SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File Number: 000-50839

Phase Forward Incorporated

(888) 703-1122
(Registrant’s telephone number, including area code)

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

Yes o            No x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes o            No x

     As of July 30, 2004, the registrant had 31,902,226 shares of Common Stock outstanding.

Phase Forward Incorporated

INDEX

Part I – Financial Information

Item 1. Condensed Consolidated Financial Statements

Phase Forward Incorporated and Subsidiaries

See accompanying notes.

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Phase Forward Incorporated and Subsidiaries

See accompanying notes.

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Phase Forward Incorporated and Subsidiaries

See accompanying notes.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(unaudited)
(in thousands, except share and per share amounts)

1. Organization and Basis of Presentation

Organization

     Phase Forward Incorporated (the “Company”) is a provider of integrated enterprise-level electronic data capture, data management and adverse event reporting software solutions for use in the clinical trial component of the Company’s customers’ global research and development initiatives. The Company offers software products, services and hosted solutions to pharmaceutical, biotechnology and medical device companies, as well as academic institutions, clinical research organizations and other entities engaged in clinical trials.

     The Company has operations in the United States, United Kingdom, France, Germany, Japan and Australia.

Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements included herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such SEC rules and regulations. Nevertheless, the management of the Company believes that the disclosures herein are adequate to make the information presented not misleading. In the opinion of management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and reflect all material adjustments (consisting only of those of a normal and recurring nature) which are necessary to present fairly the consolidated financial position of the Company as of June 30, 2004, the results of its operations for the three and six months ended June 30, 2003 and 2004 and its cash flows for the six months ended June 30, 2003 and 2004. These condensed consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Registration Statement No. 333-113594 on Form S-1. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2004.

     On July 15, 2004, the Company sold 5,250,000 shares of common stock at $7.50 per share in an initial public offering (IPO) resulting in net proceeds of $34,600 after deducting underwriters’ discounts and estimated offering-related expenses. These proceeds were received by the Company on July 20, 2004. In connection with the IPO, all of the outstanding shares of the Company’s preferred stock (and a warrant to purchase preferred stock) were converted into an equal number of shares of common stock (and a warrant to purchase common stock). Because the offering closed after June 30, 2004, the results of the offering are not reflected in the accompanying unaudited condensed consolidated financial statements. A summary of the terms of the offering can be found in the Company’s Registration Statement No. 333-113594 on Form S-1 as filed with the SEC.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

2. Accounting Policies

Principles of Consolidation

     The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

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

Revenue Recognition and Deferred Setup Costs

     The Company derives revenues from software licenses and services. License revenue is derived principally from the sale of multi-year software term licenses of the Company’s InForm, Clintrial and Clintrace software products. Service revenue is derived from the Company’s delivery of the hosted solution of its InForm software product, consulting services and customer support, including training.

     The components of revenue are as follows:

     The Company recognizes software license revenue in accordance with Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended, issued by the American Institute of Certified Public Accountants, while revenues resulting from application hosting services are recognized in accordance with Emerging Issues Task Force (EITF) Issue No. 00-03 Application of AICPA Statement of Position 97-2 to Arrangements that include the Right to Use Software Stored on Another Entity’s Hardware and Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin (SAB) Nos. 101 and No. 104, Revenue Recognition. On August 1, 2003, the Company adopted EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. This adoption did not have, and is not expected to have in future reporting periods, a material impact on the Company’s financial position or results of operations.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

     Customers generally have the ability to terminate application hosting, consulting and training service agreements upon 30 days notice to the Company. Multiple element arrangements, including license and services agreements, and certain application hosting services can generally be terminated by either party for material breach of obligations generally not corrected within 30 days after notice of the breach.

     The Company recognizes revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the collection of fees is probable; and (4) the amount of fees to be paid by the customer is fixed or determinable.

     The Company generally enters into software term licenses with its customers for three to five year periods. These arrangements typically include multiple elements: a software license, consulting services and customer support. The Company bills its customers in accordance with the terms of the underlying contract. Generally, the Company bills the annual license fee for the first year of a multi-year contract in advance and bills the license fees for the subsequent years on the anniversary date. The Company’s payment terms are generally net 30 days.

     The Company’s software license revenue is earned from the sale of off-the-shelf software requiring no significant modification or customization subsequent to delivery to the customer. Consulting services, which can also be performed by third-party consultants, are deemed to be non-essential to the functionality of the software and typically are for trial configuration, implementation planning, loading of software, building simple interfaces and running test data and documentation of procedures.

     The Company generally bundles customer support with the software license for the entire term of the license. As a result, the Company generally recognizes revenues for all elements, including consulting services, ratably over the term of the software license and support arrangement. The Company allocates the revenue recognized for these arrangements to the different elements based on management’s estimate of the relative fair value of each element. For its term-based licenses, the Company allocates to consulting services the anticipated service effort and value throughout the term of the arrangement at an amount that would have been allocated had those services been sold separately to the customer. The remaining value is allocated to license and support services, with 10% of this amount allocated to support services. The Company has allocated the estimated fair value to its multiple element arrangements to provide meaningful disclosures about each of its revenue streams. The costs associated with the consulting and customer support services are expensed as incurred. There are instances in which the Company sells software licenses based on usage levels. These software licenses can be based on estimated usage, in which case the license fee charged to the customer is fixed based on this estimate. When the fee is fixed, the revenue is recognized ratably over the contractual term of the arrangement. If the fee is based on actual usage, and therefore variable, the revenue is recognized in the period of use. Revenues from certain follow-on consulting services, which are sold separately to customers with existing software licenses and are not considered part of a multiple element arrangement, are recognized as the services are performed.

     In addition to making its software products available to customers through licenses, the Company offers its InForm electronic data capture software product through a fully-hosted, turnkey deployment. Revenues resulting from application hosting services consist of three stages for each clinical trial. The first stage includes trial and application setup, including design of electronic case report forms and edit checks, implementation of the system and server configuration. The second

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

stage consists of application hosting and related support services. The third stage, database lock, consists of services required to close out, or lock, the database for the clinical trial. Services provided for the first and third stages are provided on a fixed fee based upon the complexity of the trial and system requirements. Services for the second stage are charged separately as a fixed monthly fee. The Company recognizes revenue from application hosting and related services over the hosting period. Fees charged and costs incurred for the trial system design, setup and implementation are deferred and capitalized as applicable, until the start of the hosting period. These revenues and costs are recognized and amortized, as applicable, ratably over the estimated hosting period. The capitalized costs include incremental direct costs with third parties and certain internal direct costs of the trial and application setup, as defined under Statement of Financial Accounting Standards (SFAS) No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Indirect Costs of Leases. These costs include salary and benefits associated with direct labor costs incurred during trial setup, as well as third-party subcontract fees and other contract labor costs. Work performed outside the original scope of work is contracted for separately as an additional fee and is generally recognized over the remaining term of the hosting period.

