anduncertainties. The actual mix of sales transactions and the timing of thetransactions may cause our cost of revenues and gross profit margins tofluctuate materially from those anticipated (see “Risk Factors” beginning onpage 26 below).

 

*Sales and Marketing Expenses*

 

Sales and marketing expenses consist primarily ofemployee salaries, benefits and commissions, advertising, consulting,promotional materials, trade show expenses and certain allocated overheadcosts.

 

The decrease in the dollar amount of our sales andmarketing expenses for the three and six months ended August 31, 2005, comparedto the three and six months ended August 31, 2004, is primarily due todecreases of approximately $0.2 million and $0.3 million, respectively, fromour prior year in outside services related to marketing and advertisingas we utilize more in-house marketingresources.

 

We expect our sales and marketing expenditures infiscal year 2006 to be lower than those in fiscal year 2005. 

 

 

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We plan to continue to market and sell our services,and may market and sell proprietary software licenses, directly to customersusing our existing sales force and through resellers. We also plan to continueto develop alliances with other companies to sell our services to a broadercustomer base. The previous three sentences are forward-looking statements thatare subject to risks and uncertainties, and actual results could differmaterially from those anticipated (see “Risk Factors” beginning on page 26below).

 

*Product Development Expenses*

 

Product development expenses primarily consist ofpersonnel, consulting, software and related maintenance, equipment depreciationexpenses and allocated overhead costs.  Costs related to research, designand development of products and services have been charged to productdevelopment expense as incurred.

 

The decrease in our product development expenses forthe three and six months ended August 31, 2005, compared to the three and sixmonths ended August 31, 2004, is due primarily to a decrease in our internalefforts on product development activities of approximately $0.1 million and$0.2 million, respectively. During the three months ended August 31, 2005, theproduct development teams temporarily increased their focus on cost of revenuesactivities, as described in “Cost of Revenues” above.

 

We anticipate continuing to invest in additionalfunctionality for our SubscribeNet service and underlying proprietary software.However, we expect those investments to fluctuate over time, and expect ourproduct development expenses to fluctuate accordingly. We expect total productdevelopment expenditures in fiscal year 2006 to be lower than fiscal year 2005.The previous sentences are forward-looking statements that are subject to risksand uncertainties, and actual results could differ materially from thoseanticipated (see “Risk Factors” beginning on page 26 below). We cannot giveassurance that our product development efforts will result in new or improvedproducts, features or functionality or that the market will accept theimprovements to existing or new products, features or functionality developed.

 

*General and Administrative Expenses*

 

General and administrative expenses consist primarilyof compensation for administrative and executive personnel, fees forprofessional services and certain overhead costs.

 

Our general and administrative expenses for the threemonths ended August 31, 2005, remained consistent with the prior yearbalances.  The increase in the dollaramount of our general and administrative expenses for the six months endedAugust 31, 2005, is primarily due to an increase of approximately $0.1 millionin business consulting services and legal expenses.

 

We expect total expenditures in fiscal year 2006 toincrease slightly from our fiscal year 2005 levels. 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 page 26below).

 

*Interest Expense*

 

For the three months ended August 31, 2005, interestexpense was approximately $16,000, a decrease from $26,000 for the three monthsended August 31, 2004.  For the sixmonths ended August 31, 2005, interest expense was approximately $35,000, adecrease from $55,000 for the six months ended August 31, 2004.

 

Interest expense primarily relates to obligationsunder capital leases and notes payable.  The decrease in interest expensefor the three and six months ended August 31, 2005, is primarily due to thereduction of the principal balance on our notes payable.

 

*Interest and Other Income andExpenses, Net*

 

For the three months ended August 31, 2005, interestand other income and expenses, net was approximately a $61,000 credit, anincrease from a $26,000 credit for the three months ended August 31, 2004.   For the six months 

 

 

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ended August 31, 2005, interest and other income and expenses, net wasapproximately a $113,000 credit, an increase from a $42,000 credit for the sixmonths ended August 31, 2004.

 

Interest and other income and expenses, net primarilyrelates to interest earned on our investment balances.  The increase ininterest and other income and expenses, net for the three and six months endedAugust 31, 2005, is primarily the result of a sustained cash balance from theprior year combined with an increase in the interest rates in the investmentaccount.

 

*Income Taxes*

 

From inception through February 28, 2005, weincurred net losses for federal and state tax purposes and have not recognizedany tax provision or benefit. As of February 28, 2005, we hadapproximately $88 million of federal and $47 million of state net operatingloss carryforwards available to offset future taxable income, which expire invarying amounts between fiscal year 2006 and 2025. The Tax Reform Act of 1986limits the use of net operating losses and tax credit carryforwards in certaincircumstances where changes occur in the stock ownership of a company. Becauseof cumulative ownership changes in the past, the federal and state losscarryforwards have been reduced by the amount of the net operating losscarryforwards that will expire. Because of these cumulative ownership changes,federal loss carry forwards totaling approximately $44 million and state losscarry forwards totaling approximately $22 million are subject to limitation. AtFebruary 28, 2005, $44 million and $25 million of federal and state netoperating losses, respectively, are available without limitation to offsetfuture taxable income. Should there be a change of ownership in the future, theavailable 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 the realizationof the related deferred income tax asset meets the criteria required bygenerally accepted accounting principles.

 

**Liquidity and Capital Resources**

 

The following table presents our liquidity position atAugust 31, 2005 and 2004 (in thousands):

 

| ** **                                           | ** ** | **For the six months ended** | ** ** |
|------------------------------------------------------|------------|------------------------------|------------|
| ** **                                           | ** ** | **August 31,  2005**         | ** ** | **August 31,  2004** | ** ** |
|                                                 |       |                         |       |   |   |
| Cash and cash equivalents                            |       | $                            | 9,031      |   | $ | 10,944 |   |
| Working capital                                      |       | $                            | 6,539      |   | $ | 8,255 |   |
| Net cash provided by (used  in) operating activities |       | $                            | 105        |   | $ | (1,317 | ) |
| Net cash used in investing  activities               |       | $                            | (190       | ) | $ | (151 | ) |
| Net cash provided by (used  in) financing activities |       | $                            | (347       | ) | $ | 608 |   |

** **

 

