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UNITED STATES OF AMERICA

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended April 30, 2003

OR

Commission file number: 0-29757

VERSATA, INC.

(Exact name of registrant as specified in its charter)

300 Lakeside Drive Suite 1500

Oakland, CA 94612

(Address including zip code, of principal executive offices)

(510) 238-4100

(Registrant’s telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 ¨    No x

As of May 30, 2003, the total number of outstanding shares of the Registrant’s common stock was 7,431,944.

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VERSATA, INC.

FORM 10-Q QUARTERLY REPORT

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PART I. FINANCIAL INFORMATION

Item 1.    Financial Statements

VERSATA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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VERSATA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except per share data)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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VERSATA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements

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VERSATA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    The Company

Versata, Inc. (“Versata” or the “Company”) was incorporated in California on August 27, 1991, and was reincorporated in the State of Delaware on February 24, 2000. Versata provides a business logic management system that enables the creation, execution, change and re-use of business logic (the “heart” of the application) for companies to build large, distributed applications in the Java 2, Enterprise Edition (“J2EE”) infrastructure. Versata provides a declarative approach for transaction and process logic, which enables companies to deliver business logic as a key strategic asset of their enterprise architecture.

On May 24, 2002, the Company implemented a one for six reverse stock split. Although there were no guarantees, the reverse stock split was implemented to allow the Company’s common stock to trade above the $1.00 per share minimum bid price as required by NASDAQ Marketplace Rules, and therefore, to help the Company to continue its listing on the NASDAQ National Market. All shares and per share amounts in these condensed consolidated financial statements have been restated to give effect to this reverse stock split.

2.    Interim Financial Information and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements as of April 30, 2003, and for the three and six months ended April 30, 2003 and 2002 include the accounts of Versata and its subsidiaries, all of which are wholly owned and located in North America, Europe and Australia. All intercompany accounts and transactions have been eliminated in consolidation. Certain prior year balances have been reclassified to conform to the current year presentation.

We have prepared the condensed consolidated financial statements included herein, without audit, in accordance with accounting principles generally accepted in the United States of America for interim financial statements and pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been condensed or omitted pursuant to such rules and regulations.

We believe that all necessary adjustments, consisting of only normal recurring items, have been included in the accompanying financial statements to fairly present the results of the interim periods. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for our fiscal year ended October 31, 2003. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes for the fiscal year ended October 31, 2002.

3.    Recent Accounting Pronouncements

In June 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 146, Accounting for Exit or Disposal Activities (“SFAS 146”). SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under Emerging Issues Task Force (“EITF”) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring) (“EITF 94-3”). The scope of SFAS 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 and early application is encouraged. The Company adopted SFAS 146 during the quarter ended January 31, 2003. The provisions of EITF 94-3 shall continue to apply for an exit activity initiated under an exit plan that met the criteria of EITF No. 94-3 prior to the adoption of SFAS 146. The effect on adoption of SFAS 146 will change on a prospective basis the timing of when restructuring charges are recorded from a commitment date approach to when the liability is incurred.

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VERSATA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

In November 2002, the EITF reached a consensus on Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). EITF 00-21 sets out criteria for determining whether revenue on a deliverable can be recognized separately from other deliverables in a multiple deliverable arrangement. The criteria considers whether the delivered item has stand-alone value to the customer, whether the fair value of the delivered item can be reliably determined and the rights of return for the delivered item. EITF 00-21 will be effective for fiscal periods beginning after June 15, 2003. We do not believe the adoption of EITF 00-21 will have a material impact on our consolidated financial position, results of operations or cash flows.

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123 (“SFAS 148”). This amendment provides alternative methods of transition for voluntary change to the fair value based method of accounting for stock-based employee compensation. Additionally, prominent disclosures in both annual and interim financial statements are required for the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted SFAS 148 during the quarter ended April 30, 2003 and we have provided the disclosures required under SFAS 148 in Note 4.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We do not believe the adoption of SFAS 150 will have a material impact on our consolidated financial position, results of operations or cash flows.

4.    Stock Based Compensation Plans

We account for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and Financial Accounting Standards Board Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (“FIN 28”), and we comply with the disclosure provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Under APB 25, compensation expense is based on the difference, if any, on the date of grant, between the fair value of our Company’s common stock and the exercise price. SFAS 123 defines a “fair value” based method of accounting for an employee stock option or similar equity investment. We account for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Financial Accounting Standards Board Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services (“EITF 96-18”).

Pro forma information regarding net loss and net loss per share is required by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), which also requires that the information be determined as if our Company has accounted for its employee stock options granted under the fair value method. The fair value for these options was estimated using the minimum value method for periods to the date of our initial public offering and the Black-Scholes option-pricing model thereafter.

The following table illustrates the effect on net income and earnings per share as if the fair value based method had been applied to al outstanding and unvested awards in each period (in thousands, except per share data):

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VERSATA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5.    Restructuring and Other

The following table summarizes the restructuring and other activity during the six months ended April 30, 2003 (in thousands):

In November 2002 we received $950,000 from a subtenant as a result of the termination of a sublease agreement between us and the subtenant as of October 31, 2002 and our releasing the subtenant from its liabilities under the terms of a Termination of Sublease Agreement. As a result of the termination of the sublease, we increased our restructuring reserve during the quarter ended January 31, 2003, for the space occupied by the subtenant. The amount received from the subtenant was not recorded as income, but rather is reflected as an offset to the original estimate of future sublease income and is included in additions to the reserve.

6.    Net Loss Per Share

Basic and diluted net loss per share is computed by dividing the net loss available to holders of common stock for the period by the weighted average number of shares of common stock outstanding during the period. The calculation of diluted net loss per share excludes potential common stock if the effect is antidilutive. Potential common stock consists of 47,000 and 197,000 shares of unvested restricted common stock, and 1,079,000 and 933,000 shares of outstanding stock options as of April 30, 2003 and 2002, respectively.

