UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number: 000-50463

Callidus Software Inc.

Callidus Software Inc.
160 West Santa Clara Street, Suite 1500
San Jose, CA 95113
(Address of principal executive offices, including zip code)

(408) 808-6400
(Registrant’s Telephone Number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such requirements for the past 90 days. Yes [x] No [  ]

     Indicate by check mark if the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended). . Yes [  ] No [x]

     There were 24,037,834 shares of the registrant’s common stock, par value $0.001, outstanding on May 12, 2004, the latest practicable date prior to the filing of this report.

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CALLIDUS SOFTWARE INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CALLIDUS SOFTWARE INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CALLIDUS SOFTWARE INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CALLIDUS SOFTWARE INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

     Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared on substantially the same basis as the audited consolidated financial statements included in the Callidus Software Inc. Annual Report on Form 10-K for the year ended December 31, 2003. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the Securities and Exchange Commission rules and regulations regarding interim financial statements. All amounts included herein related to the consolidated financial statements as of March 31, 2004 and the three months ended March 31, 2003 are unaudited and should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

     In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all necessary adjustments for the fair presentation of the Company’s financial position, results of operations and cash flows. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for the full fiscal year ending December 31, 2004.

     Principles of Consolidation

     The consolidated financial statements include the accounts of Callidus Software Inc. and its wholly owned subsidiaries (collectively, the Company), which include wholly-owned subsidiaries in the United Kingdom, Germany, Australia and Italy. All intercompany transactions and balances have been eliminated in consolidation.

     Use of Estimates

     The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

     Valuation Accounts

     Trade accounts receivable are recorded at the invoiced amounts where revenue has been recognized and do not bear interest. The Company offsets gross trade accounts receivable with its allowance for doubtful accounts and sales return reserve. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days are reviewed individually for collectibility. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The sales return reserve is the Company’s best estimate of the probable amount of remediation services it will have to provide for ongoing professional service arrangements. To determine the adequacy of the sales return reserve, the Company analyzes historical experience of actual remediation service claims as well as current information on remediation service requests. Provisions for allowance for doubtful accounts are recorded in general and administrative expenses, while provisions for sales returns are offset against maintenance and service revenues.

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     Below is a summary of the changes in the Company’s valuation accounts for the three months ended March 31, 2004 and 2003 (in thousands):

     Stock-Based Compensation

     The Company accounts for its stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, deferred stock-based compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the exercise price of related equity awards. Deferred stock-based compensation is amortized and expensed on an accelerated basis over the corresponding vesting period, using the method outlined in Financial Accounting Standards Board (FASB) Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.

     The fair value of these stock-based awards to employees was estimated using the Black-Scholes option pricing model, assuming no expected dividends and using the following weighted average assumptions:

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     These calculations are based on a multiple-option valuation approach and forfeitures are recognized as they occur. For pro forma purposes, the estimated fair value of the Company’s stock-based awards to employees is amortized over the options’ vesting period of generally four years and the Company’s Employee Stock Purchase Plan’s one-year purchase period. The per share weighted-average estimated fair value of stock options granted with exercise prices that equal fair value during the three month period ended March 31, 2004 was $7.43. The per share weighted-average estimated fair value of stock options granted with exercise prices less than fair value during the three month period ended March 31, 2003 was $2.78. The per share weighted-average estimated value of share purchase rights under the Employee Stock Purchase Plan during the three month period ended March 31, 2004 was $11.43. The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts):

     Net Loss Per Share

     Basic and diluted net loss per share is calculated by dividing net loss for the period by the weighted average common shares outstanding during the period, less shares subject to repurchase.

     Diluted net loss per share does not include the effect of the following potential common shares because to do so would be antidilutive for the periods presented (in thousands):

     The weighted average exercise price of stock options excluded during the three months ended March 31, 2004 and 2003 were $3.36 and $1.47, respectively. The weighted average exercise price of warrants excluded during the three months ended March 31, 2004 and 2003 were $3.14 and $3.64, respectively.

     The calculation of basic and diluted net loss per share is as follows (in thousands, except per share amounts):

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     Reclassifications

     Certain amounts in prior period condensed consolidated financial statements have been reclassified to conform with the current period’s presentation.

2. Investments

     The Company classifies debt and marketable equity securities based on the liquidity of the investment and management’s intention on the date of purchase and re-evaluates such designation as of each balance sheet date. Debt and marketable equity securities are classified as available-for-sale and carried at fair value, which is determined based on quoted market prices, with net unrealized gains and losses, net of tax effects, included in accumulated other comprehensive income in the accompanying condensed consolidated financial statements. Interest and amortization of premiums and discounts for debt securities are included in other income, net, in the accompanying condensed consolidated financial statements. Realized gains and losses are calculated using the specific identification method. At March 31, 2004, all investment securities had maturities of less than 24 months. The components of the Company’s debt and marketable equity securities as of March 31, 2004 were as follows (in thousands):

     In the three months ended March 31, 2004, the Company received $11.0 million from the sale of available-for-sales securities. There were no realized gains or losses on the sales of these securities.

3. Debt

     In March 2004, the Company renewed their master loan and security agreement (Master Agreement) that included a revolving line of credit and two term loans. The renewed Master Agreement increased our borrowings amount from time to time up to $10.0 million bearing interest at the prime rate. The interest rate on the two existing term loans was lowered to the prime rate plus 0.05 %. The Master Agreement expires in March 2005. The Master Agreement requires us to maintain certain financial covenants. As of March 31, 2004, we were in compliance with all covenants.

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4. Segment, Geographic and Customer Information

     The Company has adopted Statement of Financial Account Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for the reporting by business enterprises of information about operating segments, products and services, geographic areas, and major customers. The method for determining what information is reported is based on the way that management organizes the operating segments within the Company for making operational decisions and assessments of financial performance. The Company’s chief operating decision maker is considered to be the Company’s chief executive officer (CEO). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. By this definition, the Company operates in one business segment, which is the development, marketing and sale of enterprise software.

Geographic Information:

     Total revenues consist of (in thousands):

Substantially all of the Company’s long-lived assets are located in the United States. Long-lived assets located outside the United States are not significant.

     Significant customers (as a percentage of total revenues):

5. Comprehensive Loss

     Comprehensive loss includes net loss, unrealized gains (losses) on investments and foreign currency translation adjustments. Comprehensive loss is comprised of the following (in thousands):

6. Subsequent Event

     In April 2004, the Company agreed to purchase an assembled workforce of approximately 20 software development and supporting employees from Cezanne Software. In May 2004, a payment of $1.4 million

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was made for this purchase. An additional payment of $350,000 is expected to be made in July 2004 subject to certain conditions.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion of financial condition and results of operations should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and the Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003 and with the condensed consolidated financial statements and the related notes hereto contained elsewhere in this Quarterly Report on Form 10-Q . This section of the Quarterly Report on Form 10-Q, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: expectations of completing transactions with prospective customers; improvements in gross margins; operating expenses; our expectations concerning our relationship with Cezanne Software; the impact of quarterly fluctuations of revenue and operating results; levels of capital expenditure; staffing and expense levels; and the adequacy of our capital resources to fund operations and growth. These statements involve known and unknown risks, uncertainties and other factors that may cause industry trends or our actual results, level of activity, performance or achievements to be materially different from any future results, level of activity, performance or achievements expressed or implied by these statements. Many of these trends and uncertainties are described in “Factors That Could Affect Future Results” set forth elsewhere in this Quarterly Report on Form 10-Q. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Quarterly Report on Form 10-Q.