     In the event that an application hosting customer cancels a clinical trial and its related statement of work, all deferred revenue is recognized and all deferred setup costs are expensed and certain termination related fees may be charged.

     The Company capitalized $719 and $849 of deferred setup costs and amortized $946 and $880 during the six months ended June 30, 2003 and 2004, respectively. The amortization of deferred setup costs is a component of cost of services.

     The Company continues to sell the Clintrial and Clintrace software products to certain existing customers as perpetual software licenses with the option to purchase customer support. The Company does not sell perpetual licenses to new customers. The Company has established vendor specific objective evidence of fair value for the customer support in these arrangements. Accordingly, the license revenue is recognized upon delivery of the software and when all other revenue recognition criteria are met. The customer support is recognized ratably over the term of the underlying support arrangement. The Company continues to generate customer support and maintenance revenue from its perpetual license customer base. Training revenue is recognized as earned.

     Deferred revenue represents amounts billed or cash received in advance of revenue recognition.

     Provisions for estimated losses on uncompleted contracts are made on a contract-by-contract basis and are recognized in the period in which such losses become probable and can be reasonably estimated. To date, the Company has not experienced any material losses on uncompleted application hosting contracts.

     In November 2001, the EITF of the Financial Accounting Standards Board (FASB) issued EITF Issue No. 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred. EITF Issue No. 01-14 requires reimbursable out-of-pocket expenses incurred to be characterized as revenue in the income statement. The Company included $526 and $424 of reimbursable out-of-pocket expenses in service revenue and cost of service revenue in the six months ended June 30, 2003 and 2004, respectively.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

Prepaid Sales Commissions and Royalties

     The Company capitalized $1,278 and $1,580 of commissions and amortized to sales and marketing expense $703 and $1,249 during the six months ended June 30, 2003 and 2004, respectively. The Company capitalized $828 and $2,201 of royalties and amortized to cost of revenues $815 and $1,189 during the six months ended June 30, 2003 and 2004, respectively.

Net Loss Per Share

     Basic net loss per common share was determined by dividing net loss applicable to common stockholders by the weighted average common shares outstanding during the period. Weighted average shares outstanding exclude unvested restricted common stock. The Company’s potentially dilutive shares, which include outstanding common stock options, warrants, and redeemable convertible preferred stock also have not been included in the computation of diluted net loss per share for all periods as the result would be anti-dilutive. The calculation of basic and diluted net loss per share is as follows:

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

     The following common share equivalents and unvested restricted shares have been excluded from the computation of diluted weighted average shares outstanding as of June 30, 2003 and 2004, as they would be anti-dilutive.

Foreign Currency Translation

     The financial statements of the Company’s foreign subsidiaries are translated in accordance with No. 52, Foreign Currency Translation. The reporting currency for the Company is the U.S. dollar (dollar). The functional currency of the Company’s subsidiaries in the United Kingdom, France, Japan and Australia are the local currencies of those countries. Accordingly, the assets and liabilities are translated into U.S. dollars using the exchange rate in effect at each balance sheet date. Revenue and expense accounts are generally translated using an average rate of exchange during the period. Foreign currency translation adjustments are accumulated as a component of other comprehensive loss as a separate component of stockholders’ deficit. Gains and losses arising from transactions denominated in foreign currencies are primarily related to intercompany accounts that have been determined to be temporary in nature and cash and accounts receivable denominated in non–functional currencies. The Company has recorded foreign currency gains of approximately $308 and $54 in the three months ended June 30, 2003 and 2004, respectively, and approximately $145 and $38 in the six months ended June 30, 2003 and 2004, respectively, and such gains are included in other income (expense) in the accompanying condensed consolidated statements of operations.

Cash and Cash Equivalents

     The Company accounts for its investments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Under SFAS No. 115, securities that the Company has the positive intent and ability to hold to maturity are reported at amortized cost, which approximates market value, and are classified as held-to-maturity. The Company considers all highly liquid investments with original maturities of 90 days or less at the time of purchase to be cash equivalents. At December 31, 2003 and June 30, 2004, cash equivalents primarily consisted of money market funds that were readily convertible to cash.

     At December 31, 2003, the Company had approximately $1,611 of restricted cash held in certificates of deposit as collateral for letters of credit related to facility leases. The certificates of deposit matured and the collateral for the letters of credit is now reflected as a reduction in the amount available under the line of credit.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

     Cash and cash equivalents as of December 31, 2003 and June 30, 2004 were as follows:

     The Company has had no realized gains or losses to date on the sale of money market funds. The numbers contained in the foregoing table do not include $34,600 of net proceeds from the Company’s initial public offering, which were received by the Company on July 20, 2004, after the end of the second quarter of 2004.

Stock-Based Compensation

     In January 2003, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123, which provides alternative methods of transition for a voluntary change to a fair-value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation, to require prominent disclosures in annual financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has determined that it will continue to account for options granted under its stock-based compensation plans for employees (see Note 11) under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and has elected the disclosure-only alternative under SFAS No. 123 and the enhanced disclosures as required by SFAS No. 148. Under APB Opinion No. 25, when the exercise price of options granted under these plans equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is required.

     The following tables illustrate the assumptions used and the effect on net loss if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. The Company has computed the pro forma disclosures required under SFAS No. 123

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

for all employee stock options granted using the Black-Scholes option pricing model prescribed by SFAS No. 123.

     The assumptions used and weighted average information are as follows:

     Had compensation costs been determined consistent with SFAS No. 123, the Company’s net loss would have been the following pro-forma amounts:

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

3. Goodwill

     A rollforward of the net carrying amount of goodwill is as follows:

     Phase Forward acquired Clinsoft Corporation, which developed and sold the Clintrial and Clintrace products, on August 14, 2001. The goodwill resulting from the acquisition is reviewed for impairment on an annual basis in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. The Company performed its annual impairment test as of October 1, 2002 and 2003 and determined that no impairment of goodwill or intangible assets existed.

     The utilization of acquired net losses reflects a reduction in cash payments to local taxing authorities for income taxes that are not reflected as a benefit in the income tax provision for financial statement purposes.

