**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

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

** **

**FOR THEQUARTERLY PERIOD ENDED AUGUST 31, 2004**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THETRANSITION PERIODFROM          TO          **

 

**Commissionfile number 000-25249**

 

**INTRAWARE, INC.**

(Exact name of Registrant asspecified in its charter) 

 

**DELAWARE**

(State or other jurisdictionof incorporation or organization) 

 

**68-0389976**

(I.R.S. EmployerIdentification Number) 

 

**25 ORINDAWAYORINDA, CA 94563**

(Address of principalexecutive offices) 

 

**(925)253-4500**

(Registrant’s telephonenumber, including area code) 

 

Indicate by check (X) whether the registrant: (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý   No  o

 

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

 

As of October 11, 2004 there were 60,302,620 shares of the registrant’scommon stock outstanding. 

 

 

----

 

**PART I—FINANCIAL INFORMATION**

**ITEM1. CONSOLIDATED FINANCIAL STATEMENTS**

 

**INTRAWARE,INC.**

**CONSOLIDATEDBALANCE SHEETS**

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

 
| ** **                                                                                                                                                     | ** ** | **August 31, 2004** | ** ** | **February 29, 2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                     | ** ** | **(unaudited)**     | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                     |       |                |       |                  |       |
| Current assets:                                                                                                                                                |       |                |       |                  |       |
| Cash and cash equivalents                                                                                                                                      |       | $                   | 10,944     |                  | $          | 11,804 |   |
| Accounts receivable, net                                                                                                                                       |       | 1,210               |       | 1,462                 |       |
| Costs of deferred revenue and prepaid  licenses and services                                                                                                   |       | 261                 |       | 214                   |       |
| Other current assets                                                                                                                                           |       | 409                 |       | 317                   |       |
| Total current assets                                                                                                                                           |       | 12,824              |       | 13,797                |       |
| Cost of deferred revenue, less current  portion                                                                                                                |       | 71                  |       | 43                    |       |
| Property and equipment, net                                                                                                                                    |       | 897                 |       | 897                   |       |
| Other assets, less current portion                                                                                                                             |       | 48                  |       | 33                    |       |
| Total assets                                                                                                                                                   |       | $                   | 13,840     |                  | $          | 14,770 |   |
|                                                                                                                                                           |       |                |       |                  |       |
| **LIABILITIES, REDEEMABLE CONVERTIBLE  PREFERRED STOCK & STOCKHOLDERS’ EQUITY**                                                                       |       |                |       |                  |       |
| Current liabilities:                                                                                                                                           |       |                |       |                  |       |
| Notes payable                                                                                                                                                  |       | $                   | 1,162      |                  | $          | 1,034 |   |
| Accounts payable                                                                                                                                               |       | 534                 |       | 577                   |       |
| Accrued expenses                                                                                                                                               |       | 803                 |       | 928                   |       |
| Deferred revenue                                                                                                                                               |       | 2,060               |       | 2,035                 |       |
| Related party deferred revenue                                                                                                                                 |       | 10                  |       | 648                   |       |
| Total current liabilities                                                                                                                                      |       | 4,569               |       | 5,222                 |       |
| Deferred revenue, less current portion                                                                                                                         |       | 289                 |       | 295                   |       |
| Notes payable, less current portion                                                                                                                            |       | 264                 |       | 766                   |       |
| Total liabilities                                                                                                                                              |       | 5,122               |       | 6,283                 |       |
| Contingencies (Note 4)                                                                                                                                         |       |                |       |                  |       |
| Redeemable convertible preferred stock;  $0.0001 par value; 10,000 shares authorized:                                                                          |       |                |       |                  |       |
| Series A; 552 at August 31 and February 29,  2004 (aggregate liquidation preference of $1,000 at August 31 and February  29, 2004)                             |       | 897                 |       | 897                   |       |
| Total redeemable convertible preferred  stock                                                                                                                  |       | 897                 |       | 897                   |       |
| Stockholders’ equity:                                                                                                                                     |       |                |       |                  |       |
| Common stock; $0.0001 par value; 250,000  shares authorized; 60,302 and 59,504 shares issued and outstanding at August  31 and February 29, 2004, respectively |       | 6                   |       | 6                     |       |
| Additional paid-in-capital                                                                                                                                     |       | 163,038             |       | 162,043               |       |
| Accumulated deficit                                                                                                                                            |       | (155,223            | )          | (154,459              | )          |
| Total stockholders’ equity                                                                                                                                |       | 7,821               |       | 7,590                 |       |
| Total liabilities, redeemable convertible  preferred stock and stockholders’ equity                                                                       |       | $                   | 13,840     |                  | $          | 14,770 |   |

 

See notes to unauditedinterim consolidated financial information.

 

2

----

 

**INTRAWARE,INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                   | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **August 31, 2004**            | ** ** | **August 31, 2003**          | ** ** | **August 31, 2004** | ** ** | **August 31, 2003** | ** ** |
|                                         |       |                           |       |                         |       |   |   |   |   |
| Revenues:                                    |       |                           |       |                         |       |   |   |   |   |
| Online services and technology               |       | $                              | 1,900      |                         | $          | 1,520 |   | $ | 3,595 |   | $ | 3,240 |   |
| Alliance and reimbursement                   |       | 690                            |       | 802                          |       | 1,266 |   | 1,664 |   |
| Related party online services and technology |       | 4                              |       | 115                          |       | 538 |   | 232 |   |
| Software product sales                       |       | —                         |       | 88                           |       | 42 |   | 202 |   |
| Total revenues                               |       | 2,594                          |       | 2,525                        |       | 5,441 |   | 5,338 |   |
| Cost of revenues:                            |       |                           |       |                         |       |   |   |   |   |
| Online services and technology               |       | 699                            |       | 636                          |       | 1,266 |   | 1,259 |   |
| Alliance and reimbursement                   |       | 421                            |       | 422                          |       | 812 |   | 912 |   |
| Software product sales                       |       | —                         |       | 67                           |       | 37 |   | 167 |   |
| Total cost of revenues                       |       | 1,120                          |       | 1,125                        |       | 2,115 |   | 2,338 |   |
| Gross profit                                 |       | 1,474                          |       | 1,400                        |       | 3,326 |   | 3,000 |   |
| Operating expenses:                          |       |                           |       |                         |       |   |   |   |   |
| Sales and marketing                          |       | 822                            |       | 695                          |       | 1,574 |   | 1,464 |   |
| Product development                          |       | 409                            |       | 757                          |       | 812 |   | 1,676 |   |
| General and administrative                   |       | 902                            |       | 891                          |       | 1,691 |   | 1,657 |   |
| Total operating expenses                     |       | 2,133                          |       | 2,343                        |       | 4,077 |   | 4,797 |   |
| Loss from operations                         |       | (659                           | )          | (943                         | )          | (751 | ) | (1,797 | ) |
| Interest expense                             |       | (26                            | )          | (61                          | )          | (55 | ) | (130 | ) |
| Interest and other income and expenses, net  |       | 26                             |       | 12                           |       | 42 |   | 26 |   |
| Net loss                                     |       | $                              | (659       | )                            | $          | (992 | ) | $ | (764 | ) | $ | (1,901 | ) |
| Basic and diluted net loss per share         |       | $                              | (0.01      | )                            | $          | (0.02 | ) | $ | (0.01 | ) | $ | (0.04 | ) |
| Weighted average shares - basic and diluted  |       | 60,119                         |       | 53,526                       |       | 59,869 |   | 52,864 |   |

 

See notes to unauditedinterim consolidated financial information.

 

3

----

 

**INTRAWARE,INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                   | ** ** | **For the six months ended** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                   | ** ** | **August  31, 2004**         | ** ** | **August  31, 2003** | ** ** |
| Cash flows from operating activities:                                        |       |                         |       |   |   |
| Net loss                                                                     |       | $                            | (764       | ) | $ | (1,901 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                         |       |   |   |
| Depreciation and amortization                                                |       | 295                          |       | 1,219 |   |
| Amortization of unearned compensation                                        |       | —                       |       | 24 |   |
| Provision for doubtful accounts                                              |       | 3                            |       | 2 |   |
| Gain on sale of fixed assets                                                 |       | (2                           | )          | — |   |
| Amortization of discount on note payable                                     |       | 13                           |       | 5 |   |
| Changes in assets and liabilities:                                           |       |                         |       |   |   |
| Accounts receivable                                                          |       | 249                          |       | 359 |   |
| Costs of deferred revenue and prepaid licenses and services                  |       | (75                          | )          | (8 | ) |
| Other assets                                                                 |       | (107                         | )          | 4 |   |
| Accounts payable                                                             |       | (185                         | )          | (223 | ) |
| Accrued expenses                                                             |       | (125                         | )          | (166 | ) |
| Deferred revenue                                                             |       | 19                           |       | (230 | ) |
| Related party deferred revenue                                               |       | (638                         | )          | (250 | ) |
| Other obligations                                                            |       | —                       |       | 1 |   |
| Net cash used in operating activities                                        |       | (1,317                       | )          | (1,164 | ) |
| Cash flows from investing activities:                                        |       |                         |       |   |   |
| Purchases of property and equipment                                          |       | (153                         | )          | (189 | ) |
| Proceeds from sale of fixed assets                                           |       | 2                            |       | — |   |
| Net cash used in investment activities                                       |       | (151                         | )          | (189 | ) |
|                                                                         |       |                         |       |   |   |
| Cash flows from financing activities:                                        |       |                         |       |   |   |
| Principal payments on note payable                                           |       | (496                         | )          | — |   |
| Proceeds from notes payable                                                  |       | 109                          |       | 2,022 |   |
| Proceeds from common stock and warrants                                      |       | 995                          |       | 138 |   |
| Principal payments on capital lease obligations                              |       | —                       |       | (2,369 | ) |
| Net cash provided by (used in) financing activities                          |       | 608                          |       | (209 | ) |
| Net decrease in cash and cash equivalents                                    |       | (860                         | )          | (1,562 | ) |
| Cash and cash equivalents at beginning of the period                         |       | 11,804                       |       | 6,841 |   |
| Cash and cash equivalents at end of the period                               |       | $                            | 10,944     |   | $ | 5,279 |   |
|                                                                         |       |                         |       |   |   |
| Supplemental disclosure of cash flow information:                            |       |                         |       |   |   |
| Cash paid for interest                                                       |       | $                            | 43         |   | $ | 119 |   |
| Supplemental non-cash activity:                                              |       |                         |       |   |   |
| Common stock issued for preferred stock conversion                           |       | $                            | —     |   | $ | 1,379 |   |
| Purchases of property and equipment in accounts payable                      |       | $                            | 142        |   | $ | 129 |   |

 

See notes to unauditedinterim consolidated financial information. 

 

4

----

 

**INTRAWARE,INC.**

 

**NOTES TOUNAUDITED INTERIM CONSOLIDATED FINANCIAL INFORMATION**

 

**NOTE 1.BASIS OF PRESENTATION**

 

**INTRAWARE**

 

The accompanying unauditedinterim consolidated financial information has been prepared pursuant to therules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted pursuant tothese rules and regulations.  However, management believes that thedisclosures are adequate to ensure the information presented is notmisleading.  The balance sheet at February 29, 2004, has been derivedfrom the audited financial statements, but does not include all disclosuresrequired by generally accepted accounting principles.  This unauditedinterim consolidated financial information should be read in conjunction withthe audited consolidated financial statements and notes thereto included in ourannual report on Form 10-K for the fiscal year ended February 29, 2004,filed with the SEC on May 5, 2004. 

 

In the opinion ofmanagement, all adjustments, consisting only of normal recurring items,considered necessary for a fair statement have been included in theaccompanying unaudited interim consolidated financial information.  Theresults of operations for the interim periods presented are not necessarilyindicative of the operating results to be expected for any subsequent interimperiod or for the fiscal year ending February 28, 2005.

