NET PERCEPTIONS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


[X]		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2002


[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the Transition Period From to .

Commission File Number: 000-25781

NET PERCEPTIONS, INC.

(Exact name of Registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		41-1844584 (I.R.S. Employer Identification Number)

7700 France Avenue South
Edina, Minnesota 55435
(Address of principal executive offices, Zip Code)

(952) 842-5000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X] No [ ]

The number of shares of the registrant’s common stock outstanding as of October 31, 2002 was 27,303,333.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONSOLIDATED BALANCE SHEETS
		CONSOLIDATED STATEMENTS OF OPERATIONS
		CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures 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
EX-99.1 Certification Pursuant to 18 USC Sec. 1350
EX-99.2 Certification Pursuant to 18 USC Sec. 1350

NET PERCEPTIONS, INC.
FORM 10-Q
For the Quarter Ended September 30, 2002

TABLE OF CONTENTS


			Page

PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		Consolidated Balance Sheets as of September 30, 2002 and December 31, 2001		4
		Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2002 and 2001		5
		Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2002 and 2001		6
		Notes to the Consolidated Financial Statements		7
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			10
	Item 3. Quantitative and Qualitative Disclosures about Market Risk			29
	Item 4. Controls and Procedures			29
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings			30
	Item 2. Changes in Securities and Use of Proceeds			30
	Item 3. Defaults Upon Senior Securities			30
	Item 4. Submission of Matters to a Vote of Security Holders			30
	Item 5. Other Information			30
	Item 6. Exhibits and Reports on Form 8-K			31
SIGNATURES				32
EXHIBIT INDEX				35

Special Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q (including exhibits and information incorporated by reference herein) contains both historical and forward-looking statements that involve risks, uncertainties and assumptions. The statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding our expectations, beliefs, intentions or strategies for the future. All forward-looking statements included in this Quarterly Report on Form 10-Q (including exhibits and information incorporated by reference herein) are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those described in our forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations under the heading “Risks That May Affect Future Results” and those described in our previous filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date that they were made. We undertake no obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect the occurrence of unanticipated events.

References in this Quarterly Report on Form 10-Q to “Net Perceptions,” the “Company,” “we,” “our” and “us” refer to Net Perceptions, Inc. and, if so indicated or the context so requires, includes our wholly owned subsidiary Knowledge Discovery One, Inc. (which we refer to in this report as “KD1”).

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NET PERCEPTIONS, INC.

CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands)


				September 30,			December 31,
				2002			2001

Assets
Current assets:
	Cash and cash equivalents			$	35,140		$	14,929
	Short-term investments				29,507			58,676
	Accounts receivable, net				564			1,309
	Prepaid expenses and other current assets				1,517			2,301

			Total current assets		66,728			77,215
Property and equipment, net					1,474			3,679
Goodwill and other intangible assets, net					6,610			6,802
Other assets					811			1,182

			Total assets	$	75,623		$	88,878

Liabilities and Stockholders’ Equity
Current liabilities:
	Accounts payable			$	264		$	314
	Accrued liabilities				2,103			3,215
	Deferred revenue				1,254			1,835
	Accrued restructuring costs				4,880			7,433
	Current portion of long-term liabilities				0			97

			Total current liabilities		8,501			12,894
Long-term liabilities, net of current portion					526			577

			Total liabilities		9,027			13,471

Commitments and contingencies
Stockholders’ equity:
	Common stock				2			2
	Additional paid-in capital				275,017			274,869
	Accumulated other comprehensive income				114			637
	Accumulated deficit				(208,537	)		(200,101	)

		Total stockholders’ equity			66,596			75,407

		Total liabilities and stockholders’ equity		$	75,623		$	88,878

See accompanying notes to the consolidated financial statements.

NET PERCEPTIONS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)


			Three Months Ended						Nine Months Ended
			September 30,						September 30,

			2002			2001			2002			2001

Revenues:
	Product		$	613		$	674		$	1,558		$	2,068
	Service and maintenance			999			1,525			2,793			5,948

		Total revenues		1,612			2,199			4,351			8,016
Cost of revenues:
	Product			68			158			254			679
	Service and maintenance			473			755			1,782			4,348

		Total cost of revenues		541			913			2,036			5,027
Gross Margin				1,071			1,286			2,315			2,989
Operating expenses:
	Sales and marketing			753			2,454			3,610			13,465
	Research and development			1,213			2,121			4,797			8,416
	General and administrative			514			1,014			2,191			5,430
	Lease abandonment expense			—			—			—			225
	Restructuring related charges			—			1,771			768			15,691
	Amortization of intangibles			28			798			83			8,852
	Impairment of goodwill and other intangibles			—			—			—			75,298

		Total operating expenses		2,508			8,158			11,449			127,377

Loss from operations				(1,437	)		(6,872	)		(9,134	)		(124,388	)
Other income (expense), net				811			714			698			3,602

Net loss			$	(626	)	$	(6,158	)	$	(8,436	)	$	(120,786	)

Net loss per share:
Basic and diluted			$	(0.02	)	$	(0.23	)	$	(0.31	)	$	(4.49	)
Shares used in computing basic and diluted net loss per share				27,298			27,037			27,211			26,917

See accompanying notes to the consolidated financial statements.

NET PERCEPTIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)


					Nine Months Ended
					September 30,

					2002			2001

Cash flows from operating activities:
	Net loss				$	(8,436	)	$	(120,786	)
	Reconciliation of net loss to net cash used in operating activities:
			Depreciation and amortization			1,754			11,960
			Provision for doubtful accounts			70			1,039
			Lease abandonment expense			—			225
			Compensation expense related to stock options			35			211
			Restructuring related charges			768			15,691
			Impairment of goodwill and other intangibles			—			75,298
			Amortization of premiums (discounts) on investments			163			(198	)
			Changes in assets and liabilities:
				Accounts receivable		675			4,201
				Royalties receivable		—			671
				Prepaid expenses & other current assets		784			(1,295	)
				Other assets		371			441
				Accounts payable		(50	)		(1,089	)
				Accrued expenses		(3,778	)		(4,467	)
				Deferred revenue		(581	)		(1,686	)
				Other long-term liabilities		(51	)		(78	)

				Total adjustments		160			100,924

				Net cash used in operating activities		(8,276	)		(19,862	)
Cash flows from investing activities:
		Purchases of short-term investments				(29,535	)		(111,428	)
		Sales and maturities of short-term investments				58,018			138,714
		Purchases of property and equipment				—			(197	)

				Net cash provided by investing activities		28,483			27,089
Cash flows from financing activities:
		Proceeds from exercise of stock options, net of stock repurchases				63			42
		Proceeds from issuance of stock under employee stock purchase plan				38			86
		Principal payments under capital lease obligations and notes payable				(97	)		(499	)

				Net cash provided by (used in) financing activities		4			(371	)

Net increase in cash and cash equivalents						20,211			6,856
Cash and cash equivalents at beginning of period						14,929			16,396

Cash and cash equivalents at end of period					$	35,140		$	23,252

See accompanying notes to the consolidated financial statements.

NET PERCEPTIONS, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share amounts)

Note 1. Basis of Presentation

In the opinion of management, the accompanying unaudited financial statements contain all adjustments necessary to fairly present the Company’s financial position, results of operations and cash flows for the periods presented. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts therein. Due to the inherent uncertainty involved in making estimates, actual results in future periods may differ from those estimates.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These financial statements should be read in conjunction with the Company’s financial statements and notes thereto for the year ended December 31, 2001, which are contained in the Company’s Annual Report on Form 10-K (File No. 000-25781). The results of operations for the interim periods presented are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year.

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant inter-company accounts and transactions have been eliminated.

Accumulated other comprehensive income (loss) consists entirely of unrealized gain (loss) on available-for-sale investments. Changes in unrealized gain (loss) on available-for-sale investments were $(209) and $537 for the third quarter of 2002 and 2001 and $(523) and $396 for the nine months ended September 30, 2002 and 2001, respectively. Comprehensive loss was $835 and $5,621 for the three months ended September 30, 2002 and 2001, respectively, and $8,959 and $120,390 for the nine months ended September 30, 2002 and 2001, respectively.

Note 2. Recently Issued Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (“FASB”) approved Statements of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and No. 142, “Goodwill and Other Intangible Assets.” The statements eliminate the pooling-of-interests method of accounting for business combinations and require that goodwill and certain intangible assets not be amortized. Instead, the statements provide that these assets should be tested, at least annually, for impairment with any related losses recognized as incurred. SFAS No. 141 is generally effective for business combinations completed after June 30, 2001. SFAS No. 142 was effective for the Company beginning January 1, 2002 for existing goodwill and intangible assets. See Note 5 to the Consolidated Financial Statements for additional discussion on the impact of SFAS No. 141 and No. 142.

In October 2001, FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This statement addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of and supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” and APB Opinion No. 30, “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” SFAS No. 144 was effective for the Company beginning January 1, 2002. The adoption of SFAS No.144 had no impact on the Company’s financial position or results of operations.

In accordance with Emerging Issue Task Force Issue No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” the Company began to account for such items as revenue and cost of revenue effective January 1, 2002. Service revenues and cost of service revenues include $4 and $113 of such amounts for the third quarter of 2002 and the nine months ended September 30, 2002, respectively. Additionally, service revenues and cost of service revenues of $16 and $195 for the third quarter of 2001 and the nine months ended September 30, 2001, respectively, have been reclassified to conform to current period presentation, these items were previously recorded net to cost of revenue.

Note 3. Net Loss Per Share

Net loss per share is computed under SFAS No. 128, “Earnings Per Share.” Basic net loss per share is computed using the weighted-average number of shares of common stock outstanding, excluding shares of common stock subject to repurchase. Diluted net loss per share does not differ from basic net loss per share since potential shares of common stock from conversion of stock options and outstanding shares of common stock subject to repurchase are anti-dilutive for all periods presented. Options to purchase 2,845 and 3,466 shares of the Company’s common stock were outstanding as of September 30, 2002 and 2001, respectively, and could potentially dilute earnings per share in future periods.