4. Accrued Expenses

     Accrued expenses consist of the following:

5. Restructuring Charge

     The Company recorded a $4,503 restructuring charge for the year ended December 31, 2003 that related to the relocation of the Company’s corporate headquarters in December 2003. $2,486 of this charge represents the loss on a facilities lease and $2,017 related to the abandonment of the related fixed assets and leasehold improvements. The facility lease loss represents 15 months of rent remaining under an existing lease and related operating expenses. The Company anticipates that the lease loss will be settled by March 2005. The Company does not anticipate any sublease income over the remaining term of the lease agreement.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

     The components of the restructuring charges are as follows:

6. Income Taxes

     The effective tax rate for 2003 was approximately 7% and represents foreign withholding taxes and income taxes payable in certain foreign locations that cannot be offset through loss carryforwards. The effective tax rate for 2004 is approximately 37% before stock–based compensation and represents income tax expense that cannot be offset through the use of acquired net operating losses for financial statement purposes. The increase in the effective tax rate is primarily due to the profitability of the Company’s U.S. operations. In utilizing its net operating loss carryforwards, the Company is required to use its oldest net operating losses first. As a result the Company will first use the net operating losses acquired in the Clinsoft acquisition. The utilization of the acquired net operating losses will reduce the amount of income taxes payable to local tax authorities. This cash benefit will be reflected as a reduction of goodwill. Additionally, the Company’s effective tax rate exceeds its statutory tax rate due to the current non-deductibility of its stock-based compensation.

7. Debt

Lines of Credit

     Between April 2000 and March 2004, the Company entered into several equipment lines of credit with a bank. All advances under these equipment lines of credit are payable in 30 to 36 equal monthly installments of principal, plus accrued interest. The interest that accrues under these notes ranges from prime rate (4.0% and 4.25% at December 31, 2003 and June 30, 2004, respectively) to prime rate plus 1.0%. As of December 31, 2003 and June 30, 2004, there was a total of $4,188 and $4,854, respectively, outstanding under all of the Company’s equipment lines of credit. At December 31, 2003 and June 30, 2004 there was $2,155 and $4,052, respectively, available under the equipment lines of credit.

     In 2003, the Company renewed its $2,500 working capital line of credit with a bank. Interest accrued at prime rate plus 0.25%. Effective March 31, 2004, the Company renewed its working capital line of credit with a bank under which it can borrow up to $5,000. Interest accrues at prime rate. All advances made under the working capital line shall be immediately due and payable on March 31, 2006. As of each of December 31, 2003 and June 30, 2004, $2,500 was outstanding under the working capital line of credit. At June 30, 2004, there was $889 available under the line of credit, which reflects amounts used to replace the restricted cash associated with the Company’s leased facilities. Subsequent to June 30, 2004, the Company paid the $2,500 outstanding under the working capital line of credit.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

     Borrowings under these agreements are secured by substantially all assets of the Company, excluding intellectual property. The Company has entered into a negative pledge agreement that, subject to certain exceptions, generally prohibits the Company from pledging its intellectual property to others. Under the terms of the agreement, the Company is required to comply with certain financial covenants, including attainment of minimum revenues, minimum earnings and financial ratios. At December 31, 2003, the Company was in violation of the financial covenant related to minimum revenue levels in the fourth quarter of 2003 and received a waiver from the bank. The bank waived the Company’s covenant violation for only the fourth quarter of 2003. At June 30, 2004, the Company was in compliance with all financial covenants.

8. Contingencies

     From time to time and in the ordinary course of business, the Company may be subject to various claims, charges and litigation. At June 30, 2004, the Company did not have any pending claims, charges or litigation that it expects would have a material adverse effect on its consolidated financial position, results of operations or cash flows.

     On April 26, 2004, Datasci, LLC (“Datasci”) filed suit (Civil Action No. 04-1328 (MJG)) in the United States District Court for the District of Maryland (Greenbelt Division) against Phase Forward Incorporated and Quintiles Inc., one of the Company’s customers. Datasci had asserted that the Company’s InForm, Clintrial and Clintrial Integration Solution products and its services, and the products and services of Quintiles, infringe a United States patent claimed to be owned by Datasci (Patent No. 6,496,827). Datasci sought an injunction and unspecified damages from each of the Company and Quintiles.

     On May 4, 2004, the Company filed an Answer and Counterclaim to Datasci’s complaint denying that it infringes the patent which Datasci claimed to own. The Answer also challenged the validity of the patent and asserted numerous affirmative defenses. The Company’s Counterclaim sought a declaratory judgment that the Company does not infringe the patent claimed to be owned by Datasci. Datasci responded by denying all the allegations in the Company’s Counterclaim. On or about June 7, 2004, Datasci filed a motion to dismiss its complaint against Phase Forward and Quintiles. In its filing, Datasci disclosed that it did not exist when its complaint against Phase Forward and Quintiles was filed. That motion was granted and, thus, the entire action was dismissed on August 5, 2004.

     Also on or about June 7, 2004, Dr. Mark L. Kozam, doing business under the name MLK Software and claiming to be the owner of the patent, filed suit (Civil Action No. 04-CV-1787 (PJM)) in the same court where Datasci filed its initial complaint against Phase Forward and Quintiles. Dr. Kozam’s complaint contains the same allegations and seeks the same remedies that were contained in the Datasci complaint. On June 22, 2004, the Company filed an Answer and Counterclaim to Dr. Kozam’s complaint denying that it infringes the patent, challenging the validity of the patent, asserting numerous affirmative defenses, and counterclaiming for a declaratory judgment that the Company does not infringe any valid claim of the patent. Dr. Kozam responded by denying all the allegations in the Company’s Counterclaim.

     Although this action is in the initial pleading stage, the Company is prepared to vigorously defend the claims and pursue its Counterclaims and any other remedies available to the Company. Due to the preliminary nature of this action, the Company is unable to assess whether its outcome will have a material adverse effect on its results of operations.

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

9. Redeemable Convertible Preferred Stock and Warrant

     On June 1, 2004, the Company’s board of directors declared a special cash dividend of $4,700, payable on September 15, 2004, to the holders of record of Series B, C and D Preferred Stock as of June 15, 2004. This distribution is included in accrued special distribution and net loss to common stockholders as of June 30, 2004.

     Accretion of Series B, C and D redeemable convertible preferred stock was $1,918 for the three months ended June 30, 2003 and 2004, and $3,836 for the six months ended June 30, 2003 and 2004.

     In connection with the closing of the Company’s initial public offering in July 2004, all outstanding shares of the redeemable convertible preferred stock were converted into 22,841,157 shares of common stock and the preferred stock warrant automatically converted into a warrant to purchase 34,330 shares of common stock.

10. Stockholders’ Equity

Common Stock

     On July 15, 2004, the Company sold 5,250,000 shares of common stock at $7.50 per share in an initial public offering (IPO) resulting in net proceeds of $34,600 after deducting underwriters’ discounts and estimated offering-related expenses.

