UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the quarterly period ended September 30, 2004

COMMISSION FILE NUMBER 0-29637

SELECTICA, INC.

(Exact name of registrant as specified in its charter)

3 WEST PLUMERIA DRIVE, SAN JOSE, CA 95134

(Address of principal executive offices)

(408) 570-9700

(Registrant’s telephone number, including area code)

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

     Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange Act. Yes [X] No [ ]

     The number of shares outstanding of the registrant’s common stock, par value $0.0001 per share, as of October 31, 2004, was 32,800,061.

FORM 10-Q
SELECTICA INC.
INDEX

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PART I: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

SELECTICA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

See accompanying notes.

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SELECTICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT - PER SHARE AMOUNTS)
(UNAUDITED)

See accompanying notes.

4

SELECTICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

See accompanying notes.

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SELECTICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Basis of Presentation

     The condensed consolidated balance sheet as of September 30, 2004, the condensed consolidated statements of operations and cash flows for the three and six months ended September 30, 2004 and 2003 have been prepared by the Company and are unaudited. In the opinion of management, all necessary adjustments (which include normal recurring adjustments) have been made to present fairly the financial position at September 30, 2004, and the results of operations and cash flows for the three and six months ended September 30, 2004 and 2003. Interim results are not necessarily indicative of the results for a full fiscal year. The consolidated balance sheet as of March 31, 2004 has been derived from the audited consolidated financial statements at that date.

     Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2004.

2. Summary of Significant Accounting Policies

Principles of Consolidation

     The consolidated financial statements include all the accounts of the Company and those of its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated.

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Foreign Currency Transactions

     Foreign currency transactions at foreign operations are measured using the U.S. dollar as the functional currency. Accordingly, monetary accounts (principally cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities) are remeasured into U.S. dollars using the foreign exchange rate at the balance sheet date. Operations accounts and non-monetary balance sheet accounts are remeasured at the rate in effect at the date of a transaction. The effects of foreign currency remeasurement are reported in current operations and were immaterial for all periods presented.

Concentrations of Credit Risk

     Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, cash equivalents, short-term investments, long-term investments, restricted investments, and accounts receivable. The Company places its short-term, long-term and restricted investments in high-credit quality financial institutions. The Company is exposed to credit risk in the event of default by these institutions to the extent of the amount recorded on the balance sheet. As of September 30, 2004, the Company has invested in short-term and long-term investments including commercial paper, corporate notes/bonds, and government agency notes/bonds. Restricted investments include corporate bonds and term deposits. Accounts receivable are derived from revenue earned from customers primarily located in the United States. The Company performs ongoing credit evaluations of its customers’ financial condition and generally does not require collateral. The Company maintains reserves for potential credit losses, and historically, such losses have been immaterial.

Cash Equivalents and Investments

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     Cash equivalents consist of short-term, highly liquid financial instruments, that are principally money market funds, commercial paper, corporate notes and government agency notes with insignificant interest rate risk that are readily convertible to cash and have maturities of three months or less from the date of purchase. The fair value, based on quoted market prices, of cash equivalents is substantially equal to their carrying value at September 30, 2004 and March 31, 2004. The Company considers all investment securities with original maturities of more than 3 months but less than one year to be short-term investments. Investments with maturities of more than one year are considered to be long-term investments.

     The Company classifies investments as available-for-sale at the time of purchase. Unrealized gains or losses on available-for-sale securities are included in accumulated other comprehensive income in stockholders’ equity until their disposition. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest and other income. The cost of securities sold is based on the specific-identification method.

Allowance for Doubtful Accounts

     The Company evaluates the collectibility of our accounts receivable based on a combination of factors. When the Company believes a collectibility issue exists with respect to a specific receivable, it records an allowance to reduce that receivable to the amount that it believes to be collectible. For all other receivables, the Company records an allowance based on an assessment of the aging of such receivables, its historical experience with bad debts and the general economic environment.

Property and Equipment

     Property and equipment are stated at cost. Depreciation is computed using the straight-line method based on estimated useful lives. The estimated useful lives for computer software and equipment is three years, furniture and fixtures is five years, and leasehold improvements is the shorter of the applicable lease term or estimated useful life. The estimated life for the building is 25 years and land is not depreciated.

Revenue Recognition

     The Company enters into arrangements for the sale of: (1) licenses of software products and related maintenance contracts; (2) bundled license, maintenance, and services; and (3) services. In instances where maintenance is bundled with a license of software products, such maintenance term is typically one year.

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

     Arrangements consisting of license and maintenance only. For those contracts that consist solely of license and maintenance, we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by Statement of Position 98-9 “Modification of SOP No. 97-2 with Respect to Certain Transactions.” We recognize maintenance revenues over the term of the maintenance contract because vendor-specific objective evidence of fair value for maintenance exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If vendor specific objective evidence does not exist to allocate the total fee to all undelivered elements of the arrangement, revenue is deferred until the earlier of the time at which (1) such evidence does exist for the undelivered elements, or (2) all elements are delivered. If unspecified future products are given over a specified term, we recognize license revenue ratably over the applicable period. We recognize license fees from resellers as revenue when the above criteria have been met and the reseller has sold the subject licenses through to the end-user.

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

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

     In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement under the percentage of completion contract method in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” We follow the percentage of completion method since reasonably dependable estimates of progress toward completion of a contract can be made. We estimate the percentage of completion on contracts utilizing hours and costs incurred to date as a percentage of the total estimated hours and costs to complete the project. Recognized revenues and profits are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. To date, when we have been primarily responsible for the implementation of the software, services have been considered essential to the functionality of the software products, and therefore license and services revenues have been recognized pursuant to SOP 81-1.

     For those contracts that include contract milestones or acceptance criteria, we recognize revenue as such milestones are achieved or as such acceptance occurs.

     For those contracts with unspecified future products and services which are not essential to the functionality of the other elements of the arrangement, license revenue is recognized by the subscription method over the length of time that the unspecified future product is available to the customer.

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

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

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

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

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

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     Arrangements consisting of consulting services. Consulting services consists of a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments. Consulting services may be recognized based on customer acceptance in the form of customer-signed timesheets, invoices, cash received, or customer-signed acceptance as defined in the master service agreement.

     Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenues.

Customer Concentrations

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

     Customers who accounted for at least 10% of total revenues were as follows:

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

Warranties and Indemnifications

     The Company generally provides a warranty for its software products to its customers and accounts for its warranties under SFAS No. 5, “Accounting for Contingencies”. The Company’s products are generally warranted to perform substantially in accordance with the functional specifications set forth in the associated product documentation for a period of 90 days. In the event there is a failure of a product under such warranties, the Company generally is obligated to correct the product to conform to the product documentation or, if the Company is unable to do so, the customer is entitled to seek a refund of the purchase price of the product. The Company has not provided for a warranty accrual or incurred any warranty costs as of September 30, 2004 and March 31, 2004. To date, the Company has not refunded any amounts in relation to the warranty.

     The Company generally agrees to indemnify its customers against legal claims that the Company’s software infringes certain third-party intellectual property rights and accounts for its indemnification under SFAS 5. In the event of such a claim, the Company is obligated to defend its customer against the claim and to either settle the claim at the Company’s expense or pay damages that the customer is legally required to pay to the third-party claimant. In addition, in the event of the infringement, the Company agrees to modify or replace the infringing product, or, if those options are not reasonably possible, to refund the cost of the software. To date, the Company

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has not been required to make any payment resulting from infringement claims asserted against our customers. As such, the Company has not provided for an infringement accrual as of September 30, 2004.

Development Costs

     Software development costs incurred prior to the establishment of technological feasibility are included in research and development expenses. The Company defines establishment of technological feasibility as the completion of a working model. Software development costs incurred subsequent to the establishment of technological feasibility through the period of general market availability of the products are capitalized, if material, after consideration of various factors, including net realizable value. To date, software development costs that are eligible for capitalization have not been material and have been expensed.

Accumulated and Other Comprehensive Income (Loss)

     Statement of Financial Accounting No. 130, “Reporting Comprehensive Income” (SFAS 130), establishes standards for reporting and displaying comprehensive net income and its components in stockholders’ equity. However, it has no impact on our net loss as presented in our financial statements. Accumulated other comprehensive income/loss is comprised of net unrealized losses of approximately $248,000 and net unrealized gains of approximately $47,000 at September 30, 2004 and March 31, 2004, respectively. We recorded approximately $3,000 in realized losses for the three and six months ending September 30, 2004, respectively. We recorded approximately $51,000 and approximately $81,000 in realized losses for the three and six months ending September 30, 2003, respectively.

     The components of comprehensive loss, net of related income tax, for the three and six months ended September 30, 2004 and 2003 are as follows:

Stock-Based Compensation

     The Company accounts for employee stock-based compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148). Under APB 25, compensation expense for fixed stock options is based on the difference between the fair market value of the Company’s stock and the exercise price of the option on the date of grant (Intrinsic Value Method), if any.