The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share amounts):

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VERSATA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

7.    Legal Proceedings

Securities Class Action and State Derivative Actions

Since April 11, 2001, several securities class action complaints have been filed against us, and certain of our current and former officers and directors. In August 2001, the class action lawsuits were consolidated in the United States District Court for the Northern District of California. On October 19, 2001, the lead plaintiffs filed an amended class action complaint naming us and certain of our former officers and a current director as defendants. The amended class action complaint alleges claims under section 10(b) and section 20(a) of the Securities Exchange Act of 1934 and claims under sections 11 and 15 of the Securities Act of 1933. The amended complaint sought an unspecified amount of damages on behalf of persons who purchased our stock during the class period between March 31, 2000 and April 30, 2001. In July 2002, the parties reached an agreement to settle the class action lawsuit in order to avoid protracted and expensive litigation and the uncertainty of the outcome at a trial. The agreement for settlement does not constitute any admission of wrongdoing on the part of Versata or the individual defendants. Our settlement calls for a payment of $9.75 million in cash by our insurance carriers, the issuance of 200,000 shares of our common stock, and for certain corporate therapeutics. The holders of the settlement stock have a put option of $3.50 per share during a period of 20 trading days commencing one year from the date of distribution; provided however, the put options shall expire if Versata shares trade above $3.50 per share for 15 consecutive trading days during the one year period following the date of distribution of the settlement stock. On February 14, 2003, the court approved the settlement agreement. We accrued $700,000 for this liability in accrued restructuring and other in fiscal 2002.

Since June 11, 2001, three derivative actions have been filed on our behalf against certain current and former officers and directors in Superior Court of Alameda County, California. The complaints also name the Company as a nominal defendant. The complaints allege that the defendants breached their fiduciary duties, abused their control of the corporation, and engaged in gross mismanagement of the corporation, by allegedly making or permitting the Company to make false financial statements and seek, among other things, compensatory damages. In July 2002, in conjunction with the settlement of the securities litigation discussed above, the parties reached an agreement to settle the derivative action. The settlement calls for certain corporate therapeutics included in the settlement of the securities litigation discussed above. As discussed, the agreement for settlement does not constitute any admission of wrongdoing on the part of Versata or the individual defendants. On February 14, 2003, the settlement agreement was approved by the court.

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Forward-Looking Statements

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties and are based on the beliefs and assumptions of our management, based on the information currently available to our management. These statements may contain words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” or other words indicating future results. These statements are based on judgments with respect to, among other things, information available to us, future economic, competitive and market conditions and future business decisions. All are difficult or impossible to predict accurately and many of which are beyond our control. Accordingly, although we believe that the assumptions underlying the forward-looking statements are reasonable, any such assumption could prove to be inaccurate and therefore there can be no assurance that the results contemplated in the forward-looking statements will be realized. Factors that could cause or contribute to these differences include, but are not limited to, those discussed in the sections entitled “Risk Factors That May Affect Future Results”. In light of significant uncertainties inherent in forward looking information included in this report on Form 10-Q, the inclusion of such information should not be regarded as a representation that our plans and objectives will be achieved. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements.

Overview

We provide software and services that accelerate and simplify the way business logic is developed and maintained for enterprise applications. Business logic is an umbrella term referring to the aggregated set of business rules and business processes that govern and define a business’ operations. Business logic is a critical part of today’s new generation of enterprise applications, which are increasingly built in the Java 2, Enterprise Edition (J2EE) programming language.

From our incorporation in August 1991 through December 1994, we were a professional services company and generated revenue from technical consulting projects. In January 1995, we commenced development efforts on our initial software products, from which we generated revenue in late 1995 through early 1998. In September 1996, we began development of our first Web-based software product, which we began shipping commercially in September 1997. In September 1998, we introduced the first generation of what is now our suite of software products. To date, we have licensed our products and provided services to over 500 customers around the world.

We derive our revenue from licensing our software and from the sale of related services. Our software is generally priced on a per central processing unit (“CPU”) basis. Maintenance and support revenue includes product maintenance, which provides the customer with unspecified software upgrades over a specified term, typically twelve months, and customer support which is priced based on the particular level of support chosen by the customer. Professional services revenue consists of fees from consulting, training, mentoring, staff augmentation and project management or rapid requirements development to complete turnkey solution services. Customers typically purchase these professional services from us to enlist our support by way of training and mentoring activities directed at optimizing the customer’s use of our software product. Professional services are sold generally on a time-and-materials basis.

We market our products and services through our direct sales force, international distributors, consulting and system integration partners, companies that sell pre-packaged software applications and companies that custom develop and integrate software applications. Our revenues to date have been derived predominantly from customers in North America and Europe.

Our cost of software license revenue consists of royalty payments to third parties for technology incorporated into our products, the cost of manuals and product documentation, as well as packaging, distribution and electronic delivery costs. Our cost of maintenance and support revenue consists of salaries of support personnel. Our cost of professional services revenue consists of salaries of professional service personnel and payments to third party consultants incurred in providing training, and consulting services. Cost of professional services revenue as a percentage of professional services revenue is likely to vary significantly from period to period depending on overall utilization rates, the mix of services we provide and whether these services are provided by us or by third-party contractors.

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Since our inception, we have incurred substantial costs to develop our technology and products, to recruit and train personnel for our product development, sales and marketing and professional services departments, and to establish our administrative infrastructure. To date, all software development costs have been expensed in the period incurred as such costs do not meet the requirements for capitalization under SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed (“SFAS 86”). Historically, our operating expenses have exceeded the revenue generated by our products and services. As a result, we have incurred net losses in each quarter since inception.

Segment Information

Versata identifies its operating segments based on the business activities, management responsibility and geographical location. For both periods presented, Versata operated in a single business segment. Revenue for geographic regions reported below is based upon the customers’ locations. Following is a summary of the geographic information related to revenues (in thousands):

Results of Operations

The following table sets forth, for the periods indicated, the percentage of total revenue represented by the lines in our Unaudited Condensed Consolidated Statements of Operations:

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Revenue

Total Revenue. Total revenue consists of software license revenue, maintenance and support revenue, and professional services revenue. Total revenue for the three months ended April 30, 2003 was flat compared to the three months ended April 30, 2002 with revenue for both quarters at $4.5 million Total revenue for the six months ended April 30, 2003 decreased 13% compared to the six months ended April 30, 2002 with revenue for the six months ended April 30, 2003 at $9.6 million compared to $11 million for the six months ended April 30, 2002.