     On March 11, 2004, the Board of Directors approved an increase to the number of authorized shares of the capital stock to 105 million shares, consisting of 100 million shares of common stock and 5 million shares of preferred stock. Also on March 11, 2004, the Board of Directors approved the 2004 Stock Option and Incentive Plan and the 2004 Employee Stock Purchase Plan, each to become effective upon the closing of the Company’s initial public offering, and an amendment to the 2003 Non-Employee Director Stock Option Plan, all of which were approved by the stockholders on April 20, 2004. The 2004 Employee Stock Purchase Plan is available to all eligible employees, who may individually purchase a maximum of 10,000 shares annually at a price equal to 85 percent of the lower of the fair market value at the start date of the offering or fair market value on the semi-annual purchase dates. The Company has reserved for issuance an aggregate of 320,000 shares of common stock for this plan. The Company has reserved for issuance an aggregate of 1,500,000 shares of common stock under the 2004 Stock Option and Incentive Plan which will be the successor equity incentive program to the 1997 Stock Option Plan. For the 2003 Non-Employee Director Stock Option Plan, the Company has reserved for issuance an aggregate of 562,000 shares of common stock.

     There was $627 and $113 of notes receivable outstanding at December 31, 2003 and June 30, 2004, respectively.

Deferred Compensation

     The Company records deferred stock-based compensation in the amount by which the exercise price of an option is less than the deemed fair value of its common stock at the date of grant. Because there had been no public market for the Company stock, the Company’s Board of Directors had determined the fair value of the common stock on the date of grant based upon several factors, including, but not limited to, the Company’s operating and financial performance, the issuances of

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Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

convertible preferred stock, the rights and preferences of all securities senior to common stock and the anticipated offering price of the common stock in connection with the Company’s initial public offering. During 2003, all stock options were granted with an exercise price of $3.00 per share, while the estimated per share fair value of the Company’s common stock ranged from $3.00 to $4.00 in the first quarter of 2003, $4.00 to $5.00 in the second quarter of 2003, $5.00 to $7.50 in the third quarter of 2003 and $7.50 to $9.00 in the fourth quarter of 2003. During the six months ended June 30, 2004, options were granted at exercise prices ranging from $4.50 to $6.00 per share while the estimated fair value of the Company’s common stock was $10.00 per share. The Company recorded deferred compensation of $3,060 and $1,508 in the year ended December 31, 2003 and the six months ended June 30, 2004, respectively. The Company amortized $62 and $68 to expense in the three months ended June 30, 2003 and 2004, respectively. The Company amortized $473 and $919 to expense in the six months ended June 30, 2003 and 2004, respectively. As of June 30, 2004, there was an aggregate of $2,922 of deferred stock-based compensation remaining to be amortized approximately as follows: $870 in the year ending December 31, 2004; $1,042 in the year ending December 31, 2005; $583 in the year ending December 31, 2006; $270 in the year ending December 31, 2007 and $157 through December 31, 2011. The Company amortizes the deferred compensation charges over the vesting period of the underlying option awards in accordance with FIN 28.

In the six months ended June 30, 2004, the Company granted options to purchase 205,000 shares of common stock that vest upon the earlier of 7 years from date of grant or the attainment of specified milestones. As a result of the Company’s initial public offering on July 15, 2004, 61,250 of these options were accelerated and became vested and exercisable, resulting in the acceleration of $264,300 in stock-based compensation.

12. Comprehensive Income (Loss)

Comprehensive income (loss) consisted of the following:

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

Forward Looking Statements May Prove Inaccurate

     The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes that appear elsewhere in this Quarterly Report on Form 10-Q. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q.

Overview

     We are a provider of integrated enterprise-level electronic data capture, management and adverse event reporting software solutions for use in the clinical trial component of our customers’ global research and development initiatives. We offer software products, services and hosted solutions to pharmaceutical, biotechnology and medical device companies, as well as academic institutions, clinical research organizations and other entities engaged in clinical trials. By automating essential elements of the clinical trial process, we believe our products allow our customers to accelerate the market introduction of new medical therapies and corresponding revenue, reduce overall research and development expenditures, enhance existing data quality control efforts and reduce clinical and economic risk.

Initial Public Offering

     On July 15, 2004, we sold 5,250,000 shares of common stock at $7.50 per share in an initial public offering (IPO) resulting in net proceeds of $34.6 million after deducting underwriters’ discounts and estimated offering-related expenses.

Sources of Revenues

     We derive our revenues from software licenses and services. License revenue is derived principally from the sale of multi-year software term licenses for our InForm, Clintrial and Clintrace software products. Service revenue is derived from our delivery of the hosted solution of our InForm software product, consulting services and customer support, including training. We generally recognize revenues ratably over the life of a license or service contract. This allows us to maintain a backlog that provides multi-year visibility in revenue. As our backlog grows, we believe that the predictability of our future revenues will increase. One customer, Eli Lilly and Company, the holder of record of approximately one percent of our capital stock, accounted for approximately 8% and 12% of our total revenues in the six months ended June 30, 2003 and 2004, respectively. Our top 20 customers accounted for approximately 68% and 69% of our total revenues in the six months ended June 30, 2003 and 2004, respectively, net of reimbursable out-of-pocket expenses.

License Revenue

     We derive our license revenues from our three major software products: InForm, our Internet based electronic data capture solution; Clintrial, our clinical data management solution; and Clintrace, our adverse event reporting solution. Although each of our InForm, Clintrial and

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Clintrace software solutions are available as stand-alone enterprise applications, we offer integrated enterprise solutions incorporating certain of our electronic data capture, data management and adverse event reporting products.

     License revenues for our InForm electronic data capture software solution, either on a stand-alone or integrated basis, are determined primarily by the number, complexity and duration of the clinical trials and the number of participants in each clinical trial. License revenues for our Clintrial and Clintrace software solutions are determined primarily by the number of users accessing the software solution. Except as discussed below, we enter into software license agreements with terms generally of three to five years with payment terms generally annually in advance. License revenues are recognized ratably over the duration of the software term license agreement, to the extent that amounts are fixed or determinable and collectable.

     In August 2001, we acquired Clinsoft Corporation, which developed, marketed and sold the Clintrial clinical data management and Clintrace adverse event reporting and tracking products. Historically, Clinsoft sold the Clintrial and Clintrace software products as a perpetual software license with the option to purchase customer support. Following the acquisition and subsequent integration of our software products, we began converting holders of Clinsoft perpetual software licenses to our software term license arrangements. We continue to sell perpetual licenses of these products in certain situations to our existing customers. We recognize revenue on the perpetual licenses upon delivery of the software. Perpetual license revenue represented less than one percent of total revenue for the six months ended June 30, 2003 and June 30, 2004. We continue to provide and charge for maintenance and support on our products to those customers who do not convert to our software term license arrangements. We generally charge 18% of the perpetual license fee for customer support. We will continue our efforts to convert the remaining former Clinsoft customer base to software term license arrangements.