Our net cash provided by operations was $0.1 millionfor the six months ended August 31, 2005, an improvement from $1.3 millionnet cash used in operations in the six months ended August 31, 2004. Thisimprovement was primarily due to increased customer collections ofapproximately $1.2 million and reduced payroll related expenditures of $0.1million during the six months ended August 31, 2005.  Although we have recorded cash provided byoperations for the six months ended August 31, 2005, we expect to report anoverall cash usage from operations for the full fiscal year.  Our ability to improve our uses of cash andgenerate continued positive cash flows in future periods will largely depend onour ability to increase the number of customers of our SubscribeNet servicewhile increasing existing subscriptions through strong contract renewals. Weexpect our cash balances to fluctuate from time to time due to the timing ofcustomer collections and vendor payments in the ordinary course ofbusiness.  The preceding paragraphcontains forward-looking statements that are subject to risks anduncertainties, and actual results could differ materially from those anticipated(see “Risk Factors” beginning on page 26 below). It is also important for us toincrease our current level of sales, and continue to control our operationaland customer support costs in future periods.

 

Our net cash used in financing activities was approximately$0.3 million for the six months ended August 31, 2005.  Thisprimarily resulted from principal payments on our notes payable ofapproximately $0.6 million.  These payments were partially offset byadditional borrowings under our equipment advance agreement (see below) of $0.2

 

 

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million, and by our issuance of approximately 14,000shares of common stock in connection with our stock option and employee stockpurchase plans for proceeds of approximately $0.1 million.

 

As of August 31, 2005, we have an agreement withSilicon Valley Bank under which we have a note payable and two equipmentadvances outstanding.  The note payable and the equipment advances bear anannual interest rate of the greater of 1% in excess of the bank’s prime rate(6.5% at August 31, 2005) or 5.25% and 5.50% respectively, and are payablein fixed monthly installments through September 2005, 2006 and 2007,respectively.  At August 31, 2005, the interest rate for the note payableand the equipment advances was 7.50%.

 

Under the agreements for the note payable andequipment advances, all borrowings are collateralized by a senior securityinterest in substantially all of our assets. The agreements also require us tocomply with financial covenants, with which we were in compliance as ofAugust 31, 2005. The agreements further restrict us from incurring orassuming additional indebtedness outside of the note payable and equipmentadvances, excluding trade payables and certain other liabilities incurred inthe ordinary course of business.

 

Our net cash used in investing activities during thesix months ended August 31, 2005, was $0.2 million. This amount wascomprised of our purchases of fixed assets. We paid for these equipment purchasesfrom our cash and cash equivalents, but later drew down approximately $0.2million under the above-mentioned second equipment advance agreement to financethese purchases. We used these fixed asset purchases primarily to upgrade andexpand our SubscribeNet infrastructure and corporate information systems. Weexpect to renew our equipment advance agreement during the three months endingNovember 30, 2005, and to continue to utilize it to finance additional fixedasset purchases at levels that approximate or are slightly higher than ourprior year levels. 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 26 below).

 

We believe our existing cash and cash equivalents,together with any cash generated from future operations, will be sufficient tofund our operating activities, capital expenditures and financing arrangementsfor the foreseeable future. However, if our SubscribeNet business fails to growsignificantly or declines from its current level, we could be forced to seekadditional capital. The previous sentence is a forward-looking statement thatis subject to risks and uncertainties, and actual results could differmaterially from those anticipated (see “Risk Factors” beginning on page 26 below).

 

At August 31, 2005, 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 debt and leaseobligations at August 31, 2005, 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, 2010, as we do not have any debt or lease obligations beyondthat point.

 

| ** **       | ** ** | **Payments due by period** | ** ** |
|------------------|------------|----------------------------|------------|
| ** **       | ** ** | **Total**                  | ** ** | **Less than  1 Year** | ** ** | **1-3 years (a)** | ** ** | **3-5 years (b)** | ** ** |
| Long-term debt   |       | $                          | 804        | (c) | $ | 319 |   | $ | 485 |   | $ | — |   |
| Operating leases |       | 2,100                      |       | 268 |   | 1,566 |   | 266 |   |
|             |       | $                          | 2,904      |   | $ | 587 |   | $ | 2,051 |   | $ | 266 |   |

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(a)   Includes payments from March 1, 2006through February 28, 2009.

 

(b)   Includes payments from March 1, 2009through February 28, 2010.

 

(c)   This amount includes approximately$46,000 in interest.

 

 

 

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As of August 31, 2005, our Series Aredeemable convertible preferred stock entitled its holders to a liquidationpreference of $1.0 million in the event of Intraware’s liquidation.

 

**Recent Accounting Pronouncements**

 

In December 2004, the FASB issued SFASNo. 123 (Revised 2004) “Share-Based Payment” (“SFAS No. 123R”). SFASNo. 123R addresses all forms of share-based payment (“SBP”) awards,including shares issued under employee stock purchase plans, stock options,restricted stock and stock appreciation rights. SFAS No. 123R will requireus to expense SBP awards with compensation cost for SBP transactions measuredat fair value. The FASB originally stated a preference for a lattice modelbecause it believed that a lattice model more fully captures the uniquecharacteristics of employee stock options in the estimate of fair value, ascompared to the Black-Scholes model which we currently use for our footnotedisclosure. The FASB decided to remove its explicit preference for a latticemodel and not require a specific valuation methodology. In April 2005, theSecurities and Exchange Commission (“SEC”) issued a release which amends thecompliance dates for SFAS No. 123R.  Accordingly, we will be requiredto adopt the new accounting provisions beginning in the first quarter of ourfiscal year ending February 28, 2007.

 

On March 29, 2005, the SEC issued Staff AccountingBulletin (SAB) 107 which expresses the views of the SEC regarding theinteraction between SFAS No. 123R and certain SEC rules and regulations andprovides the SEC’s views regarding the valuation of share-based paymentarrangements for public companies. In particular, SAB 107 provides guidancerelated to share-based payment transactions with nonemployees, the transitionfrom nonpublic to public entity status, valuation methods (includingassumptions such as expected volatility and expected term), the accounting forcertain redeemable financial instrument issues under share-based paymentarrangements, the classification of compensation expense, non-GAAP financialmeasures, first-time adoption of SFAS No. 123R in an interim period,capitalization of compensation costs related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentsarrangements upon adoption of SFAS No. 123R, the modification of employee shareoptions prior to adoption of SFAS No. 123R, and disclosures in Management’sDiscussion and Analysis of Financial Condition and Results of Operationssubsequent to adoption of SFAS No. 123R. We expect the adoption of SFASNo. 123R and SAB 107 will have a material adverse impact on our results ofoperations and loss per share. We are currently in the process of evaluatingthe extent of such impact.