Software License Revenue. Software license revenue increased by approximately $884,000, or 89% to $1.9 million in the three months ended April 30, 2003 from $1 million in the three months ended April 30, 2002. Software license revenue increased by approximately $458,000, or 11% to $4.6 million for the six months ended April 30, 2003 from $4.1 million for the six months ended April 30, 2002. The increase was mainly attributable to two large sales in the April 2003 quarter. Compared to 2002, we are selling more into our existing customer base and are seeing orders, in many cases, for deployment and production licenses as customers finish applications and need to purchase software for deployment.

Maintenance and Support Revenue. Maintenance and support revenue for the three months ended April 30, 2003 was flat compared to the three months ended April 30, 2002 with revenue for both quarters at $1.5 million. Maintenance and support revenue increased by approximately $185,000, or 7% to $2.9 million for the six months ended April 30, 2003 from $2.7 million for the six months ended April 30, 2002. The increase is primarily attributable to continuing maintenance and support agreements on prior license deals.

Professional Services Revenue. Services revenue decreased by $1 million, or 48%, to $1.1 million in the three months ended April 30, 2003 from $2 million in the three months ended April 30, 2002. Services revenue decreased by $2 million, or 49%, to $2.1 million for the six months ended April 30, 2003 from $4.1 million for the six months ended April 30, 2002. This decrease in services revenue is due to several factors. The primary factor is our high volume of sales to existing customers who are becoming more proficient with our products and therefore require less professional services and mentoring to develop new applications. We believe this trend is likely to continue through the end of the fiscal year. Additionally, as customers continue to face severe budget constraints, they are less willing to outsource development efforts when internal staff is not fully utilized.

Cost of Revenue

Total Cost of Revenue. Total cost of revenue decreased by $623,000, or 30%, to $1.5 million in the three months ended April 30, 2003 from $2.1 million in the three months ended April 30, 2002. Total cost of revenue decreased by $1.4 million, or 33%, to $2.8 million for the six months ended April 30, 2003 from $4.2 million for the six months ended April 30, 2002. This decrease was primarily attributable to management’s restructuring plan initiated to better align our costs with our revenue.

Cost of Software License Revenue. Cost of license revenue consists of royalties paid to third party vendors for use of their product embedded in ours. Cost of software license revenue increased by $100,000, or 263%, to $138 thousand for the three months ended April 30, 2003 from $38 thousand for the three months ended April 30, 2002. Cost of software license revenue increased by $80,000, or 75%, to $186,000 for the six months ended April 30, 2003 from $106,000 for the six months ended April 30, 2002. The increase is primarily a result of an accrual for a $95,000 settlement with a vendor for additional third party royalty costs.

Cost of Maintenance and Support Revenue. Cost of maintenance and support revenue consists of salaries of support personnel. Cost of maintenance and support revenue increased by $61,000, or 17%, to $422,000 for the three months ended April 30, 2003 from $361,000 for the three months ended April 30, 2002. Cost of maintenance and support revenue increased by $86,000, or 12%, to $786,000 for the six months ended April 30, 2003 from $700,000 for the six months ended April 30, 2002. The increase is a result of increased revenues and the result of continuing to support our current maintenance and support agreements.

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Cost of Professional Services Revenue. Cost of service revenue consists of salaries of professional service personnel and payments to third party consultants incurred in providing training and consulting services. Cost of service revenue decreased by $784,000, or 47%, to $892,000 for the three months ended April 30, 2003 from $1.7 million for the three months ended April 30, 2002. Cost of service revenue decreased by $1.6 million, or 45%, to $1.9 million for the six months ended April 30, 2003 from $3.4 million for the six months ended April 30, 2002. This decrease was mainly attributable to the decrease in headcount in professional services and a reduction in the use of independent contractors. As of April 30, 2003, we had 19 employees in professional services as compared to 30 employees on April 30, 2002.

Gross Profit

Gross Profit. Gross profit increased by $558,000, or 23%, to $3 million in the three months ended April 30, 2003 from $2.5 million in the three months ended April 30, 2002. Gross profit for the six months ended April 30, 2003 was flat compared the six months ended April 30, 2002 with gross profit at $6.7 million for both periods.

Operating Expenses

Operating Expenses. Operating expenses decreased $2.3 million, or 35%, to $4.3 million in the three months ended April 30, 2003 from $6.6 million in the three months ended April 30, 2002. Operating expenses decreased $4.3 million, or 32%, to $9.1 million for the six months ended April 30, 2003 from $13.4 million for the six months ended April 30, 2002. The majority of the decrease was due to our cost-cutting initiatives and reductions in our workforce.

Sales and Marketing. Sales and marketing expense consists of salaries, sales commissions, partners commissions, travel and entertainment expense, and marketing programs. Sales and marketing expense decreased by $685,000, or 29%, to $1.6 million in the three months ended April 30, 2003 from $2.3 million in the three months ended April 30, 2002. Sales and marketing expense decreased by $2.1 million, or 39%, to $3.3 million for the six months ended April 30, 2003 from $5.3 million for the six months ended April 30, 2002. These decreases were largely attributable to approximately $853,000 reduction in salary and benefit expenses for the six months ended April 30, 2003. In addition, sales and marketing expenses were lower for the six months ending April 30, 2003 as a result of decreased spending on marketing programs of $438,000 and a decrease of consulting expense of $84,000, offset by additional partner commissions of $169,000. As of April 30, 2003, we had 26 employees in sales and marketing as compared to 40 employees on April 30, 2002.

Product Development. Product development expense includes costs associated with the development of new products, enhancements to existing products, quality assurance and technical publication activities. These costs consist primarily of employee salaries and the cost of consulting resources that supplement our product development teams. Product development expense decreased by $121,000, or 9%, to $1.2 million in the three months ended April 30, 2003 from $1.4 million in the three months ended April 30, 2002. Product development expense decreased by $183,000, or 6%, to $2.7 million for the six months ended April 30, 2003 from $2.9 million for the six months ended April 30, 2002. All software development costs are expensed in the period incurred as they do not meet the requirements for capitalization under SFAS No. 86. As of April 20, 2003, we had 31 employees in product development as compared to 37 employees as of April 30, 2002.