Overview

     Total revenue increased 25% to $16.5 million for the three months ended March 31, 2004 from $13.1 million for the three months ended March 31, 2003. License revenues decreased 41% to $4.5 million for the three months ended March 31, 2004 from $7.7 million for the three months ended March 31, 2003. Maintenance and service revenues increased 120% to $11.9 million for the three months ended March 31, 2004 from $5.4 million for the three months ended March 31, 2003. Our quarterly license revenues are dependent in large part on our ability to close a relatively small number of transactions and the decrease in license revenue in the three months ended March 31, 2004 resulted from us not closing several transactions during the last few weeks of the quarter due to certain of our prospective customers’ merger and acquisition activities as well as customers’ own internal reasons. While we believe that these prospective customers remain committed to our products and we expect to conclude a number of these transactions in fiscal 2004, there can be no assurance that we will be successful in doing so.

     As a result of the decrease in license revenues, gross margins declined to 46% for the three months ended March 31, 2004 compared with 64% for the three months ended March 31, 2003. This decrease resulted from a shift in our revenue mix causing license revenue to fall to 28% of total revenues for the three months ended March 31, 2004 compared with 59% for the three months ended March 31, 2003. Our margins on license revenue have remained constant at 94% for the three months ended March 31, 2004 and 2003. Our margins on maintenance and service revenues were 28% and 21% for the three months ended March 31, 2004 and 2003, respectively. The improvement in maintenance and service gross margins is mainly the result of improvement in utilization rates for our service personnel. Our overall gross margins in the future will continue to depend on the mix of revenues between license and maintenance and service revenues.

     Total operating expenses increased 60% to $13.8 million for the three months ended March 31, 2004 from $8.7 million for the three months ended March 31, 2003. As a percentage of sales, total operating expenses increased to 84% for the three months ended March 31, 2004 from 66% for the three months ended March 31, 2003. The largest increase in operating expenses can be seen in sales and marketing which increased $2.8 million from the three months ended March 31, 2004 to the three months ended March 31, 2003 as a result of increased headcount and higher advertising and promotional activities. Research and development costs increased $1.0 million from the prior year quarter as a result of increased headcount and contract development work that was performed by Cezanne Software for the continuing

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development of our TruePerformance product. We expect total operating expenses to increase in absolute dollars in the future as we continue to expand our operations.

Application of Critical Accounting Policies and Use of Estimates

     Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The application of GAAP requires our management to make estimates that affect our reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations will be affected.

     In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, management’s judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Our management has reviewed these critical accounting policies, our use of estimates and the related disclosures with our audit committee.

     Revenue Recognition

     We generate revenues primarily by licensing software and providing maintenance and professional services to our customers. Our software arrangements typically include: (i) an end-user license fee paid in exchange for the use of our products in perpetuity, generally based on a specified number of payees; and (ii) a maintenance arrangement that provides for technical support and product updates, generally over a period of twelve months. If we are selected to provide integration and configuration services, then the software arrangement will also include professional services, generally priced on a time-and-materials basis. Depending upon the elements in the arrangement and the terms of the related agreement, we recognize license revenues under either the residual or the contract accounting method.

     Residual Method. License fees are recognized upon delivery when licenses are either sold separately from integration and configuration services, or together with integration and configuration services, provided that (i) the criteria described below have been met, (ii) payment of the license fees is not dependent upon performance of the integration and configuration services, and (iii) the services are not otherwise essential to the functionality of the software. We recognize these license revenues using the residual method pursuant to the requirements of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, Software Revenue Recognition with Respect to Certain Transactions. Under the residual method, revenues are recognized when vendor-specific objective evidence of fair value exists for all of the undelivered elements in the arrangement (i.e., professional services and maintenance), but does not exist for one or more of the delivered elements in the arrangement (i.e., the software product). Each license arrangement requires careful analysis to ensure that all of the individual elements in the license transaction have been identified, along with the fair value of each undelivered element.

     We allocate revenue to each undelivered element based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. For a certain class of transactions, the fair value of the maintenance portion of our arrangements is based on stated renewal rates rather than stand-alone sales. The fair value of the professional services portion of the arrangement is based on the hourly rates that we charge for these services when sold independently from a software license. If evidence of fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is deferred until evidence of fair value can be established, or until the items

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for which evidence of fair value cannot be established are delivered. If the only undelivered element is maintenance, then the entire amount of revenue is recognized over the maintenance delivery period.

     Contract Accounting Method. For arrangements where services are considered essential to the functionality of the software, such as where the payment of the license fees is dependent upon performance of the services, both the license and services revenues are recognized in accordance with the provisions of SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We generally use the percentage-of-completion method because we are able to make reasonably dependable estimates relative to contract costs and the extent of progress toward completion. However, if we cannot make reasonably dependable estimates, we use the completed-contract method. If total cost estimates exceed revenues, we accrue for the estimated loss on the arrangement.

     For all of our software arrangements, we will not recognize revenue until persuasive evidence of an arrangement exists and delivery has occurred, the fee is fixed or determinable and collection is deemed probable. We evaluate each of these criteria as follows:

     Evidence of an Arrangement. We consider a non-cancelable agreement signed by us and the customer to be evidence of an arrangement.

     Delivery. We consider delivery to have occurred when media containing the licensed programs is provided to a common carrier or, in the case of electronic delivery, the customer is given access to the licensed programs. Our typical end-user license agreement does not include customer acceptance provisions.

     Fixed or Determinable Fee. We consider the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within our standard payment terms. We consider payment terms greater than 90 days to be beyond our customary payment terms. If the fee is not fixed or determinable, we recognize the revenue as amounts become due and payable.

     Collection is Deemed Probable. We conduct a credit review for all significant transactions at the time of the arrangement to determine the creditworthiness of the customer. Collection is deemed probable if we expect that the customer will be able to pay amounts under the arrangement as payments become due. If we determine that collection is not probable, we defer the recognition of revenue until cash collection.

     A customer typically prepays maintenance for the first twelve months, and the related revenues are deferred and recognized over the term of the initial maintenance contract. Maintenance is renewable by the customer on an annual basis thereafter. Rates for maintenance, including subsequent renewal rates, are typically established based upon a specified percentage of net license fees as set forth in the arrangement.

     Professional services revenues primarily consist of integration and configuration services related to the installation of our products and training revenues. Our implementation services do not involve customization to, or development of, the underlying software code. Substantially all of our professional services arrangements are on a time-and-materials basis. To the extent we enter into a fixed-fee services contract, a loss will be recognized any time the total estimated project cost exceeds project revenues.

     Certain arrangements result in the payment of customer referral fees to third parties that resell our software products. In these arrangements, license revenues are recorded, net of such referral fees, at the time the software license has been delivered to a third-party reseller and an end-user customer has been identified. To the extent a referral fee is paid to a third party when we sell directly to the end-user, the referral fee is recorded as a selling expense.

Allowance for Doubtful Accounts and Sales Return Reserve

     We must make estimates of the uncollectibility of accounts receivable. The allowance for doubtful accounts, which is netted against accounts receivable on our balance sheets, totaled approximately $338,000 and $103,000 at March 31, 2004 and 2003, respectively. We record an increase in the allowance

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for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Management specifically analyzes accounts receivable and historical bad debts experience, customer creditworthiness, current economic trends, international situations (such as currency devaluation) and changes in our customer payment history when evaluating the adequacy of the allowance for doubtful accounts. Should any of these factors change, the estimates made by management will also change, which could affect the level of our future provision for doubtful accounts. Specifically, if the financial condition of our customers were to deteriorate, affecting their ability to make payments, an additional provision for doubtful accounts may be required and such provision may be material.