Service Revenue

     Application Hosting Services In addition to making our software products available to customers through licenses, we offer our InForm electronic data capture software as a hosted application solution delivered through a standard web-browser, with customer support and training services. Revenue resulting from this hosting service consists of three stages for each clinical trial:

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First stage —trial and application setup, including design of electronic case report forms and edit checks, installation and server configuration of the system;

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Second stage —application hosting and related support services; and

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Third stage —services required to close out, or lock, the database for the clinical trial.

     Services provided for the first and third stages are provided on a fixed fee basis depending upon the complexity of the trial and system requirements. Services for the second stage are charged separately as a fixed monthly fee. We recognize revenue from all stages of the hosting service over the second and third stages. Fees charged and costs incurred for the trial system design, setup and implementation are deferred until the start of the second stage and then amortized ratably over the estimated hosting period. The deferred costs include direct costs related to the trial and application setup. Fees for the first and third stages of the services are billed based upon milestones. Fees for application hosting and related services in the second stage are billed quarterly in advance. Bundled into this revenue element is the revenue attributable to the software license used by the customer.

     In the event that an application hosting customer cancels a clinical trial and its related statement of work, all deferred revenue is recognized and all deferred setup costs are expensed and certain termination-related fees may be charged. In addition, application hosting services revenue includes

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hosting services associated with term license arrangements and reimbursable out-of-pocket expenses.

     Consulting Services. Consulting services include the design and documentation of the processes related to our customers’ use of our products and services in their clinical trials. Consulting services also include project planning and management services, guidance on best practices in using our software products, as well as implementation services consisting of application architecture design, systems integration, installation and validation. In addition, consulting services revenue includes reimbursable out-of-pocket expenses. Revenues from consulting services included in a multiple element software license agreement or in a hosted solution are recognized ratably over the term of the arrangement. The associated costs are expensed as incurred. Revenues from consulting services that are not included in a multiple element software license arrangement are recognized as services are performed. Fixed priced arrangements are billed based upon contractual milestones, and time-and-materials arrangements are billed monthly.

     Customer Support. We have a multinational services organization to support our software products and hosted solutions worldwide. Customer support includes telephone support, software maintenance and training. We bundle customer support in our software term licenses and allocate 10% of the value of the license to customer support revenue. Our customer support revenue also consists of customer support fees paid by the Clintrial and Clintrace perpetual license customers. Customer support revenue is recognized ratably over the period of the customer support or term license agreement, with payment terms generally annually in advance.

Cost of Revenues and Operating Expenses

     We allocate overhead expenses such as rent and occupancy charges and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of service revenues and in the sales and marketing, research and development, and general and administrative expense categories.

     Cost of Revenues. Cost of license revenues consists primarily of the amortization of royalties paid for certain modules within our Clintrial software product and the amortization of acquired technologies. The cost of license revenue varies based upon the mix of revenue from software licenses for our products. We operate our service organization on a global basis as one distinct unit, and do not segment costs for our various service revenue elements. These services include performing application hosting, consulting and customer support services, and costs consist primarily of employee-related costs associated with these services, amortization of the deferred clinical trial setup costs, allocated overhead, outside contractors, royalties associated with providing customer support for third-party modules licensed to our customers for use with the Clintrial software product and reimbursable out-of-pocket expenses. Cost of services also includes hosting costs that primarily consist of hosting facility fees and server depreciation. The cost of service revenue varies based upon employee utilization levels in the service organization and royalties associated with revenue derived from providing customer support, as well as costs associated with the flexible use of outside contractors to support internal resources. We supplement the trial design and setup activity for application hosting services through the use of outside contractors. This allows us to utilize outside contractors in those periods where trial design and setup activity is highest while reducing the use of outside contractors in those periods where trial activity lessens, allowing for a more flexible delivery model. The percentage of the services workforce represented by outside contractors varies from period to period depending on the volume of specific support required. The cost of services is significantly higher as a percentage of revenue as compared to our cost of license revenue primarily due to the employee-related and outside contractor expenses associated with providing services.

     Gross Margin. Our gross margin on license revenue varies based on the mix of royalty-and non-royalty-bearing license revenue and the amount of amortization of acquired technologies. Our gross

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margin on service revenue varies primarily due to variations in the utilization levels of the professional service team and the timing of expense and revenue recognition under our service arrangements. In situations where the service revenue is recognized ratably over the software license term, typically three to five years, our costs associated with delivery of the services are recognized as the services are performed, which is typically during the first 9 to 12 months of the contract period. Accordingly, our gross margin on service revenue may vary depending upon the length of these arrangements.

     Sales and Marketing. Sales and marketing expenses consist primarily of employee-related expenses, including travel, marketing programs (which include product marketing expenses such as trade shows, workshops and seminars, corporate communications, other brand building and advertising), allocated overhead and the amortization of commissions. We expect that sales and marketing expenses will increase as we expand and further penetrate our customer base, expand our domestic and international selling and marketing activities associated with existing and new product and service offerings, build brand awareness and sponsor additional marketing events.

     Research and Development. Research and development expenses consist primarily of employee-related expenses, allocated overhead and outside contractors. We have historically focused our research and development efforts on increasing the functionality, performance and integration of our software products. We expect that in the future, research and development expenses will increase as we introduce additional integrated software solutions to our product suite.

     General and Administrative. General and administrative expenses consist primarily of employee-related expenses, professional fees, other corporate expenses and allocated overhead. We expect that in the future, general and administrative expenses will increase as we add personnel and incur additional professional fees and insurance costs related to the growth of our business and operations.

     Stock-Based Expenses. Our cost of service revenues and operating expenses, excluding our restructuring charges, include stock-based expenses related to the fair value of options issued to non-employees and option grants to employees in situations where the exercise price is determined to be less than the deemed fair value of our common stock at the date of grant.

Foreign Currency Translation

     With regard to our international operations, we frequently enter into transactions in currencies other than the U.S. dollar. As a result, our revenues, expenses and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Euro, British pound sterling, Australian dollar and Japanese yen. In the six months ended June 30, 2003 and 2004, approximately 39% and 40%, respectively, of our revenues were generated in locations outside the United States. In the three months ended June 30, 2003 and 2004, approximately 39% and 41%, respectively, of our revenues were generated in locations outside the United States. The majority of these revenues were in currencies other than the U.S. dollar. In periods when the U.S. dollar declines in value as compared to the foreign currencies in which we conduct business, our foreign currency-based revenues and expenses increase in value when translated into U.S. dollars.