 

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections”.  SFAS No. 154 replaces APB Opinion No. 20,“Accounting Changes”, and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial Statements”.  SFAS No. 154 requires retrospective application toprior periods’ financial statements of changes in accounting principle, unlessit is impracticable to determine either the period-specific effects or the cumulativeeffect of the change.  We do not expect the adoption of SFAS No. 154 tohave a material impact on our consolidated financial statements.

 

 

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**RISKFACTORS**

 

You should carefullyconsider the risks described below before making a decision to invest in ourcommon stock.  The risks and uncertainties described below are not theonly ones facing Intraware.  Additional risks and uncertainties notpresently known to us or that we do not currently believe are important to aninvestor may also harm our business operations.  If any of the events,contingencies, circumstances or conditions described in the following risksactually occur, our business, financial condition and our results of operationscould be seriously harmed.  If that occurs, the trading price of ourcommon stock could decline, and you may lose part or all of your investment.

 

**Revenuesto us under our sales and marketing services arrangement with Software Spectrumare likely to decline.  Also, any termination of our relationship withSoftware Spectrum in the near term, without an adequate replacement, wouldcause a substantial decrease in our revenues.**

** **

We entered into a SalesAlliance Agreement with Software Spectrum in June 2001, and entered into a newand updated version of that contract with Software Spectrum in August2005.  Under this agreement, we providesales and marketing services to Software Spectrum to assist in its resale andmarketing of Sun software licenses and maintenance.  Software Spectrumshares with us a portion of its gross profit from resales of Sun softwarelicenses and maintenance.  This contractaccounted for substantially all of our Alliance and reimbursement revenues, asignificant portion of our Online services and technology revenues, and morethan 10% of our total revenues during the six months ended August 31, 2005.

 

Revenues to us under thissales and marketing services arrangement with Software Spectrum are likely todecline for a number of reasons.  First,under the August 2005 contract we are no longer reimbursed for any of our costin maintaining a team to sell and market Sun software and maintenance, whereasunder the June 2001 contract we were reimbursed for a substantial portion ofthat cost.  While our portion of SoftwareSpectrum’s gross profit from resales of Sun software licenses and maintenanceincreased under the August 2005 agreement from the portion we received underthe June 2001 contract, gross profit is no longer impacted by charges relatedto Software Spectrum’s commission and back-office costs, and we can now use oursales and marketing services team for activities outside our agreement withSoftware Spectrum, these benefits will probably not be sufficient to offset thedecrease in Alliance and reimbursement revenue that we expect will result fromthe elimination of Software Spectrum’s reimbursement obligation.  Second, in August 2005, Sun and itsdistributor reduced the discount at which Software Spectrum can purchase Sunsoftware licenses and most Sun software maintenance for resale.  This has reduced Software Spectrum’s grossprofit from resales of Sun software licenses and maintenance and, therefore,will likely reduce the dollar amount of our portion of that gross profit.  Third, in recent years, sales and marketshare of the Sun software products that we resell with Software Spectrum havegenerally declined.  If this trend continues, it is likely to cause adecrease in revenues to us under this contract over the long term.

 

In addition, this contractis terminable by either party without cause on 60 days’ notice, and willterminate automatically upon any termination of Software Spectrum’s right toresell the applicable Sun software.  Ifthe contract were terminated under either of these provisions, we would likelyexperience a substantial and immediate decrease in our revenues and cash flowsunless and until we were able to fully implement a comparable relationship withanother business partner or fully transition to becoming an authorized resellerof Sun software (as we were before signing the June 2001 agreement withSoftware Spectrum) or to becoming an authorized reseller of a similar softwareproduct line.

 

**The lossof one or more of our key customers or partners could cause our revenue growthto slow or cause our revenues to decline.**

** **

A substantial portion ofthe revenues from our SubscribeNet service comes from a relatively small numberof companies.  These include software providers to whom we provide ourSubscribeNet service, as well as Software Spectrum, to whom we provide both ourSubscribeNet service and sales and marketing services.  Our contracts withmost of these companies are subject to renewal or cancellation annually. If any of these companies elected to cancel their agreements with us, ourrevenue growth would likely slow or our revenues might decline.  Either ofthese types of 

 

 

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events could reduce our revenue through loss ofexisting customers, or reduce our margins through increased price competition.

 

**Mergersand acquisitions in the technology sector could harm us by causing cancellationof customer contracts where our customers are acquired, or by strengthening ourcompetitors.**

** **

In recent years, therehas been an increase in mergers and acquisitions among technologycompanies.  This trend poses risks for us.  First, our customers aretechnology companies, and any acquisitions of our customers could lead tocancellation of our contracts with those customers by the acquiring companies. Second, our competitors also are technology companies.  Any acquisitionsof other companies by our competitors, or acquisitions of our competitors byother companies, are likely to result in stronger companies competing againstus.

 

**We havea history of losses and negative cash flow, and we have yet to achievesustained profitability or positive cash flow.**

 

We have incurredsignificant losses since we were formed in 1996, and have yet to achievesustained profitability or positive cash flow.  As of August 31,2005, we had an accumulated deficit of approximately $157 million.  Also,with the exception of our quarters ended November 30, 2002, and August 31,2005, we have not achieved positive cash flow from operations since ourformation in 1996.  Although we haverecorded cash provided by operations for the six months ended August 31, 2005,we expect to report an overall cash usage from operations for the full fiscalyear.  Our operating history makes it difficult to evaluate whether orwhen we will be able to achieve sustained profitability or positive cash flowin the future.

