SELECTICA INC - 10-Q Quarterly Report

Indicate by a 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 filing requirements for the past 90 days. Yes þ No o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Approximately 31,741,302 shares of Common Stock, $0.0001 par value, as of October 31, 2002.

The condensed consolidated balance sheet as of September 30, 2002, the condensed consolidated statements of operations for the three and six months ended September 30, 2002 and 2001, and the condensed consolidated statements of cash flows for the six months ended September 30, 2002 and 2001 have been prepared by the Company and are unaudited. In the opinion of management, all necessary adjustments, which include normal recurring adjustments, have been made to present fairly the financial position, results of operations, and cash flows for the periods presented. Interim results are not necessarily indicative of the results for a full fiscal year. The condensed consolidated balance sheet as of March 31, 2002 has been derived from audited consolidated financial statements at that date.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2002.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated balance sheet as of September 30, 2002, the condensed consolidated statements of operations for the three and six months ended September 30, 2002 and 2001, and the condensed consolidated statements of cash flows for the six months ended September 30, 2002 and 2001, and accompanying notes. Actual results could differ from those estimates.

Certain reclassifications have been made to prior year’s consolidated balance sheets, consolidated statements of operations, and consolidated statements of cash flows to conform to the current year presentation. Other than the reclassification of approximately $37.4 million from short-term investments to cash equivalents as of March 31, 2002, and the reclassifications to comply with the Financial Accounting Standards Board (FASB) Staff Announcement Topic D-103 (Topic D-103), “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred”, no reclassifications were material. The amounts recorded to increase Service Revenues and Cost of Service Revenues were approximately $400,000 and $1.6 million for the three and six months ended September 30, 2001, respectively.

A limited number of customers have historically accounted for a substantial portion of the Company’s revenues.

Customers who accounted for at least 10% of gross accounts receivable were as follows:

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker or group in deciding how to allocate resources and in assessing performance. The Company operates in one segment, Interactive Selling System software for electronic commerce. The Company primarily markets its products in the United States. For the three and six months ended September 30, 2002, sales to international locations were approximately 18% and 13% of total revenues, respectively, and derived primarily from the United Kingdom, Canada, India, and Japan. For the three months ended September 30, 2002, sales in the United Kingdom were approximately 13% of total revenues. For the three and six months ended September 30, 2001, sales to international locations were approximately 12% and 21% of total revenues, respectively, and derived primarily from the United Kingdom, Korea, Canada, Japan, and Germany. Export revenues are attributable to countries based on the location of the customers.

Cash equivalents as of September 30, 2002 and March 31, 2002 consist of highly liquid investments with original maturities of 90 days or less at date of purchase. The carrying values of cash equivalents approximate their fair values. The following is a summary of the aggregate cost, gross unrealized gains (losses), and estimated fair value of the Company’s cash equivalents:

All investments as of September 30, 2002 and March 31, 2002 are classified as available-for-sale securities. Short-term investments generally consist of highly liquid securities that the Company intends to hold for more than 90 days but less than 1 year. Long-term investments generally consist of securities that the Company intends to hold for more than 1 year. Such investments are carried at fair value with unrealized

gains and losses reported within accumulated other comprehensive income. The following is a summary of the aggregate cost, gross unrealized losses, and estimated fair value of the Company’s investments:

Unrealized holding gains on available-for-sale securities as of September 30, 2002 and March 31, 2002 were approximately $136,000 and $29,000, respectively and are included in accumulated other comprehensive income.

As of September 30, 2002, the Company had two operating leases that require security deposits to be maintained at financial institutions for the term of the leases. The total security deposit of the leases in the amount of approximately $278,000 is classified as a restricted long-term investment and is held in commercial paper. In addition, due to the acquisition of Wakely Software, Inc., the total escrow fund of approximately $1.0 million is held in corporate bonds and classified as a restricted long-term investment. The full amount of $1.0 million will be paid to the founder of Wakely Software, Inc. in August 2003 per the escrow agreement. The interest earned on the investment may be used in operations.

During the three and six months ending September 30, 2002, options worth approximately $4,000 and $16,000 were granted to employees with exercise prices that were less than fair value of the underlying common stock. Such compensation will be amortized over the vesting period of the options, typically four

years. For the three and six months ended September 30, 2002, the Company amortized approximately $462,000 and $931,000 of deferred compensation, respectively.

During the three months ended September 30, 2002, in connection with employee termination agreements, the Company accelerated the vesting of options to purchase approximately 235,400 shares of common stock. For the three and six months ended September 30, 2002, the Company recorded approximately $248,000 of related compensation expense of which approximately $231,000 was included in cost of goods sold and $17,000 was recorded as marketing expenses.

As a result of the repurchase of shares of common stock, which were originally issued in exchange for full recourse promissory notes, from certain key employees during the year ended March 31, 2002, the remaining outstanding shares owned by those employees representing 166,772 shares and approximately $384,000 in total outstanding notes, were deemed to be compensatory as of January 4, 2002 and became subject to variable accounting. We are required to revalue these promissory notes each period which may result in additional compensation in future quarters.

During the three months ended September 30, 2002, the Company recorded a total compensation expense of approximately $117,000 related to variable accounting of which approximately $49,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing expense and approximately $67,000 was included in general and administrative expense. During the six months ended September 30, 2002, the Company recorded a total compensation expense of approximately $228,000 related to variable accounting of which approximately $89,000 was included in cost of goods sold, approximately $2,000 was included in sales and marketing expense and approximately $137,000 was included in general and administrative expense.

During the three months ended September 30, 2002, the Company repurchased approximately 1.0 million shares of its common stock at an average price of $3.73 in the open market at a cost of approximately $3.8 million including brokerage fees. During the six months ended September 30, 2002, the Company repurchased approximately 2.2 million shares of its common stock at an average price of $3.75 in the open market at a cost of approximately $8.3 million including brokerage fees. The aggregate of the purchases since the authorization by the Board was approximately 4.0 million shares at the cost of approximately $14.6 million including brokerage fees. This program was authorized by the Board of Directors in August 2001 to allow the Company to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board.

The Company calculates earnings per share in accordance with Statement of Financial Accounting Standards (SFAS) No. 128, “Earnings per Share”. The diluted net loss per share is equivalent to the basic net loss per share because the Company has experienced losses since inception and thus no potential common shares from the exercise of stock options, conversion of convertible preferred stock, or exercise of warrants have been included in the net loss per share calculation. Options and warrants to purchase 5,531,914 and 5,749,750 shares of common stock were excluded from the three and six months ended September 30, 2002 computation, respectively, as their effect is antidilutive.

The following table presents the computation of basic and diluted net loss per share:

The components of comprehensive loss, net of related income tax, for the three and six months ended September 30, 2002 and 2001 are as follows:

Between June 5, 2001 and June 22, 2001, four securities class action complaints were filed against the Company, certain of our officers and directors, and Credit Suisse First Boston Corporation (“CSFB”), as the underwriters of our March 13, 2000 initial public offering (“IPO”), in the United States District Court for the Southern District of New York. On August 9, 2001, these actions were consolidated before a single judge along with cases brought against numerous other issuers, their officers and directors and their underwriters, that make similar allegations involving the allocation of shares in the IPOs of those issuers. The consolidation was for purposes of pretrial motions and discovery only. On April 19, 2002, plaintiffs filed a consolidated amended complaint asserting essentially the same claims as the original complaints.

The amended complaint alleges that the Company, the officer and director defendants and CSFB violated federal securities laws by making material false and misleading statements in the prospectus incorporated in our registration statement on Form S-1 filed with the SEC in March, 2000 in connection with our IPO. Specifically, the complaint alleges, among other things, that CSFB solicited and received excessive and undisclosed commissions from several investors in exchange for which CSFB allocated to those investors material portions of the restricted number of shares of common stock issued in our IPO. The complaint further alleges that CSFB entered into agreements with its customers in which it agreed to allocate the common stock sold in our IPO to certain customers in exchange for which such customers agreed to purchase additional shares of our common stock in the after-market at pre-determined prices. The complaint also alleges that the underwriters offered to provide positive market analyst coverage for the Company after the

IPO, which had the effect of manipulating the market for Selectica’s stock. Plaintiffs contend that, as a result of the omissions from the prospectus and alleged market manipulation through the use of analysts, the price of the Company’s stock was artificially inflated between the date of the IPO and December 6, 2000 and that the defendants are liable for unspecified damages to those persons who purchased stock during that period.

On July 15, 2002, the Company and the officer and director defendants, along with other issuers and their related officer and director defendants, filed a joint motion to dismiss based on common issues. Opposition and reply papers have been filed and the Court has heard oral argument. The Court has not yet decided the matter.

On October 8, 2002, the individual officers and directors entered into a stipulation of dismissal and tolling agreement with plaintiffs. As part of that agreement, plaintiffs dismissed the case without prejudice against the individual defendants. The Court ordered the dismissal without prejudice on October 9, 2002.

On April 16, 2002, a shareholder derivative action was filed in the Superior Court of California, Santa Clara County, against certain of our officers and directors, against CSFB, as the underwriters of our IPO, and against the Company as nominal defendant. The action was filed by a shareholder purporting to assert on behalf of the Company claims for breach of fiduciary duty, aiding and abetting and conspiracy, negligence, unjust enrichment, and breach of contract, relating to the pricing of shares in the Company’s IPO. On June 6, 2002, the shareholder plaintiff filed an amended complaint dropping the breach of contract claim against CSFB and adding claims against CSFB for breach of an agent’s duty to its principal and for violation of the California Unfair Competition Law, based on alleged violations of certain rules of the National Association of Securities Dealers.