Note 4. Impairment of Goodwill and Other Intangibles

In February 2000, the Company acquired Knowledge Discovery One, Inc. (“KD1”), a developer and marketer of advanced data analysis solutions for retailers. Intangible assets recorded in conjunction with the acquisition consisted of acquired technology, customer list, workforce and goodwill of $4,000, $3,000, $1,000 and $110,755, respectively. At March 31, 2001, the Company performed an impairment assessment of the KD1 goodwill and intangible assets in accordance with SFAS 121. As a result of its review, the Company recorded a $75,298 impairment charge to reduce goodwill and other intangible assets to their estimated fair values.

Note 5. Goodwill and Other Intangible Assets — Adoption of SFAS No. 141 and No. 142

Effective January 1, 2002, in accordance with SFAS No. 141 and No. 142, the Company ceased amortizing goodwill and certain other identified intangible assets that had a net book value of approximately $6,500 as of January 1, 2002. Instead these assets will be reviewed for impairment at least annually. The transitional impairment review was performed during the quarter ended June 30, 2002 and the carrying value of goodwill was not impaired.

For the three and nine months ended September 30, 2001, $771 and $8,547 of goodwill amortization expense was recorded. The following table presents the impact of SFAS 142 on net loss and the related per share amounts as if it had been in effect for the three and nine months ended September 31, 2001.


	Three Months Ended						Nine Months Ended
	September 30,						September 30,

	2002			2001			2002			2001

Reported net loss	$	(626	)	$	(6,158	)	$	(8,436	)	$	(120,786	)
Addback: Goodwill amortization					771						8,547

Adjusted net loss	$	(626	)	$	(5,387	)	$	(8,436	)	$	(112,239	)

Basic and diluted earnings per share:
Reported net loss	$	(0.02	)	$	(0.23	)	$	(0.31	)	$	(4.49	)
Goodwill amortization					0.03						0.32

Adjusted net loss	$	(0.02	)	$	(0.20	)	$	(0.31	)	$	(4.17	)

Intangible assets subject to amortization were as follows:


	September 30,			December 31,
	2002			2001

Existing Technology	$	1,775		$	1,775
Customer List		1,331			1,331

		3,106			3,106
Less: Accumulated Amortization of Existing Technology		(1,720	)		(1,610	)
Less: Accumulated Amortization of Customer List		(1,290	)		(1,207	)

		(3,010	)		(2,817	)
	$	96		$	289

Amortization expense related to other intangible assets was $65 and $193 for the third quarter of 2002 and the nine months ended September 30, 2002, respectively, and is expected to be $257 and $32 for the full fiscal year ending December 31, 2002 and three months ending March 31, 2003, respectively.

Note 6. Restructuring Related Charges

The Company recorded no restructuring related charges in the third quarter of 2002. During 2002 and 2001, the Company instituted certain restructuring plans to better align its cost structure with its business outlook and general economic conditions. Under the restructuring plans, the Company recorded restructuring related charges totaling $768 and $15,691 for the nine months ended September 30, 2002 and 2001, respectively.

A total of $654 was charged against the restructuring reserve during the third quarter of 2002, bringing the total charges against the restructuring reserve to $3,321 for the nine months ended September 30, 2002, lowering the accrued restructuring liability to $4,880. Charges against the reserve during the three months ended September 30, 2002 included $47 in employee severance payments, $702 in rent payments, $307 in costs relating to subletting facilities and $64 in costs relating to the closure of our Texas data center. These charges were partially offset by $454 of sublease income and $12 in proceeds from the sale of fixed assets. For the nine months ended September 30, 2002 the charges included $642 of non-cash fixed assets write-offs, $547 in employee severance payments, $2,146 in rent payments, $1,152 in costs relating to subletting facilities and $64 in costs relating to the closure of our Texas data center. These charges were partially offset by $1,162 of sublease income and $68 in proceeds from the sale of fixed assets. In conjunction with the restructuring related charges recorded, the Company made certain estimates regarding future sublease income that have a significant impact on its anticipated cash obligations and related restructuring reserves. Although the Company believes that the lease commitment estimates are appropriate in the current circumstances, future changes in real estate markets could impact the ultimate amount of cash paid to resolve these obligations. The Company is actively seeking to sublease its remaining excess facilities. Specifically, the Company is currently seeking to sublease an additional portion of its Edina, Minnesota office space, its entire Roseland, New Jersey office space and a portion of its office space in Austin, Texas. However, there is a risk that the Company may not be able to sublease these facilities under favorable terms, if at all, which could negatively impact the Company’s cash flow and future operating results

The following table presents a summary of the restructuring related activities and accrued restructuring charges as of September 30, 2002:


									Sublease					Accrued
		Accrued							Income and					Restructuring
		Restructuring							Proceeds from		Non-Cash			as of
		as of December 31,		Restructuring		Restructuring			the Sale of		Asset			September 30,
Description		2001		Charges		Payments			Fixed Assets		Disposals			2002

Lease commitments and related items		$	6,896	$	—	$	(3,296	)	$	1,162	$			$	4,762
Employee severance and termination costs			111		506		(547	)		—		—			70

	Subtotal		7,007		506		(3,843	)		1,162		—			4,832
Fixed asset disposals and other costs			426		262		(66	)		68		(642	)		48

		$	7,433	$	768	$	(3,909	)	$	1,230	$	(642	)	$	4,880

Note 7. Contingencies

On November 2, 2001, Timothy J. Fox filed a purported class action lawsuit against us, FleetBoston Robertson Stephens, Inc., the lead underwriter of the Company’s April 1999 initial public offering, several other underwriters who participated in the Company’s initial public offering, Steven J. Snyder, the Company’s then president and chief executive officer, and Thomas M. Donnelly, the Company’s chief operating officer and chief financial officer. The lawsuit, Fox v. Net Perceptions, Inc., et al., Civil Action No. 01-CV-9675, was filed in the United States District Court for the Southern District of New York and has been assigned to the judge who is also the pretrial coordinating judge for substantially similar lawsuits involving more than 300 other issuers. An amended class action complaint was filed on April 22, 2002, expanding the basis for the action to include allegations relating to the Company’s March 2000 follow-on public offering in addition to those relating to the Company’s initial public offering.

The amended complaint generally alleges that the defendants violated federal securities laws by not disclosing certain actions taken by the underwriter defendants in connection with the initial public offering and the follow-on public offering. The amended complaint alleges specifically that the underwriter defendants, with the Company’s direct participation and agreement and without disclosure thereof, conspired to and did raise and increase their underwriters’ compensation and the market prices of the Company’s common stock following the initial public offering and in the follow-on public offering by requiring their customers, in exchange for receiving allocations of shares of the Company’s common stock sold in the initial public offering, to pay excessive commissions on transactions in other securities, to purchase additional shares of the Company’s common stock in the initial public offering aftermarket at pre-determined prices above the initial public offering price, and to purchase shares of the Company’s common stock in the follow-on public offering. The amended complaint seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired the Company’s common stock between April 22, 1999 through December 6, 2000. The plaintiffs have since agreed to dismiss the claims against Mr. Snyder and Mr. Donnelly without prejudice, in return for their agreement to toll any statute of limitations applicable to those claims; and those claims have been dismissed without prejudice. On July 15, 2002, all of the issuer defendants filed a joint motion to dismiss the plaintiffs’ claims in all of the related cases. The Court has not ruled on this motion.

The Company believes that the allegations are without merit, and intends to vigorously defend against the plaintiff’s claims. As this litigation is in an initial stage, the Company is unable to predict its outcome or its ultimate effect, if any, on the Company’s financial condition.

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

OVERVIEW

The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this report.

We develop and market software solutions that enable our customers to interact more intelligently with their customers. Our solutions integrate and analyze information about customers, products and promotional activity to generate specific actions our customers can take to improve their marketing, selling and merchandising effectiveness, leading to increased revenue, improved profit, decreased costs and enhanced customer satisfaction. We combine our software products with industry expertise and professional services to create highly-focused, industry-specific solutions that are designed to integrate with and add significant value to existing custom or purchased CRM systems and processes.

We sell our solutions worldwide primarily through a direct sales force. We license our products under various pricing plans, such as per user, per CPU, per site and per enterprise. We generally grant licenses on a perpetual basis. License fees for our products range from $50,000 to in excess of $1.0 million. We provide product maintenance pursuant to service agreements, the pricing of which is typically based on a percentage of the related product license fee and is generally paid in advance. Professional service fees for business consulting, implementation support, data processing and educational services are generally priced on a time and materials basis. In addition, we offer some of our products on a hosted basis. Charges for hosted product related services vary across service offerings, but generally include an initial set-up fee and a recurring monthly charge based on usage.

We were incorporated in Delaware in July 1996 and our initial product was shipped in January 1997. From inception through late 2000, we expanded our organization by hiring personnel in key areas, particularly marketing, sales and research and development. Our total number of employees was 315 on December 31, 2000. During 2002 and 2001, we instituted certain restructuring plans to align our cost structure with our business outlook and general economic conditions. In connection with our restructuring activities, our total number of employees was reduced to 98 as of December 31, 2001 and 54 as of September 30, 2002.

We have sustained losses on a quarterly and annual basis since inception. As of September 30, 2002, we had an accumulated deficit of $209 million. Our net loss was $626,000 in the third quarter of 2002 (including $74,000 of amortization of intangible assets and non-cash stock compensation expense), compared to a net loss of $6.2 million in the third quarter of the prior year (including $1.8 million of restructuring charges and $888,000 of amortization of goodwill and other intangibles and non-cash stock compensation expense). For the nine months ended September 30, 2002, our net loss was $8.4 million (including $768,000 in restructuring related charges and $228,000 of amortization of intangible assets and non cash stock compensation expense) compared to a $120.8 million net loss in the same period in 2001 (including $15.7 million in restructuring charges, $9.5 million of amortization of goodwill and other intangibles and non-cash stock compensation expense and a $75.3 million charge for the impairment of goodwill and other intangibles). These losses resulted from significant costs incurred in the development and sale of our products and services as well as a decline in our product revenues since the third quarter of 2000. We anticipate that our operating expenses will continue to constitute a material use of our cash resources. We also expect to incur additional losses and continued negative cash flow from operations for the foreseeable future. We do not expect to achieve profitability (including restructuring charges, amortization and impairment of goodwill and other intangibles and stock compensation) in 2002.