Pro Forma Disclosure of the Effect of Stock-Based Compensation

     The Company uses the intrinsic value method in accounting for its employee stock options because, as discussed below, the alternative fair value accounting method requires use of option valuation models that were not developed for use in valuing employee stock options. Under the intrinsic value method, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, there is no compensation expense recognized.

     Pro forma information regarding net loss as if the Company had accounted for its employee stock purchase during the three and six months ended September 30, 2004 and 2003 under the fair value method was estimated at the date of grant using the Black-Scholes option-pricing model for the three and six months ended September 30, 2004 and 2003 with the following weighted average assumptions:

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     Pro forma information regarding net loss as if the Company had accounted for its stock options granted during the three and six months ended September 30, 2004 and 2003 under the fair value method was estimated at the date of grant using the Black-Scholes option-pricing model for the three and six months ended September 30, 2004 and 2003 with the following weighted average assumptions:

     The option valuation models were developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected life of the option.

Segment Information

     Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker or group in deciding how to allocate resources and in assessing performance. The Company operates in one segment, software products for configuration, pricing management and quoting solutions. The Company primarily markets its products in the United States.

     Export revenues are attributable to countries based on the location of the customers. During the three and six months ended September 30, 2004 and 2003, sales to international locations were derived primarily from Canada and the United Kingdom.

     As of September 30, 2004 and March 31, 2004, the Company held long-lived assets in India with a net book value of approximately $1.3 million and $1.6 million, respectively. No other country besides the United States and India held a significant amount of long-lived assets.

3. Concurrent Transaction

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     The Company, from time to time, purchases professional services from a value added reseller. The Company records the cost of the professional services purchased as a reduction of license or services revenue recorded from the reseller. For the three months ending September 30, 2004, the Company purchased approximately $153,000 of professional services from the value added reseller. For the six months ended September 30, 2004, the Company recognized approximately $515,000 of revenue, which is net of approximately $100,000 of professional services purchased by the Company. For the three and six months ending September 30, 2003, the Company recognized approximately $204,000 in license royalty revenue, which is net of approximately $68,000 professional services purchased by the Company.

4. Related Party Transaction and Severance Agreement

     In connection with the resignation of Dr. Sanjay Mittal in September 2003, the Company’s Chief Executive Officer, the Company agreed to have him continue as Chief Technical Advisor (“CTA”). Pursuant to this arrangement, Dr. Mittal will receive $20,000 per month for his services and this arrangement will continue until either party terminates his service as CTA. During the three and six months period ending September 30, 2004, the Company recorded approximately $60,000 and $120,000 as outside services expense in research and development in connection with Dr. Mittal’s role as CTA. During the three and six months period ending September 30, 2003, the Company recorded approximately $15,000 as outside services expense in research and development in connection with Dr. Mittal’s role as CTA. In the event that Dr. Mittal’s role as CTA terminates, subject to certain conditions, he will be entitled to receive a lump-sum severance payment of $412,500. The Company believes that the payment is estimatable and probable, and therefore, has accrued for this amount.

5. Stockholders’ Equity

Deferred Compensation

     During the three and six months ended September 30, 2004, approximately 24,250 and 80,750 options were granted to employees with exercise prices that were less than fair value, respectively. During the three and six months ended September 30, 2003, approximately 65,500 options were granted to employees with exercise prices that were less than fair value.

     During the three months ended September 30, 2004, the Company recorded total compensation expense of approximately $34,000, which was recorded as cost of goods sold. During the three months ended September 30, 2003, the Company recorded a total compensation expense of approximately $351,000 of which approximately $116,000 was recorded as cost of goods sold, approximately $58,000 was recorded in research and development, approximately $107,000 was recorded in sales and marketing, and approximately $70,000 was recorded as general and administrative expense.

     During the six months ended September 30, 2004, the Company recorded total compensation expense of approximately $83,000, which was recorded as cost of goods sold. During the six months ended September 30, 2003, the Company recorded a total compensation expense of approximately $743,000 of which approximately $243,000 was recorded as cost of goods sold, approximately $119,000 was recorded in research and development, approximately $228,000 was recorded in sales and marketing, and approximately $152,000 was recorded as general and administrative expense.

Stock Repurchase

     In August 2001, the Board of Directors authorized the Company to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board. This program expired in April 2003.

     In May 2003, the Board approved an additional stock buyback program to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board.

     During the three months ended September 30, 2004, the Company repurchased 96,000 shares of its common stock at an average price of $3.91 in the open market at a cost of approximately $376,000 including brokerage fees.

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     During the three months ended September 30, 2003, the Company repurchased 251,200 shares of its common stock at an average price of $3.64 in the open market at a cost of approximately $914,000 including brokerage fees.

     During the six months ended September 30, 2004, the Company repurchased approximately 96,000 shares of its common stock at an average price of $3.91 in the open market at a cost of approximately $376,000 including brokerage fees. During the six months ended September 30, 2003, the Company repurchased approximately 383,600 shares of its common stock at an average price of $3.40 in the open market at a cost of approximately $1.3 million including brokerage fees.

     The aggregate number of shares purchased since the authorizations by the Board of Directors in August 2001 and May 2003 was approximately 6.3 million shares at a cost of approximately $21.4 million, including brokerage fees.

6. Income Taxes

     The Company did not record any provision for income taxes for the three and six months ended September 30, 2004 and 2003, respectively.

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

7. Computation of Basic and Diluted Net Loss Per Share

     Basic and diluted net loss per common share is presented in conformity with Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (FAS 128), for all periods presented. In accordance with FAS 128, basic and diluted net loss per share have been computed using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase.

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

     The Company excludes potentially dilutive securities from its diluted net loss per share computation when their effect would be antidilutive to net loss per share amounts. The following common stock equivalents were excluded from the net loss per share computation:

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8. Litigation

     The Company is subject to certain routine legal proceedings, as well as demands, claims and threatened litigation, that arise in the normal course of our business. The Company currently believes that the ultimate amount of liability, if any, for any pending claims of any type, except for the items mentioned below (either alone or combined) will not materially affect our financial position, results of operations or liquidity. However, the ultimate outcome of any litigation is uncertain, and either unfavorable or favorable outcomes could have a material negative impact. Regardless of outcome, litigation can have an adverse impact on the Company because of defense costs, diversion of management resources and other factors.

Patent Infringement

     On April 22, 2004, Trilogy Software Inc. and Trilogy Development Group (“Trilogy”) filed a complaint in the United States District Court for the Eastern District of Texas Marshall Division (which has subsequently been served), alleging patent infringement against the Company. The complaint alleges that the Company has been and is willfully infringing, directly and indirectly, on Trilogy patents relating to the making, using, licensing, selling, offering for sale, or importing products including configuration and pricing software and related consulting services. The complaint seeks money damages, costs, attorneys’ fees, penalties for willful infringement, an injunction to prevent the Company from infringing Trilogy’s patents in the future, and any other relief to which Trilogy may be entitled. The Company intends to vigorously defend against Trilogy’s claims and may incur substantial costs in such defense.

     On September 2, 2004, Selectica filed counterclaims in the Eastern District of Texas Marshall Division action against Trilogy for infringement of Selectica’s U.S. Patent Nos. 6,405,308, 6,675,294, 5,878,400 and 6,553,350 for willfully infringing, directly and indirectly, by making, using, licensing, selling, offering for sale, or importing products including configuration and ordering software. The Company seeks money damages, costs, attorneys’ fees, penalties for willful infringement, an injunction to prevent Trilogy from infringing Selectica’s patents in the future, and any other relief to which Trilogy may be entitled. The Company may incur substantial costs in pursuing its claims against Trilogy.

Class Action

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

     The amended complaint alleges that the Company, the officer and director defendants and CSFB violated federal securities laws by making material false and misleading statements in the prospectus incorporated in our registration statement on Form S-1 filed with the SEC in March 2000 in connection with our IPO. Specifically, the complaint

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alleges, among other things, that CSFB solicited and received excessive and undisclosed commissions from several investors in exchange for which CSFB allocated to those investors material portions of the restricted number of shares of common stock issued in our IPO. The complaint further alleges that CSFB entered into agreements with its customers in which it agreed to allocate the common stock sold in our IPO to certain customers in exchange for which such customers agreed to purchase additional shares of our common stock in the after-market at pre-determined prices. The complaint also alleges that the underwriters offered to provide positive market analyst coverage for the Company after the IPO, which had the effect of manipulating the market for Selectica’s stock.

     On July 15, 2002, the Company and the officer and director defendants, along with other issuers and their related officer and director defendants, filed a joint motion to dismiss based on common issues. Opposition and reply papers were filed and the Court heard oral argument. Prior to the ruling on the motion to dismiss, on October 8, 2002, the individual officers and directors entered into a stipulation of dismissal and tolling agreement with plaintiffs. As part of that agreement, plaintiffs dismissed the case without prejudice against the individual defendants. The Court ordered the dismissal of the officers and directors without prejudice on October 9, 2002. The court rendered its decision on the motion to dismiss on February 19, 2003, denying dismissal of the Company.