On July 17, 2002, CSFB removed the action to the United States District Court for the Northern District of California, with our consent and the consent of the officer and director defendants. Thereafter, CSFB filed a motion to dismiss the action on the grounds that plaintiff lacks standing under federal procedural rules, and plaintiff filed a motion to transfer the action to federal court in New York for coordination with the securities class action litigation noted above. On September 16, 2002, recognizing that the action was likely to return at some point to state court, the parties stipulated to take the pending motions to dismiss and to transfer off calendar and to have the action remanded to state court. On September 23, 2002, the federal court ordered the case to be remanded back to the Santa Clara County Superior Court. The responses of all defendants to the amended complaint are currently due in late November 2002.

The Company believes that the securities class action allegations against the Company and our officers and directors are without merit and intends to contest them vigorously. However, the litigation is in its preliminary stages, and the Company cannot predict its outcome. The litigation process is inherently uncertain. If the outcome of the litigation is adverse to the Company and if, in addition, the Company is required to pay significant monetary damages, the Company’s business would be significantly harmed. The shareholder derivative litigation is also in its preliminary stages. At a minimum, the class action litigation as well as the shareholder derivative litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

During the three and six months ended September 30, 2002, the Company recorded restructuring charges of approximately $1.5 million which were the result of a plan established to align the Company’s global workforce with existing and anticipated market requirements. Approximately $259,000 of restructuring costs was accounted as cost of services revenues, $142,000 as research and development expense, $390,000 as sales and marketing expense and $720,000 as general and administrative expense. During the three months ended September 30, 2001, the Company recorded restructuring charges of approximately $49,000 which was accounted as general and administrative expense. For the six month ended September 30, 2001, the Company

recorded restructuring charges of approximately $1.4 million of which $189,000 was accounted as cost of services revenues, $287,000 as research and development expense, $359,000 as sales and marketing expense and $605,000 as general and administrative expense.

The restructuring charges were primarily for the severance and benefits paid to the terminated employees. During the six months ended September 30, 2002, the Company terminated 47 employees (or 9% of its workforce) globally, in the areas of administration, marketing, business development, engineering, sales, consulting and services support. The restructuring activities are expected to be completed in December 2002.

As of September 30, 2002 and March 31, 2002, the balance of the reserve for restructuring was approximately $587,000 and $182,000, respectively, which was included in Other Accrued Liabilities in the accompanying condensed consolidated balance sheet and is summarized as follows:

During the quarter ended June 30, 2002, we wrote off the entire remaining goodwill balance of approximately $10.0 million due to the adoption of SFAS 142 “Goodwill and Other Intangible Assets.”

In accordance with SFAS 142 adopted on April 1, 2002, we stopped the periodic amortization of goodwill. The following table shows the reconciliation of reported net loss adjusted for the adoption of SFAS 142 for the three and six months ended September 30, 2001 (unaudited in thousands, except per share data):

Deferred revenues of approximately $12 million as of September 30, 2002 and March 31, 2002 represents cash received and amounts billed for services performed which is included as part of the Accounts Receivable balance at September 30, 2002 and March 31, 2002. This is summarized as follows:

In August 2001, the Financial Accounting Standards Board (FASB) issued Statement on Financial Accounting Standards (SFAS) 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” SFAS 144, which supercedes SFAS 121, establishes a single accounting model, based on the framework established in SFAS 121, for long-lived assets to be disposed of by sale. The statement is effective for financial statements issued for fiscal years beginning after December 15, 2001. We adopted SFAS 144 beginning fiscal 2003 and the provisions of this statement did not have a significant impact on our financial condition or operating results.

methodology. The initial step requires us to determine the fair value of each reporting unit and compare it to the carrying value, including goodwill, of such unit. If the fair value exceeds the carrying value, no impairment loss would be recognized. However, if the carrying value of the reporting unit exceeds its fair value, the goodwill of this unit may be impaired. The amount, if any, of the impairment would then be measured in the second step.

During fiscal year 2002 the applicable accounting policy for reviewing for goodwill impairment was an undiscounted cash flow basis, a method allowed by SFAS 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”. When analyzed using undiscounted cash flows prescribed by SFAS 121, we did not have an impairment of any intangibles assets at March 31, 2002.

In April 2002, we performed, under SFAS 142, the first of the required impairment tests of goodwill and indefinite lived intangible assets. That test indicated that the carrying values of certain reporting units exceeded their estimated fair values, as determined utilizing various valuation techniques including discounted cash flow and comparative market analysis. Thereafter, given the indication of a potential impairment, we performed step two of the test. We compared the implied fair value of the affected reporting unit’s goodwill to its carrying value to measure the amount of impairment. The fair value of goodwill was determined by allocating the reporting unit’s fair value to all of its assets and liabilities in a manner similar to a purchase price allocation. Based on this analysis, we measured and recognized an impairment loss of approximately $10.0 million for the three months ended June 30, 2002. This loss was recorded as a cumulative effect of an accounting change in the period.

In June 2001, the FASB issued SFAS 141, “Business Combinations,” effective for fiscal years beginning after December 15, 2001. SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets separate from goodwill. We adopted SFAS 141 in the beginning of fiscal 2003. (See Note 8.)

In November 2001, the FASB issued a Staff Announcement Topic D-103 (Topic D-103), “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred.” Topic D-103 establishes that reimbursements received for out-of-pocket expenses should be reported as revenue in the statement of operations. In the past, the Company classified reimbursed out-of-pocket expenses as a reduction of cost of revenue. The Company was required to adopt this guidance effective January 1, 2002. The Company has complied with Topic D-103, and recorded reimbursable expenses as Services revenues and the corresponding Cost of services revenues. The Company’s financial results of operations for prior periods were reclassified to conform to the new presentation. The amount recorded to increase Service Revenues and Cost of Service Revenues was approximately $1.6 million for the period ended September 30, 2001. The Company’s adoption of Topic D-103 will not affect the Company’s net loss in any past or future periods.

In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses accounting for restructuring and similar costs. SFAS 146 supersedes previous accounting guidance, principally Emerging Issues Task Force Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Application of SFAS 146 is required for restructuring activities initiated after December 31, 2002. SFAS 146 requires recognition of the liability for costs associated with an exit or disposal activity when the liability is incurred. Under Issue No. 94-3, a liability for an exit cost was recognized at the date of the Company’s commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing future restructuring costs, as well as the amounts recognized.

In addition to historical information, this quarterly report contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those projected. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Management’s Discussion and Analysis‘ and “Risks Related to Our Business.” Actual results could differ materially. Important factors that could cause actual results to differ materially include, but are not limited to, the level of demand for Selectica’s products and services; the intensity of competition; the sales cycle; Selectica’s ability to effectively manage product transitions and to continue to expand and improve internal infrastructure; and risks associated with potential acquisitions. For a more detailed discussion of the risks relating to Selectica’s business, readers should refer to the section later in this report entitled “Risks Related to Our Business.” Readers are cautioned not to place undue reliance on the forward-looking statements, including statements regarding the Company’s expectations, beliefs, intentions or strategies regarding the future, which speak only as of the date of this quarterly report and Selectica assumes no obligation to update these forward-looking statements.

Selectica is a leading provider of Interactive selling system software and services that enable companies to efficiently sell complex products and services over intranets, extranets and the Internet. Our ACE suite of software products is a comprehensive Interactive Selling System solution that gives sellers the ability to manage the sales process in order to facilitate the conversion of prospective buyers into customers. Our Interactive Selling System solution allows companies to use the Internet platform to deploy a selling application to many points of contact, including personal computers, in-store kiosks and mobile devices, while offering customers, partners and employees an interface customized to their specific needs.

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expenses during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, allowance for doubtful accounts, impairment of intangible assets, income taxes, restructuring, litigation and other contingencies. The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our consolidated financial statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our financial statements and they require our most difficult, subjective or complex judgments in the preparation of our consolidated financial statements:

We enter into arrangements for the sale of (1) licenses of our software products and related maintenance contracts; (2) bundled license, maintenance, and services; and (3) services on a time and material basis. In instances where maintenance is bundled with a license of our software products, such maintenance contracts are typically for a one-year term.

For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met.

For those arrangements that consist of a license and a maintenance contract, we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered and recognize maintenance revenues over the term of the maintenance contract as vendor-specific objective evidence of fair value for maintenance is determined.

Services can consist of maintenance, training and/or consulting services. Consulting services include a range of services including installation of our off-the-shelf software, customization of our software for the customer’s specific application, data conversion and building of interfaces to allow our software to operate in customized environments.

In all cases, we assess whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In this determination we focus on whether the software is off-the-shelf software, whether the services include significant alterations to the features and functionality of the software, whether the services involve the building of complex interfaces, the timing of payments and the existence of milestones. Often the installation of our software requires the building of interfaces to the customer’s existing applications or customization of the software for specific applications. As a result, judgment is required in the determination of whether such services constitute “complex” interfaces. In making this determination we consider the following: (1) the relative fair value of the services compared to the software, (2) the amount of time and effort subsequent to delivery of the software until the interfaces or other modifications are completed, (3) the degree of technical difficulty in building of the interface and uniqueness of the application, (4) the degree of involvement of customer personnel, and (5) any contractual cancellation, acceptance, or termination provisions for failure to complete the interfaces. We also consider refunds, forfeitures and concessions when determining the significance of such services.

In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement using contract accounting.

For those arrangements accounted for using contract accounting that do not include contractual milestones or other acceptance criteria we utilize the percentage of completion method based upon input measures of hours. For those contracts that include contractual milestones or acceptance criteria we recognize revenue as such milestones are achieved or as such acceptance occurs.

In some instances the acceptance criteria in the contract requires acceptance after all services are complete and all other elements have been delivered. In these instances we recognize revenue based upon the completed contract method after such acceptance has occurred.

For those arrangements for which we have concluded that the service element is not essential to the other elements of the arrangement we determine whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether we have sufficient experience in providing the service to be able to separately account for the service. When the service qualifies for separate accounting, we use vendor-specific objective evidence to determine the fair value of the services and the maintenance. In such instances, we account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element.