Our relatively limited operating history makes the prediction of future operating results very difficult. We believe that period-to-period comparisons of our operating results should not be relied upon as predictive of future performance. Our prospects must be considered in light of the risks, expenses and difficulties encountered by companies in relatively new and rapidly evolving markets. We may not be successful in addressing these risks and difficulties.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, investments, intangible assets, restructuring liabilities, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue Recognition. Our revenues are recognized in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants and in accordance with the Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements.” We derive revenues from software licenses, software maintenance and professional services. Maintenance includes telephone and Web-based technical support, bug fixes and rights to unspecified upgrades on a when-and-if available basis. Professional services include project planning and management, implementation and testing, data analysis, user and partner training, consulting, product hosting and ongoing customer support.

For software arrangements that include multiple software products, maintenance or services, we allocate the total arrangement fee using the residual method. Under the residual method, the fair value of the undelivered maintenance and services elements, as determined by vendor-specific objective evidence, is deferred and the remaining (residual) arrangement fee is recognized as software product revenue. For software arrangements in which we do not have vendor-specific objective evidence of undelivered elements, revenue is deferred until the earlier of when vendor-specific objective evidence is determined for the undelivered elements or when all elements for which we do not have vendor-specific objective evidence have been delivered.

Revenues from license fees are recognized when a non-cancelable agreement has been executed, the product has been shipped or electronically delivered, there are no uncertainties surrounding product acceptance, the fee is fixed or determinable and collection of the related receivable is considered probable. If the fee due from the customer is not fixed or determinable, revenues are recognized as payments become due from the customer. If we do not consider collection to be probable, then revenues are recognized when the fee is collected.

License revenues related to license terms of less than twenty-four months are recognized ratably over the term of the license period. When we offer our products and services on a hosted basis, up front set-up fees are deferred and recognized ratably over the estimated service period.

We recognize revenues allocable to maintenance ratably over the term of the agreement. We evaluate arrangements that include professional and/or data processing services to determine whether those services are essential to the functionality of other elements of the arrangement. If services are considered essential, revenues from the arrangement are recognized using contract accounting, generally on a percentage-of-completion basis. When we do not consider the professional services to be essential, we recognize the revenues allocable to the services as they are performed.

Sublease income. In conjunction with the restructuring related charges recorded in 2002 and 2001, we made certain estimates regarding future sublease income that have a significant impact on our anticipated cash obligations. Although we believe that our lease commitment estimates are appropriate in the current circumstances, future changes in real estate markets could impact the ultimate amount of cash paid to resolve these obligations.

Allowance for doubtful accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Litigation. We have not recorded an estimated liability related to the class action lawsuit in which we are named. For a discussion of this matter, see the section of this report entitled “Legal Proceedings.” Due to the uncertainties related to both the likelihood and the amount of any potential loss, we are unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability and revise our estimates accordingly. Revisions in our estimates of the potential liability could materially impact our results of operations and financial position.

Valuation of long-lived and intangible assets and goodwill. We review goodwill, identifiable intangibles and other long-lived assets for impairment annually or sooner if events or changes in circumstances indicate that the carrying amount may not be recoverable. Events or changes in circumstances that indicate the carrying amount may not be recoverable include, but are not limited to, a significant decrease in the market value of business and asset acquired, a significant adverse change in the extent or manner in which the business or asset acquired is used or a significant adverse change in the business climate. If such events or changes in circumstances are present, the fair value of a reporting unit is compared with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired. If the carrying amount of a reporting unit exceeds its fair value, the amount of impairment will be measured in accordance with the guidance of SFAS 142. All of our goodwill was assigned to a single reporting unit, which is our sole operating segment.

RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND SEPTEMBER 30, 2001

The following table sets forth certain items in the Company’s consolidated statements of operations as a percentage of total revenues for the periods indicated:


			Three Months Ended						Nine Months Ended
			September 30,						September 30,

			2002			2001			2002			2001

Revenues:
	Product			38	%		31	%		36	%		26	%
	Service and maintenance			62			69			64			74

		Total revenues		100			100			100			100
Cost of revenues:
	Product			4			7			6			9
	Service and maintenance			30			34			41			54

		Total cost of revenues		34			41			47			63
Gross Margin				66			59			53			37
Operating expenses:
	Sales and marketing			47			112			83			168
	Research and development			75			97			110			105
	General and administrative			31			46			50			68
	Lease abandonment expense			—			—			—			3
	Restructuring related charges			—			81			18			196
	Amortization of intangibles			2			36			2			110
	Impairment of goodwill and other intangibles			—			—			—			939

		Total operating expenses		155			372			263			1,589

Loss from operations				(89	)		(313	)		(210	)		(1,552	)
Other income (expense), net				50			33			16			45

Net loss				(39	)%		(280	)%		(194	)%		(1,507	)%

REVENUES

Total revenues. Total revenues decreased 27% to $1.6 million in the quarter ended September 30, 2002, from $2.2 million in the third quarter of 2001. Revenues decreased 46% to $4.4 million for the nine months ended September 30, 2002, from $8.0 million for the same period in 2001. Revenues from sales in the United States were $1.4 million or 87% of total revenues in the third quarter of 2002 compared to $2.0 million or 80% of total revenues in the third quarter of 2001. Revenues from sales in the United States were $3.9 million or 89% of total revenues for the nine months ended

September 30, 2002 compared to $6.1 million or 76% of total revenues for the nine months ended September 30, 2001. Revenues from international sales in the third quarter of 2002 were $207,000 or 13% of total revenues compared to $446,000 or 20% of total revenues in the third quarter of the prior year. Revenues from international sales were $473,000 and $1.9 million, or 11% and 24% of total revenues, for the nine months ended September 30, 2002 and 2001, respectively. The majority of international sales were made in Europe by our direct sales organizations based in the United States and the United Kingdom. International sales are generally denominated in United States dollars.

During the third quarter of 2002 and as part of our strategy to focus our marketing and development efforts on our primary product NetP 7, we continued to wind-down our non-strategic product and service offerings, including Advertising Advisor, which in 2001 accounted for a significant portion of our total revenues. NetP 7 incorporates certain key components from our non-strategic product offerings, including components from Personalization Manager and Distribution Analyst.

Product revenues. Product revenues decreased 9% to $613,000 in the third quarter of 2002 compared to $674,000 for the same period in the prior year. Product revenues decreased 24% to $1.6 million for the nine months ended September 30, 2002 from $2.1 million in the same period of 2001. Product revenues comprised 38% of total revenues for the third quarter of 2002 compared to 31% for the same period in 2001. Product revenues comprised 36% of total revenues for the nine months ended September 30, 2002 compared to 26% for the same period in 2001. The decrease in product revenues in absolute dollars is attributable to a combination of factors, including the rapid deterioration of Internet retailers, a longer sales cycle due to our pursuit of larger transactions with larger organizations, increased competition, and the deferral of purchase decisions by our current and potential customers due to economic uncertainty. Historical percentage growth rates of our product revenues have not been sustainable and we do not currently expect to achieve such historical percentage growth rates in the future.

Service and maintenance revenues. Service and maintenance revenues consist primarily of professional and maintenance services and, secondarily, product hosting services. Our professional service revenues include business consulting, implementation support, data processing and educational services, and are generally offered on a time and materials basis. Maintenance revenues are generally derived from annual service agreements and are recognized ratably over the term of the agreement. Service and maintenance revenues decreased 33% to $999,000 in the third quarter of 2002 from $1.5 million in the third quarter of 2001. Service and maintenance revenues comprised 62% and 69% of total revenues in the third quarter of 2002 and 2001, respectively. Total service and maintenance revenues decreased 53% to $2.8 million for the nine months ended September 30, 2002 from $5.9 million in the same period of 2001. Service and maintenance revenues comprised 64% and 74% of total revenues for the nine months ended June 30, 2002 and 2001, respectively. The decrease in service and maintenance revenues in absolute dollars reflects lower levels of consulting and maintenance services due to the combined effect of fewer new customer acquisitions, the wind-down, during the second quarter of 2002, of non-strategic product and services offerings, including Advertising Advisor, that in 2001 accounted for a significant portion of our services revenues, and a decline in our customer base, particularly Internet retailers. Prior percentage growth rates of our service and maintenance revenues have not been sustainable and we do not currently expect to achieve such prior percentage growth rates in the future.

As stated in Note 2 to the Consolidated Financial Statements, in accordance with Emerging Issue Task Force Issue No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” we began to account for such items as revenue and cost of revenue effective January 1, 2002. Service revenues for the three months ended September 30, 2002 and the nine months ended September 30, 2002 include $4,000 and $113,000, respectively, of such amounts. Additionally, service revenues of $16,000 and $195,000 for the three months ended September 30, 2001 and the nine months ended September 30, 2001, respectively, have been reclassified to conform to current period presentation.

COST OF REVENUES

Cost of product revenues. Cost of product revenues consists primarily of the cost of royalties paid to third-party vendors, amortization of acquired technology costs, product media and duplication, manuals, packaging materials and shipping expenses. Cost of product revenues decreased 57% to $68,000 in the third quarter of 2002 from $158,000 in the third quarter of 2001, representing 11% and 23% of the related product revenues, respectively. Cost of product revenues decreased 63% to $254,000 for the nine months ended September 30, 2002 from $679,000 for the nine months ended September 30, 2001, representing 16% and 33% of the related product revenues, respectively. The decrease in cost of product revenues in absolute dollars is primarily attributable to a decrease in amortization of

acquired technology cost in connection with our acquisition of KD1 in February 2000 and to reduced product revenues and royalties payable to third parties. Since all internal development costs incurred in the research and development of new software products and enhancements to existing software products have been expensed as incurred, cost of product revenues includes no amortization of capitalized software development costs. We currently intend to decrease our reliance on licensed third-party technology in 2002, which may result in the cost of product revenues continuing to decline as a percentage of related product revenues.