     We generally guarantee that our services will be performed in accordance with the criteria agreed upon in the statement of work. Should these services not be performed in accordance with the agreed upon criteria, we would provide remediation services until such time as the criteria are met. In accordance with Statement of Financial Accounting Standards (SFAS) 48, Revenue Recognition When Right of Return Exists, management must use judgments and make estimates of sales return reserves related to potential future requirements to provide remediation services in connection with current period service revenues. When providing for sales return reserves, we analyze historical experience of actual remediation service claims as well as current information on remediation service requests as they are the primary indicators for estimating future service claims. Material differences may result in the amount and timing of our revenues if for any period actual returns differ from management’s judgments or estimates. The sales return reserve balance, which is netted against our accounts receivable on our balance sheets, was approximately $915,000 and $246,000 at March 31, 2004 and 2003, respectively.

Stock-Based Compensation

     We have adopted SFAS 123, Accounting for Stock-Based Compensation, but in accordance with SFAS 123, we have elected not to apply fair value-based accounting for our employee stock option plans. Instead, we measure compensation expense for our employee stock option plans using the intrinsic value method prescribed by Accounting Principles Board Opinion (APB) 25, Accounting for Stock Issued to Employees, and related interpretations. We record deferred stock-based compensation to the extent the fair value of our common stock for financial accounting purposes exceeds the exercise price of stock options granted to employees on the date of grant, and amortize these amounts to expense using the accelerated method over the vesting schedule of the options, generally four years. For options granted after our initial public offering, the fair value of our common stock is the closing price on the date of grant. For options which were granted prior to our initial public offering, the deemed fair value of our common stock was determined by our board of directors. The board of directors determined the deemed fair value of our common stock by considering a number of factors, including, but not limited to, our operating performance, significant events in our history, issuances of our convertible preferred stock, trends in the broad market for technology stocks and the expected valuation we obtained in an initial public offering. We recorded deferred stock-based compensation of approximately $910,000 and $0 and amortization of such compensation of $1.7 million and $1.1 million in the three months ended March 31, 2004 and 2003, respectively. As of March 31, 2004, we expect total stock-based compensation to be $5.7 million for fiscal 2004. Had different assumptions or criteria been used to determine the deemed fair value of the stock options, materially different amounts of stock compensation expenses could have been reported.

     As required by SFAS 123, as modified by SFAS 148, Accounting for Stock Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123, we provide pro forma disclosure of the effect of using the fair value-based method of measuring stock-based compensation expense. For purposes of the pro forma disclosure, we estimate the fair value of stock options issued to employees using the Black-Scholes option valuation model. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of subjective assumptions including the expected life of options and our expected stock price volatility. Therefore, the estimated fair value of our employee stock options could vary significantly as a result of changes in the assumptions used. See Note 1 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

Income Taxes

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     We are subject to income taxes in both the United States and foreign jurisdictions and we use estimates in determining our provision for income taxes. Deferred tax assets, related valuation allowances and deferred tax liabilities are determined separately by tax jurisdiction. This process involves estimating actual current tax liabilities together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded on the balance sheet. Our deferred tax assets consist primarily of net operating loss carryforwards. We assess the likelihood that deferred tax assets will be recovered from future taxable income, and a valuation allowance is recognized if it is more likely than not that some portion of the deferred tax assets will not be recognized. We provided a full valuation allowance against our net deferred tax assets at March 31, 2004. In the event we were to determine that we would be able to realize all or a portion of our deferred tax assets in the future, an adjustment to the valuation allowance would increase net income in the period such determination was made. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgment that could become subject to audit by tax authorities in the ordinary course of business.

Recent Accounting Pronouncements

     In November 2003, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain investments (EITF 03-1), which addresses how to determine the meaning of other-than temporary for impairments and how that concept should be applied to investments accounted for under the cost method, the equity method, as either available-for-sale or held-to-maturity under SFAS 115 or in accordance with SFAS 124. The provision of EITF 03-1 are applicable to fiscal years ending after December 31, 2003. The adoption of EITF 03-1 did not have a material effect on our operating results or financial condition.

Results of Operations

     The following table sets forth certain consolidated statements of operations data expressed as a percentage of period over period growth and total revenues.

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Comparison of the Three Months Ended March 31, 2004 and 2003

Revenues

     License Revenues. License revenues were $4.5 million for the three months ended March 31, 2004, a decrease of 41% from $7.7 million for the three months ended March 31, 2003. The decrease in license revenues was the result of us failing to close several expected transactions during the three months ended March 31, 2004.

     Maintenance and Service Revenues. Maintenance and service revenues were $11.9 million for the three months ended March 31, 2004, an increase of 120% from $5.4 million for the three months ended March 31, 2003. The increase in maintenance and service revenues was attributable to an increase in integration and configuration services for new customers and, to a lesser extent, increased maintenance fees associated with our larger customer base. We expect maintenance and service revenues to remain relatively constant in the second quarter of 2004.

Cost of Revenues and Gross Margin

     Cost of License Revenues. Cost of license revenues was approximately $263,000 for the three months ended March 31, 2004, a decrease of 47% from approximately $498,000 for the three months ended March 31, 2003. The decrease was attributable to less third-party royalty costs associated with the lower volume of license sales during the quarter partially offset by approximately $100,000 of amortization of the TruePerformance source code purchased in December 2003. As a percentage of license revenues, cost of license revenues was 6% for the three months ended March 31, 2004 and 2003.

     Cost of Maintenance and Service Revenues. Cost of maintenance and service revenues were $8.6 million for the three months ended March 31, 2004, an increase of 102% from $4.3 million for the three months ended March 31, 2003. The increase was primarily due to $2.1 million of higher personnel costs associated with increased headcount, $1.1 million in higher fees paid to sub-contractors that we use to

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supplement our work force and approximately $743,000 in higher travel expenses relating to the increase in integration and configuration services. As a percentage of maintenance and service revenues, cost of maintenance and service revenues decreased to 72% for the three months ended March 31, 2004 from 79% for the three months ended March 31, 2003. The decrease as a percentage of maintenance and service revenues is attributable to higher utilization rates of service personnel who bill for their services on an hourly basis and fixed overhead costs being applied to a larger amount of revenues.

     Gross Margin. Our gross margin decreased to 46% for the three months ended March 31, 2004 from 64% for the three months ended March 31, 2003. The decrease in our gross margin is attributable primarily to the shift in revenue mix to lower margin maintenance and service revenues, which represented 72% of total revenues for the three months ended March 31, 2004, compared to 41% of total revenues for the three months ended March 31, 2003. In the future, we expect our gross margins to fluctuate depending on the mix of license versus maintenance and service revenues recorded.

Operating Expenses

     Sales and Marketing. Sales and marketing expenses were $6.4 million for the three months ended March 31, 2004, an increase of 80% from $3.6 million for the three months ended March 31, 2003. Increases to our sales and marketing headcount led to an increase in personnel expense of $1.7 million. Marketing program fees increased by approximately $534,000 due to increased advertising and promotional activities. In addition, sales and marketing travel and other ancillary costs increased by approximately $414,000 due to the increased headcount of approximately 40 employees. Finally, facilities and other related costs increased approximately $152,000, primarily related to the opening of new offices in New York and Boston. We expect sales and marketing expenses to increase in the second quarter of 2004 primarily due to increased sales commissions to the sales force.