 

We have incurred losses andnegative cash flow from operations during each fiscal year since inception. Forthe six months ended August 31, 2004, we reduced our net loss to approximately$0.8 million and negative cash flows to approximately $0.9 million. Our cashbalances may decline further, although we believe that the effects of ourcapital financing, strategic actions implemented to improve revenue, and costcontrols will be adequate to generate sufficient cash resources to fund ourfuture operations.  If we fail to generate sufficient revenues oradequately control spending, we may be unable to achieve key businessobjectives.

 

**NOTE 2.SIGNIFICANT ACCOUNTING POLICIES**

 

**Revenuerecognition**

 

We derive online servicesand technology revenues primarily from our SubscribeNet electronic softwaredelivery and management (ESDM) service, and from related professional services.Through our fiscal year ended February 28, 2003, we also derived onlineservices and technology revenue from the sale of proprietary software licensesand related maintenance, primarily for our asset management software. We mayrecognize future revenues from any sale of licenses and maintenance for ourproprietary software underlying our SubscribeNet service.

 

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

 

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

 

5

----

 

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

 

We recognize revenue whenall of the following conditions are met: 

 

•                  There is persuasive evidence of anarrangement; 

 

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

 

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

 

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

 

When we directly resoldthird-party software license and maintenance, or sold our proprietary assetmanagement software licenses and maintenance, we obtained vendor-specificobjective evidence of fair value for the maintenance element of the resold andproprietary software arrangements based on historical and contractual renewalrates for maintenance.  In such cases, we deferred the maintenance revenueat the outset of the arrangement and recognized it ratably over the periodduring which the maintenance was to be provided (generally 12 months), whichnormally commenced on the date the software was delivered.

 

**Stock-BasedCompensation**

 

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

 

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

 

6

----

 
| ** **                                                                                                             | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                             | ** ** | **August 31, 2004**            | ** ** | **August 31, 2003**          | ** ** | **August 31, 2004** | ** ** | **August 31, 2003** | ** ** |
| Net loss                                                                                                               |       | $                              | (659       | )                            | $          | (992 | ) | $ | (764 | ) | $ | (1,901 | ) |
| Add:  Stock-based compensation expense included  in reported net loss                                             |       | —                         |       | 12                           |       | — |   | 24 |   |
| Deduct:  Total stock-based employee compensation  expense determined under fair value based method for all awards |       | (821                           | )          | (913                         | )          | (1,619 | ) | (1,914 | ) |
| Pro forma                                                                                                              |       | $                              | (1,480     | )                            | $          | (1,893 | ) | $ | (2,383 | ) | $ | (3,791 | ) |
| Net loss per share — basic and diluted                                                                            |       |                           |       |                         |       |   |   |   |   |
| As reported                                                                                                            |       | $                              | (0.01      | )                            | $          | (0.02 | ) | $ | (0.01 | ) | $ | (0.04 | ) |
| Pro forma                                                                                                              |       | $                              | (0.02      | )                            | $          | (0.04 | ) | $ | (0.04 | ) | $ | (0.07 | ) |

 

We calculated the fair valueof each option grant on the date of grant, using the Black-Scholes optionpricing model as prescribed by SFAS No. 123 using the following assumptions:

 
| ** **                | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|---------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                | ** ** | **August 31, 2004**            | ** ** | **August 31, 2003**          | ** ** | **August 31, 2004** | ** ** | **August 31, 2003** | ** ** |
| Risk-free interest rates  |       | 2.00-3.93                      | %          | 1.51-3.37                    | %          | 2.00-3.93 | % | 1.51-3.37 | % |
| Expected lives (in years) |       | 4                              |       | 4                            |       | 4 |   | 4 |   |
| Dividend yield            |       | 0                              | %          | 0                            | %          | 0 | % | 0 | % |
| Expected volatility       |       | 115                            | %          | 137                          | %          | 115 | % | 137 | % |

 

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

 

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

 

**Net LossPer Share**

 

Basic net loss per commonshare is computed by dividing the net loss attributable to common stockholdersfor the period by the weighted average number of common shares outstandingduring the period, excluding shares subject to repurchase. If dilutive, anyparticipation right of redeemable convertible preferred stock is reflected inthe calculation of basic income per share using the two-class method. Dilutednet loss per share is computed by dividing the net loss attributable to commonstockholders for the period by the weighted average number of common andpotential common 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. 

 

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

 

7

----

 
| ** **                             | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **August 31, 2004**            | ** ** | **August 31, 2003**          | ** ** | **August 31, 2004** | ** ** | **August 31, 2003** | ** ** |
|                                   |       |                           |       |                         |       |   |   |   |   |
| Numerator:                             |       |                           |       |                         |       |   |   |   |   |
| Net loss                               |       | $                              | (659       | )                            | $          | (992 | ) | $ | (764 | ) | $ | (1,901 | ) |
|                                   |       |                           |       |                         |       |   |   |   |   |
| Denominator:                           |       |                           |       |                         |       |   |   |   |   |
| Weighted average shares                |       | 60,119                         |       | 53,526                       |       | 59,869 |   | 52,864 |   |
|                                   |       |                           |       |                         |       |   |   |   |   |
| Basic and diluted net loss per share   |       | $                              | (0.01      | )                            | $          | (0.02 | ) | $ | (0.01 | ) | $ | (0.04 | ) |
|                                   |       |                           |       |                         |       |   |   |   |   |
| Effect of antidilutive securities:     |       |                           |       |                         |       |   |   |   |   |
| Redeemable convertible preferred stock |       | 552                            |       | 689                          |       | 552 |   | 689 |   |
| Warrants to purchase common stock      |       | 1,869                          |       | 2,229                        |       | 1,869 |   | 2,229 |   |
| Employee stock options                 |       | 11,239                         |       | 10,195                       |       | 11,239 |   | 10,195 |   |
|                                   |       | 13,660                         |       | 13,113                       |       | 13,660 |   | 13,113 |   |

 

Ouroutstanding redeemable convertible preferred stock is a participating securityaccounted for under the two-class method for earnings per share purposes.  However, because we have reported a net loss,there is no impact to the basic and diluted loss per share calculation.

 

**RecentAccounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidationof Variable Interest Entities (“VIE”), an Interpretation of ARB No. 51” (“FIN46”) and in December 2003, issued a revised interpretation (“FIN 46-R”).FIN No. 46, as revised, requires certain VIEs to be consolidated by theprimary beneficiary of the entity if the equity investors in the entity do nothave the characteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties. The provisions of FIN 46-Rare effective immediately for all arrangements entered into afterJanuary 31, 2003. For arrangements entered into prior to February 1,2003, we were required to adopt the provisions of FIN 46-R in the first quarterof our fiscal year 2005. The adoption of FIN 46-R did not have asignificant effect on our financial position or results of operations. 

 

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

 

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

 

8

----

 

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

 

During the six months endedAugust 31, 2004, our stockholders’ equity changed as follows (in thousands): 

 
| ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Stockholders’  Equity** | ** ** | **Comprehensive  Loss** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|----------------------------------|------------|--------------------------|------------|--------------------------------|------------|-------------------------|------------|
| **Common Stock**                                              |
| **Shares**                                                    | ** ** | **Amount** |
|                                                          |       |       |       |       |       |                             |       |                     |       |                           |       |                    |       |
| Balance at February 29, 2004                                  |       | 59,504     |       | $          | 6          |                             | $          | 162,043                  |       | $                              | (154,459   | )                       | $          | 7,590 |   |   |   |
| Exercise of stock options                                     |       | 365        |       | —     |       | 374                              |       | —                   |       | 374                            |       |                    |       |
| Issuance of common stock for employee stock  purchase program |       | 86         |       | —     |       | 130                              |       | —                   |       | 130                            |       |                    |       |
| Conversions of warrants into common stock                     |       | 347        |       | —     |       | 491                              |       | —                   |       | 491                            |       |                    |       |
| Net loss                                                      |       | —     |       | —     |       | —                           |       | (764                     | )          | (764                           | )          | $                       | (764       | ) |
| Other comprehensive loss                                      |       | —     |       | —     |       | —                           |       | —                   |       | —                         |       | —                  |       |
| Comprehensive loss                                            |       | —     |       | —     |       | —                           |       | —                   |       | —                         |       | $                       | (764       | ) |
| Balance at August 31, 2004                                    |       | 60,302     |       | $          | 6          |                             | $          | 163,038                  |       | $                              | (155,223   | )                       | $          | 7,821 |   |   |   |

 

**NOTE 4. CONTINGENCIES **

 

**Indemnifications**

 

In the course of our business, we have given indemnities and madecommitments and guarantees under which we may be required to make payments.These indemnities include: 

 

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

 

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

 

•                  *Indemnities to PrivateInvestors.*In our privateplacements of stock, we have made representations and warranties to theinvestors and placement agents, and have agreed to indemnify them for anydamages and costs they incur as a result of our breach of those representationsand warranties. We also have signed registration rights agreements with privateinvestors under which we indemnify them for damages they incur as a result ofany material misstatements or omissions in our registration statements, and paypenalties in the event we fail to maintain the effectiveness of registrationstatements. The duration of our indemnities to our investors under therespective stock and warrant purchase agreements ranges from one to two yearsfrom the respective closing dates, other than the purchase agreements for ourJune 2000 warrants and our January 2001 Series A Preferred Stockand warrants, which provide for indemnities of unlimited duration. Ourindemnities to our investors under the respective registration rightsagreements expire upon termination of our registration obligations, which istypically the date the securities may be sold under Rule 144(k) under theSecurities Act of 1933. Our potential payments under these indemnities areunlimited. 

 

9

----

 

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

 

Wehave historically received only a very limited number of requests forindemnification under these agreements and have not been required to makematerial payments under them. Accordingly, we have not recorded a liabilityrelated to these indemnification provisions. 

 

**LegalProceedings**

** **

*In re Intraware, Inc. Inital 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 In re Intraware, Inc. InitialPublic Offering Securities Litigation, Civ. No. 01-9349 (SAS) (S.D.N.Y.),related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS)(S.D.N.Y.). The amended complaint is brought purportedly on behalf of allpersons who purchased our common stock from February 25, 1999 (the date ofour initial public offering) through December 6, 2000. It names asdefendants Intraware, three of our present and former officers and directors,and several investment banking firms that served as underwriters of our initialpublic offering. The complaint alleges liability under Sections 11 and 15 ofthe Securities Act of 1933 and Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934, on the grounds that the registration statement for theofferings did not disclose that: (1) the underwriters had agreed to allowcertain customers to purchase shares in the offerings in exchange for excesscommissions paid to the underwriters; and (2) the underwriters hadarranged for certain customers to purchase additional shares in the aftermarketat predetermined prices. The amended complaint also alleges that theunderwriters misused their securities analysts to manipulate the price of ourstock. No specific damages are claimed. 

 

Lawsuits containing similarallegations have been filed in the Southern District of New York challengingover 300 other initial public offerings and secondary offerings conducted in1999 and 2000. All of these lawsuits have been consolidated for pretrialpurposes before United States District Court Judge Shira Scheindlin of theSouthern District of New York. On July 15, 2002, an omnibus motion todismiss was filed in the coordinated litigation on behalf of the issuerdefendants, of which Intraware and its three named current and former officersand directors are a part, on common pleadings issues. On or aboutOctober 9, 2002, the Court entered and ordered a Stipulation of Dismissal,which dismissed the three named current and former officers and directors fromthe litigation without prejudice. On February 19, 2003, the Court enteredan order denying in part the issuer defendants’ omnibus motion to dismiss,including those portions of the motion to dismiss relating to Intraware. Nodiscovery has been served on us to date. 