General and Administrative. General and administrative expense consists of salaries for executive, finance and administrative personnel, information systems costs and bad debt expense. General and administrative expense decreased by $731,000, or 53%, to $657,000 in the three months ended April 30, 2003 from $1.4 million in the three months ended April 30, 2002. General and administrative expense decreased by $1.2 million, or 45%, to $1.5 million for the six months ended April 30, 2003 from $2.7 million for the six months ended April 30, 2002. The decrease was due to a reduction in salary and benefit expense of $331,000 for the six months ending April 30, 2003 versus the six months ending April 30, 2002 related to the reductions in the number of general and administrative employees. Professional fees and outside labor costs decreased by $236,000 for the six months ending April 30, 2003 compared to the six months ended April 30, 2002, as a result of our cost cutting efforts and lower costs for external audit functions. As of April 20, 2003, we had 14 employees in general and administrative as compared to 21 employees as of April 30, 2002

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Stock-Based Compensation. Stock-based compensation expense includes the amortization of unearned employee stock-based compensation, offset by reversals of previously expensed amounts for cancellations of the related options. Employee stock-based compensation expense is amortized on an accelerated basis (under FIN 28) over the vesting period of the related options, generally 50 months. Stock-based compensation expense also includes expenses for stock options granted to consultants and employees in exchange for services. Stock-based compensation expense decreased by $229,000, or 65%, to $121,000 for the three months ended April 30, 2003 from $350,000 for the three months ended April 30, 2002. Stock-based compensation expense decreased by $268,000, or 48%, to $294,000 for the six months ended April 30, 2003 from $562,000 for the six months ended April 30, 2002. Additional unvested outstanding options will continue to vest over the next 11 months, which will result in additional compensation expense of approximately $135,000 in the aggregate in periods subsequent to April 30, 2003. This future expense will be reduced in the event of related option cancellations for employee terminations.

Amortization of Intangibles. Intangible assets consist of purchased technology that are being amortized on a straight-line basis over the expected life of three years. Amortization expense decreased by $38,000, or 7%, to $500,000 for the three months ended April 30, 2003 from $538,000 for the three months ended April 30, 2002. Amortization expense decreased by $42,000, or 4%, to $973,000 for the six months ended April 30, 2003 from $1 million for the six months ended April 30, 2002. The assets will be fully amortized by the end of fiscal 2003.

Restructuring and Other. Restructuring expense for the three months ended April 30, 2003 was $83,000, down $496,000, or 86%, from $579,000 for the three months ended April 30, 2002. Our restructuring expense this quarter was primarily related to severance costs. Restructuring expense for the six months ended April 30, 2003 was $406,000, down $482,000, or 54%, from $888,000 for the six months ended April 30, 2002. The decrease is primarily due to our restructuring efforts in prior periods resulting in expense controls over the last year and the stabilization of costs. Our restructuring expense for the six months ended April 30, 2003 was primarily related to unused office space.

Interest Income, Net. Interest income, net, is primarily comprised of interest income from our cash and investments offset by interest paid on our equipment loan and capital lease obligations. We had net interest income of $41,000 for the three months ended April 30, 2003, a decrease of $65,000, or 61%, compared to net interest income of $106,000 for the three months ended April 30, 2002. We had net interest income of $122,000 for the six months ended April 30, 2003, a decrease of $121,000, or 50%, compared to net interest income of $243,000 for the six months ended April 30, 2002. The reduction in interest income is primarily due to our reduced cash balance and lower interest rates earned.

Benefit (Provision) for Taxes. We have incurred operating losses for all periods from inception through April 30, 2003. We have recorded a valuation allowance for the full amount of our deferred tax assets, as the future realization of the tax benefits is uncertain. During the three months ended April 30, 2003 we reduced our accrued liability for a local tax by approximately $45,000 which resulted in a benefit for taxes during the period.

Liquidity and Capital Resources

Since inception, we have funded our operations primarily through the private sale of our equity securities and our initial public offering, resulting in aggregate net proceeds of $167.2 million. We have also funded our operations through equipment financing. As of April 30, 2003, we had $16.5 million in cash and cash equivalents and short-term investments, $11.4 million in working capital and $5.0 million in restricted cash. Cash and cash equivalents consist of highly liquid investments in time deposits held at major banks, commercial paper, United States government agency discount notes, money market mutual funds and other money market securities with original maturities of 90 days or less. Short-term investments include similar highly liquid investments with maturities between 91 days and 365 days. Working capital is current assets less current liabilities. Restricted cash consists primarily of a time deposit held at a major bank that secures an irrevocable letter of credit for the benefit of our landlord in lieu of a cash security deposit.

Net cash used in operating activities was $193,000 and $6.1 million for the six months ended April 30, 2003 and 2002, respectively. Net cash used in operating activities in each period reflects net losses offset by non-cash expenses, primarily depreciation and amortization and stock-based compensation. Net cash used in operating activities was also impacted by changes in working capital. During the fiscal 2003 period, cash flows from operating activities decreased primarily due to decreases in accounts payable and accrued liabilities and increased primarily due to increases in accrued restructuring and other. During the fiscal 2002 period, cash flows from operations decreased primarily due to decreases in accounts payable and decreases in accrued restructuring and other and increased primarily due to decreases in trade receivables.

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Net cash provided by investing activities was $1.8 million for the first six months of fiscal 2003 primarily due to the proceeds from sales of short-term investments. Net cash used in investing activities was $251,000 for the first six months of fiscal 2002 primarily due to purchases of short-term investments.

Net cash used in financing activities was $246,000 for the first six months of fiscal 2003 primarily due to principal payments on capital lease obligations and long term debt. Net cash provided by financing activities was $854,000 for the first six months of fiscal 2002 primarily due to the proceeds from the sale of shares held by a former officer.

We believe that our cash and cash equivalents and short-term investments as of April 30, 2003 will be sufficient to meet our general expenses, working capital and capital expenditure requirements for at least the next twelve months. However, we may find it necessary to obtain additional equity or debt financing in fiscal 2004 or beyond. In the event additional financing is required, we may not be able to raise it on acceptable terms or at all.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. In specific, management uses judgments and estimates in recognizing revenues, determining gains and losses on foreign currency, accruing contingencies, establishing the allowance for doubtful accounts, assessing the realizability of long-lived assets, and applying significant assumptions to the future obligations for office closure and sublease accruals. On an on-going basis, we evaluate our estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following are critical accounting policies and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We derive revenue from three sources as follows: (i) sale of software licenses to end users, value added resellers (“VAR’s”), distributors, system integrators and independent software vendors (“ISV’s”), (ii) maintenance and support of license holders (post-contract customer support or “PCS”) and (iii) services which include consulting, training, and mentoring. This policy establishes the standards for ensuring we recognize revenue consistently, and in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”), as amended.