     On June 25, 2003, a Special Committee of the Board of Directors of the Company approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against the Company with prejudice in return for the assignment by the Company of claims that the Company might have against its underwriters. No payment to the plaintiffs by the Company is required under the MOU. After further negotiations, the essential terms of the MOU were formalized in a Stipulation and Agreement of Settlement (“Settlement”), which has been executed on behalf of the Company. The settling parties presented the Settlement papers to the Court on June 14, 2004 and filed formal motions seeking preliminary approval on June 25, 2004. The underwriter defendants, who are not parties to the Settlement, filed a brief objecting to its terms on July 14, 2004. The Court is reviewing the matter and has had continued discussion with all of the parties regarding the terms of the Settlement.

     In the meantime, the plaintiffs and underwriters have continued to litigate the consolidated action. The litigation is proceeding through the class certification phase by focusing on six cases chosen by the plaintiffs and underwriters (“focus cases”). Selectica is not a focus case. On October 13, 2004, the Court certified classes in each of the six focus cases.

     Selectica, along with the other non-focus case issuer defendants, has not participated in the class certification phase. It is awaiting the Court’s decision on preliminary approval of the Settlement. There can be no assurance that the Court will approve the Settlement.

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

Shareholder Derivative Action

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

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     On November 25, 2002, following the removal of the case to federal court and the subsequent remand of the case back to the state court, the Company and the officer and director defendants filed answers to the amended complaint, preserving certain defenses including defenses based on plaintiff’s lack of standing to bring the action. Also on November 25, 2002, CSFB filed a motion to dismiss the case on the grounds that the plaintiff lacked standing to bring the action. That motion was heard on March 4, 2003, and on March 18, 2003 the Court issued an Order sustaining the motion but granting plaintiff 30 days to file an amended complaint.

     On April 18, 2003, the plaintiff filed a second amended complaint, which added new assertions regarding plaintiff’s claim of standing as well as additional factual allegations covered by the various causes of action. Specifically, plaintiff’s second amended complaint alleged that CSFB offered and provided, and the individual defendants accepted, improper gratuities in the form of allocations of IPO shares of other companies in order to influence the selection of CSFB as the underwriter of the Company’s IPO.

     On June 17, 2003, CSFB responded to the second amended complaint by again filing a motion to dismiss the case on the grounds that the plaintiff lacked standing to bring the action. That same day, the Company and the individual defendants responded to the second amended complaint by joining CSFB’s motion to dismiss, while reserving other objections. At the hearing on the matter on August 12, 2003, the Court again granted CSFB’s motion to dismiss, with leave for the plaintiff to further amend his complaint. The Court also granted plaintiff permission to file a motion seeking to establish his standing to bring the action pursuant to rules regarding share ownership by shareholder derivative action plaintiffs at the time of the alleged wrongdoing, and the Court permitted the plaintiff to take limited discovery in connection with such a motion. In February, 2004, plaintiff took limited depositions of three individual defendants for that purpose.

     In late August, 2004, the parties entered into a stipulation pursuant to which the parties agreed that, subject to approval by the Court, the action would be voluntarily dismissed as against all defendants with prejudice and the Company would make payment to the plaintiff in the amount of up to $40,000 in full satisfaction of plaintiff’s attorneys’ fees and costs. The parties submitted that stipulation and a related proposed order to the Court on August 30, 2004, and later that day the Court entered an order dismissing the action with prejudice, directing entry of judgment accordingly, and reserving the issue of attorneys’ fees and costs for further consideration. Thereafter, plaintiff’s counsel submitted to the Court an application for attorneys’ fees and costs and a proposed order approving the requested payment by the Company to plaintiff’s counsel of $40,000, and the Court approved such request and entered such order on September 28, 2004.

     In the future we may subject to other lawsuits. Any litigation, even if not successful against us, could result in substantial costs and divert management’s and other resources away from the operations of our business.

9. Recent Accounting Pronouncements

     In March 2004, the Financial Accounting Standards Board (FASB) issued Emerging Issues Task Force Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once final guidance is issued.

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ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

Overview

     Selectica is a leading provider of software that enables enterprises to utilize the Internet as a platform for selling complex product and services. Our software products facilitate our customers’ efforts to correctly configure, price, and quote offerings across multiple distribution channels. We have also recently deployed applications to bridge the gap between customer relationship management, or CRM, applications and other business applications with respect to the management of complex product features and business rules. As a result, we help our customers reduce process costs, optimize pricing, eliminate rework and concessions, and avoid high-risk business. Businesses that deploy our products are able to empower business managers to quickly and easily modify product, service and price information and to implement such modifications throughout the entire enterprise to ensure proper margins and to stay ahead of changing market conditions. Our product architecture has been designed specifically for the Internet and provides scalability, reliability, flexibility and ease of use. Additionally, our products have been developed with an open architecture that leverages data in existing applications, such as enterprise resource planning, or ERP, systems. This allows for an easy-to-install application and reduced deployment time. Across a wide range of industries, Selectica’s products have demonstrated an ability to increase productivity, improve order accuracy, boost return on investment and establish and maintain a competitive advantage. Selectica’s customers represent manufacturing and service leaders including: ABB, Applied Bio Systems, Bell Canada, Cisco, Dell, General Electric, Fireman’s Fund Insurance Company, Hitachi, Juniper Networks, Rockwell Automation and Tellabs.

Quarterly Financial Overview

     For the three months ended September 30, 2004, our revenues were approximately $7.2 million with license revenues representing 32% and services revenues representing 68% of total revenues. In addition, approximately 67% of our quarterly revenue came from three customers. License margins for the quarter were 91% and services margins were 38%. Services margin increased quarter over quarter was attributable to some lower margin engagements which revenue was recognized for during fiscal year 2004. Net loss for the quarter was approximately $4.1 million or $0.12 per share.

     Our bookings this quarter continued to decline in comparison to the prior quarter and we will need to increase our level of bookings on a quarterly basis in order to increase our reported revenues. Our failure to increase bookings in the previous quarters was a significant factor in the decline of our revenues this quarter. As a result, we will evaluate the need to reduce quarterly operating expense levels during the quarter ended December 31, 2004.

Critical Accounting Policies and Estimates

     We prepare our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expenses during the reporting period. We periodically evaluate our estimates including

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those relating to revenue recognition, allowance for doubtful accounts, contingencies, and litigation. The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our condensed consolidated financial statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate, and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our financial statements, and they require our most difficult, subjective or complex judgments in the preparation of our consolidated financial statements:

Revenues

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

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

     Arrangements consisting of license and maintenance only. For those contracts that consist solely of license and maintenance, we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by Statement of Position 98-9 “Modification of SOP No. 97-2 with Respect to Certain Transactions.” We recognize maintenance revenues over the term of the maintenance contract because vendor-specific objective evidence of fair value for maintenance exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If vendor specific objective evidence does not exist to allocate the total fee to all undelivered elements of the arrangement, revenue is deferred until the earlier of the time at which (1) such evidence does exist for the undelivered elements, or (2) all elements are delivered. If unspecified future products are given over a specified term, we recognize license revenue ratably over the applicable period. We recognize license fees from resellers as revenue when the above criteria have been met and the reseller has sold the subject licenses through to the end-user.

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

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

     In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement under the percentage of completion contract method in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” We follow the percentage of completion method since reasonably dependable estimates

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of progress toward completion of a contract can be made. We estimate the percentage of completion on contracts utilizing hours incurred to date as a percentage of the total estimated hours to complete the project. Recognized revenues and profits are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. To date, when we have been primarily responsible for the implementation of the software, services have been considered essential to the functionality of the software products, and therefore license and services revenues have been recognized pursuant to SOP 81-1.

     For those contracts that include contract milestones or acceptance criteria, we recognize revenue as such milestones are achieved or as such acceptance occurs.

     For those contracts with unspecified future products and services which are not essential to the functionality of the other elements of the arrangement, license revenue is recognized by the subscription method over the length of time that the unspecified future product is available to the customer.

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

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

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

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

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

Arrangements consisting of consulting services. Consulting services consists of a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments. Consulting services may be recognized based on customer acceptance in the form of customer-signed timesheets, invoices, cash received, or customer-signed acceptance as defined in the master service agreement.

     In all cases we classify revenues for these arrangements as license revenues and services revenues based on the estimates of fair value for each element. Revenue recognition broken down by method is noted below:

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     Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenues.

Allowance for Doubtful Accounts

     We evaluate the collectibility of our accounts receivable based on a combination of factors. When we believe a collectibility issue exists with respect to a specific receivable, we record an allowance to reduce that receivable to the amount that we believe to be collectible. For all other receivables, we record an allowance based on an assessment of the aging of such receivables, our historical experience with bad debts and the general economic environment.

Contingencies and Litigation

     We are subject to various proceedings, lawsuits and claims relating to product, technology, labor, shareholder and other matters. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. The amount of loss accrual, if any, is determined after careful analysis based on legal advice of each matter and is subject to adjustment if warranted by new developments or revised strategies.