 

**Competitionfrom other electronic delivery and licensing providers, and potential customers’development of their own electronic delivery and/or licensing systems, couldlimit our revenue growth and reduce our gross margins.**

** **

The market for sellingelectronic delivery and licensing services is highly competitive.  Some ofour competitors have longer operating histories, greater financial, technical,marketing and other resources, broader product and service offerings, bettername recognition, and a larger installed base of customers than we do. Some of our competitors also have well-established relationships with ourpotential customers and with third-party information technology or consultingfirms that help market our competitors’ services.  We expect competitionto intensify as current competitors expand and improve their service offeringsand new competitors enter the market.  In addition, our current andpotential customers are primarily information technology companies with strongsoftware development expertise.  When considering their alternatives forimplementing a system for electronic delivery of software or license keys,these companies sometimes elect to develop such systems in-house.  Whilewe believe our competitive position is strong against both external competitorsand in-house development, we have at times experienced reduced prices, reducedgross margins and lost sales as a result of such competitive factors. Such competition is likely to intensify, which could limit the growth of ourrevenues or gross margins.

 

**If thebid price of our stock does not close at or above $1.00 for 10 consecutivebusiness days before February 22, 2006, our stock may be delisted from the NASDAQCapital Market.**

 

On February 23, 2005, wereceived a letter from The Nasdaq Stock Market indicating that, for 30consecutive business days, the bid price of our stock had closed below theminimum $1.00 per share requirement for continued  listing on the NASDAQCapital Market and that, in accordance with NASD rules, we had 180 calendardays to regain compliance. The letter also stated that if, at any time beforeAugust 22, 2005, the bid price of our stock closes at $1.00 per share or morefor a minimum of 10 consecutive business days, Intraware should regaincompliance with the listing requirements. The letter also stated that if we do not regain compliance by August 22,2005, we may be granted an additional 180-day period (until February 21, 2006) toregain compliance if we meet The NASDAQ Capital Market initial listing criteriaother than the minimum bid price requirement. On August 23, 2005, we received another letter from The Nasdaq StockMarket extending until February 21, 2006 our grace period for regainingcompliance with the $1.00 minimum bid price requirement.   If we do not regain compliance within theallotted compliance period (including any extensions that may be granted byNasdaq), Nasdaq staff will notify us that our stock will be delisted from The NASDAQCapital Market. At that time, we would be entitled to appeal the staff’sdetermination to a Nasdaq Listing Qualifications Panel.

 

 

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At our annual meeting ofstockholders on September 8, 2005, our stockholders approved a resolutionauthorizing our Board of Directors to effect a one-for-ten reverse split of ourcommon stock.  Our Board declared such areverse stock split on September 8, 2005, and the reverse stock split becameeffective at the close of business on September 26, 2005.  As of September 30, 2005, the closing priceof our stock on The NASDAQ Capital Market was $3.70.  If the minimum bid price of our stockcontinues to close above $1.00 each trading day through October 7, 2005, weexpect The Nasdaq Stock Market to notify us that we are in compliance with the$1.00 minimum bid price requirement.

 

**Themarket for our SubscribeNet electronic software and license delivery andmanagement service is immature and volatile, and the market for our DigitalFastball hosted digital delivery service is virtually untested.  If themarket for either service does not develop or develops more slowly than weexpect, our business will be harmed.**

 

The market for hosteddigital delivery services, including both our SubscribeNet and Digital Fastballservices, is relatively unproven, and it is uncertain whether these serviceswill achieve and sustain high levels of demand and market acceptance. Oursuccess will depend to a substantial extent on the willingness of companies,large and small, to increase their use of hosted digital delivery services. Ifcompanies do not increase their use of hosted digital delivery services, ouroperating results will be hurt.  In addition, in this unproven market, wehave limited insight into trends that may develop and affect our business. Wemay make errors in predicting and reacting to relevant business trends, whichcould harm our business.

 

We market ourSubscribeNet electronic software and license delivery and management serviceprincipally to software companies.  However, many software companies haveinvested substantial personnel and financial resources to develop their ownelectronic software and/or license delivery systems, and therefore may bereluctant or unwilling to migrate to a remotely hosted service. In addition,some software companies have adopted automatic update, or “phone home,”technology for delivering software updates, whereby an end-user’s computerautomatically contacts the software company’s server to check whether updatesare available and, if so, downloads and installs those updates. This method fordelivering software updates could be viewed by our potential and existingcustomers as an alternative to our digital delivery technology, and thereforeany increased adoption of this automatic update technology could hurt ourbusiness and results of operations.

 

We plan to market ourDigital Fastball service principally to small and medium-sized companies thatneed to send large digital files as part of their businesses.  However,many systems are already available for sharing files over the Internet, in somecases at little or no cost.  In addition, some such systems have been thetargets of widely publicized litigation by copyright holders, which may makesome companies reluctant to use Internet-based digital delivery services suchas Digital Fastball.

 

Further, some companiesmay be reluctant to use either our SubscribeNet or Digital Fastball hosteddigital delivery services because they are concerned about the securitycapabilities of these services.

 

**Althoughour subscription-based sales model for our SubscribeNet service limits thevolatility of our Online services and technology revenue, other factors maycause our operating results, and therefore our stock price, to fluctuate.**

** **

Our SubscribeNet servicefees, which comprise most of our Online services and technology revenues, arerecognized ratably over contract terms of generally one year, thereby limitingthe quarter-to-quarter volatility of those revenues.  Nevertheless,certain factors may cause our Online services and technology revenues tofluctuate.  In addition, our Alliance and reimbursement revenues andoverall operating results are subject to substantial quarterly and annual fluctuation. In addition to the other risk factors described in this section, factors thatcould cause such fluctuation include:

 

•                  Fluctuations in demand for the softwarewe resell jointly with Software Spectrum, which is the basis for most of ourAlliance and reimbursement revenue and a portion of our Online services andtechnology revenue;

 

 

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•                  Deferral of SubscribeNet revenuerecognition due to delays by customers in implementing the SubscribeNetservice, due to new sales involving extensive implementations, or due tocontract modifications adding significant future deliverables;

 

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

 

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

 

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

 

Consequently, operatingresults for a particular future period are difficult to predict, and prior resultsare not necessarily indicative of results to be expected in futureperiods.  Any of these factors could materially adversely affect ourresults of operations and stock price.