Under SOP 97-2, we record revenue from licensing of software products to end-users and system integrators, who use our software to build systems for their customers, when both parties sign a license agreement, the fee is fixed or determinable, collection is reasonably assured and delivery of the product has occurred. For VAR’s and distributors, we recognize revenue upon notification of sell-through, provided all other revenue recognition criteria are met. For sales to certain ISV’s, where we receive non-refundable royalty payments and there is no obligation to provide PCS to the partner or the end user, we recognize the license revenue when paid, provided all other revenue recognition criteria are met. When additional fees are paid for PCS, the amounts are deferred and revenue is recognized ratably over the period of the contracts, which is generally twelve months.

Generally, we provide payment terms that range from thirty to ninety days from the invoice date. Accordingly, payment terms that exceed ninety days are not considered fixed or determinable and revenue is recognized as payments become due.

When contracts contain multiple elements, and for which vendor specific objective evidence (“VSOE”) of fair value exists for the undelivered elements, we recognize revenue for the delivered elements based upon the residual method. VSOE is generally the price for products sold separately or the renewal rate in the agreement for PCS. Undelivered elements consist primarily of PCS and other services such as consulting, mentoring and training. Services are generally not considered essential to the functionality of the software. We recognize revenue allocated to PCS ratably over the period of the contracts, which is generally twelve months. For revenue related to consulting services, we recognize revenue as the related services are performed. In instances where services are deemed essential to the software, both the software license fee and consulting fees are recognized using the percentage-of-completion method of contract accounting as required under SOP 81-1.

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The portion of fees related to products delivered or services rendered which are not due under our Company’s standard payment terms are reflected in deferred revenue and in unbilled receivables.

Significant management judgments and estimates must be made in connection with determination of the revenue to be recognized in any accounting period. If we made different judgments or utilized different estimates for any period, material differences in the amount and timing of revenue recognized could result.

Determining Functional Currencies for the Purpose of Consolidation

In preparing our consolidated financial statements, we are required to translate the financial statements of our foreign subsidiaries from the currency in which they keep their accounting records, generally the local currency, into United States dollars. This process results in exchange gains and losses which, under the relevant accounting guidance, are either included within the statement of operations or as a separate part of our stockholders’ equity under the caption “cumulative translation adjustment.”

If any subsidiary’s functional currency is deemed to be the local currency, then any gain or loss associated with the translation of that subsidiary’s financial statements is included in cumulative translation adjustments. If we dispose of any of our subsidiaries, any cumulative translation gains or losses would be realized in our statement of operations. If we determine that there has been a change in the functional currency of a subsidiary to the United States dollar, any translation gains or losses arising after the date of change would be included within our statement of operations.

The magnitude of these gains or losses is dependent upon movements in the exchange rates of the foreign currencies in which we transact business against the United States dollar. These currencies include the United Kingdom Pound Sterling, the Euro, the Indian Rupee, Australian and Canadian dollars. Any future translation gains or losses could be significantly higher than those noted in each of these periods. In addition, if we determine that a change in the functional currency of one of our subsidiaries has occurred at any point in time, we would be required to include any translation gains or losses from the date of change in our statement of operations.

Cash and cash equivalents and short-term investments

We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Our short-term investments consist of debt securities with maturities greater than three months at the date of purchase. We classify all short-term investments as available for sale in accordance with Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, (“SFAS 115”). Accordingly, our short-term investments are carried at fair value as of the balance sheet date. Unrealized gains and losses are reported net of taxes as a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. At each period end presented, amortized cost approximated fair value and unrealized gross gains or losses were insignificant, and during each of the periods presented, realized gains were insignificant.

Allowance for Doubtful Accounts

We make judgments as to our ability to collect outstanding receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices. For those invoices not specifically reviewed, provisions are provided at differing rates, based upon the age of the receivable. In determining these percentages, we analyze our historical collection experience and current economic trends. If the historical data we use to calculate the allowance provided for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and the future results of operations could be materially affected.

Property and equipment

Property and equipment is stated at cost and is depreciated using the straight-line method over the estimated useful lives of the related assets, which range from two to five years. Leasehold improvements are amortized on a straight-line basis over the life of the lease or the estimated useful life of the asset, whichever is shorter. Equipment under capital lease is amortized using the straight-line method over the lesser of the lease term or their estimated useful lives.

Major additions and improvements are capitalized, while replacements, maintenance, and repairs that do not improve or extend the life of the assets are charged to expense. In the period assets are retired or otherwise disposed of, the cost and related accumulated depreciation and amortization are removed from the accounts, and any gain or loss on disposal is included in results of operations.

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Intangibles

Intangibles are accounted for in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142”), which is effective for fiscal years beginning after December 31, 2001. SFAS 142 requires, among other things, the discontinuance of goodwill amortization and includes provisions upon adoption for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for the impairment of existing goodwill and other intangibles. Versata adopted SFAS 142 effective November 1, 2001.

Restructuring and other costs

Certain expenses incurred in the reorganization of the Company’s operations are considered to be restructuring expenses. Restructuring provisions are determined based on estimates prepared at the time the restructuring actions are approved by management. Office closure and sublease accruals are primarily related to future minimum lease payments for excess office space at the Company’s corporate headquarters, offset by payments received by the Company from subtenants in the space. Management uses estimates and applies significant assumptions to the future obligations for office closure and sublease accruals and although we base our estimates on various assumptions that are believed to be reasonable under the circumstances, actual results may differ from these estimates under different assumptions or conditions. Severance accruals are primarily related to future severance payments to employees that have been terminated from the Company. Other costs reflect the anticipated costs of the settlement agreement for the Securities Class Action and State Derivative Actions described in the Legal Proceedings footnote in the attached notes to condensed consolidated financial statements.