Factors Affecting Operating Results

     A relatively small number of customers account for a significant portion of our total revenues. We expect that revenue will continue to depend upon a limited number of customers. If we were to lose a customer, it would have a significant impact upon future revenue. Customers who accounted for at least 10% of total revenues were as follows:

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

     We have a limited operating history upon which we may be evaluated. We have incurred significant losses since inception and, as of September 30, 2004, we had an accumulated deficit of approximately $165.6 million. We believe our success depends on the growth of our customer base and the development of the emerging configuration, pricing management and quoting solutions market.

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

     In any given period our revenues are dependent on customer contracts booked during earlier periods. Because we typically recognize revenue in periods after contracts are entered into, a decline in the number of contracts booked

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during any particular period or the value of such contracts would cause a decrease in revenue in future periods. The number and value of our bookings has significantly decreased. If our bookings remain at current levels or if the value of such bookings decreases further, it will cause our revenues to decline in future periods that could significantly harm our business and operating results. While we plan to balance expense levels with projected revenues, if our bookings do not improve, we may not be able to sufficiently reduce our expenses, and this would adversely affect our operating results. Even if we were to achieve profitability in any period, we may not be able to sustain or increase profitability on a quarterly or annual basis.

Results of Operations

Revenues

     License. For the three months ending September 30, 2004, license revenues decreased on a quarterly basis by approximately $2.0 million compared to the three months ending September 30, 2003 primarily due to one significant contract for $12.0 million that was signed in December 2002 and $3.3 million was recognized in the three months ending September 30, 2003. The license revenue for this contract was recognized on a subscription basis for the twelve months ending in December 2003, due to the right to unspecified future products.

     For the six months ending September 30, 2004, license revenues decreased by approximately $4.7 million compared to the six months ending September 30, 2003 primarily due to the same significant contract mentioned above.

     For the six months ending September 30, 2004, license revenues primarily came from two significant customers which signed contracts in fiscal 2004. For the six months ending September 30, 2003, license revenues primarily came from two significant customers, which signed contracts in fiscal 2003.

     Our failure to increase bookings in the previous quarters was a significant factor in the decline of our revenues this quarter. We expect license revenues to continue to fluctuate in future periods as a percentage of total revenues and in absolute dollars depending on the number and size of new license contracts.

     Services. Services revenues are comprised of fees from consulting, maintenance, training and out-of pocket reimbursement. During the three and six months ending September 30, 2004, services revenues decreased year over year. The decrease primarily related to the fewer opportunities provided by new license agreements offset by our clients’ demand for additional services to expand their initial customized application.

     Due to the fluctuations in the allowance for doubtful for accounts, we recorded a decrease to services revenues of approximately $42,000 and an increase of approximately $144,000 for the three months ending September 30, 2004 and 2003, respectively. For the six months ending September 30, 2004, we recorded a decrease to services revenues of approximately $52,000 and for the six months ending September 30, 2003, we recorded an increase of approximately $276,000.

     Maintenance revenues represented 31% and 32% of total services revenues for the three months ending September 30, 2004 and 2003, respectively. Maintenance revenues represented 36% and 30% of total services revenues for the six months ending September 30, 2004 and 2003, respectively.

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     We expect services revenues to continue to fluctuate in future periods as a percentage of total revenues and in absolute dollars depending on the number and size of new software implementations and follow-on services to our existing customers. We expect maintenance revenue to fluctuate in absolute dollars and as a percentage of services revenues with respect to the number of maintenance renewals, and number and size of new license contracts. In addition, maintenance renewals are dependent upon customer satisfaction and the level of our customers’ needs to make changes or upgrade versions of our software.

Cost of revenues

     Cost of License Revenues. The cost of license revenues consists of royalty fees associated with third-party software, the costs of the product media, duplication and packaging and delivery of our software products to our customers, which may include documentation, shipping and other data transmission costs. The year over year decrease in costs of license revenue during the three and six months ending September 30 was primarily due to decreased license sales, which resulted in a decrease in the amount of royalty fees associated with third-party software and other sales associated costs. In addition, costs of licenses have a component of fixed costs that are not dependent upon sales volume. We anticipate that the cost of license revenues will remain at a relatively consistent level in absolute dollars and that the cost of license revenues in the near future will continue to fluctuate as a percentage of license revenues.

     Cost of Services Revenues. The cost of services revenues is comprised mainly of salaries and related expenses of our services organization plus certain allocated expenses. The reduction of the cost of services revenues was primarily due to a smaller professional services organization.

     During the three months ending September 30, 2004 and 2003, we amortized approximately $34,000 and approximately $116,000 for deferred compensation related to stock options, respectively. During the six months ending September 30, 2004 and 2003, we amortized approximately $83,000 and approximately $243,000 for deferred compensation related to stock options, respectively.

     We expect cost of services revenues to fluctuate as a percentage of service revenues, and we plan to reduce our investment in cost of services revenues in absolute dollars from the next year as necessary to balance expense levels with projected revenues.

Gross Margins

     Gross margins percentages for services revenues and license revenues for the respective periods are as follows:

     We experienced a slight decrease in license margins during the three and six months ending September 30, 2004 from the three and six months ending September 30, 2003 due to lower license revenues. Costs of licenses have a component of fixed costs that are not dependent upon sales volume. Some of our software has embedded third-party software for which royalties need to be paid. When our software products are licensed with royalty bearing software, margins are lower than when our software products are licensed without such third party software products. We also

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have certain fixed costs that are not dependent upon sales volume. Accordingly, margins will vary based on gross license revenue and product mix.

     The increase in service margins during the three and six months ending September 30, 2004 from the three and six months ending September 30, 2003 were attributable to some lower margin engagements which revenue was recognized for during fiscal year 2004. In addition, we experienced decreased costs in fiscal year 2005 associated with a reduction in the number of employees within the professional services organization.

Expenses

     Research and Development. Research and development expenses consist mainly of salaries and related costs of our engineering, quality assurance, technical publications efforts and certain allocated expenses. The year over year decrease in research and development expense during the three and six months ending September 30 was primarily due to the lump-sum severance payment of $231,000 to the Chief Technical Advisor (“CTA”) paid in September 2003.

     During the three and six months ending September 30, 2004, we did not amortize any deferred compensation related to stock options. During the three and six months ending September 30, 2003, we amortized approximately $58,000 and $119,000 for deferred compensation related to stock options, respectively.

     We plan to reduce our research and development expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

     Sales and Marketing. Sales and marketing expenses consist mainly of salaries and related costs for our sales and marketing organization, sales commissions, expenses for trade shows, public relations, collateral sales materials, advertising and certain allocated expenses. The year over year decrease for the three months ending September 30, 2004 compared to 2003 was primarily due to recorded charges taken last year of approximately $735,000 of severance and settlement fees paid to former employees and expenses of approximately $250,000 related to an employee bonus associated with the Wakely Software acquisition. The year over year decrease for the six months ending September 30, 2004 compared to 2003 was also due to the aforementioned expenses in addition to a reduction in spending on marketing programs, decrease of sales commissions and salaries, the reduction in the allocation of fixed overheads costs as a result of the reduced headcount, and charges taken last year associated with the closure of our German office.

     During the three and six months ending September 30, 2004, we did not amortize any deferred compensation related to stock options. During the three and six months ending September 30, 2003, we amortized approximately $107,000 and $228,000 for deferred compensation related to stock options, respectively.

     We plan to reduce our sales and marketing expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

     General and Administrative. General and administrative expenses consist mainly of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, bad debt expense and certain allocated expenses. The year over year increase in general and administrative expense during the three and six

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months ending September 30 was primarily due to increased audit fees, additional expenses related to compliance for Sarbanes-Oxley, and increased legal expenses related to IPO and patent litigation.

     During the three and six months ending September 30, 2004, we did not amortize any deferred compensation related to stock options. During the three months ending September 30, 2003, we amortized approximately $70,000 for deferred compensation related to stock options and recorded approximately $112,000 for compensation related to variable accounting. During the six months ending September 30, 2003, we amortized approximately $153,000 for deferred compensation related to stock options and recorded approximately $146,000 for compensation related to variable accounting.

     We plan to reduce our general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

Interest and Other Income, Net

     Interest income consists primarily of interest earned on cash balances and short-term and long-term investments. During the three months ending September 30, 2004 and 2003, interest income totaled approximately $515,000 and $334,000, respectively. The increase was due to slightly higher quarterly yields on our investments. During the six months ending September 30, 2004 and 2003, interest income totaled approximately $738,000 and $833,000, respectively. The decrease was due primarily to lower interest rates in the first quarter of fiscal 2005 and the reduction of cash and investments balance due to these amounts being used for the operation of our business.

Provision for Income Taxes

     The Company did not record any income tax provision for the three months ending September 30, 2004 and 2003, respectively.

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

Recent Accounting Pronouncements

     In March 2004, the Financial Accounting Standards Board (FASB) issued Emerging Issues Task Force Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once final guidance is issued.