 

**Ourprospective customers may delay purchasing, and our new customers may delayimplementing, our SubscribeNet service while they evaluate the impact of ourservice on their internal controls under Section 404 of the Sarbanes-OxleyAct of 2002.  This may delay our revenue growth.**

** **

Section 404 of theSarbanes-Oxley Act of 2002 requires most publicly traded companies to includein their annual reports an assessment by management of the companies’ internalcontrol structures and procedures for financial reporting, and an attestationby the companies’ independent registered public accounting firms of thatmanagement assessment.  To comply with this new requirement, manycompanies have created and documented detailed internal control structures andin which their information technology (“IT”) systems play an integralrole.  Accordingly, any purchase orimplementation of an important new IT system by such a company is likely torequire a detailed evaluation of the impact of the new IT system on the company’sinternal control structures and procedures. This is particularly true in the case of a publicly traded softwarecompany purchasing or implementing a new system for electronically deliveringits software products to its customers. As a result, prospective purchasers of our SubscribeNet service maydelay completing their purchases of the service, and new SubscribeNet customersmay delay implementing the service, while they assess the effect of the serviceon their internal controls.  This could, in turn, cause delays in newsales of our SubscribeNet service and/or delays in recognition of revenue fromrecent sales of our service.

 

**Thetechnological and functional requirements we must meet to stay competitive aresubject to rapid change.  If we are unable to quickly adapt to thesechanges and meet the demands of our current and potential customers, we willlikely lose sales 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 thismarket and meet the demands of current and prospective customers, we mustcontinually adapt and upgrade our technology and functionality.  We are asmall company with limited resources available for enhancing and adding to ourproducts. If we do not respond quickly enough to changing industry standards orthe demands of customers and potential customers, we will likely lose sales andmarket share to competitors and our growth prospects will be limited.  Inaddition, we could incur substantial costs to modify our services orinfrastructure in order to adapt to changing standards and demands.  If weincur such costs but our sales fail to increase commensurately, we may not beable to achieve sustained profitability and positive operating cash flow.

 

**Defectsin our SubscribeNet service could diminish demand for the service and subjectus 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-based services frequently contain undetected errors when firstintroduced or when new versions or enhancements are released.  Despitetaking precautions to avoid errors, we have from time to time found defects inour service and new errors in our existing service may be detected in thefuture.  Since 

 

 

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our customers use our service for important aspects oftheir business, any errors, defects or other performance problems with ourservice could hurt our reputation and may damage our customers’businesses.  If that occurs, customers could elect not to renew theiragreements with us, could be eligible for credits under our service levelagreements, and could delay or withhold payment to us.  We could also losefuture sales, or customers may make warranty claims against us, which couldresult in an increase in our provision for doubtful accounts, an increase incollection cycles for accounts receivable or the expense and risk of litigation.

 

**Interruptionsor delays in service from our third-party Web hosting facilities could impairthe delivery of our service and harm our business.**

** **

We provide our servicethrough computer hardware that is currently located in a third-party Web hostingfacilities in Santa Clara, California operated by SAVVIS Communications, and inIreland operated by Data Electronics.  We do not control the operation ofthese facilities, and they are subject to damage or interruption fromearthquakes, floods, fires, power loss, telecommunications failures and similarevents.  While physical security measures are in place, they are alsosubject to break-ins, sabotage, intentional acts of vandalism and similarmisconduct.  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 facilityto provide our required data communications capacity could result ininterruptions in our service.  We have an agreement with SBC E-Services,an affiliate of SBC Communications, Inc., to provide access to ageographically remote disaster recovery facility that would provide us accessto hardware, software and Internet connectivity in the event the SAVVISfacility becomes unavailable.  Even with this disaster recoveryarrangement, however, our service would be interrupted during thetransition.  Any damage to, or failure of, our systems could result ininterruptions in our service. Interruptions in our service may reduce our revenue, cause us to issuecredits or pay penalties, cause customers to terminate their subscriptions andadversely affect our renewal rates.  Our business will be harmed if ourcustomers and potential customers believe our service is unreliable.

 

**Virusesmay hinder acceptance of Internet-based digital delivery, which could in turnlimit our revenue growth.**

** **

The proliferation ofsoftware viruses is a key risk that could inhibit acceptance by informationtechnology professionals of Web-based delivery of digital goods.  Anywell-publicized transmission of a computer virus by us or another company usingdigital delivery could deter information technology professionals from usingand deter software providers from outsourcing digital delivery, therebyadversely affecting our business.  Our SubscribeNet service enables ourcustomers to upload their software products directly onto our systems fordownloading 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 ofthose periodic virus scans, our system could transmit the virus to one or moreend-users.  Any such virus transmission could result in disputes,litigation and negative publicity that could adversely affect our business.

 

**If oursecurity measures are breached and unauthorized access is obtained to acustomer’s data, our service may be perceived as not being secure and customersmay 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, our reputationwill be damaged, our business may suffer and we could incur significantliability.  Because techniques used to obtain unauthorized access or tosabotage 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 perceivedbreach of our security occurs, the market perception of the effectiveness ofour security 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 additionalcapital in the future through private or public offerings of stock, or throughother means.  The purposes of any such financing would be to increase ourcash reserves for potential use in acquiring other 

 

 

 

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businesses, product development activities, fundingour 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 hasbenefited from the tax laws of states in which purchases of software licensesare not taxable if the software is received only electronically.  Somestates currently experiencing revenue shortfalls are considering whether tochange their laws to broaden the taxability of transactions executed over theInternet.  Any new imposition of taxes on sales of software licenses,where the software is received electronically, could substantially harm demandfor our services and thereby materially adversely affect our business,operating results and financial condition.  We have also benefited fromimplementing our services in Ireland, which offers tax advantages to softwarecompanies distributing their software from Ireland to other Europeancountries.  Any regulatory change in Ireland or elsewhere that diminishesthose advantages could harm our business.  Other changes in governmentregulations, in areas such as privacy and export compliance, could also requireus to implement changes in our services or operations that increase our cost ofdoing business and thereby hurt our financial performance.

 

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

** **

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

 

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

 

•                  Claims by our customers’ competitorsalleging that our customers’ software, which we store and electronically deliverfor our customers, infringes those competitors’ intellectual property rights(our customers would typically be required to defend and indemnify us againstsuch claims, but the claims could nevertheless disrupt our business); or

 

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

 

Industry consolidation isincreasing the risk that we will become a target of the types of claimsdescribed in the first two bullets above.  Consolidation among companiesproviding digital delivery, licensing, e-commerce and related technologies isresulting in more direct competition among the surviving companies in thatsegment, heightening the risk of intellectual property infringement claimsamong those companies, including us.  Similarly, consolidation in theenterprise software industry heightens the risk of intellectual propertyinfringement claims among the companies remaining in that industry, includingmost of our customers.