 

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

 

The memorandum ofunderstanding provides that, in exchange for a release of claims against thesettling issuer-defendants, the insurers of all of the settlingissuer-defendants will provide a surety undertaking to guarantee plaintiffs a$1 billion recovery from the non-settling defendants, including theunderwriter-defendants. The ultimate amount, if any, that may be paid on behalfof Intraware will therefore depend on the final terms of the settlementagreement, including the number of issuer-defendants that ultimately approvethe final settlement agreement, and the amounts, if any, recovered by theplaintiffs from the underwriter-defendants and other non-settling defendants.If all or substantially all of the issuer-defendants approve the finalsettlement agreement, the amount our insurers would be required to pay to theplaintiffs could range from zero to approximately $3.5 million, dependingon plaintiffs’ recovery from the underwriter-defendants and from othernon-settling parties. If the plaintiffs recover at least $1 billion fromthe underwriter-defendants, our insurers would have no liability for settlementpayments under

 

10

----

 

theproposed terms of the settlement. If the plaintiffs recover less than$1 billion, we believe our insurance will likely cover our share of anypayments towards satisfying plaintiffs’ $1 billion recovery deficit. Management estimates that its range of loss relative to this matter is zero to$3.5 million. Presently there is no more likely point estimate of losswithin this range. As a consequence of the uncertainties described aboveregarding the amount we will ultimately be required to pay, if any, as of August31, 2004, we have not accrued a liability for this matter. 

 

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

* *

In July 2004, a complaintwas filed in the United States District Court for the District of Delaware,Civ. No. 04-822, against ComVest Venture Partners, LP; ComVest Management,LLC; Commonwealth Associates Management Company, Inc.; Commonwealth Associates,LP; RMC Capital, LLC; Michael S. Falk; Robert Priddy; Travis L. Provow; KeithRosenbloom; and Intraware. The complaint describes Intraware as a nominaldefendant. The complaint alleges that, between August 2001 and January 2002,all of the defendants other than Intraware were members of a group, andtherefore should be treated as a single “person,” for purposes of Sections13(d)(3) and 16(b) of the Securities Exchange Act of 1934 (the “1934 Act”). The complaint further alleges that ComVest Venture Partners, LP andMr. Priddy, while they and the other alleged group members collectivelyowned more than 10% of a class of our equity securities, bought and sold ourequity securities within a 6-month period and failed to disgorge to us theprofits allegedly realized in those trades, thereby violatingSection 16(b) of the 1934 Act.  Mr. Falk was a member of our Board ofDirectors from April 2001 to May 2002 and Mr. Provow was a member of our Boardof Directors from October 2001 to May 2002.  The complaint demands thatComVest Venture Partners, LP and Mr. Priddy pay over to Intraware theprofits they allegedly realized and retained in violation of Section 16(b)of the 1934 Act, together with interest and legal costs. According to thecompliant, the amount of those alleged profits is unknown to the plaintiff,however, the information alleged in the complaint suggests that amount may beapproximately $1.3 million. The complaint does not seek damages againstus.  After the complaint was filed, the plaintiff and Intraware signed astipulation acknowledging that Intraware takes no position with respect to theclaims in the action, and providing that Intraware accepts service of thecomplaint, that Intraware is not required to file an answer or other responseto the complaint, and that Intraware will otherwise have the rights andresponsibilities of a party to the action. 

 

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

 

**NOTE5.  REDEEMABLE CONVERTIBLE PREFERRED STOCK**

 

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

 

During the six months endedAugust 31, 2004 there was no activity in our redeemable convertible preferredstock. 

 

**NOTE6.  NOTES PAYABLE**

 

In August 2003, we issueda note payable to a bank for proceeds of approximately $2.0 million.  Thenote bears an annual interest rate of the greater of 1% in excess of the bank’sprime rate (4.50% at August 31, 2004) or 5.25%.  The interest rate on thenote payable at August 31, 2004, was 5.50%.  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 41,730shares of our common stock at an exercise price of $1.19 per share.  Thewarrant was immediately exercisable and expires in August 2010.  Weestimated the allocated fair value of such warrant at approximately $46,000,using the Black-Scholes valuation model with the following assumptions: expectedvolatility of 136%, risk-free interest rate of 4.01%, expected life of sevenyears and no dividends.  The value of the warrant was recorded as a debtdiscount and is being amortized as interest expense using the effectiveinterest method over the life of the note payable.  For the six monthsended August 31, 2004, interest expense related to such warrant amounted toapproximately $13,000.  The unamortized balance of approximately $11,000at August

 

11

----

 

31,2004, is presented as a discount against the principal balance of the notepayable outstanding.  At August 31, 2004, the warrants had not beenexercised. 

 

In August 2003, we alsoentered into a line of credit with the same bank. The line of credit bearsannual interest at the greater of the bank’s prime rate plus 1% or 5.50%. The agreement provided for borrowings of up to $500,000 throughAugust 2004 and was limited to equipment purchases.  As of August 31,2004, we had borrowed approximately $363,000 under this agreement and theinterest rate at that date was 5.50%.  Monthly payments of interest onlywere payable through August 1, 2004, after which fixed monthly principalinstallments plus interest will be made through August 2006. 

 

In September 2004, weentered into another line of credit with the same bank.  This new line of credit bears annual interestat the greater of 5.50% or the bank’s prime rate plus 1.00%.  This line ofcredit allows us to borrow up to $500,000 through August 1, 2005, solelyto finance equipment purchases. Monthly payments of interest only arepayable through August 2005, after which fixed monthly principalinstallments plus interest will be made through August 2007. 

 

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

 

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

 

| **Years  ending:** | ** ** | ** ** | ** ** |
|--------------------|------------|------------|------------|
| February 28, 2005  |       | $          | 586        |   |
| February 28, 2006  |       | 760        |       |
| February 28, 2007  |       | 91         |       |
|               |       | $          | 1,437      |   |

 

**NOTE 7.ALLIANCES**

 

**Provisionof Sales and Marketing Services to Software Spectrum for Resale of Third-PartySoftware**

 

Prior to June 2001, weresold Sun Microsystems, Inc. Internet-related application software (marketedunder the brands “Sun/Netscape Alliance” and “iPlanet”) and related maintenanceservices to end-users in North America under an agreement between us andSun.  In June 2001, we signed an agreementwith Software Spectrum under which we transferred to Software Spectrum our Sunsoftware resale business, including our agreement with Sun for resale of Sunsoftware and maintenance services.  Software Spectrum assumed primaryresponsibility for resale of Sun software and related maintenance under itsagreement with Sun (which has since been replaced by an agreement betweenSoftware Spectrum and Sun’s distributor).  We continue to assist SoftwareSpectrum in its sales and marketing of the Sun software currently marketedunder the brands “Sun ONE” and “Java Enterprise System,” as well as relatedmaintenance, and also provide our SubscribeNet service to Software Spectrum toenable it to deliver that Sun software to its customers electronically. As partof this arrangement, Software Spectrum pays us a percentage of the gross profitderived from its sales of Sun software licenses and maintenance services, andreimburses us for our cost in maintaining a team dedicated to sales of Sunsoftware licenses and maintenance (included in the Alliance and reimbursementrevenue line item on our consolidated statements of operations).  The June2001 agreement with Software Spectrum was part of our transition out of thebusiness of generally reselling third-party software. At the time we announcedthis agreement, we also ceased reselling all third-party software except alimited number of products that were complementary to our SubscribeNetservice.   

 

In December 2003 and August2004, we amended our June 2001 agreement with Software Spectrum to add Websensesoftware and Novell Linux software, respectively, to the set of products thatSoftware Spectrum and Intraware jointly resell under that agreement. Underthese arrangements, Software Spectrum pays us a percentage of the gross profitderived from our joint sales of Websense and Novell Linux software licenses andmaintenance services (included in the Alliance and reimbursement revenue lineitem on our consolidated statements of operations). 

 

12

----

 

The current term of thisagreement with Software Spectrum runs until June 30, 2005.  Either partymay terminate the agreement without cause on 90 days’ prior writtennotice.  Any termination of ourrelationship with Software Spectrum without an adequate replacement would causea substantial and immediate decrease in our revenues.

 

**Resale ofSubscribeNet Service by Zomax Incorporated**

 

On August 12, 2002, weentered into a strategic alliance agreement (the “Strategic Alliance Agreement”)with Zomax Incorporated (“Zomax”), an international outsource provider ofprocess management services.  The Strategic Alliance Agreement providedfor Zomax’ marketing and resale of our SubscribeNet ESDM service to its globalcustomer base.  Under the Strategic Alliance Agreement, Zomax was requiredto pay a minimum license fee totaling $15 million to us over 10 years, subjectto some conditions, including Zomax’ right to cancel the agreement at any timewith one year’s notice.  The annual minimum license fee was based on agraduated scale, beginning with $0.5 million in the first year of the agreementand escalating to $2.2 million in the final year of the agreement.  Theagreement also provided for Zomax’ payment to us of non-refundable quarterlyservice fees, based on sales of the SubscribeNet service by Zomax, over theterm of the agreement.  Under the agreement, our SubscribeNet service wasthe only ESDM solution Zomax was permitted to sell and Zomax was the onlysupply chain management outsourcing industry company we could authorize toresell our SubscribeNet service.  In accordance with the agreement, Zomaxmade a $1 million prepayment to us on September 3, 2002, to be applied againstfuture fees.  The Strategic Alliance Agreement also provided for Zomax’payment to us of fees for any referrals by us to Zomax of potential customersfor Zomax’ services which resulted in completed sales.  Lastly, wereimbursed Zomax for one-half of the base salary of a product sales manager, upto a maximum amount.  

 

On the day we entered intothe Strategic Alliance Agreement, we also completed a private placement ofapproximately 6.1 million shares of our common stock to Zomax for grossproceeds of approximately $5.0 million.  Upon completion of that privateplacement, Zomax held approximately 12% of our outstanding common stock. On September 18, 2003, we filed an amended registration statement toregister the resale of the common stock issued to Zomax.  The SEC declaredthat registration statement effective on September 25, 2003. 

 

On August 29, 2003,Intraware and Zomax amended the Strategic Alliance Agreement to: (1) allowZomax to terminate the agreement as of August 12, 2004, or as of any datethereafter, with or without cause, by delivery of 30 days prior written notice;(2) accelerate the due date of the payment of $0.4 million by Zomax to us forthe second year of the agreement; and (3) reduce the minimum license fee forthe third year of the agreement, which was to begin August 12, 2004, from$1.0 million to $0.6 million if Zomax had not terminated the agreement beforethen.  During the three months ended November 30, 2003, and inaccordance with that amendment, we received $0.4 million from Zomax, all ofwhich was recorded as deferred revenue at February 29, 2004, and was to beapplied to future services. 

 

On April 30, 2004,Zomax and Intraware mutually terminated the Strategic Alliance Agreement andentered into a new reseller agreement (the “Zomax Reseller Agreement”). TheZomax Reseller Agreement allows Zomax to resell our SubscribeNet service. Zomaxwill pay us fees, to be determined on a case-by-case basis, for each resale ofthe SubscribeNet service.  Under theZomax Reseller Agreement, Zomax will no longer pay minimum annual license feesto us. The term of the Zomax Reseller Agreement is one year, subject toautomatic annual renewal for one-year periods. Each party has the right toterminate the Zomax Reseller Agreement without cause upon 60 days’ notice.