Vendor-specific objective evidence of fair value of services is based upon hourly rates. As noted above, we enter into contracts for services alone and such contracts are based on a time and materials basis. Such hourly rates are used to assess the vendor-specific objective evidence in multiple element arrangements.

In accordance with paragraph 10 of Statement of Position 97-2, Software Revenue Recognition, vendor-specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration.

To date we have not entered into arrangements solely for the license of our products and, therefore, we have not demonstrated vendor-specific objective evidence for the fair value of the license element.

In all cases we classify revenues for these arrangements as license revenues and services revenues based on the estimates of fair value for each element.

For the three months ended September 30, 2002 and 2001, we recognized 43% and 27% of our licenses and services revenues under the completed contract method, 46% and 72% under the percentage-of-completion method, and 11% and 1% under the residual method, respectively. For the six months ended September 30, 2002 and 2001, we recognized 43% and 16% of our revenues under the completed contract method, 51% and 74% of license and services revenues under the percentage-of-completion method, and 6% and 10% under the residual method, respectively.

Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenue. Amounts recognized as revenue in advance of billing (typically under percentage-of-completion accounting) are recorded as unbilled receivables.

Goodwill and intangible assets, which resulted from our business combinations accounted for as purchases, were recorded at amortized cost. We periodically reviewed the carrying amounts of these intangible assets for indications of impairment based on the operational performance of the acquired businesses and market conditions or sooner whenever events or changes in circumstances indicated the carrying values of such assets might not be recoverable. We considered some of the following factors important in deciding when to perform an impairment review: significant under-performance of a product line relative to budget; shifts in business strategies, which impacted the continued uses of the assets; significant negative industry or economic trends; and the results of past impairment reviews. If indications of impairment were present, we assessed the value of the intangible assets using estimates of future undiscounted cash flows. Impairment charges, if any, resulted in situations when the fair values of these assets were less than the carrying value. During fiscal year 2002, various restructuring activities as well as the overall economic conditions signaled an indication of possible impairment. We then analyzed the value of our various intangibles by comparing the carrying value of these assets to the undiscounted cash flows estimated to be generated by these assets. Based on this analysis there was no impairment during fiscal year 2002. Beginning in fiscal year 2003, the method for assessing potential impairments of intangibles was changed based on new accounting rules issued by the Financial Accounting Standards Board (FASB), and related implementation guidance. The application of these new rules resulted in a cumulative effect of an accounting change of approximately $10.0 million in the first quarter of fiscal year 2003.

In accordance with this new accounting standard adopted on April 1, 2002, we stopped the periodic amortization of goodwill at the beginning of fiscal year 2003. Had amortization of goodwill been continued beyond April 1, 2002, we would have recognized an additional $664,000 and $1.3 million in amortization expense during the three months and six months ended September 30, 2002.

We maintain an allowance for doubtful accounts to reflect the estimated losses resulting from the inability of our customers to make required payments based on past collection history and specific risks identified in our portfolio of receivables. While we believe our existing reserve for doubtful accounts is adequate and proper, if the financial condition of our customers deteriorate resulting in an impairment of their ability to make payments, or if payments from customers are significantly delayed, or as unusual circumstances arise, additional allowances might be required.

We use the asset and liability approach to account for income taxes. This methodology recognizes deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax base of assets and liabilities. We then record a valuation allowance to reduce deferred tax assets to an amount that likely will be realized. We consider future taxable income and ongoing

prudent and feasible tax planning strategies in assessing the need for the valuation allowance. Our assessment of the recoverability of deferred tax assets is principally dependent upon our achievement of projected future taxable income in specific geographies and the ability to utilize net operating loss carryforwards. To date we have not assumed the ability to recover any of these amounts due to the uncertainty of future profitability. Our judgments regarding future profitability may change due to future market conditions and other factors. These changes, if any, may require possible material adjustments to deferred tax assets and the valuation allowance, resulting in a reduction in net income in the period when such determinations are made. If we determined during any period that we could realize a larger net deferred tax asset than the recorded amount, we would adjust the deferred tax asset to increase income for the period. Conversely, if we determine that we would be unable to realize a portion of our recorded deferred tax asset, we would adjust the deferred tax asset to record a charge to income for the period.

As of September 30, 2002, we have the remaining balance of the accruals for restructuring of $587,000 in connection with our restructuring program. These accruals included estimates primarily pertaining to employee separation costs and the settlements of contractual obligations resulting from our actions. Although we do not anticipate significant changes to these estimates, the actual costs may differ from the estimates.

We may be subject to various proceedings, lawsuits and claims relating to the normal course of business. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. The amount of loss accrual, if any, is determined after careful analysis of each matter, and is subject to adjustment if warranted by new developments or revised strategies.

A relatively small number of customers accounted for a significant portion of our total revenues. For the three months ended September 30, 2002, revenue from Customers A and B accounted for 39% and 13% of our revenues, respectively. For the three months ended September 30, 2001, revenue from Customer C accounted for 11% of our revenues. For the six months ended September 30, 2002, revenue from Customers A and B accounted for 19% and 17% of our revenues, respectively. For the six months ended September 30, 2001, we did not have any customers which accounted for over 10% of our revenues.

To date, we have foreign activities in India, Canada and some European and Asian countries because we believe international markets represent a significant growth opportunity. We anticipate that our exposure to foreign currency fluctuations will continue since we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations. In addition, if the recent conflict between India and Pakistan continues to escalate, it could adversely affect our operations in India.

We have a limited operating history upon which we may be evaluated. We have incurred significant losses since inception and, as of September 30, 2002, we had an accumulated deficit of approximately $140.1 million. We believe our success depends on the continued growth of our customer base and the development of the emerging Interactive Selling System market. Due to the recent declines in the U.S. economy, particularly in the area of technology infrastructure investment, the uncertain prospects for recovery in either technology infrastructure spending or the broader economy and in an effort to achieve profitability, we underwent certain restructuring activities. For the three months ended September 30, 2002, the Company reduced its headcount by 47 individuals globally or approximately 9% of its workforce as of June 30, 2002. We plan to reduce our investment in research and development, sales and marketing, and general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

In view of the rapidly changing nature of our business and our limited operating history, we believe that period-to-period comparisons of revenues and operating results are not necessarily meaningful and should not be relied upon as indications of future performance. Our limited operating history makes it difficult to forecast future operating results. Additionally, we do not believe that historical growth rates are indicative of future

As a result of the repurchase of shares of common stock from certain key employees 2002 which were originally issued in exchange for full recourse promissory notes, during the year ended March 31, the remaining outstanding shares owned by these employees representing 166,772 shares and approximately $384,000 in total outstanding notes, were deemed to be compensatory as of January 4, 2002 and became subject to variable accounting. We are required to revalue these promissory notes each period which may result in additional compensation in future quarters.

During the three months ended September 30, 2002, the Company repurchased approximately 1.0 million shares of its common stock at an average price of $3.73 in the open market at a cost of approximately $3.8 million including brokerage fees. During the six months ended September 30, 2002, the Company repurchased approximately 2.2 million shares of its common stock at an average price of $3.75 in the open market at a cost of approximately $8.3 million including brokerage fees. The aggregate of the purchase since the authorization by the Board was approximately 4.0 million shares at the cost of approximately $14.6 million including brokerage fees. This program was authorized by the Board of Directors in August 2001 to allow the Company to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board.

License. License revenues decreased 18% and 44% for the three and six months ended September 30, 2002, respectively, as compared to the same periods in fiscal year 2002 due primarily to a decline in sales volume arising from the weakening economic environment. The slowdown in the economy has caused a significant decrease in technology spending. We expect the economic slowdown to continue to adversely impact growth opportunities in our license business and license revenues to continue to fluctuate in future periods in absolute dollars and as a percentage of total revenues.

Services. Services revenues are comprised of fees from consulting, maintenance, training and out-of-pocket reimbursements. The services revenues have remained relatively constant in the three months ended

September 30, 2002 as compared to the three months ended September 30, 2001. Services revenues decreased 13% for the six months ended September 30, 2002 as compared to the six months ended September 30, 2001. The decrease was due primarily to the decline in license sales which resulted in a decrease in revenues from new customer implementations, maintenance and training that typically accompany the license of our products. During the three and six months ended September 30, 2001, services revenues were reduced by amortization of approximately $250,000 and $250,000, the fair value of the warrant issued to a significant customer in connection with a license and service agreement. We expect services revenues to continue to fluctuate in future periods in absolute dollars and as a percentage of total revenues.

Overall, the total revenues for the three and six months ended September 30, 2002 decreased 7% and 25%, respectively, as compared to the three and six months ended September 30, 2001 due to the reasons explained above. Revenues consisted of 66% and 71% of services revenues for the three and six months ended September 30, 2002 as compared to 61% and 60% for the same periods in fiscal year 2002. The increase was primarily due to the increasing demand for the system integration and platform expansion from our existing customers. We expect the percentage of services and licenses revenues to continue to fluctuate from quarter-to-quarter basis. We believe that the future revenues will continue to fluctuate due to the changing number and size of new customers, the number of consulting projects and maintenance contracts, changes in the demand for Interactive Selling System software and general economic conditions.

Cost of License Revenues. Cost of license revenues consists of royalty fees associated with third-party software, the costs of the product media, duplication, packaging and delivery of our software products to our customers, which may include documentation, shipping and other data transmission costs. The increase of 66% in cost of license revenues for the three months ended September 30, 2002 as compared to the three months ended September 30, 2001 was due primarily to a one-time royalty fee and costs associated with foreign sales. While the absolute cost of license revenues have remained relatively constant for the six months ended September 30, 2002 as compared to the six months ended September 30, 2001, there has been an increase of costs as a percentage of license revenues. This was due primarily to the fact that we have certain fixed costs that are not dependent upon sales volume.