     Research and Development. Research and development expenses were $3.7 million for the three months ended March 31, 2004, an increase of 37% from $2.7 million for the three months ended March 31, 2003. The increase is primarily due to an increase in personnel expense of approximately $627,000 and increased contracting fees of approximately $435,000. The increase to our contracting fees was primarily attributable to contract development work that was performed by Cezanne Software during the three months ended March 31, 2004. We expect our research and development expenses to continue to increase slightly in the second quarter of 2004 as we further develop our products.

     General and Administrative. General and administrative expenses were $2.0 million for the three months ended March 31, 2004, an increase of 54% from $1.3 million for the three months ended March 31, 2003. The increase was primarily attributable to an increase of approximately $448,000 in personnel expense associated with increased headcount of approximately 10 employees and an increase of approximately $179,000 in professional fees related to being a public company. We expect general and administrative expenses to remain relatively constant in the second quarter of 2004.

     Stock-based Compensation. Stock-based compensation was $1.7 million for the three months ended March 31, 2004 compared with $1.1 million for the three months ended March 31, 2003. Total stock-based compensation expense for the three months ended March 31, 2003 consisted of approximately $952,000 of stock-based compensation recorded in connection with the issuance of Series G Preferred Stock, which was converted into 271,800 shares of our common stock upon our initial public offering, to certain of our executive officers and key employees at a discount to the deemed fair value of such stock for financial accounting purposes. Amortization of deferred stock-based compensation was $1.7 million and approximately $168,000 for the three months ended March 31, 2004 and 2003, respectively. We expect amortization of stock-based compensation to total approximately $1.7 million for the second quarter of 2004, $1.3 million for the third quarter of 2004 and approximately $950,000 for the fourth quarter of 2004.

Interest Expense and Other Income, Net

     Interest expense was approximately $79,000 for the three months ended March 31, 2004, a decrease of 18% from approximately $96,000 for the three months ended March 31, 2003. The decrease was primarily

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attributable to lower average outstanding debt balances in the three months ended March 31, 2004 compared with the three months ended March 31, 2003.

     Other income, net was approximately $272,000 for the three months ended March 31, 2004 compared with $20,000 for the three months ended March 31, 2003. The increase from the prior period is mainly due to the interest income generated from investments on the net proceeds received from our initial public offering in November 2003.

Provision for Income Taxes

     We recorded a provision for income taxes of approximately $25,000 for the three months ended March 31, 2004. The provision relates to state franchise and net worth taxes. At March 31, 2004, we maintained a full valuation allowance against our deferred tax assets based on the determination that it was more likely than not that the deferred tax assets would not be realized. For the three months ended March 31, 2003, no provision for income taxes was recorded due to our net loss position and no income was generated in non-U.S. tax jurisdictions.

Liquidity and Capital Resources

     As of March 31, 2004, we had $79.3 million of cash and cash equivalents and short-term investments and $72.5 million in net working capital.

     Net Cash Provided by/Used in Operating Activities. Net cash provided by operating activities was approximately $21,000 for the three months ended March 31, 2004 compared with cash used in operating activities of $3.8 million for the three months ended March 31, 2003. The significant cash receipts and outlays for the two periods are as follows (in thousands):

     Net Cash Used in Investing Activities. Cash used in investing activities was $12.6 million and approximately $9,000 for the three months ended March 31, 2004 and 2003, respectively. Our principal use of cash in investing activities during the three months ended March 31, 2004 was due to net purchases of investments of $11.8 million. Purchases of equipment, software, furniture and leasehold improvements were approximately $710,000 and $50,000 for the three months ended March 31, 2004 and 2003, respectively, to support the growth in our business. Based on our current plans, we expect our capital expenditure requirements for the remaining portion of fiscal 2004 will be approximately $2.3 million as we continue to invest in infrastructure to support our planned growth. Additionally, in May 2004, we made a $1.4 million payment to Cezanne Software in connection with the purchase of an assembled workforce. An additional payment of $350,000 is expected to be made in July 2004 subject to certain conditions.

     Net Cash Provided by Financing Activities. Cash used in financing activities was approximately $141,000 for the three months ended March 31, 2004, which was a result of long-term debt paydowns of approximately $188,000 partially offset by proceeds from stock option exercises of approximately $47,000. Cash provided by financing activities was $2.0 million for the three months ended March 31, 2003, consisting of net proceeds from our revolving line of credit of $1.7 million and net proceeds from the

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issuance of preferred stock of approximately $453,000. These increases were partially offset by long-term debt paydowns of approximately $216,000.

     In March 2004, we renewed our revolving line of credit that permits borrowings from time to time of up to $10.0 million bearing interest at the prime rate. The revolving line of credit expires in March 2005. The revolving line of credit requires us to maintain certain financial covenants. As of March 31, 2004, we were in compliance with all covenants. We have no off-balance sheet arrangements, with the exception of operating lease commitments, that have not been recorded in our condensed consolidated financial statements.

     We believe our existing cash and investment balances, credit facilities, and cash anticipated to be generated from operations will be sufficient to meet our anticipated short and long term cash requirements, debt obligations and operating lease commitments. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support product development efforts, the expansion of sales and marketing activities, the timing of introductions of new products and enhancement to existing products, the continuing market acceptance of our products and our ability to achieve and sustain profitability.

Factors That Could Affect Future Results

     We operate in a dynamic and rapidly changing environment that involves numerous risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Quarterly Report on Form 10-Q. Because of the following factors, as well as other variables affecting our operating results, past financial performance should not be considered a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.

We have a history of losses, and we cannot assure you that we will achieve and sustain profitability.

     We incurred net losses of $19.1 million and $20.8 million for 2002 and 2001. Although we achieved annual profitability of approximately $835,000 in 2003, for the three months ended March 31, 2004, we had a net loss of $6.1 million. We have recently increased our expenses in the near term in order to expand our business and we expect this trend to continue. In addition, we expect to amortize $4.0 million in deferred stock-based compensation for the remainder of 2004. These increased expenses and charges will adversely affect our future operating results and may result in or contribute to net losses in future periods. Our results of operations will be harmed if our revenues do not increase at a rate equal to or greater than increases in our expenses. As a result, we cannot assure you that we will be able to achieve and sustain profitability on a quarterly or annual basis.

Our quarterly revenues and operating results can be difficult to predict and can fluctuate substantially, which may harm our results of operations.

     Our revenues, particularly our license revenues, are difficult to forecast and are likely to fluctuate significantly from quarter to quarter due to a number of factors, many of which are outside of our control. These factors include:

• The discretionary nature of our customers’ purchase and budget cycles and changes in their budgets for software and related purchases;

• competitive conditions in our industry, including new products, product announcements and special pricing offered by our competitors;

• varying size, timing and contractual terms of orders for our products, which may delay the recognition of revenues;

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• strategic decisions by us or our competitors, such as acquisitions, divestitures, spin-offs, joint ventures, strategic investments or changes in business strategy;

• our ability to timely complete our service obligations related to product sales;

• general weakening of the economy resulting in a decrease in the overall demand for computer software and services;

• the utilization rate of our professional services personnel and the degree to which we use third- party consulting services;

• changes in our pricing policies;

• timing of product development and new product initiatives;

• our ability to hire, train and retain sufficient sales and professional services staff; and

• changes in the mix of revenues attributable to higher-margin product license revenues as opposed to substantially lower-margin service revenues.

     For example, in the three months ended March 31, 2004, our license revenues were substantially lower than expected because several potential customers delayed purchases of our products due to their own acquisition activities and internal considerations. As a result, even though our total revenues were higher in the three months ended March 31, 2004 than they were in the prior year period, the increase was entirely due to the growth in lower margin maintenance and service revenues and we recorded a net loss for the period.