Software development costs

Software development costs are included in product development and are expensed as incurred. After technological feasibility is established, material software development costs are capitalized in accordance with Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed (“SFAS 86”). The capitalized cost is then amortized on a straight-line basis over the estimated product life, or in the ratio of current revenues to total projected product revenues, whichever is greater. The Company has defined technological feasibility as the establishment of a working model, and typically occurs when the beta testing commences, To date, the period between achieving technological feasibility and the general availability of such software has been short and software development costs qualifying for capitalization have been insignificant. Accordingly, the Company has not capitalized any software development costs.

Risk Factors That May Affect Future Results

We operate in a rapidly changing environment that involves numerous risks and uncertainties. The following section lists some, but not all, of these risks and uncertainties, which may have a material adverse effect on our business, financial condition or results of operations. Investors should carefully consider the following risk factors in evaluating an investment in our common stock.

Continued Weakening of World Wide Economic Conditions Realized in the Internet Infrastructure Software Market May Result in Decreased Revenues or Lower Revenue Growth Rates.

The revenue growth of our business depends on the overall demand for computer software, particularly in the product segments in which we compete. The slowdown of the worldwide economy affects the buying decision of corporate customers, such as it has in the recent years. Because our sales are primarily to Global 2000 customers, our business also depends on general economic and business conditions. A further reduction in demand for computer software, caused by the further weakening of the economy, may result in decreased revenues or lower revenue growth rates.

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If We Do Not Effectively Compete With New and Existing Competitors, Our Revenues and Operating Margins Will Decline.

The Internet infrastructure software market in general, and the market for our software and related services in particular, are new, rapidly evolving and highly competitive. Many of our competitors, including but not limited to IBM, Microsoft, Oracle, BEA Systems, Inc., and Sun Microsystems have longer operating histories and significantly greater financial, technical, marketing and other resources than we do. For example, IBM, who we have a strategic relationship with, recently announced the launch of a new product, IBM Rational Rapid Developer, that the market may deem to compete with our development software, the Versata Logic Studio. Although we believe that our Versata Logic Studio does not directly compete with IBM’s Rational Rapid Developer, we may not be able to successfully or sufficiently differentiate our product from IBM’s product. Additionally, IBM’s continued efforts in the J2EE market could materially and adversely affect our business, operating results and financial condition.

Our competitors, such as the ones mentioned herein; also have more extensive customer bases, broader customer relationships and broader industry alliances that they could leverage, thereby establishing relationships with many of our current and potential customers. These companies also have significantly more established customer support and professional service organizations. In addition, these companies may adopt aggressive pricing policies or offer more attractive terms to customers, may bundle their competitive products with broader product offerings or may introduce new products and enhancements. Furthermore, current and potential competitors may establish cooperative relationships among themselves or with third parties to enhance their products. As a result, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. If we fail to compete successfully with our competitors, the demand for our products would decrease. Any reduction in demand could lead to loss of market share, a decrease in the price of our products, fewer customer orders, reduced revenues, reduced margins, and increased operating losses. These competitive pressures could seriously harm our business and operating results.

New Versions and Releases of Our Products May Contain Errors or Defects and Result in Loss of Revenue.

The software products we offer are complex and, despite extensive testing and quality control, may have had, and in the future could have errors or defects, especially when we first introduce them. Typically we need to issue corrective releases of our software products to fix any defects or errors. Defects or errors could also cause damage to our reputation, loss of revenues, product returns or order cancellations, lack of market acceptance of our products, and expose us to litigation. Accordingly, defects or errors particularly if they are more numerous than expected could have a material and adverse effect on our business, results of operations and financial condition.

Our Failure to Accurately Forecast Sales May Impact our Cost Structure.

Our Company uses a “pipeline” system, a common industry practice, to forecast sales and trends in our business. Our sales personnel monitor the status of all proposals, such as the date when they estimate that a customer will make a purchase decision and the potential dollar amount of the sale. We aggregate these estimates periodically in order to generate a sales pipeline. We compare the pipeline at various points in time to look for trends in our business. While this pipeline analysis may provide us with some guidance in business planning and budgeting, these pipeline estimates are necessarily speculative and may not consistently correlate to revenues in a particular quarter or over a longer period of time. A variation in the conversion of the pipeline into contracts or in the pipeline itself could cause our Company to improperly plan or budget and thereby adversely affect our business or results of operations. In particular, the current slowdown in the economy is causing purchasing decisions to be delayed, reduced in amount or cancelled which will therefore reduce the overall license pipeline conversion rates in a particular period of time.

The Price of Our Common Stock is Volatile, and It May Fluctuate Significantly.

The market price of our common stock has fluctuated significantly and has declined sharply since our initial public offering in March 2000 and most recently in 2002. Our Company’s stock price is affected by a number of factors, some of which are beyond our control, including:

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As a result, our stock price is subject to significant volatility. In the past, following periods of volatility or decline in the market price of a company’s securities, securities class action litigation has at times been instituted against that company. Although we have settled the private securities class action lawsuit brought against us and certain of our former officers and directors, we may be subject to additional litigation with a few class members who have opted out of joining the class for the settlement purposes. This could cause us to incur substantial costs and experience a diversion of management’s attention and resources.

Any Potential Delisting of Versata’s Common Stock from the NASDAQ National Market Could Harm Our Business.

Versata’s common stock trades on the NASDAQ National Market, which has certain compliance requirements for continued listing of common stock. Although in May 2003 we received notification from the NASDAQ Listing Qualifications Panel that we regained full compliance with the minimum bid price of $1 listing requirement and minimum market value of publicly held shares of $5 million listing requirement, if we fail to meet these listing requirements again, or any other listing requirements, as our stock has been significantly volatile in the recent years, we may be subject to delisting.

Our Quarterly Revenues and Operating Results May Fluctuate in Future Periods.

Our revenues are relatively difficult to forecast and vary from quarter to quarter due to various factors including:

Accordingly, our quarterly results are difficult to predict until the end of the quarter. Delays in product delivery or closing of sales near the end of a quarter caused quarterly revenues and net income to fall significantly short of anticipated levels in the past year, and given the current economic slowdown, may well occur in future quarters.