Critical Accounting Policies and Estimates

     Our condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates.

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     We believe that of our significant accounting policies, which are described in Note 2 of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.

     Revenue Recognition and Deferred Setup Costs. We recognize software license revenue in accordance with Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended, issued by the American Institute of Certified Public Accountants, while revenues resulting from application services are recognized in accordance with Emerging Issues Task Force (EITF) Issue No. 00-03, Application of AICPA Statement of Position 97-2 to Arrangements that include the Right to Use Software Stored on Another Entity’s Hardware and Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin (SAB) Nos. 101 and 104, Revenue Recognition. On August 1, 2003, we adopted Emerging Issues Task Force, or EITF, Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. The adoption did not have a material impact on our financial position or results of operations.

     Our customers generally have the ability to terminate service agreements upon 30 days notice to us. License and services agreements can be terminated by either party for material breach of obligations generally not corrected within 30 days after notice of the breach.

     We recognize revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the collection of our fees is probable; and (4) the amount of fees to be paid by the customer is fixed or determinable.

     We generally enter into software term licenses with our customers for three to five year periods. These arrangements typically include multiple elements: software license, consulting services and customer support. We bill our customers in accordance with the terms of the underlying contract. Generally, we bill the annual license fee for the first year of the multi-year contract in advance and bill license fees for subsequent years on the anniversary date. Our payment terms are generally net 30 days.

     Our software license revenue is earned from the sale of off-the-shelf software requiring no significant modification or customization subsequent to delivery to the customer. Consulting services, which can also be performed by third-party consultants, are deemed to be non-essential to the functionality of the software and typically are for trial configuration, implementation planning, loading of software, building simple interfaces and running test data and documentation of procedures.

     We generally bundle customer support with the software license for the entire term of the arrangement. As a result, we generally recognize revenue for all elements ratably over the term of the multiple element arrangement. We allocate the revenue for these arrangements to the different elements based on management’s estimate of the relative fair value of each element. For our contracts accounted for ratably under SOP 97-2, we allocate to consulting services the anticipated service level throughout the term of the arrangement at an amount equal to what it would have been had those services been sold separately to the customer. The remaining value is allocated to license and support services, with a 10% value allocated to support services. The costs associated with the consulting and customer support services are expensed as incurred. There are instances in which we sell software licenses based on usage levels. These software licenses can be based on estimated usage, in which case the license fee charged to the customer is fixed based on this estimate. When the fee is fixed, the revenue is recognized over the contractual term of the arrangement. If the fee is based on actual usage, and therefore variable, the revenue is recognized in the period of use. Revenue from certain follow-on consulting services, which are sold separately to customers with existing software licenses and are not considered part of a multiple element arrangement, are generally recognized as the services are performed.

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     Revenue from perpetual software licenses represented less than one percent of total revenues for the six months ended June 30, 2003 and June 30, 2004. We continue to sell perpetual licenses for the Clintrial and Clintrace software products in certain situations to our existing customers with the option to purchase customer support. We have established vendor specific objective evidence of fair value for the customer support. Accordingly the perpetual license revenue is recognized upon delivery of the software and when all other revenue recognition criteria are met. Customer support revenues are recognized ratably over the term of the underlying support arrangement.

     In addition to making our software products available to customers through licenses, we offer our InForm electronic data capture software solution through a hosted application solution delivered through a standard web-browser. Revenue resulting from application hosting services consist of three stages for each clinical trial: the first stage involves application setup, including design of electronic case report forms and edit checks, implementation of the system and server configuration; the second stage involves application hosting and related support services; and the third stage involves services required to close out, or lock, the database for the clinical trial. Services provided for the first and third stages are provided on a fixed fee basis based upon the complexity of the trial and system requirements. Services for the second stage are charged separately as a fixed monthly fee. We recognize revenue from all stages of the hosting service over the second and third stages. Fees charged and costs incurred for the trial system design, setup and implementation are deferred and capitalized as applicable, until the start of the second stage and then amortized and recognized, as applicable, ratably over the estimated hosting period. The capitalized costs include incremental direct costs with third parties and certain internal direct costs related to the trial and application setup, as defined under SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Indirect Costs of Leases. These costs include salary and benefits associated with direct labor costs incurred during trial setup, as well as third-party subcontract fees and other contract labor costs. Work performed outside the original scope of work is contracted for separately as an additional fee and is generally recognized over the remaining term of the hosting period. Fees for the first and third stages of the services are billed based upon milestones. Fees for application hosting and related services in the second stage are billed quarterly in advance. Bundled into this revenue element is the revenue attributable to the software license used by the customer.

     We capitalized $719,000 and $849,000 of deferred setup costs and amortized $946,000 and $880,000 during the six months ended June 30 2003 and 2004, respectively. The amortization of deferred setup costs is a component of cost of services.

     Deferred revenue represents amounts billed or cash received in advance of revenue recognition.

     Accounting for Commission Payments and Royalties. For arrangements where we recognize revenue over the relevant contract period, we defer related commission payments to our direct sales force and software license royalties paid to third parties and amortize these amounts over the same period that the related revenues are recognized. This is done to better match commission and royalty expenses with the related revenues. During the six months ended June 30, 2003 and 2004, respectively, we deferred $1.3 million and $1.6 million, respectively, of commissions and amortized $703,000 and $1.2 million, respectively, to sales and marketing expenses. Royalties are paid on a percentage of billings basis for certain of our products. During the six months ended June 30, 2003 and 2004, we deferred $828,000 and $2.2 million, respectively, of royalty expenditures and amortized $815,000 and $1.2 million, respectively, to cost of license and service revenue.

     Accounting for Stock-Based Awards. We record deferred stock-based compensation charges in the amount by which the exercise price of an option is less than the deemed fair value of our common stock at the date of grant. Because there had been no public market for our stock prior to the July 2004 initial public offering of our common stock, our board of directors had determined the fair value of our common stock based upon several factors, including, but not limited to, our

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operating and financial performance, sales of convertible preferred stock to third parties, the rights and preferences of securities senior to common stock and the anticipated offering price of our common stock in connection with our July 2004 initial public offering.

     We have not historically engaged unrelated third parties to prepare valuations of our common stock. In connection with our July 2004 initial public offering, management and the board of directors retroactively assessed the fair value of our common stock during 2003 and the six months ended June 30, 2004.