     In addition, we make assumptions and estimates as to the timing and amount of future revenues in budgeting our future operating costs and capital expenditures. Specifically, our sales personnel monitor the status of all proposals, including the estimated closing date and potential dollar amount of such transactions. We aggregate these estimates periodically to generate our sales forecasts and then evaluate the forecasts to identify trends in our business. Because our costs are relatively fixed in the short term and a substantial portion of our license revenue contracts are completed in the latter part of a quarter, we may be unable to reduce our expenses to avoid or minimize the negative impact on our quarterly results of operations if our estimates prove inaccurate and our anticipated revenues are not realized as was the case in the first quarter of 2004. As a result, our quarterly results of operations could be worse than anticipated, which could adversely affect our stock price.

Our quarterly license revenues are dependent on a relatively small number of transactions involving sales of our products to new customers, and any delay or failure in closing one or more of these transactions could adversely affect our results of operations.

     Our quarterly license revenues are dependent upon a relatively small number of transactions involving sales of our products to new customers, and to date recurring license revenues from existing customers have not comprised a substantial part of our revenues. As such, even minor variations in the rate and timing of conversion of our sales prospects into revenues could result in our failure to meet revenue objectives in future periods. In addition, based upon the terms of our customer contracts, we recognize the bulk of our license revenues for a given sale either at the time we enter into the agreement and deliver the product, or over the period in which we perform any services that are essential to the functionality of the product. Unexpected changes in contractual terms late in the negotiation process or changes in the mix of contracts we enter into could therefore materially and adversely affect our license revenues in a quarter. Delays or reductions in the amount of customers’ purchases would adversely affect our revenues, results of operations and financial condition and could cause our stock price to decline.

Our stock price is likely to remain volatile.

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     The trading price of our common stock has in the past and may in the future be subject to wide fluctuations in response to a number of factors, including those listed in this “Risk Factors” section of this Quarterly Report on Form 10-Q and others such as:

	•		Our operating performance and the performance of other similar companies;
	•		developments with respect to intellectual property rights;
	•		publication of research reports about us or our industry by securities analysts;
	•		speculation in the press or investment community;
	•		terrorist acts; and
	•		announcements by us or our competitors of significant contracts, results of operations, projections, new technologies, acquisitions, commercial relationships, joint ventures or capital commitments.

     For example, following our preliminary announcement of anticipated quarterly revenues and operating results in March 2004, our stock price declined dramatically. Any further adverse announcement about our business or adverse developments in our market, or the economy generally could cause our stock price to decline further.

Our products have long sales cycles, which make it difficult to plan our expenses and forecast our results.

     The sales cycles for our products are generally between six and nine months for the majority of our sales, and in some cases can be a year or longer. It is therefore difficult to predict the quarter in which a particular sale will occur and to plan our expenditures accordingly. The period between our initial contact with a potential customer and its purchase of our products and services is relatively long due to several factors, including:

	•		The complex nature of our products;
	•		the need to educate potential customers about the uses and benefits of our products;
	•		the requirement that a potential customer invest significant resources in connection with the purchase and implementation of our products;
	•		budget cycles of our potential customers that affect the timing of purchases;
	•		customer requirements for competitive evaluation and internal approval before purchasing our products;
	•		potential delays of purchases due to announcements or planned introductions of new products by us or our competitors; and
	•		the lengthy approval processes of our potential customers, many of which are large organizations.

     The delay or failure to complete sales in a particular quarter would reduce our revenues in that quarter, as well as any subsequent quarters over which revenues for the sale would likely be recognized. If our sales cycle unexpectedly lengthens in general or for one or more large orders, it would adversely affect the timing of our revenues. If we were to experience delays on one or more large orders, as we did in the three months ended March 31, 2004, it could again harm our ability to meet our forecasts for a given quarter.

Managing large-scale deployments of our products requires substantial technical implementation and support by us or third-party service providers. Failure to meet these requirements could cause a decline

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or delay in recognition of our revenues and an increase in our expenses.

     Our customers may require large, enterprise-wide deployments of our products, which require a substantial degree of technical implementation and support. It may be difficult for us to manage the timeliness of these deployments and the allocation of personnel and resources by us or our customers. Failure to successfully manage this process could harm our reputation and cause us to lose existing customers, face potential customer disputes or limit the number of new customers that purchase our products, which could adversely affect our revenues and increase our technical support and litigation costs.

     Our software license customers have the option to receive implementation, maintenance, training and consulting services from our internal professional services organization or from outside consulting organizations. If we are unable to expand our internal professional services organization to keep pace with sales, we will be required to increase our use of third-party service providers to help meet our implementation and service obligations. If we require a greater number of third-party service providers than we currently have available, we will be required to negotiate additional arrangements, which may result in lower gross margins for maintenance or service revenues.

     If a customer selects a third-party implementation service provider and such implementation services are not provided successfully and in a timely manner, our customers may experience increased costs and errors, which may result in customer dissatisfaction and costly remediation and litigation, any of which could adversely impact our operating results and financial condition.

Our success depends upon our ability to develop new products and enhance our existing products. Failure to successfully introduce new or enhanced products to the market may adversely affect our operating results.

     The enterprise application software market is characterized by:

	•		Rapid technological advances in hardware and software development;
	•		evolving standards in computer hardware, software technology and communications infrastructure;
	•		changing customer needs; and
	•		frequent new product introductions and enhancements.

     To keep pace with technological developments, satisfy increasingly sophisticated customer requirements and achieve market acceptance, we must enhance and improve existing products and we must also continue to introduce new products and services. Accelerated product introductions and short product life cycles require high levels of expenditures for research and development that could adversely affect our operating results. Further, any new products we develop may not be introduced in a timely manner and may not achieve the broad market acceptance necessary to generate significant revenues. If we are unable to successfully develop new products or enhance and improve our existing products or if we fail to position and/or price our products to meet market demand, our business and operating results will be adversely affected.

A substantial majority of our revenues are derived from TrueComp and related products and services and a decline in sales of these products and services could adversely affect our operating results and financial condition.

     We derive a substantial majority of our revenues from TrueComp and related products and services, and revenues from these products and services are expected to continue to account for a substantial majority of our revenues for the foreseeable future. Because we generally sell licenses to our products on a perpetual basis and deliver new versions and enhancements to customers who purchase maintenance contracts, our future license revenues are substantially dependent on sales to new customers. In addition, substantially all

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of our TrueInformation product sales have historically been made in connection with TrueComp sales. As a result of these factors, we are particularly vulnerable to fluctuations in demand for TrueComp. Accordingly, if demand for TrueComp and related products and services declines significantly, our business and operating results would be adversely affected.

Errors in our products could affect our reputation, result in significant costs to us and impair our ability to sell our products.

     Our products are complex and, accordingly, they may contain errors, or “bugs,” that could be detected at any point in their product life cycle. Errors in our products could materially and adversely affect our reputation, result in significant costs to us and impair our ability to sell our products in the future. Customers relying on our products to calculate and pay incentive compensation may have a greater sensitivity to product errors and security vulnerabilities than customers for software products in general. The costs incurred in correcting any product errors may be substantial and would adversely affect our operating margins. While we plan to continually test our products for errors and work with customers through our customer support services organization to identify and correct bugs, errors in our products may be found in the future.

     Because our customers depend on our software for their critical business functions, any interruptions could result in:

	•		Lost or delayed market acceptance and sales of our products;
	•		product liability suits against us;
	•		lost sales revenues;
	•		diversion of development resources;
	•		injury to our reputation; and
	•		increased service and warranty costs.