Our license revenues in any quarter are substantially dependent on orders booked and shipped in that quarter. We typically receive and fulfill a majority of our orders within the quarter, with the substantial majority of our orders received in the last month of each fiscal quarter. As a result, we may not learn of revenue shortfalls until late in a fiscal quarter, after it is too late to adjust expenses for that quarter. Since our operating expenses are relatively fixed and are based on anticipated revenue levels, a delay in bookings from even a small number of license transactions could cause significant variations in revenues quarter to quarter and could cause net income to fall significantly short of anticipated levels. As an example, the dollar amounts of large orders for our products have been increasing and therefore the operating results for a quarter could be materially and adversely affected if a number of large orders are either not received or are delayed, due to cancellations, delays, or deferrals by customers. Revenue shortfalls below our expectations could have an immediate and significant adverse effect on our results of operations.

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Our services revenue in any quarter is substantially dependent on our license revenue. Services are normally purchased in conjunction with software licenses, although it is not a requirement. Should our license revenues decrease, there will be a reduced market for our services. Any revenue shortfall in services could have an immediate and significant adverse effect on our results of operations.

If our customers do not renew their product support and maintenance agreements, we may lose a recurring revenue stream, which could harm our operating results.

Many of our customers subscribe for software support and maintenance services, which we recognize over the term of those support and maintenance agreements. In fiscal year 2002, our maintenance and support revenue accounted for 29% of our total revenue. If a significant portion of those customers chose not to continue subscribing for product support and maintenance, our recurring revenue from those services would be adversely affected, which could harm our business, operating results and financial condition.

We May Have to Delay Recognizing License or Service Related Revenue for a Significant Period, Which Could Negatively Impact Our Results of Operations.

Although we mainly enter into standard license agreements and time-and- materials services agreements, we may occasionally have to delay recognizing license or service revenue for a significant period of time for a variety of types of transactions, including:

These factors and other specific accounting requirements for software revenue recognition, require that we have very precise terms in our license agreements to allow us to recognize revenue when we initially deliver software or perform services. Although we have a standard form of license agreement that meets the criteria for current revenue recognition on delivered elements, we negotiate and revise these terms and conditions in some transactions. Sometimes we are unable to negotiate terms and conditions that permit revenue recognition at the time of delivery or even as work on the project is completed.

If Accounting Interpretations Relating to Revenue Recognition Change, Our Reported Revenues Could Decline, or We Could be Forced to Make Changes in Our Business Practices.

Over the past several years, the American Institute of Certified Public Accountants has issued Statement of Position No. 97-2, Software Revenue Recognition (“SOP 97-2”), and Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions (“SOP 98-9”). In addition, in December 1999, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (“SAB 101”), which explains how the SEC staff believes existing revenue recognition rules should be applied to or interpreted for transactions not specifically addressed by existing rules. These standards address software revenue recognition matters primarily from a conceptual level and do not include specific implementation guidance. We believe that our revenue has been recognized in compliance with SOP 97-2, SOP 98-9 and SAB 101. However, the accounting profession and regulatory agencies continue to discuss various provisions of these pronouncements with the objective of providing additional guidance on their application. Most recently, in December 2002, the EITF reached a consensus on EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”) that sets out criteria for whether revenue on a deliverable can be recognized separately form other deliverables in a multiple deliverable arrangement. While EITF 00-21 is not required to be adopted by the Company until November 1, 2003, the issuance of new interpretations on revenue recognition could lead to unanticipated reductions in recognized revenue. They could also drive significant adjustments to our business practices, which could result in increased administrative costs, lengthened sales cycles and other changes which could adversely affect our results of operations.

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The Private Securities Class Action Lawsuits and State Derivative Action Against Us and Certain of Our Directors and Officers Could Have a Material Adverse Effect on Our Business, Financial Condition and Results of Operations.

Although the Court has approved our settlement agreement for the private securities class action lawsuit and the state derivative actions, a few class members who opted out of joining the class for the settlement purposes may still pursue their own private actions against the Company. Such actions may cause a diversion of management time and attention.

Our liability insurance for actions taken by officers and directors provides only limited liability protection. To the extent that these policies do not adequately cover our expenses related to any shareholder lawsuits, our business and financial condition could be seriously harmed. Under the Delaware General Corporation Law, the Company’s Certificate of Incorporation, as amended, the Bylaws, as amended, and the indemnification agreements we entered into with our executive officers and directors, we must indemnify our current and former officers and directors to the fullest extent permitted by law. Subject to certain conditions, the indemnification may cover expenses and liabilities reasonably incurred in connection with the investigation, defense, settlement, or appeal of legal proceedings.

We Have Incurred Operating Losses Since Our Inception and are Likely to Incur Net Losses and Negative Cash Flows for the Foreseeable Future.

We have experienced operating losses in each quarterly and annual period since inception, and we expect to incur losses in the future. If our revenue grows less than we anticipate or if our operating expenses increase more than expected or are not reduced in the event of lower revenue, we may never achieve profitability. As of April 30, 2003, we had an accumulated deficit of $197.7 million. Although we have an objective of achieving profitability as soon as practical, we cannot assure you that we will be successful. In order to achieve and maintain profitability, we will need to increase revenues while decreasing expenses.

We May Require Future Additional Funding to Stay in Business.

We may require additional financing for our operations. We have not been operating on a profitable basis and have relied on the sale of stock to finance our operations. We may need to return to the capital markets in order to receive additional financing.

This additional financing may not be available to us on a timely basis if at all, or, if available, on terms acceptable to us. Moreover, additional financing will cause dilution to existing stockholders.

If We Do Not Develop and Enhance New and Existing Products to Keep Pace With Technological, Market and Industry Changes, Our Revenues May Decline.

The markets for our products are characterized by rapid technological advances in software development, evolving standards in software technology and frequent new product introductions and enhancements. Product introductions and short product life cycles necessitate high levels of expenditures for research and development. To maintain our competitive position, we must:

The success of new products is dependent on several factors including proper new product definition, product cost, timely completion and introduction of new products, differentiation of new products from those of our competitors, and market acceptance of these products. There can be no assurance that we will successfully identify new product opportunities, develop and bring new products to market in a timely manner, and achieve market acceptance of our products or that products and technologies developed by others will not render our products or technologies obsolete or noncompetitive. Our inability to run on new or increasingly popular operating systems, and/or our failure to successfully enhance and improve our products in a timely manner could have a material adverse effect on our business, results of operations, financial condition or cash flows.