Cost of service and maintenance revenues. Cost of service and maintenance revenues consists primarily of personnel-related and infrastructure costs incurred in providing telephone and Web-based support of our software products, as well as professional, consulting, educational and hosted product related services to customers. Cost of service and maintenance revenues decreased 37% to $473,000 in the third quarter of 2002, from $755,000 in the third quarter of the prior year, representing 47% and 50% of the related service and maintenance revenues, respectively. Cost of service and maintenance revenues decreased 58% to $1.8 million for the nine months ended September 30, 2002 from $4.3 million for the same period in the prior year, representing 64% and 73% of the related service and maintenance revenues, respectively. The decrease in cost of services and maintenance revenues in absolute dollars and as a percentage of revenues is primarily due to headcount reductions in our service organization as a result of our restructuring efforts. Cost of service and maintenance revenues may vary significantly from quarter to quarter depending upon the mix of services that we provide and the utilization rate of our service personnel.

As stated above, and in Note 2 to the Consolidated Financial Statements, in accordance with Emerging Issue Task Force Issue No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” we began to account for such items as revenue and cost of revenue effective January 1, 2002. Cost of service revenues for the three months ended September 30, 2002 and the nine months ended September 30, 2002 include $4,000 and $113,000, respectively, of such amounts. Additionally, cost of service revenues of $16,000 and $195,000 for the three months ended September 30, 2001, and the nine months ended September 30, 2001, respectively, have been reclassified to conform to current period presentation.

OPERATING EXPENSES

Sales and marketing. Sales and marketing expenses consist primarily of salaries, other employee-related costs, commissions and other incentive compensation, travel and entertainment and expenditures for marketing programs such as collateral materials, trade shows, public relations and creative services. Sales and marketing expenses were $753,000 in the third quarter of 2002, a decrease of 70% from the $2.5 million in the third quarter of 2001. Sales and marketing expenses were 47% and 112% of total revenues in the third quarter of 2002 and 2001, respectively. Sales and marketing expenses were $3.6 million and $13.5 million, or 83% and 168% of total revenues, for the nine months ended September 30, 2002 and 2001, respectively. The decrease in sales and marketing expenses in absolute dollars is primarily due to headcount reductions as a result of our restructuring efforts and decreased spending on marketing programs.

Research and development. Research and development expenses consist primarily of salaries, other employee-related costs and consulting fees related to the development of our products. Research and development expenses were $1.2 million in the third quarter of 2002, a decrease of 43% from the $2.1 million in the third quarter of 2001. Research and development expenses were 75% and 97% of total revenues in the third quarter of 2002 and 2001, respectively. Research and development expenses were $4.8 million and $8.4 million, or 110% and 105% of total revenues, for the nine months ended September 30, 2002 and 2001, respectively. The decrease in research and development expenses in absolute dollars is primarily due to headcount reductions as a result of our restructuring efforts.

General and administrative. General and administrative expenses consist primarily of salaries, other employee-related costs, provision for doubtful accounts and professional service fees. General and administrative expenses were $514,000 in the third quarter of 2002, a decrease of 49% from the $1.0 million recorded in the third quarter of 2001. General and administrative expenses were 31% and 46% of total revenue in the third quarter of 2002 and 2001, respectively. General and administrative expenses were $2.1 million and $5.4 million, or 50% and 68% of total revenues, for the nine months ended September 30, 2002 and 2001, respectively. The decrease in general and administrative expenses in absolute dollars is primarily due to headcount reductions as a result of our restructuring efforts and a reduction in bad debt expense. The decline in general and administrative expenses for the nine months ended September 30, 2002 from the same period in 2001 was partially offset by $213,000 of legal and accounting fees recorded in the second quarter of 2002 related to M&A work that will not materialize in a transaction.

Lease abandonment expenses. Lease abandonment expenses relate to our August 2000 abandonment of our previous headquarters facility upon our move to new corporate headquarters. In October 2001, we entered into an agreement to sublease the majority of our previous headquarters facility to a third party. For the nine months ended September 30, 2002, no lease abandonment charges were recorded compared to $225,000 in the same period in 2001. Lease abandonment charges represented 3% of total revenues for the nine months ended September 30, 2001.

Restructuring related charges. We recorded no restructuring related charges in the third quarter of 2002. In 2002 and 2001, we instituted certain restructuring plans to better align our cost structure with our business outlook and general economic conditions. Under the restructuring plans, we recorded restructuring related charges totaling $768,000 and $15.7 million for the nine months ended September 30, 2002 and 2001, respectively.

A total of approximately $654,000 was charged against the restructuring reserve during the third quarter of 2002, bringing the total charges against the restructuring reserve to $3.3 million for the nine months ended September 30, 2002, lowering the accrued restructuring liability to approximately $4.9 million. Charges against the reserve during the third quarter of 2002 included $47,000 in employee severance payments, $702,000 in rent payments, $307,000 in costs relating to subletting facilities and $64,000 in costs relating to closure of our Texas data center. These charges were partially offset by $454,000 of sublease income and $12,000 in proceeds from the sale of fixed assets. For the nine months ended September 30, 2002 the charges included $642,000 of non-cash fixed assets write-offs, $547,000 in employee severance payments, $2.1 million in rent payments, $1.2 million in costs relating to subletting facilities, and $64,000 in costs relating to the closure of our Texas data center. These charges were partially offset by $1.2 million of sublease income and $68,000 in proceeds from the sale of fixed assets. In conjunction with the restructuring related charges recorded, we made certain estimates regarding future sublease income that have a significant impact on our anticipated cash obligations and related restructuring reserves. Although we believe that the lease commitment estimates are appropriate in the current circumstances, future changes in real estate markets could impact the ultimate amount of cash paid to resolve these obligations.

The following table presents a summary of the restructuring related activities and accrued restructuring charges as of September 30, 2002:


									Sublease					Accrued
		Accrued							Income and					Restructuring
		Restructuring							Proceeds from		Non-Cash			as of
		as of December 31,		Restructuring		Restructuring			the Sale of		Asset			September 30,
Description		2001		Charges		Payments			Fixed Assets		Disposals			2002

Lease commitments and related items		$	6,896	$	—	$	(3,296	)	$	1,162	$	—		$	4,762
Employee severance and termination costs			111		506		(547	)		—		—			70

	Subtotal		7,007		506		(3,843	)		1,162		—			4,832
Fixed asset disposals and other costs			426		262		(66	)		68		(642	)		48

		$	7,433	$	768	$	(3,909	)	$	1,230	$	(642	)	$	4,880

Amortization of intangibles. Amortization expense related to intangibles acquired in the February 2000 acquisition of KD1 was $65,000, (including $37,000 amortization of goodwill and other intangibles included in cost of product revenues) during the third quarter of 2002. This is compared to $835,000 (including $37,000 of amortization of goodwill and other intangibles included in the cost of product revenues) during the third quarter of 2001. This represented 4% and 38% of 2002 and 2001 third quarter total revenues, respectively. Amortization expense was $193,000 (including $110,000 amortization of intangibles included in cost of product revenues) for the nine months ended September 30, 2002. This is compared to $9.3 million (including $407,000 of amortization of goodwill and other intangibles included in the cost of product revenues) for the nine months ended September 30, 2001. This represented 4% and 116% of total revenues for the nine months ended September 30, 2002 and 2001, respectively. Total amortization of goodwill and other intangibles is expected to be significantly lower for 2002 and through the first quarter of 2003 due to the $75.3 million impairment of goodwill and other intangibles charge recorded in the first quarter of 2001 discussed below and our adoption of Statements of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002, under which we are no longer amortizing goodwill and certain other identified intangible assets. See also Note 5 to the Consolidated Financial Statements.

Impairment of goodwill and other intangibles. At March 31, 2001, we performed an impairment assessment of the goodwill and other intangible assets recorded in connection with the acquisition of KD1. As a result of our review, we recorded a $75.3 million impairment charge to reduce goodwill and other intangible assets to their estimated fair values. In accordance with SFAS No. 142, beginning January 1, 2002, goodwill and certain other intangibles are no longer being amortized, resulting in a reduction of quarterly amortization of $771,000 and annual amortization expense of approximately $3.1 million in 2002. Amortization expense related to other intangible assets is expected to be $257,000 and $32,000 for 2002 and the first quarter of 2003, respectively. However, as noted above, the remaining unamortized goodwill and intangible asset balances are subject to periodic impairment analysis, which could require a write-down of these assets in the future.

Stock compensation expense. Compensation charges related to stock options were $9,000 in the third quarter of 2002 and $53,000 in the third quarter of 2001, comprising 0.6% and 2% of total revenues in each of the respective periods. Stock compensation was $35,000 and $211,000, or 0.8% and 3% of total revenues, for the first nine months of 2002 and 2001, respectively. Stock compensation expense represents the amortization of deferred compensation related to stock options granted in 1999 and 1998. Such compensation is amortized over the four-year repurchase period of the common stock underlying the related options. Stock compensation expense was recorded in the functional operating expense categories as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,

	2002		2001		2002		2001

Sales and marketing	$	7	$	9	$	23	$	34
Research and development		—		37		3		146
General and administrative		2		7		9		31

	$	9	$	53	$	35	$	211

Other income (expense), net. Other income (expense), net, consists of interest income, interest expense, foreign currency transaction losses or gains and other expense. Net other income was $811,000 in the third quarter of 2002 compared to net other income of $714,000 in the same period in 2001. Net other income was $698,000 compared to net other income of $3.6 million for the nine months ended September 30, 2002 and 2001, respectively. The decrease in net other income for the three months ended September 30, 2002 compared to the same period in 2001 was largely attributable to a decrease in interest income and accrued taxes, offset against $200,000 received this quarter as a result of a dispute settlement. The decrease in net other income for the nine months ended September 30, 2002 compared to the same period in 2001 was largely attributable to the $1.6 million loss on investment resulting from our sale of $2.1 million in WorldCom bonds upon announcement of accounting issues by WorldCom.

PROVISION FOR INCOME TAXES

We have incurred significant operating losses for all periods from inception through September 30, 2002. As of December 31, 2001, we had net operating loss carry-forwards of approximately $91.6 million available to reduce future taxable income expiring at various dates beginning in 2011. In addition, as of December 31, 2001, we had $195,000 of tax credit carry-forwards expiring at various dates beginning in 2011. Under the provisions of the Internal Revenue Code of 1986, as amended, if certain substantial changes in our ownership were to occur, we could be limited in the future in the amount of net operating loss and tax credit carry-forwards that could be utilized annually to offset future taxable income.