 

These intellectualproperty claims could be made for patent, copyright or trademark infringementor for misappropriation of trade secrets.  They could be made directlyagainst us, or indirectly through our contractual indemnification obligationsto our customers and channel partners.  Any claims could result in costlylitigation and be time-consuming to defend, divert management’s attention andresources, or cause delays in releasing new or upgrading existingservices.  Royalty or licensing agreements, if required, may be availableonly on onerous terms, if at all.  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 believe we own therights in, or have the required rights to use, our SubscribeNettechnology.  However, there can be no assurance that this technology doesnot infringe the rights of third parties.  In addition, we take steps toverify that end-users who download our customers’ software through ourSubscribeNet service are entitled to deploy and use that software. However, there can be no assurance that this verification procedure will helpus defend against claims by, or protect us against liability to, our customerswhose software is downloaded.

 

 

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We are aware that certainother companies are using the name “Intraware” as a company name or as atrademark or service mark.  While we have received no notice of any claimsof trademark infringement from any of those companies, we cannot assure youthat these companies may not claim superior rights to “Intraware” or to othermarks we use.

 

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

 

Through our SubscribeNetservice we globally distribute software containing high encryption and otherfeatures restricted by U.S. laws and regulations from exportation to certaincountries, types of recipients, and specific end-users.  Our SubscribeNetsolution incorporates automated procedures to help ensure that the software wedeliver electronically is not downloaded in violation of U.S. export laws andregulations.  However, these procedures may not prevent unauthorizedexports of restricted software in every case.  If an unauthorized exportof software occurs through the SubscribeNet service and the U.S. governmentdetermines that we violated the U.S. export laws or regulations, we could besanctioned under those laws or regulations.  Sanctions include fines,suspension or revocation of export privileges, and imprisonment.

 

**If ourkey personnel left the company, our product development, sales, and corporatemanagement could suffer.**

 

Our future successdepends upon the continued service of our executive officers and other key technology,sales, marketing and support personnel.  None of our officers or keyemployees is bound by an employment agreement for any specific term.  Ifwe lost the services of one or more of our key employees, or if one or more ofour executive officers or key employees decided to join a competitor orotherwise compete directly or indirectly with us, this could have a significantadverse effect on our business.

 

**FinancialAccounting Standards Board (“FASB”)’s adoption of Statement 123 (Revised 2004)will cause, and changes to existing accounting pronouncements or taxationrules or practices may cause, adverse revenue fluctuations and/or affectour reported results of operations and how we conduct our business.**

 

In December 2004,FASB adopted Statement 123 (Revised 2004), “Share-Based Payment,” which willrequire us to measure compensation costs for all employee stock-basedcompensation (including stock options and our employee stock purchase plan) atfair value and take a compensation charge equal to that value.  The SEChas amended the deadline to adopt SFAS No. 123R.  As a result, wewill be required to adopt the provisions of SFAS No. 123R during the firstquarter of our fiscal year ending February 28, 2007.  Also, a changein accounting pronouncements or taxation rules or practices can have asignificant effect on our reported results and may even affect our reporting oftransactions completed before the change is effective.  Other newaccounting pronouncements or taxation rules and varying interpretations ofaccounting pronouncements or taxation practice have occurred and may occur inthe future.  This change to existing rules, future changes, if any, or thequestioning of current practices may adversely affect our reported financialresults or the way we conduct our business.

 

**Recentlegislation, especially the Sarbanes Oxley Act of 2002, requires that weevaluate our internal control structure and while we believe that we currentlyhave adequate internal control procedures in place, this exercise has no precedentavailable by which to measure the adequacy of our compliance, and in additionit may cause our operating expenses to increase.**

 

The Sarbanes-Oxley Act of2002, the California Disclosure Act and newly proposed or enactedrules and regulations of the SEC and the National Association ofSecurities Dealers impose new duties on us and our executives, directors,attorneys and independent registered public accounting firms.  In order tocomply with the Sarbanes-Oxley Act and such new rules and regulations, weare evaluating our internal control over financial reporting to allowmanagement to report on, and our independent registered public accounting firmto attest to, our internal control over financial reporting.  We areperforming the system and process evaluation and testing (and any necessaryremediation) required in an effort to comply with the management certificationand independent registered public accounting firm attestation requirements ofSection 404 of the Sarbanes-Oxley Act.  As a result, we are incurringadditional expenses and diversion of management’s time and we may be requiredto hire additional personnel as well as to use additional outside legal,accounting and advisory services.  Any of these developments couldmaterially increase our operating expenses and 

 

 

 

 

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accordingly reduce our net income or increase our netlosses.  While we anticipate being able to fully implement therequirements relating to internal control over financial reporting and allother aspects of Section 404 in a timely fashion, we cannot be certain asto the outcome of our testing and resulting remediation actions or the impactof the same on our operations since there is no precedent available by which tomeasure compliance adequacy.  If we are not able to implement therequirements of Section 404 in a timely manner or with adequatecompliance, we may be subject to sanctions or investigation by regulatoryauthorities, such as the SEC or The Nasdaq Stock Market and our reputation maybe harmed.  Any such action could adversely affect our financial resultsand the market price of our common stock.

 

Moreover, our management,including our CEO and CFO, does not expect that our disclosure controls or ourinternal controls over our financial reporting will prevent all error and allfraud.  A control system, no matter how well conceived and operated, canprovide only reasonable, not absolute, assurance that the objectives of thecontrol system are met.  Our disclosure controls or procedures can becircumvented by the individual acts of some persons, by collusion of two ormore people or by management override of the control.  Because of theinherent limitations in a cost-effective control system, misstatements due to erroror fraud may occur and not be detected.

 

**If weacquire any companies or technologies in the future, they could prove difficultto integrate, disrupt our business, dilute stockholder value and adverselyaffect 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 ourpast acquisitions, and therefore any new acquisitions or investments could bemore disruptive to our organization than in the past.  Acquisitions andinvestments involve 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 revenueto offset acquisition or investment costs; and

 

•                  delays in customer purchases due touncertainty.