     During 2003, all stock options were granted with an exercise price of $3.00 per share, while the estimated per share fair value of our common stock ranged from $3.00 to $4.00 in the first quarter of 2003, $4.00 to $5.00 in the second quarter of 2003, $5.00 to $7.50 in the third quarter of 2003 and $7.50 to $9.00 in the fourth quarter of 2003.

     At the beginning of 2003, we determined the value of our common stock based principally on the per share amounts that would have been distributed to the common stockholders, after all required distributions to the preferred stockholders, in the event of a sale of the Company at the value established in our January 2002 preferred stock financing. We chose this valuation methodology based on our operating performance during 2002 and the limited, if any, access we had to the public equity markets at the time.

     The increase in our estimated per share fair value of common stock since the beginning of 2003 reflects a number of significant factors, including an improvement in our operating results, especially in the second half of the year, changes to our management team throughout 2003, additions to our board of directors in the second half of 2003 and an overall improvement in stock market indices and increasing volume of initial public offerings of common stock throughout 2003.

     We improved our operating results during each of the four quarters of 2003. In the first, second and third quarters, we incurred operating losses of $1.4 million, $1.1 million and $31,000, respectively. In the fourth quarter, we had an operating profit of $432,000, excluding a restructuring charge in the fourth quarter. Our increasing per share fair value of common stock throughout 2003 reflects this positive trend in operating results. In addition, in the second half of 2003, because of our improved operating performance and the improving equity markets, we began to contemplate an initial public offering of our common stock.

     During the six months ended June 30, 2004, options were granted at exercise prices ranging from $4.50 to $6.00 per share while the estimated fair value of our common stock was $10.00 per share. The fair value of our common stock in the six months ended June 30, 2004 was based on the high end of the range of estimated offering prices of common stock as contemplated in the preliminary prospectus for our initial public offering that was filed with the Securities and Exchange Commission.

     As of June 30, 2004, there was an aggregate of $2.9 million of deferred stock-based compensation remaining to be amortized approximately as follows: $870,000 in the year ending December 31, 2004; $1.0 million in the year ending December 31, 2005; $583,000 in the year ending December 31, 2006; $270,000 in the year ending December 31, 2007 and $157,000 through December 31, 2011. We have elected not to record the fair value of employee stock-based awards. The impact of recording employee stock-based awards at fair value, using the Black-Scholes option-pricing model, is further described in Note 2 of the notes to our 2003 consolidated financial statements contained in our Registration Statement No. 333-113594 on Form S-1 filed with the Securities and Exchange Commission.

     In the six months ended June 30, 2004, we granted options to purchase 205,000 shares of common stock that vest upon the earlier of 7 years from date of grant or the attainment of specified milestones. Upon completion of our July 2004 initial public offering, 61,250 options automatically

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vested, which accelerated $264,000 in stock-based compensation in the six months ended June 30, 2004.

     In the past, we have awarded a limited number of stock options to non-employees. For these options, we recognize the stock-based compensation over the vesting periods of the underlying awards, based on an estimate of their fair value on the vesting dates using the Black-Scholes option-pricing model.

Other Significant Estimates

     Goodwill Impairment. We review the carrying value of goodwill periodically based upon the expected future discounted operating cash flows of our business. Our cash flow estimates are based on historical results adjusted to reflect our best estimate of future markets and operating conditions. Actual results may differ materially from these estimates. The timing and size of impairment charges involves the application of management’s judgment and could significantly affect our operating results.

     Accounting for Income Taxes. In connection with preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves the assessment of our net operating loss carryforwards and credits, as well as estimating the actual current tax liability together with assessing temporary differences resulting from differing treatment of items, such as reserves and accrued liabilities, for tax and accounting purposes. We then assess the likelihood that deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance. Based on historical results, we do not believe that it is more likely than not that we will realize the value of our deferred tax assets and therefore have provided a full valuation allowance against our net deferred tax assets.

     Restructuring Expenses. In December 2003, we recorded a $4.5 million restructuring charge related to the relocation of our corporate headquarters. Approximately $2.5 million of this charge represents the estimated future obligation under a non-cancelable lease and approximately $2.0 million related to the write-off of the related abandoned leasehold improvements and fixed assets. These estimates are reviewed annually and, if revised, may result in changes to our restructuring expense should different conditions prevail than were anticipated in our original estimates.

Overview of Results of Operations for the Three Months Ended June 30, 2003 and 2004

     License revenue increased by approximately 23% in the three months ended June 30, 2004 as compared to the three months ended June 30, 2003. Service revenue increased by approximately 19% in the three months ended June 30, 2004 as compared to the three months ended June 30, 2003.

     Our gross margin increased by approximately 45% or $3.2 million in the quarter ended June 30, 2004 to $10.4 million, compared to $7.2 million for the same period in 2003, primarily due to the increase in license and application hosting services revenues.

     Operating income increased by $2.1 million from an operating loss of $1.1 million in the three months ended June 30, 2003 to an operating income of $946,000 for the three months ended June 30, 2004. The operating income (loss) in the three months ended June 30, 2003 and 2004 included approximately $62,000 and $473,000 of stock-based compensation. As of June 30, 2004, we had $26.4 million of cash and cash equivalents, an increase of $7.3 million from $19.0 million at December 31, 2003.

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     Revenues

     Total revenues increased in the three months ended June 30, 2004 as compared to the same period in 2003 due to an increase in license revenue across all products, primarily Clintrial as well as an increase in InForm application hosting services. The increase in license revenue in the three months ended June 30, 2004 was primarily due to an increase in sales of Clintrial into our existing InForm customer base. This increase was a result of our continued strategy to expand the usage of our software products by cross selling the InForm, Clintrial and Clintrace products to our existing customer base, additional utilization of our products within our customer base and sales to new customers. The increase in revenue associated with the hosted-application version of our InForm product in the three months ended June 30, 2004 was due to an increase in clinical trials under management. Consulting services revenue for the three months ended June 30, 2004 was relatively unchanged compared to the same period in 2003. The decrease in customer support revenue for the three months ended June 30, 2004 was due primarily to a reduction in the Clintrial and Clintrace maintenance renewal base as a result of the conversion of the former Clinsoft customers to term-based licenses that have a lower customer support fee. In the future, we anticipate that license revenue will become a more significant component of total revenues.

     The increase in revenues worldwide was due primarily to the increase in sales of our Clintrial products and InForm application hosting services, which we believe reflects a continued increase in the worldwide adoption of our products.

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     Cost of Revenues

     The cost of license revenue decreased in the three months ended June 30, 2004 primarily due to a $400,000 decrease in amortization expense from acquired technologies partially offset by an increase in royalty expense of $181,000 as revenue increased on certain modules of the Clintrial software product. Cost of services for the three months ended June 30, 2004 remained relatively constant but included a $268,000 increase in employee and related expenses, while headcount remained relatively unchanged. This increase was offset by decreases in reimbursable out-of-pocket expenses of $149,000 and facilities expense of $104,000.