 

As part of the terminationof the Strategic Alliance Agreement, Zomax and Intraware will no longer besubject to exclusivity requirements or restrictions on sales to othercompanies. In addition, in consideration for Zomax’ termination of theStrategic Alliance Agreement, we refunded approximately $0.1 million of the$0.4 million prepayment for future services paid by Zomax to us during thethree months ended November 30, 2003.  The remaining deferred revenuebalance of approximately $0.4 million at April 30, 2004, was recognized asrevenue during the three months ended May 31, 2004, given that we no longer hadany obligations under the Strategic Alliance Agreement. 

 

13

----

 

**Resale ofSubscribeNet Service by Hewlett-Packard Company**

 

In September 2004, weentered into an agreement with Hewlett-Packard Company (“HP”) for its resale ofour SubscribeNet service through HP’s Software Publisher Services division (the“HP Reseller Agreement”).  Under the HPReseller Agreement, HP will pay us service fees based on its resales of theSubscribeNet service.  The term of the HPReseller Agreement is one year, subject to automatic annual renewal forone-year periods. Each party has the right to terminate the HP ResellerAgreement without cause upon 120 days’ notice. 

 

14

----

 

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussion ofour financial condition and results of operations should be read in conjunctionwith our consolidated financial statements and related notes included in ourannual report on Form 10-K for the fiscal year ended February 29, 2004,which was filed with the Securities and Exchange Commission (“SEC”) on May 5,2004.  This discussion contains forward-looking statements that involverisks and uncertainties. Forward-looking statements include statementsregarding our future cash and liquidity position, the extent and timing offuture revenues and expenses and customer demand, the deployment of our productsand services, and our reliance on third parties.  All forward-lookingstatements included in this document are based on information available to usas of the date hereof, and we assume no obligation to update anyforward-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. 

 

**INTRAWAREOVERVIEW**

 

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

 

We currently see a number oftrends in the marketplace that are potentially important for our business.First, after signs of improvement earlier in the year, growth in themacroeconomy and the technology sector seem to have become less certain inrecent months, apparently due in part to concerns about geopolitical issues andpotential terrorist attacks.  In thecurrent climate, spending by technology companies is cautious. Second, in thepast year there have been a number of mergers and acquisitions in theenterprise software sector. These consolidations pose both opportunities andrisks for us, potentially leading either to growth in our contracts with thosecustomers or to cancellation of customer contracts. Third, technology companiesare increasingly outsourcing operational functions to reduce costs. Ourservices enable enterprise software companies to outsource key operationalfunctions in a manner that we believe is financially compelling. Therefore, wemay benefit from this outsourcing trend. Fourth, the use of hosted web-basedapplications, which in the past has been limited by concerns about speed,reliability and security, is now becoming more accepted among mainstreambusinesses, largely because of a desire for cost savings. This trend maybenefit us because our SubscribeNet service is a hosted web-based application. 

 

Our management is focused onfour key opportunities. The first is what appears to be growing demand forelectronic delivery and management of enterprise software applications. Thesecond opportunity is to further penetrate the enterprise software providermarket by better integrating and cross-selling our suite of services, includingour SubscribeNet digital delivery service, our outsourced sales and marketingservices, and the digital rights management and desktop update management anddeployment services that we provide through strategic alliances. The thirdopportunity is to continue expanding into vertical markets other thanenterprise software, and into other untapped markets. The fourth is to continueforging alliances with adjacent technology providers to build our marketposition and develop new revenue streams. 

 

We also face a number of keyrisks, which are described in the “Risk Factors” beginning on page 26 below. 

 

We earn revenues andgenerate cash principally through recurring service fees charged for ourSubscribeNet service, professional services fees charged for customization ofour SubscribeNet service, and profit-sharing and cost reimbursement receivedfor our sales and marketing services. Historically, we have also raisedsubstantial amounts of cash through private stock placements. 

 

Despite our revenue- andcash-generating activities, we have incurred losses and negative cash flows fromoperations during each fiscal year since inception. For the six months endedAugust 31, 2004, our net loss was

 

15

----

 

approximately$0.8 million and we had negative cash flows from operations of approximately $1.3million.  Our cash balances may declinefurther, although we believe that the effects of our capital financing,strategic actions implemented to improve revenue, and cost controls will beadequate to generate sufficient cash resources to fund our futureoperations.  If we fail to generate sufficient revenues or adequatelycontrol spending, we may be unable to achieve key business objectives. 

 

**CriticalAccounting Policies and Estimates**

 

This MD&A discusses ourunaudited interim consolidated financial information, which has been preparedin accordance with generally accepted accounting principles in the UnitedStates of America. In preparing this financial information, we are required tomake estimates and assumptions affecting the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the financial information and the reported amounts of revenues and expensesduring the reporting period. On an ongoing basis, we evaluate our estimates andjudgments. We base our estimates and judgments on historical experience and onvarious other factors believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities not readily apparent from other sources. Actualresults may differ from these estimates under different assumptions orconditions. 

 

We consider accountingpolicies related to revenue recognition, costs of deferred revenue, stock-basedcompensation, allowance for doubtful accounts, goodwill and intangibles, andincome taxes to be critical accounting policies due to the estimation processinvolved in each. 

 

*RevenueRecognition*

 

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

 

Alliance and reimbursementrevenue primarily relates to our alliance agreement with Software Spectrum forsales and marketing services. This revenue consists of a percentage of thegross profit derived from Software Spectrum’s sales of the third-party softwareand maintenance for which we provide sales and marketing services, andreimbursement 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. 

 

We derive software productrevenues from our past resales of licenses and maintenance for multiplebusiness software product lines. As of July 1, 2001, we generally nolonger resell third party software licenses and maintenance, though we stillresell licenses for third party products complementary to our SubscribeNetservice. Since July 1, 2001, we have continued to recognize revenue from ourresale of third party software licenses and related maintenance contracts overthe life of the arrangements made prior to July 1, 2001. Vendor specificobjective evidence of fair value for the maintenance element of the resoldsoftware arrangements has been based on historical and contractual renewalrates for maintenance. We have deferred the maintenance revenue at the outsetof the arrangement and recognized it ratably over the period during which themaintenance was to be provided.  Thisperiod normally commenced on the date the software was delivered and generallycontinued for 12 months, although certain maintenance contracts continued forlonger periods.  At August 31, 2004, wedid not have any deferred revenue relating to software product revenues. 

 

16

----

 

We defer online services andtechnology revenues related to our SubscribeNet ESDM service and generallyrecognize them ratably over the term of the service arrangement. SomeSubscribeNet service implementations for new customers involve customizationessential to the functionality of the service.  In those cases, we deferrevenue recognition until the service go-live date is reached and recognize therevenue on a ratable basis over the remaining contract term.  The go-livedate is the later of the date on which the essential functionality isdelivered, the date on which the website through which the service is providedenters the production environment, or the point at which no additionalcustomization is required.  Our SubscribeNet contracts with customerstypically give the customer a period of time (generally five days) to evaluatea SubscribeNet implementation after we have completed it, and provide that thecustomer is deemed to have accepted the implementation if it has notaffirmatively rejected it within that period.  We typically rely on suchnon-rejections by customers to indicate their acceptance ofimplementations.  Any subsequent indications by our customers that theirimplementations have not been properly completed could have a material adverseimpact on our financial condition or results of operations. 

 

When we sell additionalprofessional services related to a SubscribeNet agreement, we defer recognitionof that revenue until the go-live date for the professional services, similarto the manner in which we treat SubscribeNet service revenues as discussedabove.  Such professional services revenues are recognized ratably overthe longer of the remaining estimated customer life or the remaining contractterm, commencing with the completion of the professional services. Estimatedcustomer life requires that we periodically estimate the projected life of ourexisting customers, based on historical information, such as customer renewalrates. Since revenues generated from additional professional services representless than 6% of our overall revenues for the year ended February 29, 2004,any change to our estimated customer life is unlikely to have a materialadverse impact on our financial condition or results of operations. 

 

We recognize revenue whenall of the following conditions are met: 

 

•                  There is persuasive evidence of anarrangement; 

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

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

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

 

Revenue from transactionsthrough authorized resellers has been recognized when the licenses andmaintenance have been resold or utilized by the reseller or when our relatedobligations have been satisfied. Those transactions primarily consisted ofresales, through our authorized resellers, of our proprietary Asset Managementsoftware licenses and maintenance (we sold our Asset Management softwarebusiness to Computer Associates International, Inc during our fiscal year endedFebruary 28, 2003).  For those transactions, we based vendor specificobjective evidence of fair value for the maintenance element of the proprietarysoftware arrangements on historical and contractual renewal rates for maintenance.We deferred the maintenance revenue at the outset of the arrangement andrecognized it ratably over the period during which the maintenance was to beprovided (generally 12 months), which normally commenced on the date thesoftware was delivered. 

 

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

 

*Costs ofDeferred Revenue*

 

We capitalize direct costsof revenues related to significant implementation and professional servicescontracts associated with our SubscribeNet services.  Direct costs includecompensation and payroll-related fringe benefits directly related to the timespent on significant implementation and professional services activities.  These costs are recognized over the same termas the associated revenue from those contracts (see “Revenue Recognition”above). Any change in our revenue recognition estimates could result incorresponding changes to our recognition of costs of deferred revenues. AtAugust 31, 2004, we had approximately $0.3 million in capitalized costs ofdeferred revenues.  We expense customer acquisition costs, including salescommissions, as incurred. 

 

17

----

 

*Stock-basedCompensation*

 

Weaccount for stock-based compensation for our employees using the intrinsicvalue method presented in Accounting Principles Board (APB) No. 25, ”Accountingfor Stock Issued to Employees,” and related interpretations, and comply withthe disclosure provisions of Statement of Financial Accounting Standard (SFAS)No. 123, ”Accounting for Stock-Based Compensation,” and with thedisclosure provisions of SFAS No. 148, ”Accounting for Stock-BasedCompensation—Transition and Disclosure Amendment of SFAS No. 123.” Under APBNo. 25, compensation expense is based on the difference, as of the date of thegrant, between the fair value of our stock and the exercise price. For ourfiscal quarter ended August 31, 2004, no stock-based compensation was recordedfor stock options granted to our employees because the exercise price of allstock options granted to our employees was equal to the market price of theunderlying stock on the date of grant. 

 

OnMarch 31, 2004, the Financial Accounting Standards Board (FASB) issued anexposure draft on a proposed standard for the accounting of stock options. Theproposed standard requires companies to value employee stock options and stockissued under employee stock purchase plans using the fair value based method onthe grant date and record stock-based compensation expense. The fair valuebased models that companies are allowed to use could be different from theBlack-Scholes option-pricing model, which we currently use to calculate the proforma effect on net income and earnings per share if we had applied SFAS No.123 to employee option grants. Note 1 to our unaudited interim consolidatedfinancial information shows what the pro forma net loss and loss per share forthe three months ended August 31, 2004 and 2003 would have been if we hadapplied SFAS No. 123.  However, the actualimpact to our results of operations upon adoption of the proposed standardcould materially differ from the pro forma information included in Note 1 toour unaudited interim consolidated financial information due to differences inthe option-pricing model used, estimates and assumptions required, and optionsto be included in the calculation upon adoption. The fair value based modelsrequire the input of highly subjective assumptions and do not necessarilyprovide a reliable single measure of the fair value of our stock options. Weclosely monitor the status of this proposed standard and will evaluate theimpact to our financial position and results of operations when the finalstandard is issued. 

 

*Allowancefor Doubtful Accounts*

 

We maintain an allowance fordoubtful accounts for estimated losses from our inability to collect requiredpayments from our customers. When evaluating the adequacy of this allowance, weanalyze specific accounts receivable, historical bad debts, customercredit-worthiness, current economic trends and changes in our customer paymenthistory.  We may need to record increases to our allowance balances in thefuture.  At August 31, 2004, we have many accounts receivable balances andone large unbilled receivable balance.  Any dispute, early contract terminationor other collection issue related to these receivable balances could have amaterial adverse impact on our financial condition or result of operations. AtAugust 31, 2004, our unbilled receivable balance was $0.2 million. Thisbalance relates to our Software Spectrum agreement (see “Revenue Recognition”above). There are no allowances for doubtful accounts related to this balance.This estimate 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. 