Liquidity and Capital Resources

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     In addition to our operating capital, we have funded our operations with proceeds from the private sale of common stock and our initial public offering. Our primary sources of liquidity consisted of approximately $77.4 million in cash, cash equivalents and short-term investments and approximately $32.5 million in long-term investments for a total of approximately $109.9 million as of September 30, 2004 compared to approximately $99.4 million in cash, cash equivalents and short-term investments and approximately $19.4 million in long-term investments for a total of approximately $118.8 million as of March 31, 2004. During the six months ending September 30, 2004, the decrease in cash and cash equivalents was primarily related to approximately $8.3 million of cash used in operations and approximately $4.9 million net purchases of short and long-term investments, offset by the proceeds from the issuance of common stock, net of repurchases, of approximately $304,000. During the six months ending September 30, 2003, the decrease in cash and cash equivalents was primarily related to approximately $11.3 million of cash used in operations and approximately $18.2 million net purchases of short and long-term investments, offset by the proceeds from the issuance of common stock, net of repurchases, of approximately $1.6 million. We experienced a net decrease in working capital at September 30, 2004 as compared to March 31, 2004 primarily due to the cash used in operations and purchases in excess of proceeds from short-term and long-term investments.

     The net cash used for operating activities for the six months ending September 30, 2004 was due primarily to the $7.7 million in net loss, the $1.1 million increase in accounts receivable, and the $400,000 decrease in deferred revenues, offset by $700,000 in depreciation expense. The net cash used in operating activities for the six months ending September 30, 2003 was due primarily to the $5.0 million in net loss, the $1.3 million decrease in accrued liabilities, and the $8.9 million decrease in deferred revenues, offset by $1.2 million in depreciation and the $1.6 million decrease in accounts receivable.

     The net cash used for investing activities for the six months ending September 30, 2004 was due primarily to approximately $4.3 million of net purchases of short and long-term investments as compared to approximately $19.1 million of net purchases of short and long-term investments for the six months ending September 30, 2003. For the six months ending September 30, 2004 and 2003, we spent approximately $575,000 and $110,000 for capital expenditures respectively.

     The net cash provided by financing activities for the six months ending September 30, 2004 was due primarily to the proceeds from the issuance of common stock through the exercise of options for approximately $680,000 offset by approximately $376,000 for stock repurchases in the open market. In the six months period ending September 30, 2003, the net cash provided by financing activities was due primarily to the proceeds from the issuance of common stock through the exercise of options for approximately $2.2 million and the proceeds from an officer note receivable for $730,000, offset by $1.3 million for stock repurchases in the open market.

     We had no significant commitments for capital expenditures as of September 30, 2004. We expect to fund our future capital expenditures, liquidity and strategic operating programs from a combination of available cash balances and internally generated funds. We believe that we have a sufficient amount of cash to meet our needs for the next twelve months. We have no outside debt and do not have any plans to enter into borrowing arrangements.

     We engage in global business operations and are therefore exposed to foreign currency fluctuations. As of September 30, 2004, the effects of the foreign currency fluctuations were immaterial, and we are not engaged in any foreign currency hedging activities.

RISKS RELATED TO OUR BUSINESS

     In addition to other information in this Form 10-Q, the following risk factors should be carefully considered in evaluating Selectica and its business because such factors currently may have a significant impact on Selectica’s business, operating results and financial condition. As a result of the risk factors set forth below and elsewhere in this Form 10-Q, and the risks discussed in Selectica’s other Securities and Exchange Commission filings including our Form 10-K for our fiscal year ended March 31, 2004, actual results could differ materially from those projected in any forward-looking statements.

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

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     We have experienced operating losses in each quarterly and annual period since inception. We incurred net losses of approximately $8.8 million, $29.7 million, and $26.4 million for the fiscal years ended March 31, 2004, 2003 and 2002, respectively. We have incurred net losses of approximately $7.7 million for the six months ending September 30, 2004 and have an accumulated deficit of approximately $165.6 million as of September 30, 2004. We plan to reduce our investment in research and development, sales and marketing, and general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues; however our fixed cost structure may not permit us to reduce our operating expenses to a level where we no longer experience operating losses. We will need to generate significant increases in our revenues to achieve and maintain profitability. If our revenue fails to grow or grows more slowly than we anticipate or our operating expenses exceed our expectations, our losses will significantly increase which would significantly harm our business and operating results.

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

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

     Our quarterly revenues may fluctuate as a result of our ability to recognize revenue in a given quarter. We enter into arrangements for the sale of: (1) licenses of software products and related maintenance contracts; (2) bundled license, maintenance, and services; and (3) consulting services. In instances where maintenance is bundled with a license of software products, such maintenance term is typically one year.

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

     Arrangements consisting of license and maintenance only. For those contracts that consist solely of license and maintenance, we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by Statement of Position 98-9 “Modification of SOP No. 97-2 with Respect to Certain Transactions.” We recognize maintenance revenues over the term of the maintenance contract because vendor-specific objective evidence of fair value for maintenance exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If vendor specific objective evidence does not exist to allocate the total fee to all undelivered elements of the arrangement, revenue is deferred until the earlier of the time at which (1) such evidence does exist for the undelivered elements, or (2) all elements are delivered. If unspecified future products are given over a specified term, we recognize license revenue ratably over the applicable period. We recognize license fees from resellers as revenue when the above criteria have been met and the reseller has sold the subject licenses through to the end-user.

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

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

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interfaces. We also consider the likelihood of refunds, forfeitures and concessions when determining the significance of such services.

     In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement under the percentage of completion contract method in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” We follow the percentage of completion method since reasonably dependable estimates of progress toward completion of a contract can be made. We estimate the percentage of completion on contracts utilizing hours and costs incurred to date as a percentage of the total estimated hours and costs to complete the project. Recognized revenues and profits are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. To date, when we have been primarily responsible for the implementation of the software, services have been considered essential to the functionality of the software products, and therefore license and services revenues have been recognized pursuant to SOP 81-1.

     For those contracts that include contract milestones or acceptance criteria, we recognize revenue as such milestones are achieved or as such acceptance occurs.

     For those contracts with unspecified future products and services which are not essential to the functionality of the other elements of the arrangement, license revenue is recognized by the subscription method over the length of time that the unspecified future product is available to the customer.

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

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

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

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

Arrangements consisting of consulting services. Consulting services consists of a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments. Consulting services may be recognized based on customer acceptance in the form of customer-signed timesheets, invoices, cash received, or customer-signed acceptance as defined in the master service agreement.

     Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenues.

     Because we rely on a limited number of customers, the timing of customer acceptance or milestone achievement, or the amount of services we provide to a single customer can significantly affect our operating results or the failure to replace a significant customer. For example, our services and license revenues declined significantly on separate occasions in the quarters ending on March 31, 2003, March 31, 2001 and June 30, 1999 due to the delays of milestone achievement of services and customer acceptance under a particular contract. See “Management’s

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Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations.” Because expenses are relatively fixed in the near term, any shortfall from anticipated revenues could cause our quarterly operating results to fall below anticipated levels.

     We may also experience seasonality in revenues. For example, our quarterly results may fluctuate based upon our customers’ calendar year budgeting cycles. These seasonal variations may lead to fluctuations in our quarterly revenues and operating results.

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

If our bookings do not improve, our results of operations could be significantly harmed.

     In any given period our revenues are dependent on customer contracts booked during earlier periods. Because we typically recognize revenue in periods after contracts are entered into, a decline in the number of contracts booked during any particular period or the value of such contracts would cause a decrease in revenue in future periods. The number and value of our bookings has significantly decreased. Our failure to increase bookings in the previous quarters was a significant factor in the decline of our revenues this quarter. If our bookings remain at current levels or if the value of such bookings decreases further, it will cause our revenues to decline in future periods and could significantly harm our business and operating results.

If our new product marketing strategy is unsuccessful, it could significantly harm our business and operating results.

     We have recently shifted our product marketing focus. We had previously positioned our company as a seller of Internet Selling Solutions, however, we now emphasize our products’ ability to bridge the gap that exists between CRM and other business applications, which we refer to as the opportunity to order gap. We are in the process of bringing new products to market which are specifically tailored to address this gap. If the market for products that address the opportunity to order gap is smaller than we anticipated or if our products fail to gain widespread acceptance in this market, our results of operations would be adversely affected. In addition, if there is a delay in bringing our new products to market, it would delay our ability to derive revenues from such products and our business and operating results could be significantly harmed.

The loss of any of our key personnel or the failure of our new management team to integrate with our current team would harm our competitiveness because of the time and effort that we would have to expend to replace such personnel.

     We believe that our success will depend on the continued employment of our management team and key technical personnel, none of whom, except Stephen Bennion, our Chief Financial Officer have an employment agreement with us. If one or more members of our senior management team or key technical personnel were unable or unwilling to continue in their present positions, these individuals would be difficult to replace and our ability to manage day-to-day operations, including our operations in Pune and Chennai, India, develop and deliver new technologies, attract and retain customers, attract and retain other employees and generate revenues would be significantly harmed We have recently hired a new Chief Executive Officer. The addition of a new executive may cause disruptions both internally and with our partners and customers. If our Chief Executive Officer does not successfully integrate with our employees, partners and customers, it could significantly harm our business and operating results.