     While our software license agreements typically contain limitations and disclaimers that purport to limit our liability for damages for errors in our software, such limitations and disclaimers may not be enforced by a court or other tribunal or otherwise effectively protect us from such claims.

If we do not compete effectively with companies selling EIM software, our revenues may not grow and could decline.

     We have experienced, and expect to continue to experience, intense competition from a number of software companies. We compete principally with vendors of EIM software, enterprise resource planning software, and customer relationship management software. Our competitors may announce new products, services or enhancements that better meet the needs of customers or changing industry standards. Increased competition may cause price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, results of operations and financial condition.

     Many of our enterprise resource planning competitors and potential competitors have significantly greater financial, technical, marketing, service and other resources than we have. Many of these companies also have a larger installed base of users, have longer operating histories or have greater name recognition than we have. Some of our competitors’ products may be more effective than our products at performing particular EIM system functions or may be more customized for particular customer needs in a given market. Even if our competitors provide products with more limited EIM system functionality than our products, these products may incorporate other capabilities, such as recording and accounting for transactions, customer orders or inventory management data. A product that performs these functions, as well as some of the functions of our software solutions, may be appealing to some customers because it

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would reduce the number of different types of software used to run their business. Further, our competitors may be able to respond more quickly than we can to changes in customer requirements.

     Our products must be integrated with software provided by a number of our existing or potential competitors. These competitors could alter their products in ways that inhibit integration with our products, or they could deny or delay access by us to advance software releases, which would restrict our ability to adapt our products to facilitate integration with these new releases and could result in lost sales opportunities.

If we are required to change our pricing models to compete successfully, our margins and operating results will be adversely affected.

     The intensely competitive market in which we do business may require us to reduce our prices. If our competitors offer deep discounts on certain products or services in an effort to recapture or gain market share or to sell other software or hardware products, we may be required to lower prices or offer other favorable terms to compete successfully. Any such changes would be likely to reduce our margins and could adversely affect our operating results. Some of our competitors may bundle software products that compete with ours for promotional purposes or as a long-term pricing strategy or provide guarantees of prices and product implementations. These practices could, over time, limit the prices that we can charge for our products. If we cannot offset price reductions with a corresponding increase in the number of sales or with lower spending, then the reduced revenues resulting from lower prices would adversely affect our margins and operating results.

Potential customers that outsource their technology projects offshore may come to expect lower rates for professional services than we are able to provide profitably, which could impair our ability to win customers and achieve profitability.

     Many of our potential customers have begun to outsource technology projects offshore to take advantage of lower labor costs, and we believe that this trend will continue. Due to the lower labor costs in some countries, these customers may demand lower hourly rates for the professional services we provide, which may erode our margins for our maintenance and service revenues or result in lost business.

Our maintenance and service revenues produce substantially lower gross margins than our license revenues, and an increase in service revenues relative to license revenues would harm our overall gross margins.

     Our maintenance and service revenues, which include fees for consulting, implementation, maintenance and training, were 72%, 48% and 63% of our revenues for the three months ended March 31, 2004 and fiscal years 2003 and 2002, respectively. Our maintenance and service revenues have substantially lower gross margins than our license revenues. The increase in the percentage of total revenues represented by maintenance and service revenues in the first quarter of 2004 adversely affected our overall gross margins and resulted in a net loss for the period. Failure to increase our higher margin license revenues in the future would again adversely affect our gross margin and operating results.

     Maintenance and service revenues as a percentage of total revenues have varied significantly from quarter to quarter due to fluctuations in licensing revenues, economic changes, change in the average selling prices for our products and services, our customers’ acceptance of our products and our sales force execution. In addition, the volume and profitability of services can depend in large part upon:

	•		Competitive pricing pressure on the rates that we can charge for our professional services;
	•		the complexity of the customers’ information technology environment;
	•		the resources directed by customers to their implementation projects; and
	•		the extent to which outside consulting organizations provide services directly to customers.

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     Any erosion of our margins for our maintenance and service revenues, or any adverse changes in the mix of our license versus maintenance and service revenues would adversely affect our operating results.

We will not be able to achieve or sustain sales growth if we do not attract, train or retain qualified sales personnel.

     We depend on our direct sales force for most of our sales and have made significant expenditures in recent years to expand our sales force. Our future success will depend in part upon the continued expansion and increased productivity of our sales force. To the extent we experience attrition in our direct sales force, we will need to hire replacements. We face intense competition for sales personnel in the software industry, and we cannot be sure that we will be successful in hiring, training or retaining these personnel in accordance with our plans. Even if we hire and train a sufficient number of sales personnel, we cannot be sure that we will generate enough additional revenues to exceed the cost of the new personnel. If we fail to successfully maintain and expand our sales force, our future sales will be adversely affected.

We may lose sales opportunities and our business may be harmed if we do not successfully develop and maintain strategic relationships to implement and sell our products.

     We have relationships with third-party consulting firms, systems integrators and software vendors. These third parties may provide us with customer referrals, cooperate with us in marketing our products and provide our customers with systems implementation services or overall program management. However, we do not have formal agreements governing our ongoing relationship with certain of these third-party providers and the agreements we do have generally do not include obligations with respect to generating sales opportunities or cooperating on future business. Should any of these third parties go out of business or choose not to work with us, we may be forced to increase the development of those capabilities internally, incurring significant expense and adversely affecting our operating margins. Any of our third-party providers may offer products of other companies, including products that compete with our products. We could lose sales opportunities if we fail to work effectively with these parties or they choose not to work with us.

Acquisitions and investments present many risks, and we may not realize the anticipated financial and strategic goals for any such transactions.

     In May 2004, we acquired a part of the development team of Cezanne Software in order to continue the development of our TruePerformance product. In addition, we may in the future acquire or make investments in other complementary companies, products, services and technologies. Such acquisitions and investments involve a number of risks, including:

	•		We may find that the acquired company or assets do not further our business strategy, or that we overpaid for the company or assets, or that economic conditions change, all of which may generate a future impairment charge;
	•		we may have difficulty integrating the operations and personnel of the acquired business, and may have difficulty retaining the key personnel of the acquired business;
	•		we may have difficulty incorporating the acquired technologies or products with our existing product lines;
	•		there may be customer confusion where our products overlap with those of the acquired company;
	•		we may have product liability associated with the sale of the acquired company’s products;
	•		our ongoing business and management’s attention may be disrupted or diverted by transition or integration issues and the complexity of managing geographically and culturally diverse locations;

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	•		we may have difficulty maintaining uniform standards, controls, procedures and policies across locations;
	•		the acquisition may result in litigation from terminated employees or third-parties; and
	•		we may experience significant problems or liabilities associated with product quality, technology and legal contingencies.

     These factors could have a material adverse effect on our business, results of operations and financial condition or cash flows, particularly in the case of a larger acquisition or multiple acquisitions in a short period of time. From time to time, we may enter into negotiations for acquisitions or investments that are not ultimately consummated. Such negotiations could result in significant diversion of management time, as well as out-of-pocket costs.

     The consideration paid in connection with an investment or acquisition also affects our financial condition and operating results. If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash to consummate any acquisition. To the extent we issue shares of stock or other rights to purchase stock, including options or other rights, existing stockholders may be diluted and earnings per share may decrease. In addition, acquisitions may result in the incurrence of debt, large one-time write-offs (such as of acquired in-process research and development costs) and restructuring charges. They may also result in goodwill and other intangible assets that are subject to impairment tests, which could result in future impairment charges.

For our business to succeed, we need to attract, train and retain qualified employees and manage our employee base effectively. Failure to do so may adversely affect our operating results.