 

*Goodwilland Intangibles*

 

We are required to regularlyreview all of our long-lived assets, including goodwill and other intangibleassets, for impairment whenever events or changes in circumstances indicatethat the carrying value may not be recoverable.  We review goodwillbalances for impairment at least once annually.  Factors we considerimportant which could trigger an impairment review include, but are not limitedto, significant underperformance relative to historical or projected futureoperating results, significant changes in the manner of use of the acquiredassets or the strategy for our overall business, significant negative industryor economic trends, a significant decline in our stock price for a sustainedperiod, and our market capitalization relative to net book value. When wedetermine that an impairment review for intangible and long-lived assets isnecessary based upon the existence of one or more of the above indicators ofimpairment, we compare the book value of such assets to the future undiscountedcash flows attributable to those assets. If the book value is greater than thefuture undiscounted cash flows, we measure any impairment based on a projecteddiscounted cash flow method using a discount rate commensurate with the riskinherent in our current business model. When we determine an impairment reviewof goodwill is necessary based on

 

18

----

 

animpairment indicator or based on our annual testing requirements, we comparethe fair value of the reporting unit to the carrying value of the reportingunit. If the carrying value of the reporting unit is greater than the fairvalue of the reporting unit, an impairment may be necessary. Significantjudgment is required in the development of projected cash flows for thesepurposes, including assumptions regarding the appropriate level of aggregationof cash flows, their term and discount rate as well as the underlying forecastsof expected future revenue and expense. 

 

*IncomeTaxes*

 

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

 

**Results ofOperations**

 

*TotalRevenue*

 

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

 
| ** **                                   | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **August 31, 2004**            | ** ** | **August 31, 2003**          | ** ** | **August 31, 2004** | ** ** | **August 31, 2003** | ** ** |
| ** **                                   | ** ** | **Total**                      | ** ** | **Change ($)**               | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **Change ($)** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** |
| Revenues:                                    |       |                           |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Online services and technology               |       | $                              | 1,900      |                         | $          | 380 |   | 73 | % | $ | 1,520 |   | 60 | % | $ | 3,595 |   | $ | 355 |   | 66 | % | $ | 3,240 |   | 61 | % |
| Alliance and reimbursement                   |       | 690                            |       | (112                         | )          | 27 | % | 802 |   | 32 | % | 1,266 |   | (398 | ) | 23 | % | 1,664 |   | 31 | % |
| Related party online services and technology |       | 4                              |       | (111                         | )          | 0 | % | 115 |   | 5 | % | 538 |   | 306 |   | 10 | % | 232 |   | 4 | % |
| Software product sales                       |       | —                         |       | (88                          | )          | 0 | % | 88 |   | 3 | % | 42 |   | (160 | ) | 1 | % | 202 |   | 4 | % |
| Total revenues                               |       | $                              | 2,594      |                         | $          | 69 |   | 100 | % | $ | 2,525 |   | 100 | % | $ | 5,441 |   | $ | 103 |   | 100 | % | $ | 5,338 |   | 100 | % |

 

Combined online services and technology revenue results primarily fromsales of our SubscribeNet services. Revenues for combined online services and technology for the three andsix months ended August 31, 2004, increased from the three and six months endedAugust 31, 2003, respectively.  The year-over-year increase during thethree months ended August 31, 2004, is mainly due to a net increase ofapproximately $0.3 million in revenue recognized primarily from four of ourexisting customers.  The year-over-yearincrease during the six months ended August 31, 2004, is primarily due to theadditional revenue recognized from the four customer contracts referenced aboveand a $0.3 million increase in related party online services and technologyrevenue.  The related party online services and technology revenueincrease resulted from our recognition of the remaining deferred revenue underour strategic alliance agreement with Zomax, upon termination of that agreementin April 2004.   We expect ourcombined online services and technology revenue and related party onlineservices and technology revenues for our fiscal quarter ending November 30,2004, to be at approximately the same levels as those during the three monthsended August 31, 2004.  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 page26 below). 

 

Alliance and reimbursementrevenue primarily relates to our alliance agreement with Software Spectrum forsales and marketing services. This revenue consists of a percentage of thegross profit derived from Software Spectrum’s sales of Sun, Novell Linux andWebsense software and maintenance for which we provide sales and marketingservices, and reimbursement for the costs of maintaining a team dedicated toproviding sales and marketing services to Software Spectrum for thatthird-party software and maintenance. This alliance agreement with Software Spectrum accounted for more than10% of our total revenue during the three months ended August 31, 2004 (seeNote 7 of our “Notes to Unaudited Interim Consolidated Financial Information”in Item 8 above and

 

19

----

 

“RiskFactors” beginning on page 26 below). The decrease in alliance andreimbursement revenue for the three and six months ended August 31, 2004, wasprimarily due to a reduction of the shared gross profit derived from the salesof Sun software licenses and maintenance services, of $0.1 million and $0.3million, respectively.  This reduction in shared gross profit was due tolower sales of Sun software through our alliance with Software Spectrum duringthe three and six months ended August 31, 2004.  We expect our allianceand reimbursement revenues in our fiscal quarter ending November 30, 2004, tobe approximately the same as or lower than those in our fiscal quarter endedAugust 31, 2004.  More generally, the Sun software we resell through ouralliance with Software Spectrum has experienced a decrease in market share overthe past several quarters, which has contributed to a reduction in our allianceand reimbursement revenues, and we expect this product line to experiencecontinued pressure in the marketplace over the longer term. 

 

The decline in softwareproduct revenue for the three and six months ended August 31, 2004, was due toour transition out of the business of directly reselling third-party softwareproducts and related maintenance.  We do not expect to recognize future revenuesfrom our exited third-party resale business.  However, we may recognizefuture revenues from resales of software licenses and related services that arecomplementary to our SubscribeNet service and which we resell as part of acomprehensive ESDM business solution.  The previous two sentences areforward-looking statements that are subject to risks and uncertainties, andactual results could differ materially from those anticipated (see “RiskFactors” beginning on page 26 below). 

 

*Costs andExpenses*

 

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

 
| ** **                                  | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|---------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | **August 31, 2004**            | ** ** | **August 31, 2003**          | ** ** | **August 31, 2004** | ** ** | **August 31, 2003** | ** ** |
| ** **                                  | ** ** | **Total**                      | ** ** | **Change ($)**               | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **Change ($)** | ** ** | **% of  Revenue** | ** ** | **Total** | ** ** | **% of  Revenue** | ** ** |
|                                        |       |                           |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total cost of revenues                      |       | $                              | 1,120      |                         | $          | (5 | ) | 43 | % | $ | 1,125 |   | 45 | % | $ | 2,115 |   | $ | (223 | ) | 39 | % | $ | 2,338 |   | 44 | % |
| Gross margin                                |       | 1,474                          |       | 74                           |       | 57 | % | 1,400 |   | 55 | % | 3,326 |   | 326 |   | 61 | % | 3,000 |   | 56 | % |
| Operating expenses:                         |       |                           |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                         |       | 822                            |       | 127                          |       | 32 | % | 695 |   | 28 | % | 1,574 |   | 110 |   | 29 | % | 1,464 |   | 27 | % |
| Product development                         |       | 409                            |       | (348                         | )          | 16 | % | 757 |   | 30 | % | 812 |   | (864 | ) | 15 | % | 1,676 |   | 31 | % |
| General and administrative                  |       | 902                            |       | 11                           |       | 35 | % | 891 |   | 35 | % | 1,691 |   | 34 |   | 31 | % | 1,657 |   | 31 | % |
| Total operating expenses                    |       | 2,133                          |       | (210                         | )          | 82 | % | 2,343 |   | 93 | % | 4,077 |   | (720 | ) | 75 | % | 4,797 |   | 90 | % |
| Loss from operations                        |       | (659                           | )          | 284                          |       | -25 | % | (943 | ) | -37 | % | (751 | ) | 1,046 |   | -14 | % | (1,797 | ) | -34 | % |
| Interest expense                            |       | (26                            | )          | 35                           |       | -1 | % | (61 | ) | -2 | % | (55 | ) | 75 |   | -1 | % | (130 | ) | -2 | % |
| Interest and other income and expenses, net |       | 26                             |       | 14                           |       | 1 | % | 12 |   | 0 | % | 42 |   | 16 |   | 1 | % | 26 |   | 0 | % |
| Net loss                                    |       | $                              | (659       | )                            | $          | 333 |   | -25 | % | $ | (992 | ) | -39 | % | $ | (764 | ) | $ | 1,137 |   | -14 | % | $ | (1,901 | ) | -36 | % |

 

*Cost ofRevenues*

 

Our cost of revenues for thethree months ended August 31, 2004, remained consistent with our costs ofrevenues during the three months ended August 31, 2003.  The marginpercentage increase for the three months ended August 31, 2004, primarilyreflects our focus on the sale of our own online services and technology, whichgenerate higher margins than third-party products we resold and alliance andreimbursement revenue. 

 

The decrease in cost ofrevenues for the six months ended August 31, 2004, is primarily due to the $0.1million decrease in alliance and reimbursement revenue and to the phasing outof our direct software reseller business, which resulted in a $0.1 millionreduction in cost of revenues.  The margin percentage increase for the sixmonths ended August 31, 2004, primarily reflects our focus on the sale of ourown online services and technology, which generate higher margins thanthird-party products we resold and alliance and reimbursement revenue. 

 

Cost of revenues primarilyconsists of certain allocated costs related to our Internet connectivity,assets supporting cost of revenues, and customer support, as well as the costsassociated with maintaining our team dedicated to helping Software Spectrumsell Sun, Novell Linux and Websense software, for which we are reimbursed bySoftware Spectrum. Cost of revenues also consists of professional servicespersonnel costs and the cost of third-party products sold.  When we werein the business of directly reselling third-party software products, wepurchased those products at a discount from the third-parties’ established listprices according to standard

 

20

----

 

resellerterms.  We expect total cost of revenues for the current fiscal year to beapproximately the same as or lower than, and gross profit margin percentage forthe current fiscal year to be greater than, for our fiscal year 2004.  Theprevious sentence is a forward-looking statement that is 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 andMarketing Expenses*

 

Sales and marketing expensesconsist primarily of employee salaries, benefits and commissions, advertising,consulting, promotional materials, trade show expenses and certain allocatedoverhead costs. 

 

The increase in the dollaramount of our sales and marketing expenses for the three and six months endedAugust 31, 2004, compared to the three and six months ended August 31, 2003, isprimarily due to an increase of approximately $0.2 million and $0.4 million,respectively, in consulting expenditures which were part of our plannedincrease in sales and marketing expenditures, as discussed below.  This increase was partially offset by adecrease in the number of our sales and marketing personnel, which resulted ina reduction in payroll related expenses of approximately $0.2 million and $0.1million during the three and six months ended August 31, 2004, respectively. 

 

We plan to continue toincrease our expenditures on sales and marketing in fiscal year 2005 over thosein fiscal year 2004, both in dollar amounts and as a percentage of revenue. Weplan to continue to market and sell our services, and may market and sellproprietary software licenses, directly to customers using our existing salesforce and through resellers. We also plan to continue to develop alliances withother companies to sell our services to a broader customer base. The previousthree sentences are 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). 

 

*ProductDevelopment Expenses*

 

Product development expensesprimarily consist of personnel, consulting, software and related maintenance,equipment depreciation expenses and allocated overhead costs.  Costsrelated to research, design and development of products and services have beencharged to product development expense as incurred. 