Cost of Services Revenues. Cost of services revenues is comprised mainly of salaries and related expenses of our services organization plus certain allocated expenses. The decrease of 29% and 33% in cost of services revenues for the three and six months ended September 30, 2002 as compared to the three and six months ended September 30, 2001 were due primarily to the restructuring activities in fiscal year 2002 which reduced the number of consultants, product support staff and training staff, and the adoption of SFAS 142. With the adoption of SFAS 142, we have ceased amortization of goodwill as of April 1, 2002. For the three months ended September 30, 2002, we amortized approximately $171,000 for deferred compensation expenses related to stock options, $50,000 for compensation expenses related to variable accounting, $259,000 for restructuring charges and $231,000 for compensation expenses related to option acceleration, respectively. For the three months ended September 30, 2001, we amortized approximately $220,000 for the deferred compensation expenses related to stock option and $281,000 for goodwill in connection with the Wakely Software acquisition, respectively. For the six months ended September 30, 2002, we amortized approximately $345,000 for deferred compensation expenses related to stock options and $90,000 for compensation expenses related to variable accounting, $259,000 for restructuring charges and $231,000 for compensation expenses related to option acceleration. For the six months ended September 30, 2001, we amortized approximately

Research and Development. Research and development expenses consist mainly of salaries and related costs of our engineering, quality assurance, technical publications efforts and certain allocated expenses. The decreases of 9% and 15% in research and development expenses for the three and six months ended September 30, 2002 as compared to the same periods in fiscal year 2002 were due primarily to the fact that the development agreement entered into with a significant customer was fully amortized in fiscal year 2002. For the three months ended September 30, 2002, we recorded approximately $65,000 for amortization of deferred compensation expenses related to stock options and $142,000 for restructuring charges. For the three months ended September 30, 2001, we recorded approximately $67,000 for deferred compensation expenses related to stock options and $544,000 for the development agreement entered into with a significant customer. For the six months ended September 30, 2002, we recorded approximately $130,000 for amortization of deferred compensation expenses related to stock options and $142,000 for restructuring charges. For the six months ended September 30, 2001, we recorded approximately $137,000 for deferred compensation expenses related to stock options, $1.1 million for the development agreement entered into with a significant customer, $287,000 for restructuring charges and $7,000 for compensation expenses related to option acceleration, respectively. We plan to reduce our investment in research and development in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

Sales and Marketing. Sales and marketing expenses consist mainly of salaries and related costs for our sales and marketing organization, sales commissions, expenses for trade shows, public relations, collateral sales materials, advertising and certain allocated expenses. The decreases of 19% and 28% in the sales and marketing expenses for the three and six months ended September 30, 2002 as compared to the three and six months ended September 30, 2001 were due primarily to a reduction in spending on marketing programs and a decrease of sales commissions as a result of the decline of the sales volume. For the three months ended September 30, 2002, we recorded amortization expenses of approximately $143,000 for deferred compensation related to stock options, $390,000 for restructuring charges, $17,000 for compensation expenses related to option acceleration and $1,000 for compensation expenses related to variable accounting, respectively. For the three months ended September 30, 2001, we recorded expenses of approximately $160,000 for deferred compensation related to stock options. For the six months ended September 30, 2002, we recorded amortization expenses of approximately $290,000 for deferred compensation related to stock options, $390,000 for restructuring charges, $17,000 for compensation expenses related to option acceleration and $2,000 for compensation expenses related to variable accounting, respectively. For the six months ended September 30, 2001, we recorded amortization expenses of approximately $422,000 for deferred compensation related to stock options, $359,000 for restructuring charges, $106,000 for compensation expenses related to option acceleration, respectively. We plan to reduce our sales and marketing expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

General and Administrative. General and administrative expenses consist mainly of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, facilities

and information system expenses. The increase of 13% in general and administrative expenses for the three months ended September 30, 2002 as compared to the three months ended September 30, 2001 was due primarily to the severances and legal fees related to defend the IPO litigation. The decrease of 29% in general and administrative expenses for the six months ended September 30, 2002 as compared to the six months ended September 30, 2001 was due primarily to the adoption of SFAS 142. With the adoption of SFAS 142, we have ceased amortization of goodwill as of April 1, 2002. For the three months ended September 30, 2002, we amortized approximately $83,000 for deferred compensation expenses related to stock options, $720,000 for restructuring charges and $67,000 for compensation expenses related variable accounting, respectively. For the three months ended September 30, 2001, we amortized approximately $106,000 for deferred compensation expenses related to stock options, $49,000 for restructuring charges and $383,000 for the amortization of goodwill in connection with the Wakely Software acquisition, respectively. For the six months ended September 30, 2002, we amortized approximately $166,000 for deferred compensation expenses related to stock options, $720,000 for restructuring charges and $136,000 for compensation expenses related variable accounting, respectively. For the six months ended September 30, 2001, we amortized approximately $213,000 for deferred compensation expenses related to stock options, $12,000 for compensation expenses related to option acceleration, $605,000 for restructuring charges and $766,000 for the amortization of goodwill in connection with the Wakely Software acquisition. We plan to reduce our general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

Interest and other income, net, consists primarily of interest earned on cash balances, short-term and long-term investments, and stockholders’ notes receivable. Interest and other income, net, totaled approximately $762,000 and $1.7 million for the three and six months ended September 30, 2002 as compared to interest income of approximately $1.8 million and $3.8 million, respectively, for the same periods in fiscal year 2002. The decrease was due primarily to lower interest rates and the decrease of our investments due to these amounts being used for the operation of our business.

We did not record any tax provision for the three and six months ended September 30, 2002 as compared to approximately $79,000 and $154,000 for the three and six months ended September 30, 2001. The provision for income taxes consists solely of foreign taxes.

FASB Statement No. 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and the reported cumulative net losses in all prior years, we have provided a full valuation allowance against our net deferred tax assets. We intend to evaluate the realizability of the deferred tax assets on a quarterly basis.

In August 2001, the Financial Accounting Standards Board (FASB) issued Statements on Financial Accounting Standards (SFAS) 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” SFAS 144, which supercedes SFAS 121, establishes a single accounting model, based on the framework established in SFAS 121, for long-lived assets to be disposed of by sale. The statement is effective for financial statements issued for fiscal years beginning after December 15, 2001. We adopted SFAS 144 beginning fiscal 2003 and the provisions of this statement did not have a significant impact on our financial condition or operating results.

In April 2002, we performed, under SFAS 142, the first of the required impairment tests of goodwill and indefinite lived intangible assets. That test indicated that the carrying values of certain reporting units exceeded their estimated fair values, as determined utilizing various valuation techniques including discounted cash flow and comparative market analysis. Thereafter, given the indication of a potential impairment, we performed step two of the test. We compared the implied fair value of the affected reporting unit’s goodwill to its carrying value to measure the amount of impairment. The fair value of goodwill was determined by allocating the reporting unit’s fair value to all of its assets and liabilities in a manner similar to a purchase price allocation. Based on this analysis, we measured and recognized an impairment loss of approximately $10.0 million in the first quarter of fiscal year 2003. This loss was recorded as a cumulative effect of an accounting change for the period.

In November 2001, the FASB issued a Staff Announcement Topic D-103 (Topic D-103), “Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred.” Topic D-103 establishes that reimbursements received for out-of-pocket expenses should be reported as revenue in the statement of operations. In the past, the Company classified reimbursed out-of-pocket expenses as a reduction of cost of revenue. The Company was required to adopt this guidance effective January 1, 2002. The Company has complied with Topic D-103, and recorded reimbursable expenses as Services revenues and the corresponding Cost of services revenues. The Company’s financial results of operations for prior periods were reclassified to conform to the new presentation. The amount recorded to increase Service Revenues and Cost of Service Revenues was approximately $400,000 and $1.6 million for the three and six months ended September 30, 2001, respectively. The Company’s adoption of Topic D-103 will not affect the Company’s net loss in any past or future periods.

Cash, cash equivalents, short-term and long-term investments were approximately $127.0 million at September 30, 2002 compared to $144.2 million at March 31, 2002. The decrease primarily related to approximately $8.1 million of cash used in operations, $8.3 million for stock repurchase in the open market and $1.2 million for capital expenditures during the six months ended September 30, 2002. Accounts

Current liabilities of approximately $19.4 million have remained relatively constant at September 30, 2002 as compared to $19.9 million at March 31, 2002.

Total stockholders’ equity was approximately $126.1 million at September 30, 2002 and approximately $153.4 million at March 31, 2002. The net decrease of approximately $27.3 million was due primarily to approximately $20.7 million of net loss by the Company for the current period and $8.3 million of stock repurchase in the open market offset by approximately $107,000 of unrealized gain on securities, $240,000 of proceeds from issuance of common stock, $228,000 of compensation expenses related to variable accounting and $931,000 for deferred compensation expenses.

We have funded our operations with proceeds from the private sale of common and preferred stock, and our initial public offering. The net cash used in operating activities has remained relatively constant for the six months ended September 30, 2002 as compared to the six months ended September 30, 2001. For the six months ended September 30, 2002, the decrease was primarily due to a non-cash charge of goodwill amounting to approximately $10.0 million offset by increases in current assets and deferred revenue and offset by an increase in current liabilities. For the six months ended September 30, 2001, the decrease was primarily related to the decrease in accounts receivable offset by decrease in current liabilities and deferred revenue.

The decrease in net cash used in investing activities was due primarily to the net purchases of approximately $7.0 million in net purchases of available-for-sale investments and $1.2 million for capital expenditures during the six months ended September 30, 2002. The decrease in net cash used in investing activities was due primarily to the net purchases of approximately $9.7 million in net purchases of available-for-sale investments during the six months ended September 30, 2001.

The decrease in cash used in financing activities was due primarily to the repurchase of our common stock in the open market for $8.3 million during the six months ended September 30, 2002. The decrease in cash used in financing activities was due primarily to the repurchase of our common stock in the open market for $3.0 million during the six months ending September 30, 2001.