We have recorded a valuation allowance for the full amount of our net deferred tax assets, as the realization of the future tax benefit is presently not likely.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, we have financed our operations primarily through the sale of equity securities. At September 30, 2002, we had $64.6 million of cash, cash equivalents and short-term investments, compared to $76.4 million at September 30, 2001.

Cash used in operations was $8.3 million for the nine months ended September 30, 2002, compared to $19.9 million for the same period in 2001. Cash used in operations in both periods resulted primarily from net losses, as adjusted for non-cash expenses. In April 2000, we signed a ten-year lease for a new corporate facility in Edina, Minnesota, with annual total rent payments beginning at $1.4 million per year, excluding operating expenses.

A total of $28.4 million in net cash was provided from investing activities for the nine months ended September 30, 2002, compared to $27.1 million of cash provided in the same period for 2001. Our investing activities consisted primarily of net sales of short-term investments and marketable securities offset, in 2001, by purchases of property and equipment. Our investment portfolio as a percentage of total cash and investments as of September 30, 2002, was comprised of 54% in money market accounts, 10% in corporate bonds and papers, 23% in municipal bonds and 13% in federal agency securities. We will continue to invest cash in excess of current requirements in investment grade, interest-bearing securities.

Capital expenditures were $0 for the nine months ended September 30, 2002 as compared to $197,000 in the same period for 2001. Capital expenditures were even higher in years prior to 2001 and reflected our rapidly growing employee base and expanded operations.

Net cash provided from financing activities was $4,000 for the nine months ended September 30, 2002 and net cash used for financing activities was $371,000 for the same period in 2001.

No restructuring related charges were recorded in the third quarter of 2002. During 2002 and 2001, we instituted certain restructuring plans to better align our cost structure with our business outlook and general economic conditions. Under the restructuring plans, we recorded restructuring related charges totaling $768,000 and $15.7 million for the nine months ended September 30, 2002 and 2001, respectively. A total of approximately $654,000 was charged against the restructuring reserve during the third quarter of 2002, and a total of approximately $3.3 million was charged against the restructuring reserve for the first nine months of 2002, lowering the accrued restructuring liability to approximately $4.9 million.

Of the $4.9 million restructuring reserve remaining as of September 30, 2002, management estimates that approximately $4.8 million will be a use of cash in future periods through July, 2010, for remaining rent commitments and other carrying costs, less estimated sublease income, related to facilities we have vacated. The remaining $100,000 of accrued restructuring costs relates to other miscellaneous restructuring related costs. Although we believe that our lease commitment estimates are appropriate in the current circumstances, future changes in real estate markets could impact the ultimate amount of cash paid to resolve these obligations.

As of September 30, 2002, we had no material long-term commitments for capital expenditures.

Since 1999, we have purchased property and equipment with cash. From inception through 1998, we generally funded the purchase of property and equipment with capital leases. At September 30, 2002, we had $526,000 in long-term liabilities, all comprised of deferred rent credits.

The following summarizes our contractual obligations at September 30, 2002, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands). See the discussion below regarding our operating lease obligations and related sublease agreements.


	2002		2003		2004		2005		Thereafter

Operating leases	$	1,013	$	4,067	$	3,282	$	3,141	$	14,277

Total contractual cash obligations	$	1,013	$	4,067	$	3,282	$	3,141	$	14,277

Expected sublease income		602		2,428		1,894		1,626		7,608

Net contractual cash obligation	$	411	$	1,639	$	1,388	$	1,515	$	6,669

Operating lease obligations relate to our existing facilities. As of September 30, 2002, we have signed agreements to sublease approximately 107,000 square feet of our existing facilities. We are actively seeking to sublease our remaining excess facilities. Specifically, we are currently seeking to sublease an additional portion of our Edina, Minnesota office space, our entire Roseland, New Jersey office space and a portion of our office space in Austin, Texas. However, there is a risk that we may not be able to sublease these facilities under favorable terms, if at all, which could negatively impact our cash flow and future operating results.

We believe that existing cash and investments will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. If we need to raise additional funds, we may not be able to do so on favorable terms or at all. If we raise additional funds through the issuance of equity securities, the percentage ownership of our current stockholders will be reduced.

RISKS THAT MAY AFFECT FUTURE RESULTS

The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or which are currently deemed immaterial may also impair our business, financial condition and results of operations. If any of these risks actually occur, our business, financial condition and results of operations could be materially adversely affected.

We are an early-stage company and we expect to encounter risks and difficulties frequently encountered by early-stage companies in new and rapidly evolving markets.

We were founded in July 1996. We began shipping products in the first quarter of 1997. The market for our products is unproven and our limited operating history makes an evaluation of our future prospects very difficult. We will encounter risks and difficulties frequently encountered by early-stage companies in new and rapidly evolving markets. We may not successfully address any of these risks. If we do not successfully address these risks, we may not achieve profitability and we could suffer increased operating losses.

Our quarterly operating results are volatile and difficult to predict. If we fail to meet the expectations of public market analysts and investors, the market price of our common stock may decrease significantly.

Our quarterly operating results have varied in the past and may vary significantly in the future. Because our operating results are volatile and difficult to predict, we believe that period-to-period comparisons of our results of operations are not a good indication of our future performance. Historically, our operating results have been below the expectations of public market analysts and investors and it is likely that in some future quarter or quarters our operating results will again be below the expectations of public market analysts and investors. In this event, the market price of our common stock may decrease significantly.

We cannot predict our future quarterly revenues with any degree of certainty for a variety of reasons, including:

• we operate with a limited order backlog, and revenues in any quarter are substantially dependent on orders booked and shipped in that quarter;

• the market in which we compete is relatively new and rapidly evolving and has many new entrants;

• we expect that, for the foreseeable future, revenues will come from licenses to a small number of customers, so delays or cancellations of orders by a few customers can significantly impact revenues within a quarter;

• our sales cycle varies substantially from customer to customer; and

• the timing of large orders can significantly affect revenues within a quarter.

Historically, we have recognized a substantial portion of our revenues in the last month of a quarter, with these revenues frequently concentrated in the last two weeks of the quarter. Accordingly, we cannot predict our financial results for any quarter until very late in the quarter. A delay in an anticipated sale or revenue recognition near the end of a quarter can seriously harm our operating results for that quarter.

Our expense levels are relatively fixed in the short term and are based, in part, on our expectations as to our future revenues. As a result, any delay in generating or recognizing revenues could cause significant variations in our operating results from quarter to quarter and could result in increased operating losses.

Our business could be materially adversely affected as a result of general economic and market conditions.

We are subject to the effects of general global economic and market conditions. A sustained general economic slowdown could have serious negative consequences for our business and operating results. For example, an economic slowdown may cause some current or potential customers to defer purchases, to go out of business or to have insufficient capital to buy our products. An economic slowdown could also cause a significant reduction in the value of our investments. If economic and market conditions do not improve, our business, results of operations or financial condition could be materially adversely affected.

We have a history of losses and expect to incur losses in the future.

We had net losses of $4.7 million in 1997, $5.0 million in 1998, $12.0 million in 1999, $53.5 million in 2000 (including $27.6 million of amortization of goodwill and other intangibles related to the acquisition of KD1 and non-cash stock compensation expense) and $123.8 million (including $15.6 million in restructuring related charges, $10.3 million of amortization of goodwill and other intangibles and non-cash stock compensation expense and a $75.3 million charge for the impairment of goodwill and other intangibles related to the acquisition of KD1) for the year ended December 31, 2001. As of September 30, 2002, we had an accumulated deficit of $208.5 million. We have not had a profitable quarter and do not expect to have a profitable quarter in 2002. We expect to continue to incur significant sales and marketing, research and development and general and administrative expenses. We will need to generate significant additional revenues to achieve profitability. We may never achieve profitability.

A decline in the price of, demand for, or market acceptance of NetP 7 would seriously harm our business.

Recently, we have derived a substantial portion of our revenues from one product — NetP 7. As part of our strategy to focus our marketing and development efforts on NetP 7, we have continued to wind-down our non-strategic product and service offerings, including Advertising Advisor, which in 2001 accounted for a significant portion of our revenues.

We anticipate that NetP 7 will account for a substantial majority of our revenues for the foreseeable future. Consequently, a decline in the price of or demand for NetP 7, or failure to achieve broad market acceptance for NetP 7, would materially adversely affect our business and results of operations.

The market price of our common stock may be volatile, which could result in substantial losses for individual stockholders.

The market price for our common stock has been and is likely to continue to be highly volatile and subject to wide fluctuations in response to factors including the following, some of which are beyond our control:

• actual or anticipated variations in our quarterly operating results;

• announcements of new technological innovations, increased cost of operations or new products or services by us or our competitors;

• changes in financial estimates by securities analysts;

• conditions or trends in the industries into which we sell our products and services;

• changes in the economic performance and/or market valuations of other comparable companies;

• volatility in the stock markets, particularly with respect to technology stocks, and decreases in the availability of capital for technology-related businesses;

• announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;

• additions or departures of key personnel;

• sales of additional shares of common stock; and

• potential litigation.

From April 23, 1999 (the first day of public trading of our common stock), through September 30, 2002, the high and low sales prices for our common stock fluctuated between $66.50 and $0.76. On October 31, 2002, the last reported sale price of our common stock on the Nasdaq National Market was $1.16. In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities.

On November 2, 2001, Timothy J. Fox filed a purported class action lawsuit against us, FleetBoston Robertson Stephens, Inc., the lead underwriter of our initial public offering in April 1999, several other underwriters who participated in our initial public offering, Steven J. Snyder, our then president and chief executive officer, and Thomas M. Donnelly, our chief financial officer and chief operating officer. For a discussion of this matter, see the section of this report entitled “Legal Proceedings.” We may in the future be the target of other similar litigation. Securities litigation could result in substantial costs and divert management’s attention and resources.

Our common stock may be delisted from Nasdaq.