 

The decrease in the dollaramount and percentage of revenue of our product development expenses for thethree and six months ended August 31, 2004, compared to the three and sixmonths ended August 31, 2003, is due primarily to a decrease in software andequipment depreciation expense of approximately $0.3 million and $0.7 million,respectively, as many fixed assets have become fully depreciated during thepast several quarters.  The decrease isalso due to a one-time expense of approximately $0.2 million related to lease buyoutsthat occurred during the three and six months ended August 31, 2003. 

 

We anticipate continuing toinvest in additional functionality for our SubscribeNet service and underlyingproprietary software. However, we expect those investments to fluctuate overtime, and expect our product development expenses to fluctuate accordingly. Weexpect total product development expenditures to be lower in fiscal year 2005than in fiscal year 2004, both in dollar amounts and as a percentage ofrevenue, primarily due to expected lower depreciation of equipment. Theprevious sentences are 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 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. 

 

*Generaland Administrative Expenses*

 

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

 

21

----

 

Our general andadministrative expenses for the three and six months ended August 31, 2004,remained consistent with those in the prior year.  

 

We expect total expendituresin fiscal year 2005 to approximate fiscal year 2004 levels. The previous sentenceis a forward-looking statement that is subject to risks and uncertainties, andactual results could differ materially from those anticipated (see “RiskFactors” beginning on page 26 below). 

 

*InterestExpense*

 

For the three months endedAugust 31, 2004, interest expense was approximately $26,000, a decrease from$61,000 for the three months ended August 31, 2003.  For the six months ended August 31, 2004,interest expense was approximately $55,000, a decrease from $130,000 for thesix months ended August 31, 2003.  

 

Interest expense primarilyrelates to obligations under capital leases and notes payable.  Thedecrease in interest expense for the three and six months ended August 31,2004, is primarily due to the reduction of the principal balance on our capitallease obligations.  In August 2003, we replaced certain capital leaseswith a note payable bearing a lower interest rate (see “Liquidity and CapitalResources” below). 

 

*Interestand Other Income and Expenses, Net*

 

For the three months endedAugust 31, 2004, interest and other income and expenses, net was approximatelya $26,000 credit, an increase from a $12,000 credit for the three months endedAugust 31, 2003.   For the six monthsended August 31, 2004, interest and other income and expenses, net wasapproximately a $42,000 credit, an increase from a $26,000 credit for the sixmonths ended August 31, 2003.

 

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

 

*IncomeTaxes*

 

From inception throughFebruary 29, 2004, we incurred net losses for federal and state tax purposesand have not recognized any tax provision or benefit. As of February 29, 2004,we had approximately $129 million of federal and $59 million of state netoperating loss carryforwards available to offset future taxable income, whichexpire in varying amounts between 2004 and 2025. Because of cumulativeownership changes, federal loss carryforwards totaling approximately$90 million and state loss carryforwards totaling approximately$39 million are subject to limitation. At February 29, 2004, $39 millionand $20 million of federal and state net operating losses, respectively, areavailable, without limitation to offset future taxable income. Should there bea change of ownership in the future; the available net operating losses may befurther limited. Given our limited operating history, losses incurred to dateand the difficulty in accurately forecasting our future results, managementdoes not believe that the realization of the related deferred income tax assetmeets the criteria required by generally accepted accounting principles.Accordingly, we have recorded a 100% valuation allowance. 

 

**Liquidityand Capital Resources**

 

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

 
| ** **                                          | ** ** | **For the six months ended** | ** ** |
|-----------------------------------------------------|------------|------------------------------|------------|
| ** **                                          | ** ** | **August 31, 2004**          | ** ** | **August 31, 2003** | ** ** |
|                                                |       |                         |       |   |   |
| Cash and cash equivalents                           |       | $                            | 10,944     |   | $ | 5,279 |   |
| Working capital                                     |       | $                            | 8,255      |   | $ | 1,838 |   |
| Net cash used in operating activities               |       | $                            | (1,317     | ) | $ | (1,164 | ) |
| Net cash used in investing activities               |       | $                            | (151       | ) | $ | (189 | ) |
| Net cash provided by (used in) financing activities |       | $                            | 608        |   | $ | (209 | ) |

 

22

----

 

Our net cash used in operations was $1.3 million for the six monthsended August 31, 2004, up from $1.2 million net cash used in operations inthe six months ended August 31, 2003. This increase was primarily due toapproximately $0.1 million in additional general payroll relatedexpenditures. Our overall net cash used in operating activities primarilyresulted from our net loss for the year and the timing of our payments tovendors and receipts from customers. The majority of our operating costscontinue to relate to employee payroll and related expenditures.  The netcash used in operations for the six months ended August 31, 2004 came from ourexisting cash and cash equivalents, and from our issuance of common stock inconnection with warrant exercises, our employee stock purchase plan and ouremployee stock option plans.  We expect to continue to improve our cashused in operations by increasing our billings to customers as more end-usersare added to our SubscribeNet service. We plan to use part of those expectedincreased cash receipts in additional sales and marketing expenditures toexpand our market reach. 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).  Our ability to improve our uses of cash and generate positivecash flows in future periods will largely depend on our ability to increase thenumber of customers of our SubscribeNet service while increasing existingsubscriptions through strong contract renewals. It is also important for us toincrease our current level of sales through our Software Spectrum salesalliance, and continue to control our operational and customer support costs infuture periods. 

 

Our net cash provided byfinancing activities was approximately $0.6 million for the six monthsended August 31, 2004.  Most of this amount came from the issuance ofapproximately 0.8 million shares of common stock in connection with warrantexercises and our stock option and employee stock purchase plan forapproximately $1.0 million.  The proceeds from these stock issuances wereoffset by payments on our notes payable of approximately $0.5 million (seebelow). 

 

In August 2003, we entered into an agreement with a bank underwhich we issued a note payable for proceeds of approximately $2.0 millionand obtained access to a $500,000 line of credit. The note payable and line ofcredit both bear an annual interest rate of the greater of 1% in excess of thebank’s prime rate (4.50% at August 31, 2004) or 5.25%, and are both payable infixed monthly installments through September 2005.  At August 31, 2004, the interest rate was5.50%.  We used the proceeds from thenote payable to settle our remaining liability under a capital lease bearing aninterest rate of approximately 12%. This refinancing enabled us to significantlyreduce our monthly capital financing and interest expenditures. The line ofcredit allowed us to draw for equipment purchases through August 1,2004.   In September 2004, we enteredinto an additional $500,000 line of credit at the same interest rate thatapplies to the note payable and the first line of credit.  The new line of credit allows us to draw forequipment purchases through August 1, 2005.

 

Under the agreement for thenote payable and lines of credit, all borrowings are collateralized by a seniorsecurity interest in substantially all of our assets. The agreement alsorequires us to comply with financial covenants, with which we were incompliance as of August 31, 2004. The agreement further restricts us fromincurring or assuming additional indebtedness outside of the note payable andlines of credit, excluding trade payables and certain other liabilitiesincurred in the ordinary course of business. 

 

Our net cash used in investing activities during the six months endedAugust 31, 2004 was $0.2 million. This amount was primarily comprised ofapproximately $0.2 million for our purchase of fixed assets. We paid for theseequipment purchases from our cash and cash equivalents, but later drew downapproximately $0.1 million under the first of the above-mentioned lines ofcredit to finance these purchases. We used these fixed asset purchasesprimarily to upgrade and expand our SubscribeNet infrastructure and corporateinformation systems. We expect to continue to use and renew our line of creditto finance additional fixed asset purchases at levels that approximate or areslightly higher than our prior year levels. The previous sentence is aforward-looking statement that is subject to risks and uncertainties, andactual results could differ materially from those anticipated (see “RiskFactors” beginning on page 26 below).

 

We believe our existing cash and cash equivalents, together with anycash generated from operations, will be sufficient to fund our operatingactivities, capital expenditures and financing arrangements for the foreseeable

 

23

----

 

future.However, if our SubscribeNet business fails to grow significantly or declinesfrom its current level, we could be forced to seek additional capital. 

 

At August 31, 2004, we did not have any relationships withunconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance or special purpose entities, which would havebeen established for the purpose of facilitating off-balance sheet arrangementsor other contractually narrow or limited purposes. As such, we are notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in such relationships. 

 

The following table summarizes our debt and lease obligations at August31, 2004, and the effect such obligations are expected to have on our liquidityand cash flow in future periods (in thousands). This table provides informationthrough our year ending February 28, 2008, as we do not have any debt orlease obligations beyond that point. 

 
| ** **       | ** ** | **Payments due by period** | ** ** |
|------------------|------------|----------------------------|------------|
| ** **       | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Total** | ** ** |
| Long-term debt   |       | $                          | 619        |   | $ | 781 |   | $ | 92 |   | $ | — |   | $ | 1,492 | (a) |
| Operating leases |       | 288                        |       | 287 |   | 2 |   | 1 |   | 578 | (b) |
|             |       | $                          | 907        |   | $ | 1,068 |   | $ | 94 |   | $ | 1 |   | $ | 2,070 |   |

 

----

(a)          This amount includes approximately $55,000 in interest. 

 

(b)         This amount excludes approximately $281,000, $569,000, $579,000,$597,000, and $300,000 per year for the periods of 2006 through 2010, whichwill become due and payable as monthly rent payments if we do not exercise ourright to exit our operating lease for our Orinda office. In addition, thisamount excludes potential sublease receipts. 

 

As of August 31, 2004, ourSeries A redeemable convertible preferred stock entitled its holders to aliquidation preference of $1.0 million in the event of Intraware’sliquidation. 

 

**RecentAccounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidationof Variable Interest Entities (“VIE”), an Interpretation of ARB No. 51” (“FIN46”) and in December 2003, issued a revised interpretation (“FIN 46-R”).FIN No. 46, as revised, requires certain VIEs to be consolidated by theprimary beneficiary of the entity if the equity investors in the entity do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. The provisions ofFIN 46-R are effective immediately for all arrangements entered into afterJanuary 31, 2003. For arrangements entered into prior to February 1,2003, we were required to adopt the provisions of FIN 46-R in the first quarterof our fiscal year 2005. The adoption of FIN 46-R did not have a significanteffect on our financial position or results of operations. 

 

In May 2003, the FASB issued SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity” (“SFAS No. 150”). SFAS No. 150 establishes standards for theclassification and measurement of financial instruments with characteristics ofboth liabilities and equity. The provisions of SFAS No. 150 apply to thefirst interim period beginning after June 15, 2003.  During the threemonths ended November 30, 2003, we adopted the relevant provisions of SFAS No.150.  While the effective date of certain elements of SFAS No. 150 havebeen deferred, the adoption of SFAS No. 150 when finalized is not expectedto have a material impact on our financial position, results of operations orcash flows. 

 

In April 2004, the EITF issued Statement No. 03-06 “ParticipatingSecurities and the Two-Class Method Under FASB Statement No. 128, *Earnings Per Share*“ (“EITF 03-06”). EITF03-06 addresses a number of questions regarding the computation of earnings pershare by companies that have issued securities other than common stock thatcontractually entitle the holder to participate in dividends and earnings of acompany when, and

 

24

----

 

if,it declares dividends on its common stock. The issue also provides furtherguidance in applying the two-class method of computing earnings per share onceit is determined that a security is participating, including how to allocateundistributed earnings to such a security. EITF 03-06 is effective for fiscalperiods beginning after March 31, 2004. The adoption of EITF 03-06 did nothave a significant effect on our financial position or results of operations. 

 

25

----

 

**RISK FACTORS**

 

Youshould carefully consider the risks described below before making a decision toinvest in our common stock. The risks and uncertainties described below are notthe only 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 or our results of operationscould be seriously harmed. If that occurs, the trading price of our commonstock could decline, and you may lose part or all of your investment.