We had no significant commitments for capital expenditures as of September 30, 2002. We expect to fund our future capital expenditures, liquidity and strategic operating programs from a combination of available cash balances and internally generated funds. We have no outside debt, and do not have any plans to enter into borrowing arrangements.

We engage in global business operations and are therefore exposed to foreign currency fluctuations. As of September 30, 2002, the effects of the foreign currency fluctuations were immaterial.

In addition to other information in this Form 10-Q, the following risk factors should be carefully considered in evaluating Selectica and its business because such factors currently may have a significant impact on Selectica’s business, operating results and financial condition. As a result of the risk factors set forth below and elsewhere in this Form 10-Q, and the risks discussed in Selectica’s other Securities and Exchange Commission filings including our Form 10-K for our fiscal year ended March 31, 2002, actual results could differ materially from those projected in any forward-looking statements.

In the past, our quarterly operating results have varied significantly, and we expect these fluctuations to continue. Future operating results may vary depending on a number of factors, many of which are outside of our control.

Our quarterly revenues may fluctuate as a result of our ability to recognize revenue in a given quarter. We enter into arrangements for the sale of (1) licenses of our software products and related maintenance contract; (2) bundled license, maintenance, and services; and (3) services on a time and material basis. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met. Additionally, because we rely on a limited number of customers for our revenue, the loss or delay of one prospective customer may seriously significantly harm our operating results.

For those contracts that consist solely of license and maintenance, we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered since we have vendor-specific objective evidence of fair value of maintenance, we recognize maintenance revenues over the term of the maintenance contract. For those contracts that bundle the license with maintenance, training, and/or consulting services, we assess whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement using contract accounting.

For those arrangements accounted for using contract accounting that do not include contractual milestones or other acceptance criteria we utilize the percentage of completion method based upon input measures of hours. For those contracts that include contract milestones or acceptance criteria we recognize revenue as such milestones are achieved or as such acceptance occurs.

For those arrangements for which we have concluded that the service element is not essential to the other elements of the arrangements we determine whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether we have sufficient experience in providing the service to be able to separately account for the service. When the service qualifies for separate accounting we use vendor-specific objective evidence of fair value for the service.

Because we rely on a limited number of customers, the timing of customer acceptance or milestone achievement, or the amount of services we provide to a single customer can significantly affect our operating results. For example, our services and license revenues declined significantly in March 31, 2001 and June 30, 1999 due to the delay of milestone achievement of services under a particular contract. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations.” Because our expenses are relatively fixed in the near term, any shortfall from anticipated revenues could cause our quarterly operating results to fall below anticipated levels.

We may also experience seasonality in revenues. For example, in the quarter ended September 30, 2002, our bookings were significantly weaker than they had previously been in previous quarters. Because of the timing of our revenue recognition, this could impact a number of different quarterly results. In addition our quarterly results may fluctuate based upon our customers’ calendar year budgeting cycles. These seasonal variations may lead to fluctuations in our quarterly revenues and operating results.

Based upon the foregoing, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and that such comparisons should not be relied upon as indications of future performance. In some future quarter, our operating results may be below the expectations of public market analysts and investors, which could cause volatility or a decline in the price of our common stock.

We have experienced operating losses in each quarterly and annual period since inception. We incurred net losses applicable to common stockholders of approximately $26.4 million, $49.9 million and $31.8 million for the fiscal years ended March 31, 2002, 2001 and 2000, respectively. We have incurred net losses of approximately $20.7 million for the six months ended September 30, 2002 and an accumulated deficit of approximately $140.1 million as of September 30, 2002. We plan to reduce our investment in research and development, sales and marketing, and general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues. We will need to generate significant increases in our revenues to achieve and maintain profitability. If our revenue fails to grow or grows more slowly than we anticipate or our operating expenses exceed our expectations, our losses will significantly increase which would significantly harm our business and operating results.

The change in economic conditions may lead to revised budgetary constraints regarding information technology spending for our customers. We have had potential customers select our Interactive Selling System, but decide to delay or not to implement any configuration system. Companies have decided to reduce their expenditures for information technology by either delaying non-mission critical projects or abandoning them until their levels of business justifies the expense. A continuation of the general slowdown in information technology spending due to economic conditions or other factors could significantly harm our business and operating results.

The sales cycle of our products has historically averaged between six and nine months, and may sometimes be significantly longer. We are generally required to provide a significant level of education regarding the use and benefits of our products, and potential customers tend to engage in extensive internal reviews before making purchase decisions. In addition, the purchase of our products typically involves a significant commitment by our customers of capital and other resources, and is therefore subject to delays that are beyond our control, such as customers’ internal budgetary procedures and the testing and acceptance of new technologies that affect key operations. In addition, because we intend to target large companies, our sales cycle can be lengthier due to the decision process in large organizations. As a result of our products’ long sales cycles, we face difficulty predicting the quarter in which sales to expected customers may occur. If anticipated sales from a specific customer for a particular quarter are not realized in that quarter, our operating results for that quarter and subsequent quarters could fall below the expectations of financial analysts and investors, which could cause our stock price to decline.

The market for Interactive Selling System software, which has only recently begun to develop, is evolving rapidly and likely will have an increased number of competitors. Because this market is new, it is difficult to assess its competitive environment, growth rate and potential size. The growth of the market is dependent upon the willingness of businesses and consumers to purchase complex goods and services over the Internet and the acceptance of the Internet as a platform for business applications. In addition, companies that have already invested substantial resources in other methods of Internet selling may be reluctant or slow to adopt a new approach or application that may replace, limit or compete with their existing systems.

The relative youth of the market poses a number of concerns. The acceptance and growth of the Internet as a business platform may not continue to develop at historical rates and a sufficiently broad base of companies may not adopt Internet platform-based business applications. The decrease in technology infrastructure spending may reduce the size of the market for Internet Selling System software and other server based products. Our potential customers may decide to purchase more complete solutions offered by larger competitors instead of individual applications. If the market for Interactive Selling System software is slow to develop, or if our customers purchase more fully integrated products, it would significantly harm our business and operating results.

We were founded in June 1996 and have a limited operating history. We began marketing our ACE suite of products in early 1997 and released ACE 5.0, the newest version of our software, in August 2001. Our business model is still emerging, and the revenue and income potential of our business and market are unproven. As a result of our limited operating history, we have limited financial data that you can use to evaluate our business. You must consider our prospects in light of the risks and difficulties we may encounter as an early stage company in the new and rapidly evolving market for Interactive Selling Systems.

Our strategy has been to rely in part upon systems integrators and consulting firms to recommend our products to their customers and to install and deploy our products. To date, we have had limited success in utilizing these firms as a sales channel or as a provider of professional services. To increase our revenues and implementation capabilities, we must continue to develop and expand our relationships with these systems integrators and consulting firms. If these systems integrators and consulting firms are unwilling to install and deploy our products, we may not have the resources to provide adequate implementation services to our customers and our business and operating results could be significantly harmed.

The market for software and services that enable electronic commerce is new, intensely competitive and rapidly changing. We expect competition to persist and intensify, which could result in price reductions, reduced gross margins and loss of market share. Our principal competitors include FirePond, Trilogy Software, Oracle Corporation, SAP, I2, and Siebel Systems, all of which offer integrated solutions for electronic commerce incorporating some of the functionality of an Interactive Selling System. These competitors may intensify their efforts in our market. In addition, other enterprise software companies may offer competitive products in the future.

Competitors vary in size and in the scope and breadth of the products and services offered. Some of our competitors and potential competitors have a number of significant advantages over us, including:


	•	a longer operating history;

	•	preferred vendor status with our customers;

	•	more extensive name recognition and marketing power; and

	•	significantly greater financial, technical, marketing and other resources, giving them the ability to respond more quickly to new or changing opportunities, technologies, and customer requirements.

Our competitors may also bundle their products in a manner that may discourage users from purchasing our products. Current and potential competitors may establish cooperative relationships with each other or with third parties, or adopt aggressive pricing policies to gain market share. Competitive pressures may require us to reduce the prices of our products and services. We may not be able to maintain or expand our sales if competition increases and we are unable to respond effectively.

Our industry is characterized by rapid technological change, changes in customer requirements, frequent new product and service introductions and enhancements and emerging industry standards. In order to achieve broad customer acceptance, our products must be compatible with major software and hardware platforms used by our customers. Our products currently operate on the Microsoft Windows NT, Sun Solaris, IBM AIX, Linux, and Microsoft Windows 2000 Operating Systems. In addition, our products are required to interoperate with electronic commerce applications and databases. We must continually modify and enhance our products to keep pace with changes in these operating systems, applications and databases. Interactive Selling System technology is complex and new products and product enhancements can require long development and testing periods. If our products were to be incompatible with a popular new operating system, electronic commerce application or database, our business would be significantly harmed. In addition, the development of entirely new technologies to replace existing software could lead to new competitive products that have better performance or lower prices than our products and could render our products obsolete and unmarketable.

Our business and financial condition is dependent on a limited number of customers. Our five largest customers accounted for approximately 53% and 36% of our revenues for the six months ending September 30, 2002 and 2001, respectively, and our ten largest customers accounted for 68% and 58% of our revenues for the six months ending September 30, 2002 and 2001, respectively. There was no significant customer who accounted for more than 10% of total revenues for the six months ended September 30, 2001. Revenues from significant customers as a percentage of total revenues for the three and six months ended September 30, 2002 are as follows:

We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenues for the foreseeable future. The increase in the percentage of revenues from these customers represents an increased dependence on a smaller number of customers. Contracts with our customers can generally be terminated on short notice by the customer. As a result, if we fail to successfully sell our products and services to one or more customers in any particular period, or a large customer purchases less of our products or services, defers or cancels orders, or terminates its relationship with us, our business and operating results would be harmed.