Since July 1, 2002, the closing price of our common stock has been below $1.00 for as many as 14 consecutive business days. We may fail to maintain the minimum closing bid price of $1.00 for 30 consecutive business days as required by the Nasdaq National Market. If we are unable to demonstrate compliance with this or any other Nasdaq requirement, Nasdaq may take further action with respect to a potential delisting of our common stock. We may appeal any such decision by Nasdaq to the Nasdaq Listing Qualifications Panel. If our common stock were delisted from Nasdaq this could result, among other things, in a number of negative implications, including reduced liquidity in our common stock as a result of the loss of market efficiencies associated with Nasdaq, as well as the potential loss of confidence by suppliers, customers and employees, the loss of analyst coverage and institutional investor interest, fewer business development opportunities and greater difficulty in obtaining financing.

We face intense competition and, if we are unable to compete successfully, we may be unable to increase our product sales and market share.

The market for our products is intensely competitive, evolving and subject to rapid technological change. We expect the intensity of competition to increase in the future. Competitors vary in size and in the scope and breadth of the products and services offered.

We believe that the principal competitive factors affecting our market include core technology, product features, product quality and performance, customer service and price. Although we believe that our products currently compete favorably with respect to such factors, our market is relatively new and is rapidly evolving. We may not be able to maintain our competitive position against current and potential competitors, especially those with significantly greater financial, marketing, service, support, technical and other resources.

Many of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we have. In addition, many of our competitors have well-established relationships with current and potential customers of ours, have extensive knowledge of our industry and are capable of offering a single-vendor solution. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, promotion and sale of their products than we can. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address customer needs. Also, relationships with large systems integrators such as Accenture, large consulting firms and others are an important factor in successfully achieving widespread deployment of these solutions. Many of our competitors have such relationships in place today, and this may hinder our ability to gain equivalent access to systems integration

resources. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of software industry consolidations. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share. We may not be able to compete successfully against current and future competitors.

We may need to make acquisitions to remain competitive.

A component of our business strategy is to seek to buy businesses, products and technologies that complement or augment our existing businesses, products and technologies. Acquisitions are difficult to identify and complete for a number of reasons, including the cost of potential transactions, competition among prospective buyers and the need for regulatory approvals. We may not be able to complete any given acquisition. Furthermore, in order to finance a potential acquisition, we may need to raise additional funds by selling our stock or borrowing money. We may not be able to find financing on favorable terms, and the sale of our stock may result in the dilution of our existing stockholders. If we do undertake any transaction of this sort, the process of integrating an acquired business, product or technology may result in unforeseen operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. Moreover, we may fail to realize the anticipated benefits of any acquisition.

Our products have a lengthy sales cycle. As a result, it is difficult to predict the quarter in which a sale may occur.

Our solutions are relatively new to the marketplace. As a result, we must use significant resources to educate potential customers on the use and benefits of our products. In addition, we believe that the purchase of our products is relatively discretionary and involves a significant commitment of capital and other resources by a customer. As a result, it usually takes our sales organization several months to finalize a sale. This makes it difficult to predict the quarter in which a sale may occur.

Our products can have a lengthy and/or complex implementation cycle. In addition, only a limited number of our customers have a deployed and operating application that utilizes our products. As a result, we cannot be certain that our products will perform and be received as expected.

The implementation, including application design and deployment, of our products requires a commitment of resources by our customers. The time required for implementation of our products has varied depending on the customer’s application of the product.

We have licensed one or more of our products to more than 200 customers. However, only a limited number of these customers have a fully deployed operating application that utilizes our products. In addition, a significant number of Internet retailer customers have gone out of business, and are no longer utilizing our products. Because many of our customers have not yet fully implemented and deployed our products, we cannot be certain that our products will:

• perform as designed;

• deliver the desired level of economic benefit to our customers;

• meet the other expectations and needs of our customers;

• achieve any significant degree of market acceptance; or

• perform to the level necessary to generate repeat customers and customer references.

If implementation services performed by us constitute a significant part of a product sales transaction, we recognize a substantial portion of our revenues from the sales transaction upon the delivery of the implementation services. As a result, delays in service delivery could cause significant reduction in our license revenues and operating results for any particular period.

We have a new product that may not achieve market acceptance.

In June 2002, we announced the commercial launch of NetP 7.0. In October, 2002, we announced the launch of NetP 7.1, offering enhancements to NetP 7.0, and we expect to continue to introduce new and enhanced product features.

Our products have not received a significant degree of market acceptance. There are significant risks inherent in product introductions such as these. These products may not address some or all of the needs of customers and may contain undetected errors or failures. A lack of necessary features or errors or failures in the products will likely result in loss or delay of market acceptance. We expect that our future financial performance will depend significantly on the successful sales, implementation and market acceptance of these new or enhanced products which may not occur on a timely basis or at all.

NetP 7.0 and NetP 7.1, enhancements thereof, and any new products will be subject to significant technical risks. We may fail to introduce or deploy new products or new releases on a timely basis, or at all. In the past, we have experienced some delays in the commencement of commercial shipments of our new releases and new products. These delays caused customer frustrations and delay or loss of product revenues. Some of our competitors currently offer products with features and functionality similar to those of NetP 7.0 and NetP 7.1. In the past, we have also experienced delays in purchases of our products by customers anticipating our launch of new releases or new products. We could experience increased expenses or lost revenues if customers defer material orders in anticipation of new releases or new product introductions.

The software products we offer are complex and may contain undetected errors or failures when first introduced, or as new versions are released. We have in the past discovered software errors in our new releases and new products after their introduction. We experienced delays in release during the period required to correct these errors. We may discover errors in new releases or new products after the commencement of commercial shipments, despite testing by our personnel and our current and potential customers. This may result in loss of or delay in market acceptance of our products, which could seriously impair our ability to achieve profitability.

Acts of terrorism or war may hurt global economic conditions, which could harm our business.

Our business is subject to and affected by forces, pressures and events affecting global economic conditions. The September 11, 2001 terrorist attacks exacerbated global economic conditions and adversely impacted many businesses, including that of Net Perceptions. Future terrorist acts or acts of war may cause damage or disruption to our employees, facilities, customers and suppliers, which could have a material adverse effect on our business, results of operations and financial condition.

If we fail to generate repeat or expanded business from our current and future customers, we may be unable to build a critical mass of customers necessary to achieve increased sales and market share.

Our success is dependent on the continued growth of our customer base and the retention of our customers. We currently depend on a limited number of key, high-profile customers. Our ability to attract new customers will depend on a variety of factors, including the accuracy, scalability, reliability and cost-effectiveness of our products and services and our ability to effectively market such products and services. In the past, we have lost potential customers to competitors for various reasons, including lower prices and other incentives not matched by us. Many of our customers initially purchase a limited license for our products and services for evaluation. If such evaluation is successful, the customer may purchase a license to expand the use of our products in its organization or license additional products and services. If we fail to generate repeat and expanded business from our current and future customers, we may be unable to build a critical mass of customers necessary to achieve increased sales and market share.

If we fail to attract or retain skilled salespeople as needed, we may be unable to increase market awareness and sales of our products and services.

Our products and services require a sophisticated sales effort targeted at the senior management of our prospective customers. As of September 30, 2002, our direct sales organization consisted of 11 employees. We may need to hire additional direct sales personnel in the future. Competition for qualified sales personnel is intense, and we might not be able to attract or retain the kind and number of sales personnel we need. New hires require

extensive training, typically take several months to achieve productivity and may not be as productive as necessary. If we are unable to attract or retain additional skilled sales personnel as needed, we may not be able to capture increased market share for our products and services.

If we are unsuccessful in attracting and retaining qualified service personnel, we may lose current customers or be unable to attract new customers.

Customers that license our software typically engage our professional services organization to assist with support, training, consulting and implementation. We believe that growth in our product sales depends on our ability to provide our customers with these services and to educate resellers on how to use our products. From time to time, we receive customer complaints about the timeliness and accuracy of our customer support. As of September 30, 2002, our professional services and customer support organization consisted of 9 employees. There are a limited number of people who have the skills needed to provide the services that our customers demand. Competition for qualified service personnel is intense. We cannot be certain that we can attract or retain a sufficient number of the highly qualified service personnel that our business needs.

We generate revenues from international sales and, therefore, our business is susceptible to numerous risks associated with international operations.

Licenses and services sold to customers outside of the United States accounted for approximately 22% of our total revenues in 2000, 20% in 2001 and 11% for nine months ended September 30, 2002. We expect to generate additional international revenues in the future, and we believe that we must expand our international sales and marketing activities in order to be successful. We have limited experience in marketing, selling, distributing and supporting our products and services internationally and international operations are generally subject to a number of risks, including:

• expenses associated with customizing products and services for foreign countries;

• protectionist laws and business practices that favor local competition;

• conflicting and changing governmental laws and regulations;

• longer sales cycles;

• difficulties in collecting accounts receivable; • foreign currency exchange rate fluctuations; and

• political and economic instability.

As of September 30, 2002, we had two employees located in the United Kingdom. All other employees were located in the United States.

We may be unable to sublease or find suitable sub-tenants for a portion of our principal executive offices and some of our other offices, and tenants may fail to make sublease payments.

In April 2000, we executed a ten-year lease for a new facility for our principal executive offices in Edina, Minnesota. We have sublet a significant portion of this facility to third parties and are currently seeking to sublease an additional portion of this facility. We have also sublet all of the space at our Berkshire, United Kingdom facility and a portion of the space at our San Francisco, California facility. We are also currently seeking to sublease our Roseland, New Jersey office space and a portion of our office space in Austin, Texas. We may not be able to find suitable sub-tenants for these properties in a timely manner, if at all. If we are unable to find suitable sub-tenants in a timely manner, or if our existing sub-tenants fail to make sublease payments required under their respective sublease agreements, we may experience greater than anticipated operating expenses in the future.

If our intellectual property is not protected adequately, we may lose our competitive advantage in the market.

We are a technology company. Our success depends in large part on protecting our intellectual property, which is one of our most important assets. We rely upon a combination of trademark, copyright, patent and trade secret laws to protect our rights in our technology. We license our software and require our customers to enter into license agreements, which impose restrictions on our customers’ ability to utilize the software. In addition, we seek to avoid disclosure of our trade secrets, including but not limited to requiring those persons with access to our proprietary information to execute confidentiality agreements with us and restricting access to the source code for our software.