Gross Margin

     The license gross margin percentage increased in the three months ended June 30, 2004 primarily due to an increase in Clintrial license revenue and a reduction in amortization expense associated with acquired technology, partially offset by an increase in royalty expense as revenue grew for certain modules of the Clintrial software product. The services gross margin percentage increased for the three months ended June 30, 2004 due to the increase in InForm application hosting revenues while the overall cost base remained relatively constant with an increase in employee and related expenses which was offset by decreases in reimbursable out-of-pocket expenses and facilities expense.

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     Operating Expenses

     Sales and Marketing. Sales and marketing expenses increased for the three months ended June 30, 2004 primarily due to a $338,000 increase in commission expense due to an increase in revenues and an increase in the effective commission rate and a $21,000 increase in both stock-based compensation, which was partially offset by a $52,000 reduction in travel expense and a $41,000 decrease in outside consultant expense. We expect that our sales and marketing expenses will continue to increase in absolute dollars as commission expense increases with our revenues and we continue to build our brand awareness through what we believe are the most cost-effective channels available. However, sales and marketing expenses may fluctuate, quarter by quarter, due to the timing of marketing programs.

     Research and Development. Research and development expenses increased in the three months ended June 30, 2004 primarily due to an increase in employee related expenses of $642,000 as we hired 21 additional people to improve our quality assurance and product development team, and $42,000 of stock-based compensation. This was partially offset by a $279,000 decrease in outside consultant expense as we brought certain research and development activities in-house. We expect that our research and development costs will continue to increase in absolute dollars as we continue to add features and functionality to our products and expand our product and service offerings.

     General and Administrative. General and administrative expenses increased in the three months ended June 30, 2004 primarily due to a $326,000 increase in stock-based compensation and an increase in employee related expenses of $205,000, while headcount remained the same during these periods. We expect our general and administrative expenses to increase in absolute dollars as we incur additional costs associated with being a public company.

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     Operating Income (Loss), Other Income (Expense)

     Operating Income (Loss). The increase in operating income in the three months ended June 30, 2004 was primarily due to an increase in gross margins from both license and services, partially offset by increased operating expenses.

     Other Income (Expense). The increase in interest income in the three months ended June 30, 2004 was primarily due to an increase in cash and cash equivalents available for investment. The increase in interest expense in the three months ended June 30, 2004 was primarily due to an increase in outstanding borrowings. Other income (expense) decreased due to a decrease in the foreign exchange gain as a result of a reduction in the outstanding non-U.S. dollar denominated accounts receivable and intercompany balances.

     Provision for Income Taxes

     Provision for Income Taxes. The effective tax rate for 2003 was approximately 7% and represents foreign withholding taxes and income taxes payable in certain foreign locations that could not be offset through loss carryforwards. The effective tax rate for 2004 is approximately 37% before stock-based compensation and represents income tax expense that cannot be offset through the use of acquired net operating losses for financial statement purposes. The increase in the effective tax rate is primarily due to the profitability of our U.S. operations. In utilizing our net operating loss carryforwards, we are required to use our oldest net operating losses first. As a result we will first use the net operating losses acquired in the Clinsoft acquisition. The utilization of the acquired net operating losses will reduce the amount of income taxes payable to local tax authorities. This cash benefit will be reflected as a reduction of goodwill. Additionally, our effective tax rate exceeds our statutory tax rate due to the current non-deductibility of our stock-based compensation expense.

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Overview of Results of Operations for the Six Months Ended June 30, 2003 and 2004

     License revenue increased by approximately 26% in the six months ended June 30, 2004 as compared to the six months ended June 30, 2003. Service revenue increased by approximately 12% in the six months ended June 30, 2004 as compared to the six months ended June 30, 2003.

     Our gross margin increased by approximately 43% or $6.1 million in the quarter ended June 30, 2004 to $20.2 million, as compared to $14.1 million for the same period in 2003, primarily due to the increase in license and application hosting services revenues.

     Operating income increased by $4.4 million from an operating loss of $2.6 million in the six months ended June 30, 2003 to an operating income of $1.8 million for the six months ended June 30, 2004. The operating income (loss) in the six months ended June 30, 2003 and 2004 included $68,000 and $919,000 of stock-based compensation.

Revenues

     Total revenues increased in the six months ended June 30, 2004 as compared to the same period in 2003 due to an increase in license revenue across all products, primarily Clintrial, as well as an increase in InForm application hosting services. The increase in license revenue in the six months ended June 30, 2004 was primarily due to an increase in sales of Clintrial into our existing InForm customer base. This increase was a result of our continued strategy to expand the usage of our software products by cross selling the InForm, Clintrial and Clintrace products to our existing customer base, additional utilization of our products within our customer base and sales to new customers. The increase in revenue associated with the Inform application hosting services in the six months ended June 30, 2004 was due an increase in clinical trials under management. The increase in consulting services revenue for the six months ended June 30, 2004 was due primarily to an increase in consulting services associated with integrated enterprise solutions of our products to our existing InForm customer base compared to the same period in 2003. The decrease in customer support revenue for the six months ended June 30, 2004 was due primarily to a reduction in the Clintrial and Clintrace maintenance renewal base as a result of the conversion of the former Clinsoft customers to term-based licenses that have a lower customer support fee. In the future, we anticipate that license revenue will become a more significant component of total revenues.

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     The increase in revenues worldwide was due primarily to the increase in sales of our Clintrial products and InForm application hosting services, which we believe reflects a continued increase in the worldwide adoption of our products.

Cost of Revenues

     The cost of license revenue decreased in the six months ended June 30, 2004 primarily due to an $800,000 decrease in amortization expense from acquired technologies partially offset by an increase in royalty expense of $378,000 as revenue increased on certain modules of the Clintrial software product, and to a lesser extent, the Japanese version of our InForm software product. The decrease in the cost of services for the six months ended June 30, 2004 was due primarily to a $196,000 reduction in expense resulting from the incremental capitalization of deferred setup costs related to an increase in the number of new clinical trials in the trial design, setup and implementation phase. This increase was associated with an increase in new clinical trial activity from both existing and new customers. Additionally, cost of services decreased for the six months ended June 30, 2004 due to a decrease in depreciation and facilities expense of $201,000 and $205,000, respectively, primarily resulting from cost savings associated with the relocation of our corporate headquarters in the fourth quarter of 2003. This was partially offset by a $175,000 increase in employee and related expenses and an increase of $48,000 in stock-based compensation.

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Gross Margin