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

     Our business and financial condition is dependent on a limited number of customers. Our five largest customers accounted for approximately 64% and 81% of our revenues for the six months ended September 30, 2004 and 2003,

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respectively. Our ten largest customers accounted for 76% and 88% of our revenues for the six months ended September 30, 2004 and 2003, respectively. Our failure to obtain another significant customer this quarter was largely responsible for the decrease in our revenues as compared to the prior periods. Revenues from significant customers as a percentage of total revenues are as follows:

* Revenues were less than 10%.

     We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenues for the foreseeable future. As a result, if we fail to successfully sell our products and services to one or more customers in any particular period or a large customer purchases fewer of our products or services, defers or cancels orders, or terminates its relationship with us, our business and operating results would be harmed.

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

     A change in economic conditions could lead to revised budgetary constraints regarding information technology spending for our customers. We have had potential customers select our software, but decide to delay or not to implement any configuration system. Many companies have decided to reduce their expenditures for information technology by either delaying non-mission critical projects or abandoning them until their levels of business justify the expenses. A stagnation in information technology spending due to economic conditions or other factors could significantly harm our business and operating results.

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

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

We are currently subject to intellectual property litigation, and could be subject to additional such litigation in the future, in connection with which we may incur substantial costs, which would harm our operating results.

     Our success and ability to compete are dependent on our ability to operate without infringing upon the proprietary rights of others. Any intellectual property litigation could result in substantial costs and diversion of resources and could significantly harm our business and operating results. On April 22, 2004, Trilogy Software Inc. and Trilogy Development Group (“Trilogy”) filed a complaint in the United States District Court for the Eastern District of Texas Marshall Division (which has subsequently been served), alleging patent infringement against the Company. The complaint alleges that the Company has been and is willfully infringing, directly and indirectly, on Trilogy patents relating to the making, using, licensing, selling, offering for sale, or importing products including configuration and pricing software and related consulting services. The complaint seeks money damages, costs,

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attorneys’ fees, penalties for willful infringement, an injunction to prevent the Company from infringing Trilogy’s patents in the future, and any other relief to which Trilogy may be entitled. The Company is currently evaluating the merits of this complaint and we may incur substantial costs to defend against such claim.

     In addition, from time to time, we receive correspondence from patent holders recommending that we license their patents. After reviewing these patents, we have informed these patent holders that it would not be necessary to license these patents. However, we may be required to license such patents or incur legal fees to defend our position that such licenses are not necessary, and there can be no assurance that we would be able to obtain a license to use such patents on commercially reasonable terms, or at all.

     Any intellectual property litigation, including the litigation with Trilogy, or any threat of such litigation could force us to do one or more of the following:

	•		cease selling, incorporating or using products or services that incorporate the challenged intellectual property;
	•		obtain from the holder of the infringed intellectual property right a license to sublicense or use the relevant intellectual property, which license may not be available on reasonable terms;
	•		redesign those products or services that incorporate such intellectual property; and/or
	•		pay money damages to the holder of the infringed intellectual property right.

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

Developments in the market for configuration, pricing management and quoting solutions may harm our operating results, which could cause a decline in the price of our common stock.

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

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

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

     We were founded in June 1996 and have a limited operating history. We began marketing our products in early 1997 and released ACE 7.0 in September 2004. The revenue and income potential of our business and market are uncertain. As a result of our limited operating history, we have limited financial data that you can use to evaluate our business. Our revenue is dependent on our ability to enter into significant software license transactions with new and existing customers. Our success depends on gaining new customers and maintaining relationships with our existing

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customers. You must consider our prospects in light of the risks and difficulties we may encounter as an early stage company in the new and rapidly evolving market for configuration, pricing and quoting software.

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

     The market for software and services that enable electronic commerce is intensely competitive and rapidly changing. We expect competition to persist and intensify, which could result in price reductions, reduced gross margins and loss of market share. Our principal competitors include large public-traded companies such as Oracle Corporation, SAP and Siebel Systems, all of which offer integrated solutions for electronic commerce incorporating some of the functionality of our configuration, pricing and quoting software, as well as private companies such as Comergent.

     Our competitors may intensify their efforts in our market. In addition, other enterprise software companies may offer competitive products in the future. Competitors vary in size and in the scope and breadth of the products and services offered. Although we believe we have advantages over our competitors including the comprehensiveness of our solution, our use of Java technology and our multi-threaded architecture, some of our competitors and potential competitors have significant advantages over us, including:

	•		a longer operating history;
	•		preferred vendor status with our customers;
	•		more extensive name recognition and marketing power; and
	•		significantly greater financial, technical, marketing and other resources, giving them the ability to respond more quickly to new or changing opportunities, technologies, and customer requirements.

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

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

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

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

     In the past, our customers have experienced difficulties or delays in completing implementation of our products. We may experience similar difficulties or delays in the future. Our configuration, pricing and quoting products rely

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

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

     We depend on our direct sales force for all of our current sales, and our future growth depends on the ability of our direct sales force to develop customer relationships and increase sales to a level that will allow us to reach and maintain profitability. If we are unable to retain qualified sales personnel or if newly hired personnel fail to develop the necessary skills or to reach productivity when anticipated, we may not be able to increase sales of our products and services, and our results of operation could be significantly harmed. We continue to have a high rate of turnover in our executive sales positions. If our sales management fails to successfully integrate into the Company or improve the performance of the sales personnel, our business may be harmed.

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

     We need to better manage our professional services organization to assist our customers with implementation and maintenance of our products. Because professional services have been expensive to provide, we must improve the management of our professional services organizations to improve our results of operations. Improving the efficiency of our consulting services is dependent upon attracting and retaining experienced project managers. In addition, because of market conditions, the pricing of professional services projects has made it difficult to improve operating margins.

     Services revenues, which are comprised primarily of revenues from consulting fees, maintenance contracts and training, are important to our business. Services revenues have lower gross margins than license revenues. During the three and six month ending September 30, 2004 and 2003, gross margins percentages for services revenues and license revenues for the respective periods are as follows:

     We intend to charge for our professional services on a time and materials rather than a fixed-fee basis. However in current market conditions, many customers insist on services provided on a fixed-fee basis. To the extent that customers are unwilling to utilize third-party consultants or require us to provide professional services on a fixed fee basis, our cost of services revenues could increase and could cause us to recognize a loss on a specific contract, either of which would adversely affect our operating results. In addition, if we are unable to provide these professional services, we may lose sales or incur customer dissatisfaction, and our business and operating results could be significantly harmed.

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

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

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	•		issue cash;
	•		issue stock that would dilute our current stockholders’ percentage ownership;
	•		incur debt;
	•		assume liabilities;
	•		incur amortization expenses related to other intangible assets; or
	•		incur large and immediate write-offs.

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

	•		problems combining the purchased operations, technologies or products with ours;
	•		unanticipated costs;
	•		diversion of managements’ attention from our core business;
	•		adverse effects on existing business relationships with suppliers and customers; and
	•		potential loss of key employees, particularly those of the acquired organizations.

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

Our sale of intellectual property assets to Accenture presents a number of new challenges to the Company.

     We previously sold the rights to intellectual property assets targeted specifically for the health insurance market segment to Accenture. This transaction requires us to take on a number of responsibilities that we have not previously undertaken. Our business relationship requires us to provide support to users of our software products through a third party, assist in the transition of existing eInsurance customers to a new support and services arrangement and transition a number of our employees to Accenture. If we fail to successfully transition our existing customers or provide support for our new partner, it could damage our reputation in the marketplace. If we are unable to transition our employees, we may need to deploy additional resources to assist in the success of our partner and our customers. A failure in any of these undertakings could harm our results of operations.

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

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

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

     We conduct development, quality assurance and professional services operations in India. As of September 30, 2004, there were 171 persons employed in India. We are dependent on our India-based operations for these aspects of our business. As a result, we are directly influenced by the political and economic conditions affecting India. Operating expenses incurred by our operations in India are denominated in Indian currency, and accordingly, we are

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exposed to adverse movements in currency exchange rates. This, as well as any other political or economic problems or changes in India, could have a negative impact on our India-based operations, resulting in significant harm to our business and operating results. Furthermore, the intellectual property laws of India may not adequately protect our proprietary rights. We believe that it is particularly difficult to find quality management personnel in India, and we may not be able to timely replace our current India-based management team if any of them were to leave our Company.

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

Demand for our products and services will decline significantly if our software cannot support and manage a substantial number of users.

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

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

     Our success depends on our ability to attract and retain qualified management, engineering, sales and marketing and professional services personnel. We do not have employment agreements with most of our key personnel. If we are unable to retain our existing key personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products. Competition for such personnel has markedly intensified in India, where we have a large portion of our workforce. Many multinational corporations have expanded their operations into India, and there is an increased demand for individuals with relevant technology experience.

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

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

Any reduction in expenses will place a significant strain on our management systems and resources, and if we fail to manage these changes, our business will be harmed.