We have fourteen pending United States patent applications and four issued United States patents. We also have license rights to three issued United States patents from the University of Minnesota. It is possible that no patents will issue from the currently pending patent applications. It is also possible that our current patents and potential future patents may be invalid or unenforceable. It is also possible that any patent issued to us may not provide us with any competitive advantages. Moreover, we may not develop future proprietary products or technologies that are patentable, and the patents of others may seriously limit our ability to conduct our business. In this regard, we have not performed any comprehensive analysis of patents of others that may limit our ability to conduct our business.

Our efforts to protect our proprietary rights may not succeed. Copyright and trade secret laws afford only limited protection for our proprietary rights in our software, documentation and other written materials. Unauthorized parties may be able to copy aspects of our products or to obtain and use information that we regard as confidential and proprietary. Policing unauthorized use of our products is difficult, and while we are unable to determine the extent to which piracy of our software products exists, software piracy can be expected to be a persistent problem. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as the laws of the United States. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around patents issued to us or our other intellectual property. We may not be able to detect infringement or enforce our patent or other rights and, as a result, our competitive position in the market may suffer.

Third-party infringement claims against us or our technology suppliers could result in delays in product development, the loss of customers, or costly and time-consuming litigation.

There has been a substantial amount of litigation in the software industry regarding intellectual property rights. We have from time to time received claims that we are infringing third parties’ intellectual property rights. It is possible that in the future third parties may claim that our current or potential future products infringe their intellectual property rights, including under issued patents. We expect that software companies such as Net Perceptions will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements in order to secure continued access to required technology. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all. Claims of intellectual property infringement may also require us to pay significant damages or subject us to an injunction against the use of our products. Any successful claim of intellectual property infringement against us could have an immediate and significant impact on our ability to carry on our business and market our products.

In addition, in all of our paid software license agreements, we generally indemnify our customers against losses attributable to intellectual property infringement by our software. Should a third party bring a suit against a customer alleging that the customer’s use of our software infringes its intellectual property rights, we could incur substantial costs in defending and resolving the suit.

If we are unable to continue to utilize technology licensed from third parties, we may be unable to conduct our business.

We license technology from various third parties for integration into our products. Licenses to such third-party technology may not continue to be available to us on commercially reasonable terms. We may not be able to renew

existing agreements or to license or develop alternative technology. If we cannot maintain license rights to key third-party software, develop similar technology or license similar technology from another source on a timely or commercially feasible basis, we may be unable to market our current products or develop new products in a timely manner.

Our ability to increase our customer base and our sales depends on the continuing contribution of our key personnel and our ability to attract, assimilate and retain other highly qualified personnel.

Our future success depends on the continued service of our key personnel. The loss of the services of one or more of our key employees could seriously harm our ability to increase our customer base and sales. As of September 30, 2002, we had 54 employees. We do not carry any key person life insurance policies.

Our future success also depends on our continuing ability to attract and retain an adequate number of highly skilled managerial, technical, sales, marketing and customer support personnel. Competition for skilled personnel is intense, and we may fail to retain our key employees, or attract, assimilate or retain other highly qualified personnel in the future. If so, we may be unable to service our current customers, attract new customers and increase our sales.

The market price of our common stock has been volatile and has fluctuated significantly in the past. To the extent this volatility and fluctuation continues, equity-based compensation policies and plans, which have historically been significant in our attracting, hiring and retaining highly skilled personnel, may not be as effective as in the past.

We may need to raise additional capital that may not be available on reasonable terms, or at all.

We believe we have sufficient cash and investments to meet our working capital and capital expenditure needs for at least the next 12 months. After that, we may need to raise additional funds and we cannot be certain that we will be able to obtain additional financing on favorable terms, or at all. If we raise additional funds through the issuance of equity or convertible debt, the percentage ownership of our stockholders will be reduced, and these newly issued securities may have rights, preferences or privileges senior to those of our existing stockholders. If we cannot raise funds as needed on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements.

Future sales of our common stock could depress its market price.

If our stockholders sell substantial amounts of our common stock, or there is a belief that such sales could occur, the market price of our common stock could fall. These factors could also make it more difficult for us to raise funds through future offerings of common stock. As of September 30, 2002, we had outstanding 27,303,333 shares of common stock and options to acquire an aggregate of 2,844,561 shares of common stock, of which 1,280,002 were exercisable. Substantially all of our outstanding shares are freely tradeable and all shares acquired upon exercise of options will be freely tradeable. Those shares which are not freely tradeable may be resold publicly at any time, subject to the volume and other restrictions of Rule 144 under the Securities Act. If large numbers of these shares are sold over a short period of time, the price of our common stock could be adversely affected.

We may be subject to potential product liability claims that could result in costly and time-consuming litigation.

Because our customers use our products for important applications, errors or defects in, or other performance problems with, our products could result in financial or other damages to our customers. Our customers could seek damages for losses from us. Although our license agreements typically contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. Any product liability claim brought against us, even if unsuccessful, would likely be time-consuming and costly, and potential liabilities could exceed our available insurance coverage.

Our current revenue recognition practices may need to change, which could seriously harm our business.

The American Institute of Certified Public Accountants issued Statement of Position 97-2, “Software Revenue Recognition,” in October 1997 and amended it by Statements of Position 98-4 and 98-9. There may be additional pronouncements issued in the future. Our current revenue accounting practices may need to change and such changes could seriously harm our future revenues and earnings.

Provisions of our corporate organizational documents and rights agreement could delay or prevent a change of control, even if it would be beneficial to our stockholders.

Various provisions of our certificate of incorporation and bylaws could have the effect of delaying or preventing a change in control and make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. In addition, the rights issued under our rights agreement may be a substantial deterrent to a person acquiring 15% or more of our common stock without the approval of our board of directors. These provisions in our certificate of incorporation, by-laws and rights agreement could reduce the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions.

Our business could be seriously impacted by privacy and security concerns.

In some cases, our customers capture user preference and profile information each time a user interacts with the application utilizing our products or volunteers information in response to survey questions. Our customers generally have implemented security measures to protect such customer data from unauthorized disclosure or interception by third parties. However, the security measures may not be effective against all potential security threats. If a breach of customer data security were to be publicized, our products may be perceived as less desirable, and our future sales could be negatively impacted. More importantly, even the perception of privacy and security concerns, whether or not valid, may indirectly inhibit market acceptance of our products. In addition, legislative or regulatory requirements may heighten such concerns if, for example, our customers were required to notify users that the data captured after these interactions may be used by marketing entities to direct product promotion and advertising to that user. Legislation has been proposed at the federal and state levels that address some aspects of the Internet, including a number of bills that specifically address Internet privacy matters. Such proposed legislation indicates that some federal and state legislators believe that certain aspects of the Internet and e-commerce, including data privacy, are appropriate matters for regulation and review. Various other countries and political entities, such as the European Union, have adopted legislation or regulatory requirements addressing issues, such as data privacy, that may directly impact some of our customers. If user privacy concerns are not adequately addressed or if restrictive legislation is adopted in the United States, our business could be seriously harmed and we could experience increased operating losses.

If we do not respond to rapid technological changes, our products could become obsolete and we could lose our competitive advantage in the market.

The life cycles of our products are difficult to predict because the markets for our products are characterized by rapid technological change, changing customer needs, frequent new software product introductions and evolving industry standards.

The introduction of products embodying new technologies and the emergence of new industry standards could render our existing products obsolete and unmarketable. To be successful, we need to develop and introduce new software products and enhancements to existing products on a timely basis that:

• keep pace with technological developments and emerging industry standards; and

• address the increasingly sophisticated needs of our customers.

In addition, we may:

• fail to develop and market new products and enhancements to existing products that respond to technological changes or evolving industry standards;

• experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and enhancements to existing products; and

• fail to develop new products and enhancements to existing products that adequately meet the requirements of the marketplace or achieve market acceptance.

If any of these events occur, we may be unable to compete successfully in the market for our products and services, and as a result, our business could fail.

The growth of the market for our products and services would be impaired if the use of the Internet and electronic commerce do not grow as anticipated, and third parties do not continue to develop and improve the Internet infrastructure.

Our future revenues depend, in part, upon the increased acceptance and use of the Internet and other on-line services as a medium of commerce. Acceptance and use of the Internet and on-line services may not continue to develop at historical rates and a sufficiently broad base of customers may not adopt or continue to use the Internet and other on-line services as a medium of commerce. Demand and market acceptance for recently-introduced services and products over the Internet are subject to a high level of uncertainty and few proven services and products exist.

In addition, the Internet may not be accepted as a viable long-term commercial marketplace for a number of reasons, including potentially inadequate development of the necessary network infrastructure or delayed development of enabling technologies and performance improvements. To the extent that the Internet continues to experience significant expansion in the number of users, frequency of use or bandwidth requirements, the infrastructure for the Internet may be unable to support the demands placed upon it. In addition, the Internet could lose its viability as a commercial medium due to delays in the development or adoption of new standards and protocols required to handle increased levels of Internet activity, or due to increased governmental regulation. Changes in, or insufficient availability of, telecommunications services to support the Internet also could result in slower response times and adversely affect usage of the Internet generally.

The growth of the market for our products and services would be impaired if:

• use of the Internet, the Web and other on-line services does not continue to increase or increases more slowly than expected;

• the infrastructure for the Internet, the Web and other on-line services does not effectively support expansion that may occur; or

• the Internet, the Web and other on-line services do not become a viable commercial marketplace, which would inhibit the development of electronic commerce.

Increasing government regulation could limit the market for our products and services, which could seriously impair the growth of our business or expose us to unanticipated liabilities.