We believe that the securities class action claims against us are without merit and intend to defend against the complaints vigorously. At a minimum, the securities class action litigation as well as the shareholder derivative litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

In the past, our customers have experienced difficulties or delays in completing implementation of our products. We may experience similar difficulties or delays in the future. Our Interactive Selling System solution relies on defining a knowledge base that must contain all of the information about the products and services being configured. We have found that extracting the information necessary to construct a knowledge base can be more time consuming than we or our customers anticipate. If our customers do not devote the resources necessary to create the knowledge base, the deployment of our products can be delayed. Deploying our ACE products can also involve time-consuming integration with our customers’ legacy systems, such as existing databases and enterprise resource planning software. Failing to meet customer expectations on deployment of our products could result in a loss of customers and negative publicity regarding us and our products, which could adversely affect our ability to attract new customers. In addition, time-consuming deployments may also increase the amount of professional services we must allocate to each customer, thereby increasing our costs and adversely affecting our business and operating results.

We depend on our direct sales force for all of our current sales and our future growth depends on the ability of our direct sales force to develop customer relationships and increase sales to a level that will allow us to reach and maintain profitability. If we are unable to retain qualified sales personnel, or if newly hired personnel fail to develop the necessary skills or to reach productivity when anticipated, we may not be able to increase sales of our products and services. In addition, our Executive Vice President of Sales recently resigned from the Company. If we are not able to hire another Executive Vice President of Sales or if our sales force fails to compensate after his departure, our results of operation could be significantly harmed.

Our professional services organization assists our customers with implementation and maintenance of our products. Because these professional services have been expensive to provide, we must improve the management of our professional services organizations to improve our results of operations. Improving the efficiency of our consulting services is dependent upon attracting and retaining experienced project managers and we may not be able to hire qualified individuals to fill these positions.

Although services revenues, which are primarily comprised of revenues from consulting fees, maintenance contracts and training, are important to our business, representing 71% and 58% of total revenues for the six months ended September 30, 2002 and 2001 respectively, services revenues have lower gross margins than license revenues. Gross margins for services revenues were 25% and 2% for the six months ended September 30, 2002 and 2001, respectively, compared to gross margins for license revenues of 91% and 95% for the six months ended September 30, 2002 and 2001.

We intend to charge for our professional services on a time and materials rather than a fixed-fee basis. However in current market conditions, many customers insist on services provided on a fixed-fee basis. To the extent that customers are unwilling to utilize third-party consultants or require us to provide professional

services on a fixed fee basis, our cost of services revenues could increase and could cause us to recognize a loss on a specific contract, either of which would adversely affect our operating results. In addition, if we are unable to provide these resources, we may lose sales or incur customer dissatisfaction and our business and operating results could be significantly harmed.

Complex software products such as ours often contain errors or defects, including errors relating to security, particularly when first introduced or when new versions or enhancements are released. In the past, we have discovered defects in our products and provided product updates to our customers to address such defects. Our ACE products and other future products may contain defects or errors, which could result in lost revenues, a delay in market acceptance or negative publicity, which would significantly harm our business and operating results.

We believe that our success will depend on the continued employment of our management team and key technical personnel, none of whom, except Dr. Sanjay Mittal, our President and Chief Executive Officer, has an employment agreement with us. If one or more members of our senior management team or key technical personnel were unable or unwilling to continue in their present positions, these individuals would be difficult to replace. Consequently, our ability to manage day-to-day operations, including our operations in Pune and Chennai, India, develop and deliver new technologies, attract and retain customers, attract and retain other employees and generate revenues would be significantly harmed.

We conduct development, quality assurance and professional services operations in India. As of September 30, 2002, there were 228 persons employed in India. We are dependent on our India-based operations for these aspects of our business and we intend to grow our operations in India. As a result, we are directly influenced by the political and economic conditions affecting India. Operating expenses incurred by our operations in India are denominated in Indian currency and accordingly, we are exposed to adverse movements in currency exchange rates. This, as well as any other political or economic problems or changes in India, could have a negative impact on our India-based operations, resulting in significant harm to our business and operating results. Furthermore, the intellectual property laws of India may not adequately protect our proprietary rights. We believe that it is particularly difficult to find quality management personnel in India, and we may not be able to timely replace our current India-based management team if any of them were to leave our company.

Our training program for some of our India-based employees includes an internship at our San Jose, California headquarters. Additionally, we provide services to some of our customers internationally with India-based employees. We presently rely on a number of visa programs to enable these India-based employees to travel and work internationally. Any change in the immigration policies of India or the countries to which these employees travel and work could cause disruption or force the termination of these programs, which would harm our business.

If the recent conflict between India and Pakistan continues to escalate, it could adversely affect our operations in India.

Our success depends on our ability to attract and retain qualified management, engineering, sales and marketing and professional services personnel. We do not have employment agreements with most of our key personnel. If we are unable to retain our existing key personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products.

Since our products are company-wide, mission-critical computer applications with a potentially strong impact on our customers’ sales, errors, defects or other performance problems could result in financial or other damages to our customers. Although our license agreements generally contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate such limitation of liability provisions. Product liability litigation, even if it were unsuccessful, would be time consuming and costly to defend.

We rely on a combination of trademark, trade secret and copyright law and contractual restrictions to protect the proprietary aspects of our technology. These legal protections afford only limited protection for our technology. We currently hold five patents. In addition, we have one trademark registered in the U.S., one trademark registered in South Korea and have applied to register a total of eight trademarks in the United States, Canada, Europe, India and Korea. Our trademark applications might not result in the issuance of any trademarks. Our patents or any future issued patents or trademarks might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We seek to protect source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to signed license agreements, which impose certain restrictions on the licensee’s ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of many countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Our failure to adequately protect our intellectual property could significantly harm our business and operating results.

We may acquire or make investments in complementary companies, products or technologies. In the event of any such investments, acquisitions or joint ventures, we could:


	•	issue stock that would dilute our current stockholders’ percentage ownership;

	•	incur debt;

	•	assume liabilities;

	•	incur amortization expenses related to goodwill and other intangible assets; or

	•	incur large and immediate write-offs.

These investments, acquisitions or joint ventures also involve numerous risks, including:


	•	problems combining the purchased operations, technologies or products with ours;

	•	unanticipated costs;


	•	diversion of managements’ attention from our core business;

	•	adverse effects on existing business relationships with suppliers and customers;

	•	potential loss of key employees, particularly those of the acquired organizations; and

	•	reliance to our disadvantage on the judgment and decisions of third parties and lack of control over the operations of a joint venture partner.

Any acquisition or joint venture may cause our financial results to suffer as a result of these risks.

Our success and ability to compete are dependent on our ability to operate without infringing upon the proprietary rights of others. Any intellectual property litigation could result in substantial costs and diversion of resources and could significantly harm our business and operating results. In the past, we received correspondence from two patent holders recommending that we licensed their respective patents. After review of these patents, we informed these patent holders that in our opinion, it would not be necessary to license these patents. However, we may be required to license either or both patents or incur legal fees to defend our position that such licenses are not necessary. We cannot assure you that if required to do so, we would be able to obtain a license to use either patent on commercially reasonable terms, or at all.

Any threat of intellectual property litigation could force us to do one or more of the following:


	•	cease selling, incorporating or using products or services that incorporate the challenged intellectual property;

	•	obtain from the holder of the infringed intellectual property right a license to sell or use the relevant intellectual property, which license may not be available on reasonable terms;

	•	redesign those products or services that incorporate such intellectual property; or

	•	pay money damages to the holder of the infringed intellectual property right.

In the event of a successful claim of infringement against us and our failure or inability to license the infringed intellectual property on reasonable terms or license a substitute intellectual property or redesign our product to avoid infringement, our business and operating results would be significantly harmed. If we are forced to abandon use of our trademark, we may be forced to change our name and incur substantial expenses to build a new brand, which would significantly harm our business and operating results.

Our software utilizes encryption technology, the export of which is regulated by the United States government. If our export authority is revoked or modified, if our software is unlawfully exported or if the United States adopts new legislation restricting export of software and encryption technology, we may experience delay or reduction in shipment of our products internationally. Current or future export regulations could limit our ability to distribute our products outside of the United States. While we take precautions against unlawful exportation of our software, we cannot effectively control the unauthorized distribution of software across the Internet.

We intend to expand our operations internationally. This expansion may be more difficult or take longer than we anticipate, and we may not be able to successfully market, sell or deliver our products internationally.


	•	longer accounts receivable collection cycles;

	•	expenses associated with localizing products for foreign markets;

	•	difficulties in managing operations across disparate geographic areas;

	•	difficulties in hiring qualified local personnel;

	•	difficulties associated with enforcing agreements and collecting receivables through foreign legal systems;

	•	unexpected changes in regulatory requirements that impose multiple conflicting tax laws and regulations; and

	•	fluctuations in foreign exchange rates and the possible lack of financial stability in foreign countries that prevent overseas sales growth.

We have recently experienced a drastic reduction in headcount which followed a period of rapid growth and expansion. These changes have placed significant demands on our managerial, administrative, operational, financial and other resources.

Our rapid growth required us to manage a large number of relationships with customers, suppliers and employees, as well as a large number of complex contracts. Our recent restructuring has forced us to handle these demands with a smaller number of employees. If we are unable to initiate procedures and controls to support our future operations in an efficient and timely manner, or if we are unable to otherwise manage these changes effectively, our business would be harmed.

We have in the past and expect in the future to incur a significant amount of amortization of charges related to securities issuances in future periods, which will negatively affect our operating results. Since inception we have recorded approximately $8.5 million in net deferred compensation charges. During the three months ended September 30, 2002 and 2001, we amortized approximately $462,000 and $553,000 million of such charges, respectively. For the six months ended September 30, 2002 and 2001, we amortized approximately $931,000 and $1.2 million of such charges, respectively. We expect to amortize approximately $1.9 million of stock-based compensation for the fiscal year ending March 31, 2003 and we may incur additional charges in the future in connection with grants of stock-based compensation at less than fair value.