     We may further reduce our operating expenses, and as a result, this would place increased demands on our managerial, administrative, operational, financial and other resources.

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

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

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

Our results of operations will be harmed by charges associated with stock-based compensation, accelerated vesting associated with stock options issued to employees, charges associated with other securities issued by us, and charges related to variable accounting.

     We have in the past and expect in the future to incur a significant amount of amortization of charges related to securities issuances in future periods, which will negatively affect our operating results. Since inception we have recorded approximately $12.1 million in net deferred compensation charges. During the three months period ending September 30, 2004, we amortized approximately $34,000 of such charges. During the three months period ending September 30, 2003, we recorded approximately $351,000 of such charges, which included variable accounting. During the six months period ending September 30, 2004, we amortized approximately $83,000 of such charges. During the six months period ending September 30, 2003, we recorded approximately $743,000 of such charges, which included the compensation expenses related to option acceleration and variable accounting. We expect to amortize approximately $37,000 of deferred compensation expense for the remaining six months ending March 31, 2005 and we may incur additional charges in the future in connection with grants of stock-based compensation at less than fair market value, charges related to variable plan accounting, and acceleration vesting of stock options to employees.

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

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

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

Patent Infringement

     On April 22, 2004, Trilogy Software Inc. and Trilogy Development Group (“Trilogy”) filed a complaint in the United States District Court for the Eastern District of Texas Marshall Division (which has subsequently been served), alleging patent infringement against the Company. The complaint alleges that the Company has been and is willfully infringing, directly and indirectly, on Trilogy patents relating to the making, using, licensing, selling,

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offering for sale, or importing products including configuration and pricing software and related consulting services. The complaint seeks money damages, costs, attorneys’ fees, penalties for willful infringement, an injunction to prevent the Company from infringing Trilogy’s patents in the future, and any other relief to which Trilogy may be entitled. The Company intends to vigorously defend against Trilogy’s claims and may incur substantial costs in such defense.

Class Action

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

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

     On July 15, 2002, the Company and the officer and director defendants, along with other issuers and their related officer and director defendants, filed a joint motion to dismiss based on common issues. Opposition and reply papers were filed and the Court heard oral argument. Prior to the ruling on the motion to dismiss, on October 8, 2002, the individual officers and directors entered into a stipulation of dismissal and tolling agreement with plaintiffs. As part of that agreement, plaintiffs dismissed the case without prejudice against the individual defendants. The Court ordered the dismissal of the officers and directors without prejudice on October 9, 2002. The court rendered its decision on the motion to dismiss on February 19, 2003, denying dismissal of the Company.

     On June 25, 2003, a Special Committee of the Board of Directors of the Company approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against the Company with prejudice in return for the assignment by the Company of claims that the Company might have against its underwriters. No payment to the plaintiffs by the Company is required under the MOU. After further negotiations, the essential terms of the MOU were formalized in a Stipulation and Agreement of Settlement (“Settlement”), which has been executed on behalf of the Company. The settling parties presented the Settlement papers to the Court on June 14, 2004 and filed formal motions seeking preliminary approval on June 25, 2004. The underwriter defendants, who are not parties to the Settlement, filed a brief objecting to its terms on July 14, 2004. The Court is reviewing the matter and has had continued discussion with all of the parties regarding the terms of the Settlement.

     In the meantime, the plaintiffs and underwriters have continued to litigate the consolidated action. The litigation is proceeding through the class certification phase by focusing on six cases chosen by the plaintiffs and underwriters (“focus cases”). Selectica is not a focus case. On October 13, 2004, the Court certified classes in each of the six focus cases.

     Selectica, along with the other non-focus case issuer defendants, has not participated in the class certification phase. It is awaiting the Court’s decision on preliminary approval of the Settlement. There can be no assurance that the Court will approve the Settlement.

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

Shareholder Derivative Action

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

     On November 25, 2002, following the removal of the case to federal court and the subsequent remand of the case back to the state court, the Company and the officer and director defendants filed answers to the amended complaint, preserving certain defenses including defenses based on plaintiff’s lack of standing to bring the action. Also on November 25, 2002, CSFB filed a motion to dismiss the case on the grounds that the plaintiff lacked standing to bring the action. That motion was heard on March 4, 2003, and on March 18, 2003 the Court issued an Order sustaining the motion but granting plaintiff 30 days to file an amended complaint.

     On April 18, 2003, the plaintiff filed a second amended complaint, which added new assertions regarding plaintiff’s claim of standing as well as additional factual allegations covered by the various causes of action. Specifically, plaintiff’s second amended complaint alleged that CSFB offered and provided, and the individual defendants accepted, improper gratuities in the form of allocations of IPO shares of other companies in order to influence the selection of CSFB as the underwriter of the Company’s IPO.

     On June 17, 2003, CSFB responded to the second amended complaint by again filing a motion to dismiss the case on the grounds that the plaintiff lacked standing to bring the action. That same day, the Company and the individual defendants responded to the second amended complaint by joining CSFB’s motion to dismiss, while reserving other objections. At the hearing on the matter on August 12, 2003, the Court again granted CSFB’s motion to dismiss, with leave for the plaintiff to further amend his complaint. The Court also granted plaintiff permission to file a motion seeking to establish his standing to bring the action pursuant to rules regarding share ownership by shareholder derivative action plaintiffs at the time of the alleged wrongdoing, and the Court permitted the plaintiff to take limited discovery in connection with such a motion. In February, 2004, plaintiff took limited depositions of three individual defendants for that purpose.

     In late August, 2004, the parties entered into a stipulation pursuant to which the parties agreed that, subject to approval by the Court, the action would be voluntarily dismissed as against all defendants with prejudice and the Company would make payment to the plaintiff in the amount of up to $40,000 in full satisfaction of plaintiff’s attorneys’ fees and costs. The parties submitted that stipulation and a related proposed order to the Court on August 30, 2004, and later that day the Court entered an order dismissing the action with prejudice, directing entry of judgment accordingly, and reserving the issue of attorneys’ fees and costs for further consideration. Thereafter, plaintiff’s counsel submitted to the Court an application for attorneys’ fees and costs and a proposed order approving the requested payment by the Company to plaintiff’s counsel of $40,000, and the Court approved such request and entered such order on September 28, 2004.

     In the future we may subject to other lawsuits. Any litigation, even if not successful against us, could result in substantial costs and divert management’s and other resources away from the operations of our business.

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Anti-takeover defenses that we have in place could prevent or frustrate attempts by stockholders to change our board of directors or the direction of the company.

     Provisions of our amended and restated certificate of incorporation and amended and restated bylaws, Delaware law and the stockholder rights plan adopted by the Company on February 4, 2003 may make it more difficult for or prevent a third party from acquiring control of us without approval of our directors. These provisions include:

	•		providing for a classified board of directors with staggered three-year terms;
	•		restricting the ability of stockholders to call special meetings of stockholders;
	•		prohibiting stockholder action by written consent;
	•		establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings; and
	•		granting our board of directors the ability to designate the terms of and issue new series of preferred stock without stockholder approval.

     These provisions may have the effect of entrenching our board of directors and may deprive or limit your strategic opportunities to sell your shares.

Compliance with new regulations dealing with corporate governance and public disclosure may result in additional expenses and require significant management attention.

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

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

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

Unauthorized break-ins or other assaults on our computer systems could harm our business.

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

Changes to accounting standards and financial reporting requirements, may affect our financial results.

     We are required to follow accounting standards and financial reporting set by governing bodies in the U.S. and other countries where we do business. From time to time, these governing bodies implement new and revised laws and regulations. These new and revised accounting standards, financial reporting and tax laws may require changes to accounting principles used in preparing our financial statements. These changes may have a material impact on our business and financial results. For example, a change in accounting rules can have a significant effect on our

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reported results and may even affect our reporting of transactions completed before the change became effective. As a result, changes to existing rules or reconsideration of current practices caused by such changes may adversely affect our reported financial results or the way we conduct our business.

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RISKS RELATED TO THE INDUSTRY

If use of the Internet does not continue to reliably support the demands placed on it as a business platform, the market for our products and services may be adversely affected, and we may not achieve anticipated sales growth.

     Growth in sales of our products and services depends upon the continued and increased use of the Internet as a medium for commerce and communication. The use of the Internet as a business platform is a relatively recent phenomenon and may not continue to develop. In addition, the Internet infrastructure may not continue to develop to support additional usage and the accompanying bandwidth requirements. Concerns over well-publicized security breaches may slow the use of the Internet as a businesses platform, while privacy concerns over inadequate security of information distributed over the Internet may also slow the adoption of electronic commerce by individual consumers. Other risks associated with commercial use of the Internet could slow its growth, including:

	•		inadequate reliability of the network infrastructure;
	•		slow development of enabling technologies and complementary products; and
	•		limited accessibility and ability to deliver quality service.

     If these concerns are not sufficiently addressed the Internet may not continue develop as an important channel for business communication, which is necessary for us to increase sales.