 

In addition, if wefinance acquisitions by issuing convertible debt or equity securities, ourexisting stockholders may be diluted which could affect the market price of ourstock.  As a result, if we fail to properly evaluate and executeacquisitions or investments, our business and prospects may be seriouslyharmed.

 

**Provisions of our charterdocuments could make it more difficult for a third party to acquire us even ifthe offer may be considered beneficial by our stockholders.**

 

Our certificate of incorporation and bylaws containprovisions that could make it harder for a third party to acquire us withoutthe consent of our Board of Directors. Additionally, our Board of Directors has adopted a stockholder rightsplan, or “poison pill,” which would significantly dilute the ownership of ahostile acquiror.  These provisions makeit more difficult for a third party to acquire us without negotiation.  These provisions may apply even if the offermay be considered beneficial by our stockholders.

 

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

At August 31, 2005, we had cash and cash equivalentsof $9.0 million. We have not used derivative financial instruments in ourinvestment portfolio during fiscal 2005 or the six months ended August 31,2005. We place our investments with high quality issuers, by policy, in aneffort to limit the amount of credit exposure to any one issue or issuer.

 

Our exposure to market risk for changes in interestrates relates primarily to our cash and cash equivalents portfolio, notepayable and lines of credit. We have not used derivative financial instruments.The effect of changes in interest rates of +/-10% over a six-month horizonwould not have a material effect on the fair value of the portfolio or ourdebt. Declines in interest rates will, over time, cause a decrease in ourinterest income from our portfolio.  Increases in interest rates willincrease the interest we pay on our credit facilities.

 

**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 SecuritiesExchange Act of 1934 (the “Exchange Act”)) as of the end of the period coveredby this quarterly report, have concluded that our disclosure controls andprocedures are effective based on their evaluation of the controls and proceduresrequired by paragraph (b) of the Exchange Act Rules 13a-15 or 15d-15.

 

(b) *Changes in Internal Controls over Financial Reporting*.No changes in our internal control over financial reporting identified inconnection with the evaluation required by paragraph (d) of Exchange ActRules 13a-15 or 15d-15 occurred during our last fiscal quarter that havematerially affected or are reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**PART II**

 

**OTHERINFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

*In reIntraware, Inc. Initial Public Offering Securities Litigation*

 

In October 2001, wewere served with a summons and complaint in a purported securities class actionlawsuit.  On or about April 19, 2002, we were served with an amendedcomplaint in this action, which is now titled *Inre Intraware, Inc. Initial Public Offering Securities Litigation*,Civ. No. 01-9349 (SAS) (S.D.N.Y.), related to *In re Initial Public Offering Securities Litigation*, 21 MC92 (SAS) (S.D.N.Y.).  The amended complaint is brought purportedly onbehalf of all persons who purchased our common stock from February 25,1999 (the date of our initial public offering) through December 6,2000.  It names as defendants Intraware, three of our present and former officersand directors, and several investment banking firms that served as underwritersof our initial public offering.  The complaint alleges liability underSections 11 and 15 of the Securities Act of 1933 andSections 10(b) and 20(a) of the Securities Exchange Act of 1934,on the grounds that the registration statement for the offerings did notdisclose that: (1) the underwriters had agreed to allow certain customersto purchase shares in the offerings in exchange for excess commissions paid tothe underwriters; and (2) the underwriters had arranged for certaincustomers to purchase additional shares in the aftermarket at predeterminedprices.  The amended complaint also alleges that the underwriters misusedtheir securities analysts to manipulate the price of our stock.  Nospecific damages are claimed.

 

Lawsuits containingsimilar 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 consolidatedfor pretrial purposes before United States District Court Judge ShiraScheindlin of the Southern District of 

 

 

 

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New York.  On July 15, 2002, an omnibusmotion to dismiss was filed in the coordinated litigation on behalf of theissuer defendants, of which Intraware and its three named current and formerofficers and directors are a part, on common pleadings issues.  On orabout October 9, 2002, the Court entered and ordered a Stipulation ofDismissal, which dismissed the three named current and former officers anddirectors from the litigation without prejudice.  On February 19,2003, the Court entered an order denying in part the issuer-defendants’ omnibusmotion to dismiss, including those portions of the motion to dismiss relatingto Intraware.

 

In June 2004, astipulation of settlement for the claims against the issuer-defendants,including us, was submitted to the Court.  The underwriter-defendants inthe *In re Initial Public Offering SecuritiesLitigation* (collectively, the “underwriter-defendants”), includingthe underwriters of our initial public offering, are not parties to thestipulation of settlement.

 

The settlement providesthat, in exchange for a release of claims against the settlingissuer-defendants, the insurers of all of the settling issuer-defendants willprovide a surety undertaking to guarantee plaintiffs a $1 billion recoveryfrom the non-settling defendants, including the underwriter-defendants. The amount our insurers would be required to pay to the plaintiffs could rangefrom zero to approximately $3.5 million, depending on plaintiffs’ recoveryfrom the underwriter-defendants and from other non-settling parties.  Ifthe plaintiffs recover at least $1 billion from theunderwriter-defendants, our insurers would have no liability for settlementpayments under the terms of the settlement.  If the plaintiffs recoverless than $1 billion, we believe our insurance will likely cover our shareof any payments towards satisfying plaintiffs’ $1 billion recoverydeficit.  Management estimates that its range of loss relative to thismatter is zero to $3.5 million.  Presently there is no more likelypoint estimate of loss within this range.  As a consequence of the uncertaintiesdescribed above regarding the amount we will ultimately be required to pay, ifany, as of August 31, 2005, we have not accrued a liability for thismatter.

 

On August 31, 2005, thecourt granted preliminary approval of the settlement.  A fairness hearingfor the settlement is scheduled for April 2006. There is no guarantee the settlement will become final as it is subjectto a number of conditions, including the final approval of the court.