In connection with a development agreement entered into in April 2001, we issued a warrant to purchase 100,000 shares of our common stock. We determined the fair value of the warrant using the Black-Scholes valuation model assuming a fair value of our common stock at $3.53 per share, risk free interest rate of 6%, dividend yield of 0%, volatility factor of 99% and expected life of 3 years. The value of the warrant was estimated to be approximately $227,000 and was fully amortized as of March 31, 2002.

Due to the repurchase of our common stock from certain key employees during the year ended March 31, 2002, the remaining outstanding shares of our common stock which were purchased with full recourse promissory notes, were deemed to be compensatory as of January 4, 2002 and became subject to variable accounting. As a result, the Company recorded a total compensation expense of approximately $53,000 of which approximately $20,000 was included in cost of goods sold and approximately $33,000 was included in general and administrative expense. See Note 9 of Notes to Consolidated Financial Statements for the year ended March 31, 2002. During the three months ending September 30, 2002, the Company recorded a total

compensation expense of approximately $117,000 related to variable accounting of which approximately $49,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing and approximately $67,000 was included in general and administrative expense. During the six months ending September 30, 2002, the Company recorded a total compensation expense of approximately $227,000 related to variable accounting of which approximately $89,000 was included in cost of goods sold, approximately $2,000 was included in sales and marketing expense and approximately $136,000 was included in general and administrative expense.

We accounted for the acquisition of Wakely as a purchase for accounting purposes and allocated approximately $13.1 million to identify intangible assets and goodwill. These assets were being amortized over a period of three to seven years. We also expensed approximately $1.9 million of in-process research and development at the time of acquisition. See Note 8 of the Notes to Consolidated Financial Statements for the year ended March 31, 2002, Note 9 of Notes to Consolidated Financial Statements for the year ended March 31, 2001 and Note 10 of the Notes to Consolidated Financial Statements for the year ended March 31, 2000. In August 2001, the Financial Accounting Standards Board (FASB) issued Statements on Financial Accounting Standards (SFAS) 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” SFAS 144, which supercedes SFAS 121, establishes a single accounting model, based on the framework established in SFAS 121, for long-lived assets to be disposed of by sale. The statement is effective for financial statements issued for fiscal years beginning after December 15, 2001. The provisions of this statement did not have a significant impact on our financial condition or operating results.

In June 2001, the FASB issued SFAS 142, “Goodwill and Other Intangible Assets,” effective for fiscal years beginning after December 15, 2001. Under SFAS 142, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives. SFAS 142 also requires that goodwill be tested for impairment at the reporting unit level at adoption and at least annually thereafter, utilizing a two-step methodology. The initial step requires us to determine the fair value of each reporting unit and compare it to the carrying value, including goodwill, of such unit. If the fair value exceeds the carrying value, no impairment loss would be recognized. However, if the carrying value of the reporting unit exceeds its fair value, the goodwill of this unit may be impaired. The amount, if any, of the impairment would then be measured in the second step. We applied the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of fiscal year 2003. As of March 31, 2002, under SFAS 121, we did not have any impairment of goodwill and other intangible assets because the gross cash receipts exceeded book value.

In April 2002, we performed, under SFAS 142, the first of the required impairment tests of goodwill and indefinite lived intangible assets. That test indicated that the carrying values of certain reporting units exceeded their estimated fair values, as determined utilizing various valuation techniques including discounted cash flow and comparative market analysis. Thereafter, given the indication of a potential impairment, we performed step two of the test. We compared the implied fair value of the affected reporting unit’s goodwill to its carrying value to measure the amount of impairment. The fair value of goodwill was determined by allocating the reporting unit’s fair value to all of its assets and liabilities in a manner similar to a purchase price allocation. Based on this analysis, we measured and recognized an impairment loss of approximately $10.0 million for the first quarter of fiscal year 2003. This loss was recorded as the cumulative effect of an accounting change for the period.

Our common stock has recently traded on the Nasdaq National Market at a significant discount to the cash value of our common stock. As a result, we have from time to time received, and may in the future receive, solicitations from third parties offering to purchase the company for the market value of our common

stock. We believe that these offers may be being made to arbitrage the difference between the market price and the cash value of our common stock and are not in the best interests of our stockholders. Although we have not received any indication that any third party intends to make a hostile offer for our common stock, any significant differential between the market value and the cash value of our common stock may make such activities more likely. If we were to receive a hostile offer for our common stock, the company may be required to incur significant costs to respond which could have a negative effect on our business and financial results. If successful in causing a change in control, such an offer could result our stockholders receiving less than what we believe to be the fair value of our common stock. Although the company has certain anti-takeover protections in place to try to prevent this result, for example, a classified board, such protections may not be sufficient to protect shareholder value.

Our servers are vulnerable to physical or electronic break-ins and similar disruptions, which could lead to loss of data or public release of proprietary information. In addition, unauthorized persons may improperly access our data. We have experienced an unauthorized break-in by a “hacker” who has stated that he could, in the future, damage our systems or take confidential information. These and other types of attacks could harm us. Actions of this sort may be very expensive to remedy and could adversely affect results of operations.

Our strategy requires that our products be highly scalable. To date, only a limited number of our customers have deployed our ACE products on a large scale. If our customers cannot successfully implement large-scale deployments, or if they determine that we cannot accommodate large-scale deployments, our business and operating results would be significantly harmed.

We are required to follow accounting standards and financial reporting set by governing bodies in the U.S. and other countries where we do business. From time to time, these governing bodies implement new and revised laws and regulations. These new and revised accounting standards, financial reporting and tax laws may require changes to accounting principles used in preparing our financial statements. These changes may have a material impact on our business and financial results. For example, a change in accounting rules can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change became effective. As a result, changes to existing rules or reconsideration of current practices caused by such changes may adversely affect our reported financial results or the way we conduct our business.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules, are creating uncertainty for companies such as ours. For example, new laws and regulations may require us to change the composition of our board of directors, the composition, the responsibility and manner of operation of various board-level committees, and the type and volume of information filed by us with governing bodies. We are committed to complying with these requirements and maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards. This investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.

Growth in sales of our products and services depends upon the continued and increased use of the Internet as a medium for commerce and communication. Growth in the use of the Internet is a recent phenomenon and may not continue. In addition, the Internet infrastructure may not be able to support the demands placed on it by increased usage and bandwidth requirements. There have also been well-publicized security breaches involving “denial of service” attacks on major web sites. Concerns over these and other security breaches may slow the adoption of electronic commerce by businesses, while privacy concerns over inadequate security of information distributed over the Internet may also slow the adoption of electronic commerce by individual consumers. Other risks associated with commercial use of the Internet could slow its growth, including:


	•	inadequate reliability of the network infrastructure;

	•	slow development of enabling technologies and complementary products; and

	•	limited accessibility and ability to deliver quality service.

In addition, the recent growth in the use of the Internet has caused frequent periods of poor or slow performance, requiring components of the Internet infrastructure to be upgraded. Delays in the development or adoption of new equipment and standards or protocols required to handle increased levels of Internet activity, or increased government regulation, could cause the Internet to lose its viability as a commercial medium. If the Internet infrastructure does not develop sufficiently to address these concerns, it may not develop as a commercial marketplace, which is necessary for us to increase sales.

As electronic commerce and the Internet continue to evolve, federal, state and foreign governments may adopt laws and regulations covering issues such as user privacy, taxation of goods and services provided over the Internet, pricing, content and quality of products and services. If enacted, these laws and regulations could limit the market for electronic commerce, and therefore the market for our products and services. Although many of these regulations may not apply directly to our business, we expect that laws regulating the solicitation, collection or processing of personal or consumer information could indirectly affect our business.

Laws or regulations concerning telecommunications might also negatively impact us. Several telecommunications companies have petitioned the Federal Communications Commission to regulate Internet service providers and online service providers in a manner similar to long distance telephone carriers and to impose access fees on these companies. This type of legislation could increase the cost of conducting business over the Internet, which could limit the growth of electronic commerce generally and have a negative impact on our business and operating results.

We develop products in the United States and India and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since our sales are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets. Interest income is sensitive to changes in the general level of U.S. interest rates.

We established policies and business practices regarding our investment portfolio to preserve principal while obtaining reasonable rates of return without significantly increasing risk. This is accomplished by investing in widely diversified short-term investments, consisting primarily of investment grade securities,

substantially all of which mature within the next twelve months or have characteristics of short-term investments. A hypothetical 50 basis point increase in interest rates would result in an approximate $463,000 (less than .40%) in the fair value of our available-for-sale securities. This potential change is based upon a sensitivity analysis performed on our financial positions at September 30, 2002.

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 because of a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations because of changes in interest rates or we may suffer losses in principal if forced to sell securities that have seen a decline in market value because of changes in interest rates. Our investments are made in accordance with an investment policy approved by the Board of Directors. In general, our investment policy requires that our securities purchases be rated A1/P1, AA/Aa3 or better. No securities may have a maturity that exceeds 18 months and the average duration of our investment portfolio may not exceed 9 months. At any time, no more than 15% of the investment portfolio may be insured by a single insurer and 25% in any one industry other than the US government, commercial paper and money market funds.


	(a)	Evaluation of disclosure controls and procedures. Within the ninety-day period prior to the filing date of this report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934). Based on the evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective as of November 14, 2002.

	(b)	Changes in internal controls. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

uncertain. If the outcome of the litigation is adverse to the Company and if, in addition, the Company is required to pay significant monetary damages, the Company’s business would be significantly harmed. The shareholder derivative litigation is also in its preliminary stages. At a minimum, the class action litigation as well as the shareholder derivative litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

The Company held its annual meeting of stockholders in San Jose, California on September 13, 2002. Of the 33,734,913 shares outstanding as of the record date, 27,783,589 shares were represented by proxy at the meeting on September 13, 2002. At the meeting the following actions were voted upon:


	•	To elect the following directors to serve for a term ending upon the 2005 Annual Meeting of Stockholders or until their successors are elected and qualified:


	•	To ratify the appointment of Ernst & Young LLP as the Company’s independent public accountants for the fiscal year ending March 31, 2003:


	The following Current Report on Form 8-K has been filed by the Company during the quarter for which this report is filed:


	•	On July 9, 2002, the Company reported under Item 5 “Other Events” the resignation of Raj Jaswa as President and Chief Executive Officer and the appointment of Sanjay Mittal to both offices.