 

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

 

Underour June 2001 agreement with Software Spectrum, we provide Sales andMarketing Services to Software Spectrum to assist in its resale and marketingof Sun, Novell and Websense software licenses and maintenance. SoftwareSpectrum shares with us a portion of its gross profit from resales of Sun,Novell and Websense software licenses and maintenance, and reimburses us for asubstantial portion of our cost of maintaining a team dedicated to sales andmarketing of that software and maintenance. This contract accounted forsubstantially all of our Alliance and reimbursement revenues, a significantportion of our Online services and technology revenues, and more than 10% ofour total revenues in our 2004 fiscal year and our quarter endedAugust 31, 2004. While this agreement covers resales of Sun, Novell andWebsense software and maintenance, most of the sales under the agreement are ofSun software and maintenance.  In recentyears, sales and market share of those Sun software product lines havegenerally declined. If this trend continues, revenues to us under this contractare likely to decrease over the long term. In addition, the term of thisagreement will expire in June 2005, is renewable for subsequent one-yearterms, and may be terminated without cause by either party on 90 days’ notice.It is possible that Software Spectrum will terminate this agreement withoutcause or will choose not to renew the agreement at any renewal point. It isalso possible that Sun, Novell and/or Websense will choose to stop permittingSoftware Spectrum to resell their software. Any termination or non-renewal ofour agreement with Software Spectrum, or termination of Software Spectrum’srights to resell Sun software, would likely cause a substantial and immediatedecrease in our revenues.

 

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

 

Asubstantial amount of the revenues from our SubscribeNet service come from arelatively small number of companies. These include software providers to whomwe provide our SubscribeNet service, as well as Software Spectrum, to whom weprovide both our SubscribeNet service and sales and marketing services. Our contractswith most 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.

 

**Our prospective customers maydelay purchasing, and our new customers may delay implementing, ourSubscribeNet service while they assess their internal controls in preparationfor compliance with Section 404 of the Sarbanes-Oxley Act of 2002.   This may delay our revenue growth.**

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires most publiclytraded companies to include in their annual reports an assessment by managementof the companies’ internal control structures and procedures for financialreporting, and an attestation by the companies’ registered public accountingfirms of that management assessment. To comply with this new requirement, manypublic companies are preparing detailed documentation of their informationtechnology (“IT”) systems supporting their internal control structures andprocedures.  To minimize their risk oferror, these companies may be reluctant to add new IT systems until theirSection 404 assessments are complete and have been filed with the SEC as partof their annual reports.  As a result,prospective purchasers of our SubscribeNet service may delay completing theirpurchases of the service, and new SubscribeNet customers may delay implementingthe service, while they complete the Section 404 assessments over the nextseveral months.  This could, in turn,cause delays in new sales of our SubscribeNet service and/or delays inrecognition of revenue from recent sales of our service.

 

**We have ahistory of losses and negative cash flow, and we have yet to achieve sustainedprofitability or positive cash flow. We have recently increased spending onsales and marketing, which could limit or prevent any near-term improvement inour net income and cash flow.**

 

Wehave incurred significant losses since we were formed in 1996, and have yet toachieve sustained profitability or positive cash flow. As of August 31,2004, we had an accumulated deficit of approximately $155 million. Also,with the exception of our quarter ended November 30, 2002, we have notachieved positive cash flow from operations since our formation in 1996. Ouroperating history makes it difficult to evaluate whether or when we will beable to achieve sustained profitability or positive cash flow in the future.

 

Wehave recently increased, and plan to increase further, our spending on salesand marketing activities and programs. We believe these investments willcontribute to improved financial performance over the longer term, although wecannot assure you that these investments will be successful.  In the near term this increase in our costsmay limit or prevent any improvement in our net loss or cash flows.

 

26

----

 

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

 

Themarket for selling electronic software delivery services is highlycompetitive.  Some of our competitors have longer operating histories,greater financial, technical, marketing and other resources, broader productand service offerings, better name recognition, and a larger installed base ofcustomers than we do. Some of our competitors also have well-establishedrelationships with our potential customers and with third-party informationtechnology or consulting firms that help market our competitors’ services. Weexpect competition to intensify as current competitors expand and improve theirservice offerings and new competitors enter the market. Mergers and consolidationin the information technology industry may also increase competition byenlarging our competitors and their product and service offerings, and/or byreducing the pool of potential customers. In addition, our current andpotential customers are primarily information technology companies with strongsoftware development expertise. When considering their alternatives forimplementing an electronic software delivery and management system, thesecompanies sometimes elect to develop such systems in-house. While we believeour competitive position is strong against both external competitors andin-house development, we have at times experienced reduced prices, reducedgross margins and lost sales as a result of such competitive factors. Suchcompetition is likely to intensify, which could limit the growth of ourrevenues or gross margins.

 

**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.**

 

OurSubscribeNet service fees, which comprise most of our Online services andtechnology revenues, are recognized ratably over contract terms of generallyone year, thereby limiting the quarter-to-quarter volatility of thoserevenues.   Nevertheless, certain factorsmay cause our Online services and technology revenues to fluctuate.  In addition, our Alliance and reimbursementrevenues and overall operating results are subject to substantial quarterly andannual fluctuation.  In addition to theother risk factors described in this section, factors that could cause suchfluctuation include:

 

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

 

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

 

•                  Lengtheningof the sales cycle for our SubscribeNet service due to macroeconomic or otherfactors;

 

•                  Corporatemergers involving one or more of our customers;

 

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

 

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

 

Asa consequence, operating results for a particular future period are difficultto predict, and therefore, prior results are not necessarily indicative ofresults to be expected in future periods. Any of the foregoing factors, or anyother factors discussed elsewhere herein, could have a material adverse effecton our business, results of operations, or financial condition that could adverselyaffect our stock price.

 

27

----

 

**The marketfor our technology delivery model and hosted electronic software delivery andmanagement services is immature and volatile, and if it does not develop ordevelops more slowly than we expect, our business will be harmed.**

 

Themarket for hosted electronic software delivery and management services is newand unproven, and it is uncertain whether these services will achieve andsustain high levels of demand and market acceptance. Our success will depend toa substantial extent on the willingness of software companies, large and small,to increase their use of hosted ESDM services. Many software companies haveinvested substantial personnel and financial resources to develop their ownelectronic software delivery systems and therefore may be reluctant orunwilling to migrate to a remotely hosted service. In addition, some softwarecompanies have adopted automatic update, or “phone home,” technology fordelivering software updates, whereby an end-user’s computer automaticallycontacts the software company’s server to check whether updates are availableand, 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 ESDM technology, and therefore any increasedadoption of this automatic update technology could hurt our business andresults of operations. Further, some software companies may be reluctant to usehosted ESDM services because they are concerned about the security capabilitiesof these services. If software companies do not perceive the benefits of hostedESDM services, then the market for these services may develop more slowly thanwe expect, which would significantly adversely affect our operating results. Inaddition, in this unproven market, we have limited insight into trends that maydevelop and affect our business. We may make errors in predicting and reactingto relevant business trends, which could harm our business.

 

**Thetechnological and functional requirements we must meet to stay competitive aresubject to rapid change. If we are unable to quickly adapt to these changes andmeet the demands of our current and potential customers, we will likely losesales and market share and our revenue growth will be limited.**

 

Wemarket primarily to software providers, who generally demand that a servicelike ours meet high technological and functional standards. To remaincompetitive in this market and meet the demands of current and prospectivecustomers, we must continually adapt and upgrade our technology andfunctionality. If we do not respond quickly enough to changing industrystandards or the demands of customers and potential customers, we will likelylose sales and market share to competitors and our growth prospects will belimited. In addition, we could incur substantial costs to modify our servicesor infrastructure 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.

 

**Defects inour SubscribeNet service could diminish demand for the service and subject usto substantial liability.**

 

Becauseour service is complex, it may have errors or defects that users identify afterthey begin using 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. Despite takingprecautions to avoid errors, we have from time to time found defects in ourservice and new errors in our existing service may be detected in the future.Since our customers use our service for important aspects of their business,any errors, defects or other performance problems with our service could hurtour reputation and may damage our customers’ businesses. If that occurs,customers could elect not to renew their agreements with us, could be eligiblefor credits under our service level agreements, and could delay or withholdpayment to us.  We could also lose futuresales, or customers may make warranty claims against us, which could result inan increase in our provision for doubtful accounts, an increase in collectioncycles 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.**

 

Weprovide our service through computer hardware that is currently located in athird-party Web hosting facilities in Santa Clara, California operated bySAVVIS Communications, and in Ireland operated by Data Electronics. We do notcontrol the operation of these facilities, and they are subject to damage orinterruption from earthquakes, floods, fires, power loss, telecommunicationsfailures and similar events. While physical security measures are in place,they are also subject to break-ins, sabotage, intentional acts of vandalism andsimilar

 

28

----

 

misconduct. Despite precautions taken at the facilities, the occurrenceof a natural disaster, a decision to close a facility without adequate noticeor other unanticipated problems at a facility could result in lengthyinterruptions in our service. In addition, the failure by either facility toprovide our required data communications capacity could result in interruptionsin our service. We have an agreement with SBC E-Services, an affiliate of SBCCommunications, Inc., to provide access to a geographically remote disasterrecovery facility that would provide us access to hardware, software andInternet connectivity in the event the SAVVIS facility becomes unavailable.Even with this disaster recovery arrangement, however, our service would beinterrupted during the transition. Any damage to, or failure of, our systemscould result in interruptions in our service. Interruptions in our service mayreduce our revenue, cause us to issue credits or pay penalties, cause customersto terminate their subscriptions and adversely affect our renewal rates. Ourbusiness will be harmed if our customers and potential customers believe ourservice is unreliable.

 

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

 

Theproliferation of software viruses is a key risk that could inhibit acceptanceby information technology professionals of Web-based electronic softwaredelivery and management. Any well-publicized transmission of a computer virusby us or another company using electronic software delivery could deterinformation technology professionals from using and deter software providersfrom outsourcing electronic software delivery, thereby adversely affecting ourbusiness. Our SubscribeNet service enables our customers to upload theirsoftware products directly onto our systems for downloading by their end-users.Our systems automatically scan our customers’ software products for knowncomputer viruses on an ongoing basis while they are on our systems. However, itis possible that, in spite of those periodic virus scans, our system couldtransmit the virus to one or more end-users. Any such virus transmission couldresult in disputes, litigation and negative publicity that could adverselyaffect 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.**

 

Ourservice involves the storage and transmission of customers’ proprietaryinformation, and security breaches could expose us to a risk of loss of thisinformation, litigation and possible liability. If our security measures arebreached as a result of third-party action, employee error, malfeasance orotherwise, and, as a result, someone obtains unauthorized access to one of ourcustomers’ data, our reputation will be damaged, our business may suffer and wecould incur significant liability. Because techniques used to obtainunauthorized access or to sabotage systems change frequently and generally arenot recognized until launched against a target, we may be unable to anticipatethese techniques or to implement adequate preventative measures. If an actualor perceived breach of our security occurs, the market perception of theeffectiveness of our security measures could be harmed and we could lose salesand customers.

 

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

 

Wemay raise additional capital in the future through private or public offeringsof stock, or through other means. The purposes of any such financing would beto increase our cash reserves for potential use in acquiring other businesses,product development activities, funding our operations and generallystrengthening our balance sheet. Any such additional financing would likelydilute the investments of our current shareholders.