     Our success depends on our ability to hire, train and retain qualified employees and to manage our employee base effectively. Competition for qualified personnel is intense, particularly in the San Francisco Bay area where our headquarters is located, and the high cost of living increases our recruiting and compensation costs. We cannot assure you that we will be successful in hiring, training or retaining qualified personnel. If we are unable to do so, our business and operating results will be adversely affected.

We have recently experienced changes in our senior management team and the loss of key personnel or any inability of these personnel to perform in their new roles could adversely affect our business.

     In September 2002, we hired Ronald J. Fior as our Chief Financial Officer. In June 2003, we hired Bertram W. Rankin as our Senior Vice President of Worldwide Marketing. In April 2004, we promoted Richard Furino to Vice President, North American Services and Support, Daniel J. Welch to Senior Vice President of EMEA and General Manager of TruePerformance and Christopher W. Cabrera to Senior Vice President, Operations.

     Prior to joining Callidus, Mr. Fior served as Chief Financial Officer of Remedy Corporation from 1998 until its acquisition by Peregrine Systems in 2001. As a result of Peregrine’s subsequent financial restatements and bankruptcy case, Mr. Fior and the former officers and directors of Remedy have become involved in litigation both as plaintiffs against the former board and management of Peregrine for fraud and as defendants against former Remedy stockholders in relation to the sale of Remedy to Peregrine. While these cases do not allege any impropriety with respect to Remedy’s financial statements and Mr. Fior believes the litigation pending against him is without merit, these matters could nonetheless require significant amounts of Mr. Fior’s attention, which could distract him from his responsibilities with Callidus.

     In addition, we continue to recruit senior management personnel to support our growing operations. Our success will depend to a significant extent on our ability to assimilate these changes in our leadership team and to retain the services of our executive officers, including Reed D. Taussig, our President and Chief Executive Officer, and our other key employees. If we lose the services of one or more of our executives or key employees, if we fail to successfully assimilate our recent changes in our management team or if one or more of our executives or key employees decides to join a competitor or otherwise compete directly or

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indirectly with us, this could harm our business and could affect our ability to successfully implement our business plan.

If we fail to adequately protect our proprietary rights and intellectual property, we may lose valuable assets, experience reduced revenues and incur costly litigation to protect our rights.

     We rely on a combination of copyrights, trademarks, service marks, trade secret laws and contractual restrictions to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the United States. To the extent that we engage in international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.

     We enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products. Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management resources, either of which could seriously harm our business.

Our results of operations may be adversely affected if we are subject to a protracted infringement claim or one that results in a significant damage award.

     From time to time, we receive claims that our products or business infringe or misappropriate the intellectual property of third parties. Our competitors or other third parties may challenge the validity or scope of our intellectual property rights. We believe that software developers will be increasingly subject to claims of infringement as the functionality of products in our market overlaps. A claim may also be made relating to technology that we acquire or license from third parties. If we were subject to a claim of infringement, regardless of the merit of the claim or our defenses, the claim could:

	•		Require costly litigation to resolve;
	•		absorb significant management time;
	•		cause us to enter into unfavorable royalty or license agreements;
	•		require us to discontinue the sale of our products;
	•		require us to indemnify our customers or third-party systems integrators; or
	•		require us to expend additional development resources to redesign our products.

     We may also be required to indemnify our customers and third-party systems integrators for third-party products that are incorporated into our products and that infringe the intellectual property rights of others. Although many of these third parties are obligated to indemnify us if their products infringe the rights of others, this indemnification may not be adequate.

     In addition, from time to time there have been claims challenging the ownership of open source software against companies that incorporate open source software into their products. We use a limited

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amount of open source software in our products and may use more open source software in the future. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Any of this litigation could be costly for us to defend, have a negative effect on our results of operations and financial condition or require us to devote additional research and development resources to change our products.

We depend on technology of third parties licensed to us for our TruePerformance product, our rules engine and the analytics and web viewer functionality for our products and the loss or inability to maintain these licenses or errors in such software could result in increased costs or delayed sales of our products.

     We license technology from several software providers for our TruePerformance product, our rules engine, analytics and web viewer. We anticipate that we will continue to license technology from third parties in the future. This software may not continue to be available on commercially reasonable terms, if at all. Some of the products we license from third parties could be difficult to replace, and implementing new software with our products could require six months or more of design and engineering work. The loss of any of these technology licenses could result in delays in the license of our products until equivalent technology, if available, is developed or identified, licensed and integrated. In addition, our products depend upon the successful operation of third-party products in conjunction with our products, and therefore any undetected errors in these products could prevent the implementation or impair the functionality of our products, delay new product introductions and/or injure our reputation. Our use of additional or alternative third-party software would require us to enter into license agreements with third parties, which could result in higher royalty payments and a loss of product differentiation.

Our revenues might be harmed by resistance to adoption of our software by information technology departments.

     Some potential customers may have already made a substantial investment in other third-party or internally developed software designed to model, administer, analyze and report on pay-for-performance programs. These companies may be reluctant to abandon these investments in favor of our software. In addition, information technology departments of potential customers may resist purchasing our software solutions for a variety of other reasons, particularly the potential displacement of their historical role in creating and running software and concerns that packaged software products are not sufficiently customizable for their enterprises. If the market for our products does not grow for any of these reasons, our revenues may be harmed.

Our inability to manage growth could affect our business adversely and harm our ability to sustain profitability.

     To support our growth plans, we need to expand our existing management, operational, financial, human resources, customer service and management information systems and controls. This expansion will require significant capital expenditures and may divert our financial resources from other projects such as the development of new products or product upgrades. We may be unable to expand these systems and to manage our growth successfully, and this inability would adversely affect our business.

Mergers of or other strategic transactions by our competitors could weaken our competitive position or reduce our revenues.

     If one or more of our competitors were to merge or partner with another of our competitors, the change in the competitive landscape could adversely affect our ability to compete effectively. Our competitors may also establish or strengthen cooperative relationships with our current or future systems integrators, third-party compensation consulting firms or other parties with whom we have relationships, thereby limiting our ability to promote our products and limiting the number of consultants available to implement our software. Disruptions in our business caused by these events could reduce our revenues.

If we are required to account for employee stock option and employee stock purchase plans using the

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fair value method, it could significantly increase our net loss and net loss per share.

     In March 2004, the Financial Accounting Standards Board released an Exposure Draft, Share-Based Payment, an Amendment of FASB Statements No. 123 and 95, which would require all forms of share-based payments to employees, including employee stock options, to be treated the same as other forms of compensation by recognizing the related fair value cost in the income statement. Comments on the Exposure Draft are due by June 30, 2004. Although we are not currently required to record any compensation expense using the fair value method in connection with option grants, when the Exposure Draft becomes effective, it could significantly increase our net loss and net loss per share.

We may expand our international operations but do not have substantial experience in international markets, and may not achieve the expected results.

     In May 2004, we acquired part of the development team of Cezanne Software, located in Bari, Italy, in order to enhance our TruePerformance product. We may in the future also further expand our international operations. Any international expansion would require substantial financial resources and a significant amount of attention from our management. International operations involve a variety of risks, particularly:

	•		Unexpected changes in regulatory requirements, taxes, trade laws and tariffs;
	•		differing ability to protect our intellectual property rights;
	•		differing labor regulations;
	•		greater difficulty in supporting and localizing our products;
	•		changes in a specific country’s or region’s political or economic conditions;
	•		greater difficulty in establishing, staffing and managing foreign operations; and
	•		fluctuating exchange rates.

     We have limited experience in marketing, selling and supporting our products and services abroad. If we invest substantial time and resources in order to grow our international operations and are unable to do so successfully and in a timely manner, our business and operating results could be seriously harmed.