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If the Versata Products and Related Services Do Not Achieve Widespread Market Acceptance, the Source of Substantially All of Our Revenue Will be at Risk.

We cannot predict the level of market acceptance that will be achieved or maintained by our products and services. If either the Internet infrastructure software market in general, or the market for our software or related services in particular, fails to grow or grows more slowly than we anticipate, or if either market fails to accept our products and related services, the source of substantially all of our revenue will be at risk. We expect to continue to derive substantially all our revenue from and be dependent upon the Versata products and related services in the future. The market for the Versata products and related services is new, rapidly evolving and highly competitive, and we cannot be certain that a viable market for our products will ever develop or be sustained. Our future financial performance will depend in large part on the successful development, introduction and customer acceptance of our new products, product enhancements and related services in a timely and cost-effective manner. We expect to continue to commit significant resources to market and further develop our products and related services and to enhance the brand awareness of our software and services.

If Java Technology Does Not Continue to be Widely Adopted for E-business Application Development, Our Business Will Suffer.

Our products are based on Java technology, an object-oriented software programming language and distributed computing platform developed by Sun Microsystems. Java is a relatively new language and was developed primarily for the Internet and corporate intranet applications. It is still too early to determine whether Java will achieve greater acceptance as a programming language and platform for enterprise applications. Alternatives to Java include Microsoft’s C# language and .net computing platform. Should Java not continue to be widely adopted, or is adopted more slowly than anticipated, our business will suffer. Alternatively, if Sun Microsystems makes significant changes to the Java language or its proprietary technology, or fails to correct defects and limitations in these products, our ability to continue improving and shipping our products could be impaired. In the future, our customers also may require the ability to deploy our products on platforms for which technically acceptable Java implementations either do not exist or are not available on commercially reasonable terms.

We Depend on Increased Business from Our Current and New Customers and if We Fail to Generate Repeat and Expanded Business or Grow Our Customer Base, Our Products and Services Revenue Will Likely Decline.

In order to be successful, we need to broaden our business by selling product licenses and services to current and new customers. Many of our customers initially make a limited purchase of our products and services for pilot programs. These customers may not choose to purchase additional licenses to expand their use of our products. These and other potential customers also may not yet have developed or deployed initial software applications based on our products. If these customers do not successfully develop and deploy these initial software applications, they may choose not to purchase deployment licenses or additional development licenses. In addition, as we introduce new versions of our products or new products, our current customers may not require the functionality of our new products and may not license these products.

If we fail to add new customers who license our software, our maintenance and support revenue and our professional services revenue will also likely decline. These revenues are derived from fees for professional services and customer support related to our products. The total amount of services and support fees we receive in any period depends in large part on the size and number of software licenses that we have previously sold as well as our customers electing to renew their customer support agreements. In the event of a further downturn in our software license revenue such as it occurred during fiscal 2002 and fiscal 2001, or a decline in the percentage of customers who renew their annual support agreements, our maintenance and support revenue and our professional services revenue could become flat or further decline.

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Our Failure to Maintain Ongoing Sales Through Distribution Channels Will Result in Lower Revenues.

To date, we have sold our products principally through our direct sales force, as well as through indirect sales channels, such as Independent Software Vendors (“ISVs”), systems integrators and independent consultants, application service providers (“ASPs”) and distributors, particularly IBM. Our ability to achieve revenue growth in the future will depend in part on our success in making our direct sales force more efficient and in further establishing and expanding relationships with distributors, ASPs, ISVs, Original Equipment Manufacturers (“OEMs”) and systems integrators. We intend to seek distribution arrangements with additional ISVs to embed our Versata Logic Server and Versata Process Logic Engine in their products. It is possible that we will not be able to increase the efficiency of our direct sales force or other distribution channels, or secure license agreements with additional ISVs on commercially reasonable terms. Moreover, even if we succeed in these endeavors, it still may not increase our revenues. If we invest resources in these types of expansion and our revenues do not correspondingly increase, our business, results of operations and financial condition will be materially and adversely affected.

We rely on informal relationships with a number of consulting and systems integration firms to enhance our sales, support, service and marketing efforts, particularly with respect to implementation and support of our products as well as lead generation and assistance in the sales process. We will need to expand our relationships with third parties in order to support license revenue growth. Many such firms have similar, and often more established, relationships with our principal competitors. It is possible that these and other third parties will not provide the level and quality of service required to meet the needs of our customers, that we will not be able to maintain an effective, long term relationship with these third parties, and that these third parties will not successfully meet the needs of our customers.

Our Business is Subject to Risks from International Operations.

We conduct business internationally. Accordingly, a portion of our revenues is derived from international sales and is therefore subject to the related risks including the general economic conditions in each country, the overlap of different tax structures, the difficulty of managing an organization spread over various countries, changes in regulatory requirements, compliance with a variety of foreign laws and regulations, longer payment cycles and volatilities of exchange rates in certain countries. There can be no assurances that we will be able to successfully address each of these challenges. Other risks associated with international operations include import and export licensing requirements, trade restrictions and changes in tariff rates.

A portion of our business is conducted in currencies other than the U.S. dollar. Changes in the value of major foreign currencies relative to the value of the U.S. dollar may adversely affect revenues and operating results.

Also, any further terrorist activities or military or security operations involving the U.S. that are significant enough to further weaken the U.S. or global economy could result in reductions in information technology spending, and deferrals, reductions or cancellations of customer orders for our products and services, which ultimately would have an adverse effect on our operating results.

If We Infringe the Patents or Proprietary Rights of Others Our Business, Financial Condition and Operating Results Would Be Harmed.

We do not believe our products infringe the proprietary rights of third parties, but third parties may nevertheless assert infringement claims against us in the future. Regardless of whether these claims have merit, they can be time consuming and expensive to defend or settle, and can harm our business and reputation. Furthermore, we may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Litigation, whether resolved in our favor or not, could be time-consuming to defend, result in increased costs, divert management’s attention and resources, cause product shipment delays or require us to enter into unfavorable royalty or licensing agreements.

We May Incur Substantial Expenses If We are Sued for Product Liability.