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


	By:	/s/ STEPHEN R. BENNION



	Stephen R. Bennion
	Chief Financial Officer and Secretary


Delaware		77-0432030
(State of Incorporation)		(IRS Employer Identification No.)


	CONDENSED CONSOLIDATED BALANCE SHEETS
	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
MANAGEMENT’S DISCUSSION AND ANALYSIS
	Item 3. Quantitative and Qualitative Disclosure About Market Risk
	Item 4. Controls and Procedures
PART II OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
EXHIBIT 99.1
EXHIBIT 99.2
EXHIBIT 99.3
EXHIBIT 99.4


		Page

PART I. FINANCIAL INFORMATION
ITEM 1:	Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets as of September 30, 2002 and March 31, 2002		2
	Condensed Consolidated Statements of Operations for the three and six months ended September 30, 2002 and 2001		3
	Condensed Consolidated Statements of Cash Flows for the six months ended September 30, 2002 and 2001		4
	Notes to Condensed Consolidated Financial Statements		5
ITEM 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
ITEM 3:	Quantitative and Qualitative Disclosure about Market Risk		37
ITEM 4:	Controls and Procedures		38
PART II. OTHER INFORMATION
ITEM 1:	Legal Proceedings		39
ITEM 2:	Changes in Securities and Use of Proceeds		40
ITEM 3:	Defaults Upon Senior Securities		40
ITEM 4:	Submission of Matters to a Vote of Security Holders		40
ITEM 5:	Other Information		40
ITEM 6:	Exhibits and Reports on Form 8-K		41
Signatures			42


		September 30,			March 31,
		2002			2002*


		(Unaudited)
		(In thousands)
ASSETS
Current assets:
	Cash and cash equivalents	$	28,306		$	52,757
	Short-term investments		60,738			74,056
	Accounts receivable, net of allowance for doubtful accounts of $694 and $694, respectively		8,158			8,100
	Prepaid expenses and other current assets		2,826			2,691

	Total current assets		100,028			137,604
Property and equipment, net			6,704			7,325
Goodwill, net			—			9,974
Long-term investments			37,983			17,355
Investments, restricted			1,282			1,463
Other assets			762			724

Total assets		$	146,759		$	174,445

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable	$	1,116		$	1,325
	Accrued payroll and related liabilities		2,365			2,717
	Other accrued liabilities		3,684			3,878
	Deferred revenues		12,230			11,950

Total current liabilities			19,395			19,870
Other long term liabilities			1,283			1,223
Commitments and contingencies
Stockholders’ equity:
	Preferred stock		—			—
	Common stock		4			4
	Additional paid-in capital		284,384			283,847
	Deferred compensation		(2,922	)		(4,032	)
	Stockholder notes receivable		(880	)		(880	)
	Accumulated deficit		(140,078	)		(119,366	)
	Accumulated other comprehensive income		136			29
	Treasury stock		(14,563	)		(6,250	)

	Total stockholders’ equity		126,081			153,352

Total liabilities and stockholders’ equity		$	146,759		$	174,445



			Three Months Ended						Six Months Ended
			September 30,						September 30,

			2002			2001			2002			2001


			(Unaudited)
			(In thousands, except per share amounts)
Revenues:
	License		$	3,225		$	3,953		$	5,612		$	10,038
	Services			6,186			6,133			13,434			15,374

		Total revenues		9,411			10,086			19,046			25,412
Cost of revenues:
	License			296			178			527			513
	Services			4,671			6,616			10,013			15,045

		Total cost of revenues		4,967			6,794			10,540			15,558

Gross profit				4,444			3,292			8,506			9,854
Operating expenses:
Research and development				3,379			3,721			6,945			8,145
Sales and marketing				4,859			5,999			10,368			14,322
General and administrative				2,163			1,907			3,610			5,069

Total operating expenses				10,401			11,627			20,923			27,536

Loss from operations				(5,957	)		(8,335	)		(12,417	)		(17,682	)
Interest and other income, net				762			1,766			1,679			3,768

Loss before provision for income taxes and cumulative effect of an accounting change				(5,195	)		(6,569	)		(10,738	)		(13,914	)
Provision for income taxes				—			79			—			154

Loss before cumulative effect of an accounting change				(5,195	)		(6,648	)		(10,738	)		(14,068	)
Cumulative effect of an accounting change to adopt SFAS 142				—			—			(9,974	)		—

Net loss			$	(5,195	)	$	(6,648	)	$	(20,712	)	$	(14,068	)

Basic and diluted net loss per share before cumulative effect of an accounting change			$	(0.16	)	$	(0.19	)	$	(0.32	)	$	(0.40	)
Cumulative effect of an accounting change				—			—			(0.30	)		—

Basic and diluted net loss per share			$	(0.16	)	$	(0.19	)	$	(0.62	)	$	(0.40	)

Weighted-average shares of common stock used in computing basic and diluted, net loss per share				32,694			35,574			33,197			35,547


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


*	Amounts derived from audited financial statements at the date indicated


*	Customer account was less than 10% of gross accounts receivable.


	(In thousands)
FY 2001 Restructuring Charges	$	667
Payments for severance and related costs for FY 2001		(317	)

Accrual balance, March 31, 2001		350
FY 2002 Restructuring Charges		1,759
Payments for severance and related costs for FY 2002		(1,927	)

Accrual balance, March 31, 2002	$	182
Payments for severance and related costs for the three months ended June 30, 2002		(161	)

Accrual balance, June 30, 2002	$	21
Restructuring Charges for the three months ended September 30, 2002		1,758
Payments for severance and related costs for the three months ended September 30, 2002		(1,192	)

Accrual balance, September 30, 2002	$	587


	Three Months			Six Months
	Ended			Ended
	September 30,			September 30,
	2001			2001

Reported net loss	$	(6,648	)	$	(14,068	)
Add back: Goodwill amortization		664			1,334

Adjusted net loss	$	(5,984	)	$	(12,734	)

Basic and diluted net loss per share:
Reported net loss	$	(0.19	)	$	(0.40	)
Add back: Goodwill amortization		0.02			0.04

Adjusted net loss	$	(0.17	)	$	(0.36	)


	The unpredictability of our quarterly revenues and results of operations makes it difficult to predict our financial performance and may cause volatility or a decline in the price of our common stock if we are unable to satisfy the expectations of investors or the market.


	*We have a history of losses and expect to continue to incur net losses in the near-term.*


	*A continued decline in general economic conditions or a decrease in information technology spending could harm our results of operations.*


	*Our lengthy sales cycle makes it difficult for us to forecast revenue and aggravates the variability of quarterly fluctuations, which could cause our stock price to decline.*


	*Developments in the market for Interactive Selling System software may harm our operating results, which could cause a decline in the price of our common stock.*


	*Basis of Presentation*


	*Reclassification of Prior Year Balances*


	*Customer Concentrations*


	*Segment Information*


	*Our limited operating history and the fact that we operate in a new industry makes evaluating our business prospects and results of operations difficult.*


	Failure to improve and maintain relationships with systems integrators and consulting firms, which assist us with the sale and installation of our products, would impede the acceptance of our products and the growth of our revenues.


	*We face intense competition, which could reduce our sales, prevent us from achieving or maintaining profitability and inhibit our future growth.*


	If we do not keep pace with technological change, including maintaining interoperability of our product with the software and hardware platforms predominantly used by our customers, our product may be rendered obsolete and our business may fail.


	We have relied and expect to continue to rely on a limited number of customers for a significant portion of our revenues, and the loss of any of these customers could significantly harm our business and operating results.


Three Months Ended September 30, 2002
	Customer A	39%
	Customer B	13%
Six Months Ended September 30, 2002
	Customer A	19%
	Customer B	17%


	We are the target of several securities class action complaints, and are involved in shareholder derivative litigation, all of which could result in substantial costs and divert management attention and resources.


	Our failure to meet customer expectations on deployment of our products could result in negative publicity and reduced sales, both of which would significantly harm our business and operating results.


	If we are unable to maintain our direct sales forces, sales of our products and services may not meet our expectations and our business and operating results will be significantly harmed.


	If we are unable to manage our professional services organization, we will be unable to provide our customers with technical support for our products, which could significantly harm our business and operating results.


	*If new versions and releases of our products contain errors or defects, we could suffer losses and negative publicity, which would adversely affect our business and operating results.*


	*The loss of any of our key personnel would harm our competitiveness because of the time and effort that we would have to expend to replace such personnel.*


	A substantial portion of our operations are conducted by India-based personnel, and any change in the political and economic conditions of India or in immigration policies, which would adversely affect our ability to conduct our operations in India, could significantly harm our business.


	*We may not be able to recruit or retain personnel, which could impact the development or sales of our products.*


	*If we become subject to product liability litigation, it could be costly and time consuming to defend and could distract us from focusing on our business and operations.*


	Our future success depends on our proprietary intellectual property, and if we are unable to protect our intellectual property from potential competitors our business may be significantly harmed.


	*Any acquisitions that we may make could disrupt our business and harm our operating results.*


	*If we are subject to intellectual property litigation, we may incur substantial costs, which would harm our operating results.*


	*Restrictions on export of encrypted technology could cause us to incur delays in international product sales, which would adversely impact the expansion and growth of our business.*


	If we are unable to expand our operations internationally or are unable to manage the greater collections, management, hiring, legal, regulatory, and currency risks from these international operations, our business and operating results will be harmed.