Natural disasters or other incidents may disrupt our business.

     Our business communications, infrastructure and facilities are vulnerable to damage from human error, physical or electronic security breaches, power loss and other utility failures, fire, earthquake, flood, sabotage, vandalism and similar events. Although the source code for our software products is held by escrow agents outside of the San Francisco Bay Area, our internal-use software and back-up are both located in the San Francisco Bay Area. If a natural or man-made disaster were to hit this area, we may lose all of our internal-use software data. Despite precautions, a natural disaster or other incident could result in interruptions in our service or significant damage to our infrastructure. In addition, failure of any of our telecommunications providers could result in interruptions in our services and disruption of our business operations. Any of the foregoing could impact our provision of services and fulfillment of product orders, and our ability to process product orders and invoices and otherwise timely conduct our business operations.

Our current officers, directors and entities affiliated with us may be able to exercise control over matters requiring stockholder approval.

     Our current officers, directors and entities affiliated with us together beneficially owned a significant portion of the outstanding shares of common stock as of March 31, 2004. As a result, if some of these persons or entities act together, they will have the ability to control all matters submitted to our

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stockholders for approval, including the election and removal of directors, amendments to our certificate of incorporation and bylaws and the approval of any business combination. This may delay or prevent an acquisition or cause the market price of our stock to decline. Some of these persons or entities may have interests different than yours.

A substantial number of shares are eligible for sale or will be in the near future, which could cause our common stock price to decline significantly.

     Substantially all of our existing stockholders prior to our initial public offering are subject to lock-up agreements with the underwriters that restrict their ability to transfer their stock until May 18, 2004. After the lock-up agreements expire, an aggregate of approximately 18.3 million additional shares will be eligible for sale in the public market, subject in most cases to the limitations of either Rule 144 or Rule 701 under the Securities Act. In addition, Citigroup, on behalf of the underwriters, may in its sole discretion, at any time without notice, release all or any portion of the shares subject to the lock-up agreements, which would result in more shares being available for sale in the public market at earlier dates. Sales of common stock by existing stockholders in the public market, the availability of these shares for sale, our issuance of securities or the perception that any of these events might occur could materially and adversely affect the market price of our common stock.

Provisions in our charter documents and Delaware law may delay or prevent an acquisition of our company.

     Our certificate of incorporation and bylaws contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. For example, if a potential acquirer were to make a hostile bid for us, the acquirer would not be able to call a special meeting of stockholders to remove our board of directors or act by written consent without a meeting. In addition, our board of directors has staggered terms, which means that replacing a majority of our directors would require at least two annual meetings. The acquirer would also be required to provide advance notice of its proposal to replace directors at any annual meeting, and would not be able to cumulate votes at a meeting, which would require the acquirer to hold more shares to gain representation on the board of directors than if cumulative voting were permitted.

     Our board of directors also has the ability to issue preferred stock that could significantly dilute the ownership of a hostile acquirer. In addition, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by the board of directors. These provisions and other similar provisions make it more difficult for a third party to acquire us without negotiation. These provisions may apply even if the offer may be considered beneficial by some stockholders.

     Our board of directors could choose not to negotiate with an acquirer that it did not believe was in our strategic interests. If an acquirer is discouraged from offering to acquire us or prevented from successfully completing a hostile acquisition by these or other measures, you could lose the opportunity to sell your shares at a favorable price.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates and foreign exchange rates. We do not hold or issue financial instruments for trading purposes.

     Interest Rate Risk. We invest our cash in a variety of financial instruments, consisting primarily of investments in money market accounts, high quality corporate debt obligations or United States government obligations. Our investments are made in accordance with an investment policy approved by our Board of Directors. All of our investments are classified as available-for-sale and carried at fair value, which is determined based on quoted market prices, with net unrealized gains and losses included in

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“Accumulated other comprehensive income” in the accompanying consolidated balance sheets.

     Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities, that typically have a shorter duration, may produce less income than expected if interest rates fall. Due in part to these factors, our investment income may decrease in the future due to changes in interest rates. At March 31, 2004, the average maturity of our investments was nine months and all investment securities had maturities of less than twenty-four months. The following table presents certain information about our financial instruments at March 31, 2004 that are sensitive to changes in interest rates (in thousands, except for interest rates):

     Our exposure to market risk also relates to the increase or decrease in the amount of interest expense we must pay on our outstanding debt instruments. In March 2004, we renewed our revolving line of credit for borrowings up to $10.0 million and outstanding term loans totaling $1.1 million. The revolving line of credit and term loans bear a variable interest rate based on the lender’s prime rate and prime rate plus 0.50%, respectively. The risk associated with fluctuating interest expense is limited to these debt instruments. We currently have no borrowings against our revolving line of credit. Due to our low amount of debt as of March 31, 2004, we do not believe that any change in the prime rate would have a significant impact on our interest expense.

     Foreign Currency Exchange Risk. Our revenues and our expenses, except those related to our United Kingdom, German, Italian and Australian operations, are generally denominated in United States dollars. For the year ended March 31, 2004, we derived approximately 8% of our revenues from our international operations. As a result, we have relatively little exposure to currency exchange risks and foreign exchange losses have been minimal to date. We expect to continue to do a majority of our business in United States dollars. We have not entered into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we believe our foreign currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.

Item 4. Controls and Procedures

     Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this quarterly report of Callidus Software Inc. on Form 10-Q, have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were adequate and designed to ensure that material information related to us and our consolidated subsidiaries would be made known to them by others within these entities.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

     In March 2002, we received a copy of a complaint filed by Gordon Food Service (Gordon Food) in the United States District Court for the Western District of Michigan alleging breach of contract and misrepresentation in connection with software purchased by Gordon Food and seeking monetary damages. In December 2002, the court granted our motion to transfer venue and ordered that the case be transferred to the San Jose division of the United States District Court for the Northern District of California. After a court-ordered mediation took place in July 2003, Gordon Food filed a motion for leave to amend its complaint in order to add several California state law claims, including intentional misrepresentation and unfair competition, as well as to add a demand for a jury trial. In a hearing in September 2003, we did not oppose the amendment to the extent that it sought to add claims but objected to the jury trial demand on the grounds that Gordon Food had waived this right previously. In October 2003, the court granted leave to amend the complaint but denied the jury trial demand and Gordon Food filed its amended complaint. We have filed an answer to the amended complaint and intend to continue to contest the claims vigorously. Trial is currently set for November 2004, and pre-trial discovery and investigation are ongoing.

     In addition, we are from time to time a party to various litigation matters incidental to the conduct of our business. There is no pending or threatened legal proceeding to which we are a party that, in our opinion, is likely to have a material adverse effect on our future financial results.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

     We have used and intend to continue to use the net proceeds of our initial public offering for working capital and general corporate purposes, including expanding our sales efforts, research and development and international operations. Pending use for these or other purposes, we have invested the net proceeds of the offering in interest-bearing, investment-grade securities.

Item 3. Defaults Upon Senior Securities

     None.

Item 4. Submission of Matters to a Vote of Security Holders

     None.

Item 5. Other Information

     None.

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

(b) Reports on Form 8-K

     On January 22, 2004, we filed a Current Report on Form 8-K with respect to a press release issued by us discussing our results of operations and financial condition for the fourth quarter 2003.

     On March 29, 2004, we filed a Current Report on Form 8-K with respect to a press release issued by us discussing the anticipated revenues and net loss for the fiscal quarter ending March 31, 2004.

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on May 14, 2004.

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EXHIBIT INDEX

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