Increasing government regulation of the Internet could limit the market for our products and services, or impose greater tax burdens on us or liability for transmission of protected data.

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

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

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The following discusses our exposure to market risk related to changes in foreign currency exchange rates and interest rates. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in the Risk Factors section of this quarterly report on Form 10-Q.

Foreign Currency Exchange Rate Risk

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

     Our exposure to fluctuation in the relative value of other currencies has been limited because substantially all of our assets are denominated in U.S. dollars. The impact to our financial statements has therefore not been material.

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To date, we have not entered into any foreign exchange hedges or other derivative financial instruments. We will continue to evaluate our exposure to foreign currency exchange rate risk on a regular basis.

Interest Rate Risk

     We established policies and business practices regarding our investment portfolio to preserve principal while obtaining reasonable rates of return without significantly increasing risk. This is accomplished by investing in widely diversified short-term and long-term investments, consisting primarily of investment grade securities. Our interest income is sensitive to changes in the general level of U.S. interest rates.

     During the six months ending September 30, 2004, a hypothetical 50 basis point increase in interest rates would have resulted in a reduction of approximately $136,000 (less than 0.12%) in the fair market value of our cash equivalents and investments. This potential change is based upon a sensitivity analysis performed on our financial positions at September 30, 2004. During the six months ending September 30, 2003, a hypothetical 50 basis point increase in interest rates would have resulted in a reduction of approximately $185,000 (less than 0.20%) in the fair value of our cash equivalents and investments. This potential change is based upon a sensitivity analysis performed on our financial positions at September 30, 2003.

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

     The following summarizes short-term and long-term investments at fair value, weighted average yields and expected maturity dates as of September 30, 2004:

ITEM 4: CONTROLS AND PROCEDURES

     (a) Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (Interim) and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934). Based on the evaluation, the Company’s management, including the Chief Executive Officer (Interim) and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2004.

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

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PART II: OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

Patent Infringement

     On April 22, 2004, Trilogy Software Inc. and Trilogy Development Group (“Trilogy”) filed a complaint in the United States District Court for the Eastern District of Texas Marshall Division (which has subsequently been served), alleging patent infringement against the Company. The complaint alleges that the Company has been and is willfully infringing, directly and indirectly, on Trilogy patents relating to the making, using, licensing, selling, offering for sale, or importing products including configuration and pricing software and related consulting services. The complaint seeks money damages, costs, attorneys’ fees, penalties for willful infringement, an injunction to prevent the Company from infringing Trilogy’s patents in the future, and any other relief to which Trilogy may be entitled. The Company intends to vigorously defend against Trilogy’s claims and may incur substantial costs in such defense.

     On September 2, 2004, Selectica filed counterclaims in the Eastern District of Texas Marshall Division action against Trilogy for infringement of Selectica’s U.S. Patent Nos. 6,405,308, 6,675,294, 5,878,400 and 6,553,350 for willfully infringing, directly and indirectly, by making, using, licensing, selling, offering for sale, or importing products including configuration and ordering software. The Company seeks money damages, costs, attorneys’ fees, penalties for willful infringement, an injunction to prevent Trilogy from infringing Selectica’s patents in the future, and any other relief to which Trilogy may be entitled. The Company may incur substantial costs in pursuing its claims against Trilogy.

Class Action

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

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

     On July 15, 2002, the Company and the officer and director defendants, along with other issuers and their related officer and director defendants, filed a joint motion to dismiss based on common issues. Opposition and reply papers were filed and the Court heard oral argument. Prior to the ruling on the motion to dismiss, on October 8, 2002, the individual officers and directors entered into a stipulation of dismissal and tolling agreement with plaintiffs. As part of that agreement, plaintiffs dismissed the case without prejudice against the individual defendants. The Court ordered the dismissal of the officers and directors without prejudice on October 9, 2002. The court rendered its decision on the motion to dismiss on February 19, 2003, denying dismissal of the Company.

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     On June 25, 2003, a Special Committee of the Board of Directors of the Company approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against the Company with prejudice in return for the assignment by the Company of claims that the Company might have against its underwriters. No payment to the plaintiffs by the Company is required under the MOU. After further negotiations, the essential terms of the MOU were formalized in a Stipulation and Agreement of Settlement (“Settlement”), which has been executed on behalf of the Company. The settling parties presented the Settlement papers to the Court on June 14, 2004 and filed formal motions seeking preliminary approval on June 25, 2004. The underwriter defendants, who are not parties to the Settlement, filed a brief objecting to its terms on July 14, 2004. The Court is reviewing the matter and has had continued discussion with all of the parties regarding the terms of the Settlement.

     In the meantime, the plaintiffs and underwriters have continued to litigate the consolidated action. The litigation is proceeding through the class certification phase by focusing on six cases chosen by the plaintiffs and underwriters (“focus cases”). Selectica is not a focus case. On October 13, 2004, the Court certified classes in each of the six focus cases.

     Selectica, along with the other non-focus case issuer defendants, has not participated in the class certification phase. It is awaiting the Court’s decision on preliminary approval of the Settlement. There can be no assurance that the Court will approve the Settlement.

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

Shareholder Derivative Action

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

     On November 25, 2002, following the removal of the case to federal court and the subsequent remand of the case back to the state court, the Company and the officer and director defendants filed answers to the amended complaint, preserving certain defenses including defenses based on plaintiff’s lack of standing to bring the action. Also on November 25, 2002, CSFB filed a motion to dismiss the case on the grounds that the plaintiff lacked standing to bring the action. That motion was heard on March 4, 2003, and on March 18, 2003 the Court issued an Order sustaining the motion but granting plaintiff 30 days to file an amended complaint.

     On April 18, 2003, the plaintiff filed a second amended complaint, which added new assertions regarding plaintiff’s claim of standing as well as additional factual allegations covered by the various causes of action. Specifically, plaintiff’s second amended complaint alleged that CSFB offered and provided, and the individual defendants accepted, improper gratuities in the form of allocations of IPO shares of other companies in order to influence the selection of CSFB as the underwriter of the Company’s IPO.

     On June 17, 2003, CSFB responded to the second amended complaint by again filing a motion to dismiss the case on the grounds that the plaintiff lacked standing to bring the action. That same day, the Company and the individual defendants responded to the second amended complaint by joining CSFB’s motion to dismiss, while

43

reserving other objections. At the hearing on the matter on August 12, 2003, the Court again granted CSFB’s motion to dismiss, with leave for the plaintiff to further amend his complaint. The Court also granted plaintiff permission to file a motion seeking to establish his standing to bring the action pursuant to rules regarding share ownership by shareholder derivative action plaintiffs at the time of the alleged wrongdoing, and the Court permitted the plaintiff to take limited discovery in connection with such a motion. In February, 2004, plaintiff took limited depositions of three individual defendants for that purpose.

     In late August, 2004, the parties entered into a stipulation pursuant to which the parties agreed that, subject to approval by the Court, the action would be voluntarily dismissed as against all defendants with prejudice and the Company would make payment to the plaintiff in the amount of up to $40,000 in full satisfaction of plaintiff’s attorneys’ fees and costs. The parties submitted that stipulation and a related proposed order to the Court on August 30, 2004, and later that day the Court entered an order dismissing the action with prejudice, directing entry of judgment accordingly, and reserving the issue of attorneys’ fees and costs for further consideration. Thereafter, plaintiff’s counsel submitted to the Court an application for attorneys’ fees and costs and a proposed order approving the requested payment by the Company to plaintiff’s counsel of $40,000, and the Court approved such request and entered such order on September 28, 2004.

     In the future we may subject to other lawsuits. Any litigation, even if not successful against us, could result in substantial costs and divert management’s and other resources away from the operations of our business.

ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     Items 2(a) and 2(b) are inapplicable.

     (c) Issuer Purchases of Equity Securities.

     The following table presents information with respect to purchases of common stock of the Company made during the three months ended September 30, 2004 by Selectica, Inc. or any “affiliated purchaser” of Selectica, Inc., as defined in Rule 10b-18(a)(3) under the Exchange Act.

ITEM 3: DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

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The Company held its annual meeting of stockholders in Santa Clara, California on September 16, 2004. Of the 32,716,029 shares outstanding as of the record date, 27,532,590 shares were represented by proxy at the meeting on September 16, 2004. At the meeting the following actions were voted upon:

1.  To elect the following director to serve for a term ending upon the 2007 Annual Meeting of Stockholders or until his successor is elected and qualified:

2.  To ratify the appointment of Ernst & Young LLP as the Company’s independent public accountants for the fiscal year ending March 31, 2005:

ITEM 5: OTHER INFORMATION

     (a) None.

     (b) Not applicable.

ITEM 6: EXHIBITS AND REPORT ON FORM 8-K

     Exhibits

            Exhibit 31.1

            Exhibit 31.2

            Exhibit 32.1

            Exhibit 32.2

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SIGNATURES

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

Date: November 9, 2004

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EXHIBIT INDEX

            Exhibit 31.1

            Exhibit 31.2

            Exhibit 32.1

            Exhibit 32.2