 

*LeonSegen v. ComVest Venture Partners. LP. et al.*

 

In July 2004, acomplaint was filed in the United States District Court for the District ofDelaware, Civ. No. 04-822, against ComVest Venture Partners, LP; ComVestManagement, LLC; Commonwealth Associates Management Company, Inc.;Commonwealth Associates, LP; RMC Capital, LLC; Michael S. Falk; RobertPriddy; Travis L. Provow; Keith Rosenbloom; and Intraware.  The complaintdescribes Intraware as a nominal defendant.  The complaint alleges that,between August 2001 and January 2002, all of the defendants otherthan Intraware were members of a group, and therefore should be treated as asingle “person,” for purposes of Sections 13(d)(3) and 16(b) ofthe Securities Exchange Act of 1934 (the “1934 Act”).  The complaintfurther alleges that ComVest Venture Partners, LP and Mr. Priddy, whilethey and the other alleged group members collectively owned more man 10% of aclass of our equity securities, bought and sold our equity securities within a6-month period 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 of Directors from April 2001 toMay 2002 and Mr. Provow was a member of our Board of Directors fromOctober 2001 to May 2002.  The complaint demands that ComVestVenture Partners, LP and Mr. Priddy pay over to Intraware the profits theyallegedly realized and retained in violation of Section 16(b) of the1934 Act, together with interest and legal costs.  According to thecomplaint, 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 damagesagainst 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.  In June 2005, thecourt denied motions filed by the defendants other than Intraware to dismissthe plaintiff’s claims. The parties, including Intraware, are currently engagedin discovery.  A trial in this case is currently scheduled to begin inJuly 2006.

 

We are also subject to legal proceedings, claims andlitigation arising in the ordinary 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.

 

 

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**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

 

None.

**ITEM 3. DEFAULTSUPON SENIOR SECURITIES**

 

None.

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

 

None.

**ITEM 5. OTHERINFORMATION**

 

None.

**ITEM 6. EXHIBITS**

**Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                     |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Amended and Restated Certificate of Incorporation of  Intraware, Inc.                                                                                                                                                                                                                               |
| 3.2                 |       | Certificate of Amendment to Amended and Restated  Certificate of Incorporation of Intraware, Inc.                                                                                                                                                                                                   |
| 3.3(1)              |       | Certificate of Designations, Preferences and Rights  of Series A Convertible Preferred Stock                                                                                                                                                                                                   |
| 3.4                 |       | Certificate of Designations, Preferences and Rights  of the Series D Convertible Preferred Stock                                                                                                                                                                                                    |
| 3.5(2)              |       | Amended and Restated Bylaws of Intraware, Inc.                                                                                                                                                                                                                                                      |
| 4.1(2)              |       | Preferred Stock Rights Agreement, dated as of  September 8, 2005, between Intraware, Inc. and Computershare Investor  Services LLC, including the Certificate of Designation, the form of Rights  Certificate and the Summary of Rights attached thereto as Exhibits A, B  and C, respectively |
| 10.1+               |       | Sales Alliance Agreement dated August 1, 2005,  between Intraware, Inc. and Software Spectrum, Inc.                                                                                                                                                                                                 |
| 10.2*               |       | Bonus Plan for Peter H. Jackson                                                                                                                                                                                                                                                                     |
| 10.3*               |       | Bonus Plan for Wendy A. Nieto                                                                                                                                                                                                                                                                       |
| 10.4*               |       | Bonus Plan for John J. Moss                                                                                                                                                                                                                                                                         |
| 10.5*               |       | Amendment Two dated September 16, 2005, to Change of  Control Severance Agreement between Intraware, Inc. and Peter H. Jackson                                                                                                                                                                      |
| 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                                                                                                                                                                                                                               |

----

*                 Indicates management contract or compensatory plan orarrangement.

 

+                 Confidential treatment has been requested for certainportions of this exhibit.

 

(1)          Incorporated by reference to Intraware’s CurrentReport on Form 8-K dated April 2, 2001 (File No. 000-25249) and filedwith the SEC on April 13, 2001.

(2)          Incorporated by reference to Intraware’s CurrentReport on Form 8-K dated September 12, 2005 (File No. 000-25249) and filedwith the SEC on September 12, 2005.

** **

36

 

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**SIGNATURE**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                        | **INTRAWARE, INC.** |
|-----------------------------|---------------------|
|                        | ** **          |
|                        | ** **          |
| Date:  October 5, 2005 | By:                 | /s/  WENDY A. NIETO |   |
|                        |                | Wendy A.  Nieto |
|                        |                | *Chief Financial Officer and Executive Vice  President of Intraware, Inc.* |

 

 

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**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                     |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Amended and Restated Certificate of Incorporation of  Intraware, Inc.                                                                                                                                                                                                                               |
| 3.2                 |       | Certificate of Amendment to Amended and Restated  Certificate of Incorporation of Intraware, Inc.                                                                                                                                                                                                   |
| 3.3(1)              |       | Certificate of Designations, Preferences and Rights  of Series A Convertible Preferred Stock                                                                                                                                                                                                   |
| 3.4                 |       | Certificate of Designations, Preferences and Rights  of Series D Convertible Preferred Stock                                                                                                                                                                                                   |
| 3.5(2)              |       | Amended and Restated Bylaws of Intraware, Inc.                                                                                                                                                                                                                                                      |
| 4.1(2)              |       | Preferred Stock Rights Agreement, dated as of  September 8, 2005, between Intraware, Inc. and Computershare Investor  Services LLC, including the Certificate of Designation, the form of Rights  Certificate and the Summary of Rights attached thereto as Exhibits A, B  and C, respectively |
| 10.1+               |       | Sales Alliance Agreement dated August 1, 2005, between  Intraware, Inc. and Software Spectrum, Inc.                                                                                                                                                                                                 |
| 10.2*               |       | Bonus Plan for Peter H. Jackson                                                                                                                                                                                                                                                                     |
| 10.3*               |       | Bonus Plan for Wendy A. Nieto                                                                                                                                                                                                                                                                       |
| 10.4*               |       | Bonus Plan for John J. Moss                                                                                                                                                                                                                                                                         |
| 10.5*               |       | Amendment Two dated September 16, 2005, to Change of  Control Severance Agreement between Intraware, Inc. and Peter H. Jackson                                                                                                                                                                      |
| 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                                                                                                                                                                                                                               |

----

*                 Indicates management contract or compensatory plan orarrangement.

 

+                 Confidential treatment has been requested for certainportions of this exhibit.

 

(1)          Incorporated by reference to Intraware’s CurrentReport on Form 8-K dated April 2, 2001 (File No. 000-25249) and filedwith the SEC on April 13, 2001.

(2)          Incorporated by reference to Intraware’s CurrentReport on Form 8-K dated September 12, 2005 (File No. 000-25249) and filedwith the SEC on September 12, 2005.

 

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