As Internet commerce evolves, we expect that federal, state or foreign governmental authorities will enact laws or adopt regulations covering issues such as user privacy, pricing, content and quality of products and services. If enacted, such laws, rules or regulations could limit the market for our products and services. Although many of these regulations may not apply to our business directly, we expect that laws regulating the solicitation, collection or processing of personal/customer information could indirectly affect our business.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Through September 30, 2002, the majority of our recognized revenues were denominated in United States dollars and were primarily from customers in the United States, and our exposure to foreign currency exchange rate changes has been immaterial. We expect, however, that future product license and service revenues may increasingly be derived from international markets and may be denominated in the currency of the applicable market. As a result, our operating results may become subject to significant fluctuations based upon changes in the exchange rates of certain currencies in relation to the United States dollar. Furthermore, to the extent that we engage in international sales denominated in United States dollars, an increase in the value of the United States dollar relative to foreign currencies could make our products less competitive in international markets. Although we will continue to monitor our exposure to currency fluctuations, and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, exchange rate fluctuations may adversely affect our financial results in the future.

Our exposure to market risk is otherwise limited to interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because the majority of our investments are in debt securities issued by corporations and the United States government. A hypothetical 100 basis point increase in interest rates would result in an approximate $101,000 decrease in the fair value of our investments as of September 30, 2002. The same hypothetical increase in interest rates as of December 31, 2001 would have resulted in a decrease in the fair value of our investments of approximately $496,000. Our objective in managing our exposure to interest rate risk is to preserve principal while at the same time maximizing the income we receive from our investments. To minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities in addition to debt and have adopted practices and policies to ensure that our portfolio remains adequately diversified. Due to the conservative nature of our investments and relatively short duration, interest risk is mitigated. Furthermore, we place our investments with high-quality issuers and limit the amount of credit exposure to any one issuer. We do not have any derivative financial instruments and do not hold any instruments for trading purposes.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures. Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Exchange Act) as of an evaluation date within 90 days prior to the filing date of this Quarterly Report on Form 10-Q. Based on this evaluation, they have concluded that, as of the evaluation date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company (including our consolidated subsidiaries) required to be included in our reports filed or submitted under the Exchange Act.

Changes in Internal Controls. Since the evaluation date referred to above, there have not been any significant changes in our internal controls or in other factors that could significantly affect such controls.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

As previously mentioned in our two most recent Quarterly Reports on Form 10-Q, Timothy J. Fox filed a purported class action lawsuit on November 2, 2001, against us, FleetBoston Robertson Stephens, Inc., the lead underwriter of our April 1999 initial public offering, several other underwriters who participated in our initial public offering, Steven J. Snyder, our then president and chief executive officer, and Thomas M. Donnelly, our chief operating officer and chief financial officer. The lawsuit, Fox v. Net Perceptions, Inc., et al., Civil Action No. 01-CV-9675, was filed in the United States District Court for the Southern District of New York and has been assigned to the judge who is also the pretrial coordinating judge for substantially similar lawsuits involving more than 300 other issuers. An amended class action complaint was filed on April 22, 2002, expanding the basis for the action to include allegations relating to our March 2000 follow-on public offering in addition to those relating to our initial public offering.

The amended complaint generally alleges that the defendants violated federal securities laws by not disclosing certain actions taken by the underwriter defendants in connection with our initial public offering and our follow-on public offering. The amended complaint alleges specifically that the underwriter defendants, with our direct participation and agreement and without disclosure thereof, conspired to and did raise and increase their underwriters’ compensation and the market prices of our common stock following our initial public offering and in our follow-on public offering by requiring their customers, in exchange for receiving allocations of shares of our common stock sold in our initial public offering, to pay excessive commissions on transactions in other securities, to purchase additional shares of our common stock in the initial public offering aftermarket at pre-determined prices above the initial public offering price, and to purchase shares of our common stock in our follow-on public offering. The amended complaint seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired our common stock between April 22, 1999 through December 6, 2000. The plaintiffs have since agreed to dismiss the claims against Mr. Snyder and Mr. Donnelly without prejudice, in return for their agreement to toll any statute of limitations applicable to those claims; and those claims have been dismissed without prejudice. On July 15, 2002, all of the issuer defendants filed a joint motion to dismiss the plaintiffs’ claims in all of the related cases. The Court has not ruled on this motion.

We believe that the allegations are without merit, and we intend to vigorously defend against the plaintiff’s claims. As this litigation is in an initial stage, we are unable to predict its outcome or its ultimate effect, if any, on our financial condition.

Item 2. Changes in Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits


Exhibit
Number		Description

3.1(a)		Amended and Restated Certificate of Incorporation(1)

3.1(b)		Certificate of Amendment to the Amended and Restated Certificate of Incorporation(2)

3.2		Amended and Restated Bylaws as amended through April 18, 2001(3)

4.1		Amended and Restated Investor Rights Agreement, dated December 18, 1997, among Net Perceptions, Inc. and the investors and founders named therein, as amended(1)

4.2		Specimen common stock certificate(1)

4.3		Specimen common stock certificate (including Rights Agreement Legend)(4)

4.4		Rights Agreement between Net Perceptions, Inc. and Wells Fargo Bank Minnesota, as Rights Agent(5)

4.5		Form of Certificate of Designation of Series A Junior Participating Preferred Stock (attached as Exhibit A to the Rights Agreement filed as Exhibit 4.4 hereto)(5)

4.6		Form of Rights Certificate (attached as Exhibit B to the Rights Agreement filed as Exhibit 4.4 hereto)(5)

99.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Incorporated by reference to Net Perceptions’ Registration Statement on Form S-1 (Registration No. 333-71919).

(2) Incorporated by reference to Net Perceptions’ Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2000 (File No. 000-25781)

(3) Incorporated by reference to Net Perceptions’ Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2001 (File No. 000-25781)

(4) Incorporated by reference to Net Perceptions’ Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2001 (File No. 000-25781)

(5) Incorporated by reference to Net Perceptions’ Registration Statement on Form 8-A filed June 6, 2001 (File No. 000-25781)

(b) Reports on Form 8-K

During the third quarter of 2002 the Company did not file any Current Reports on Form 8-K.

SIGNATURES

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


		Net Perceptions, Inc.


Date: November 13, 2002		By: /s/ Thomas M. Donnelly Thomas M. Donnelly Chief Financial Officer

		(Duly authorized officer and principal financial officer)

CERTIFICATIONS

I, Donald C. Peterson, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Net Perceptions, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 13, 2002

/s/ Donald C. Peterson

Donald C. Peterson
Chief Executive Officer

I, Thomas M. Donnelly, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Net Perceptions, Inc.;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Date: November 13, 2002

/s/ Thomas M. Donnelly

Thomas M. Donnelly
Chief Financial Officer

NET PERCEPTIONS, INC.
FORM 10-Q
For the Quarter Ended September 30, 2002

EXHIBIT INDEX


Exhibit
Number		Description

3.1(a)		Amended and Restated Certificate of Incorporation(1)

3.1(b)		Certificate of Amendment to the Amended and Restated Certificate of Incorporation(2)

3.2		Amended and Restated Bylaws as amended through April 18, 2001(3)

4.1		Amended and Restated Investor Rights Agreement, dated December 18, 1997, among Net Perceptions, Inc. and the investors and founders named therein, as amended(1)

4.2		Specimen common stock certificate(1)

4.3		Specimen common stock certificate (including Rights Agreement Legend)(4)

4.4		Rights Agreement between Net Perceptions, Inc. and Wells Fargo Bank Minnesota, as Rights Agent(5)

4.5		Form of Certificate of Designation of Series A Junior Participating Preferred Stock (attached as Exhibit A to the Rights Agreement filed as Exhibit 4.4 hereto)(5)

4.6		Form of Rights Certificate (attached as Exhibit B to the Rights Agreement filed as Exhibit 4.4 hereto)(5)

99.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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	•		we operate with a limited order backlog, and revenues in any quarter are substantially dependent on orders booked and shipped in that quarter;

	•		the market in which we compete is relatively new and rapidly evolving and has many new entrants;

	•		we expect that, for the foreseeable future, revenues will come from licenses to a small number of customers, so delays or cancellations of orders by a few customers can significantly impact revenues within a quarter;

	•		our sales cycle varies substantially from customer to customer; and

	•		the timing of large orders can significantly affect revenues within a quarter.

	•		actual or anticipated variations in our quarterly operating results;

	•		announcements of new technological innovations, increased cost of operations or new products or services by us or our competitors;

	•		changes in financial estimates by securities analysts;

	•		conditions or trends in the industries into which we sell our products and services;

	•		changes in the economic performance and/or market valuations of other comparable companies;

	•		volatility in the stock markets, particularly with respect to technology stocks, and decreases in the availability of capital for technology-related businesses;

	•		announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;

	•		additions or departures of key personnel;

	•		sales of additional shares of common stock; and

	•		potential litigation.

	•		perform as designed;

	•		deliver the desired level of economic benefit to our customers;

	•		meet the other expectations and needs of our customers;

	•		achieve any significant degree of market acceptance; or

	•		perform to the level necessary to generate repeat customers and customer references.

	•		expenses associated with customizing products and services for foreign countries;

	•		protectionist laws and business practices that favor local competition;

	•		conflicting and changing governmental laws and regulations;

	•		longer sales cycles;

	•		difficulties in collecting accounts receivable; • foreign currency exchange rate fluctuations; and

	•		political and economic instability.

	•		keep pace with technological developments and emerging industry standards; and

	•		address the increasingly sophisticated needs of our customers.

	•		experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and enhancements to existing products; and

	•		fail to develop new products and enhancements to existing products that adequately meet the requirements of the marketplace or achieve market acceptance.

	•		use of the Internet, the Web and other on-line services does not continue to increase or increases more slowly than expected;

	•		the infrastructure for the Internet, the Web and other on-line services does not effectively support expansion that may occur; or

	•		the Internet, the Web and other on-line services do not become a viable commercial marketplace, which would inhibit the development of electronic commerce.

(1)		Incorporated by reference to Net Perceptions’ Registration Statement on Form S-1 (Registration No. 333-71919).

(2)		Incorporated by reference to Net Perceptions’ Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2000 (File No. 000-25781)

(3)		Incorporated by reference to Net Perceptions’ Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2001 (File No. 000-25781)

(4)		Incorporated by reference to Net Perceptions’ Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2001 (File No. 000-25781)

(5)		Incorporated by reference to Net Perceptions’ Registration Statement on Form 8-A filed June 6, 2001 (File No. 000-25781)