 

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

 

Ourbusiness has benefited from the tax laws of states in which purchases ofsoftware licenses are not taxable if the software is received onlyelectronically. Some states currently experiencing revenue shortfalls areconsidering whether to change their laws to broaden the taxability oftransactions executed over the Internet. Any new imposition of taxes on sales ofsoftware licenses, where the software is received electronically, couldsubstantially harm demand for our services and thereby materially adverselyaffect our business, operating results and financial condition. We have alsobenefited from implementing our services in Ireland, which offers tax

 

29

----

 

advantages to software companies distributing their software fromIreland to other European countries. Any regulatory change in Ireland orelsewhere that diminishes those advantages could harm our business. Otherchanges in government regulations, in areas such as privacy and exportcompliance, could also require us to implement changes in our services oroperations that increase our cost of doing business and thereby hurt ourfinancial performance.

 

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

 

Ourbusiness involves a high risk that we will be the target of intellectualproperty infringement claims.  Theseclaims could take a number of forms, including:

 

**•**                  Claims by other digital delivery companiesalleging that our digital delivery and related technology infringes theirintellectual property rights;

 

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

 

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

 

Theseclaims could be made for patent, copyright or trademark infringement or formisappropriation of trade secrets.  Theycould be made directly against us, or indirectly through our contractualindemnification obligations to our customers and channel partners.  Any claims could result in costly litigationand be time-consuming to defend, divert management’s attention and resources,or cause delays in releasing new or upgrading existing services. Royalty orlicensing agreements, if required, may be available only on onerous terms, ifat all.  Although we carry generalliability insurance, our insurance may not cover all potential claims or maynot be adequate to protect us from all liability that may be imposed.

 

Webelieve we own the rights in, or have the required rights to use, ourSubscribeNet technology.  However, therecan be no assurance that this technology does not infringe the rights of thirdparties.  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 help us defendagainst claims by, or protect us against liability to, our customers whosesoftware is downloaded. 

 

Weare aware that certain other companies are using the name “Intraware” as acompany name or as a trademark or service mark. While we have received nonotice of any claims of trademark infringement from any of those companies, wecannot assure you that these companies may not claim superior rights to “Intraware”or to other marks we use. 

 

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

 

Throughour SubscribeNet service we globally distribute software containing highencryption and other features restricted by U.S. laws and regulations fromexportation to certain countries, types of recipients, and specific end-users.Our SubscribeNet solution incorporates automated procedures to help ensure thatthe software we deliver electronically is not downloaded in violation of U.S.export laws and regulations. However, these procedures may not preventunauthorized exports of restricted software in every case. If an unauthorizedexport of software occurs through the SubscribeNet service and the U.S.government determines that we violated the U.S. export laws or regulations, wecould be sanctioned under those laws or regulations. Sanctions include fines,suspension or revocation of export privileges, and imprisonment.

 

30

----

 

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

 

Ourfuture success depends upon the continued service of our executive officers andother key technology, sales, marketing and support personnel. None of ourofficers or key employees is bound by an employment agreement for any specificterm. If we lost the services of one or more of our key employees, or if one ormore of our 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.

 

**Ourreported financial results may be adversely affected by changes in accountingprinciples generally accepted in the United States.**

 

Generallyaccepted accounting principles in the United States are subject tointerpretation by the Financial Accounting Standards Board (“FASB”), Public CompanyAccounting Oversight Board, the American Institute of Certified PublicAccountants, the Securities and Exchange Commission, and various bodies formedto promulgate and interpret appropriate accounting principles. A change inthese principles or interpretations could have a significant effect on ourreported financial results, and could affect the reporting of transactionscompleted before the announcement of a change.

 

Forexample, we currently are not required to record stock-based compensation chargesif the employee’s stock option exercise price is equal to or exceeds the deemedfair value of our common stock at the date of grant. However, several companieshave recently elected to change their accounting policies and begun to recordthe fair value of stock options as an expense. Although the standards have notbeen finalized and the timing of a final statement has not been established,FASB has announced its support for recording expense for the fair value ofstock options granted. If we were required to change our accounting policy inaccordance with Statement of Financial Accounting Standards (SFAS) No. 123, *Accounting for Stock-Based Compensation*andSFAS No. 148. *Accounting for Stock-BasedCompensation—Transition and Disclosure*, then our net loss and netloss per share would have increased (see Note 1 to our unaudited interimconsolidated financial information for the pro forma net loss and loss pershare for the three and six months ended August 31, 2003 and 2004). However, the actual impact to our results of operations upon adoption of theproposed new standard could materially differ from the pro forma informationincluded in Note 1 to our unaudited interim consolidated financial informationdue to differences in the option-pricing model used, estimates and assumptionsrequired, and options to be included in the calculation upon adoption. The fairvalue based models require the input of highly subjective assumptions and donot necessarily provide a reliable single measure of the fair value of ourstock options.

 

**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.**

 

Wemay acquire or make investments in complementary companies, services andtechnologies in the future. We are considerably smaller now than we were whenwe made our past acquisitions, and therefore any new acquisitions orinvestments could be more disruptive to our organization than in the past. Acquisitionsand investments 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 revenue tooffset acquisition or investment costs; and

 

**•****                 **delays in customer purchases due touncertainty.

 

31

----

 

Inaddition, if we finance acquisitions by issuing convertible debt or equitysecurities, our existing stockholders may be diluted which could affect themarket price of our stock. As a result, if we fail to properly evaluate andexecute acquisitions or investments, our business and prospects may beseriously harmed.

 

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

 

At August 31, 2004, wehad cash and cash equivalents of $10.9 million. We have not usedderivative financial instruments in our investment portfolio during fiscal 2004or the six months ended August 31, 2004. We place our investments withhigh quality issuers, by policy, in an effort to limit the amount of creditexposure to any one issue or issuer. 

 

Our exposure to market riskfor changes in interest rates relates primarily to our cash and cashequivalents portfolio, note payable and lines of credit. We have not usedderivative financial instruments. The effect of changes in interest rates of+/-10% over a six-month horizon would not have a material effect on the fairvalue of the portfolio or our debt. 

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

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

 

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

 

**PART II**

 

**OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

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

* *

In October 2001, we were served with a summons and complaint in apurported securities class action lawsuit. On or about April 19, 2002, wewere served with an amended complaint in this action, which is now titled In reIntraware, Inc. Initial Public Offering Securities Litigation, Civ.No. 01-9349 (SAS) (S.D.N.Y.), related to In re Initial Public OfferingSecurities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The amended complaint isbrought purportedly on behalf of all persons who purchased our common stockfrom February 25, 1999 (the date of our initial public offering) throughDecember 6, 2000. It names as defendants Intraware, three of our presentand former officers and directors, and several investment banking firms thatserved as underwriters of our initial public offering. The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 and Sections10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that theregistration statement for the offerings did not disclose that: (1) theunderwriters had agreed to allow certain customers to purchase shares in theofferings in exchange for excess commissions paid to the underwriters; and(2) the underwriters had arranged for certain customers to purchaseadditional shares in the aftermarket at predetermined prices. The amended complaintalso alleges that the underwriters misused their securities analysts tomanipulate the price of our stock. No specific damages are claimed.

 

Lawsuitscontaining similar allegations have been filed in the Southern District of NewYork challenging over 300 other initial public offerings and secondaryofferings conducted in 1999 and 2000. All of these lawsuits have beenconsolidated for pretrial purposes before United States District Court JudgeShira Scheindlin of the Southern District of New York. On July 15, 2002,an omnibus motion to dismiss was filed in the coordinated

 

32

----

 

litigation on behalf of the issuer defendants, of which Intraware andits three named current and former officers and directors are a part, on commonpleadings issues. On or about October 9, 2002, the Court entered andordered a Stipulation of Dismissal, which dismissed the three named current andformer officers and directors from the litigation without prejudice. OnFebruary 19, 2003, the Court entered an order denying in part the issuerdefendants’ omnibus motion to dismiss, including those portions of the motionto dismiss relating to Intraware. No discovery has been served on us to date.

 

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

 

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

 

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

* *

InJuly 2004, a complaint was filed in the United States District Court forthe District of Delaware, Civ. No. 04-822, against ComVest VenturePartners, LP; ComVest Management, LLC; Commonwealth Associates ManagementCompany, Inc.; Commonwealth Associates, LP; RMC Capital, LLC; Michael S. Falk;Robert Priddy; Travis L. Provow; Keith Rosenbloom; and Intraware. The complaintdescribes Intraware as a nominal defendant. The complaint alleges that, betweenAugust 2001 and January 2002, all of the defendants other thanIntraware were members of a group, and therefore should be treated as a single “person,”for purposes of Sections 13(d)(3) and 16(b) of the Securities Exchange Act of1934 (the “1934 Act”).  The complaint further alleges that ComVest VenturePartners, LP and Mr. Priddy, while they and the other alleged group memberscollectively owned more than 10% of a class of our equity securities, boughtand sold our equity securities within a 6-month period and failed to disgorgeto us the profits allegedly realized in those trades, thereby violatingSection 16(b) of the 1934 Act.  Mr. Falk was a member of our Board ofDirectors from April 2001 to May 2002 and Mr. Provow was a member of ourBoard of Directors from October 2001 to May 2002.  The complaintdemands that ComVest Venture Partners, LP and Mr. Priddy pay over to Intrawarethe profits they allegedly realized and retained in violation ofSection 16(b) of the 1934 Act, together with interest and legal costs.According to the compliant, the amount of those alleged profits is unknown tothe plaintiff, however, the information alleged in the complaint suggests thatamount may be approximately $1.3 million. The complaint does not seekdamages against us.  After the complaint was filed, the plaintiff andIntraware signed a stipulation acknowledging that Intraware takes no positionwith respect to the claims in the action, and providing that Intraware acceptsservice of the complaint, that Intraware is not required to file an answer orother response to the complaint, and that Intraware will otherwise have therights and responsibilities of a party to the action.

 

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

 

33

----

 

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

 

None. 

 

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

 

None. 

 

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

 

OnAugust 4, 2004, we held our Annual Meeting of Stockholders. Below are theresults of matters submitted to a vote at that meeting.

 

*ProposalNo. 1:*          The stockholders elected each of the followingpersons as a Class III Director to hold office until the 2007 Annual Meeting ofStockholders or until earlier resignation or removal. 

 
| **Director’s  Name** | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------------------|------------|---------------|------------|-------------------------|------------|
| ** **                | ** ** | ** **    | ** ** | ** **              | ** ** |
| Peter H. Jackson          |       | 51,178,437    |       | 950,650                 |       |
|                      |       |          |       |                    |       |
| Mark B. Hoffman           |       | 42,118,237    |       | 10,010,870              |       |

 

Thefollowing directors were not subject to re-election at the Annual Meeting, andeach such director’s term continued after the Annual Meeting:  Brendan A. McLoughlin, Raymond L. Ocampo Jr.,Peter F. Pervere, and Bradley M. Shuster.

 

*ProposalNo. 2:**         *The stockholders ratified the Audit Committee’sappointment of PricewaterhouseCoopers LLP as our independent registered publicaccounting firm for the fiscal year ending February 28, 2005, with51,202,521 affirmative votes, 910,506 negative votes, and 16,060 votesabstaining. 

 

**ITEM 5. OTHER INFORMATION**

 

None. 

 

**ITEM 6. EXHIBITS**

 

**Exhibits**

 
| **Exhibit   Number** | ** ** | **Description**                                                                                                                                                       |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                            |
| 3(ii)                |       | Bylaws                                                                                                                                                                |
|                 |       |                                                                                                                                                                  |
| 10.1                 |       | Amendment Three to Sales  Alliance Agreement dated June 28, 2001 between Intraware, Inc. and  Software Spectrum, Inc. (as successor-in-interest CorpSoft, Inc.). |
|                 |       |                                                                                                                                                                  |
| 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                                                                                                 |

 

34

----

 

**SIGNATURE**

 

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

 

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

 

35

----