Description of Business and Basis of Presentation

Description of the Company
Headquartered in Atlanta, Georgia, with an office in Surrey, England, Firstwave Technologies, Inc. (“Firstwave” or “the Company”) is a leading provider of Customer Relationship Management (CRM) solutions to mid-size and large-scale enterprises worldwide. Firstwave’s corporate and product mission reflects our customer-first commitment: To develop and integrate the best software solutions to manage customer interactions and information. As a provider of sports and high tech CRM, Firstwave offers a suite of industry-focused solutions. Firstwave CRM is adaptive, scalable and easily integrates with existing systems. Firstwave supports several product lines: Firstwave CRM (includes eCRM and v.10 products), Firstwave Sports, Firstwave Technology and TakeControl.

Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, the consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements and should be read in conjunction with the consolidated financial statements contained in the Company’s Form 10-K for the period ended December 31, 2003. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the consolidated financial statements have been included.

The consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements for the Company at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

The consolidated financial statements include the accounts of Firstwave Technologies, Inc. and its wholly owned subsidiaries, Connect-Care, Inc. and Firstwave Technologies UK, Ltd. All intercompany transactions and balances have been eliminated in consolidation.

Use of estimates and Critical Accounting Policies

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 the 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. Examples of estimates which require management’s judgment include revenue recognition, accounts receivable reserve, valuation of long-lived assets and intangible assets, and goodwill. Management bases its estimates on historical experience and on other various factors which are believed to be reasonable under the circumstances. All accounting estimates and the basis for these estimates are discussed between the Company’s senior management and the Audit Committee. Actual results could differ from those estimates.

Critical Accounting Policies
The Company believes that the following accounting policies are critical to understanding the consolidated financial statements:
     ·    Revenue Recognition
     ·    Capitalization of Software Development Costs
     ·    Intangible Assets

Summary of Significant Accounting Policies

Revenue recognition
The Company recognizes revenue in accordance with Statement of Position (SOP) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, and related interpretations.

Revenue from software product sales is recognized upon shipment of the product when the Company has a signed contract, the fees are fixed and determinable, no significant obligations remain and collection of the resulting receivable is probable. The Company accrues for estimated warranty costs at the time it recognizes revenue.

The Company’s products are licensed on a per-user model, except for hosting services. In accordance with Paragraph 8 of SOP 97-2, license revenues under the per-user model are recognized under the Company’s revenue recognition polices when revenue recognition criteria are met. Hosting services are priced as a monthly or yearly fixed amount based upon number of users, and are recognized ratably by month over the period of service. Hosting services revenues are consolidated into services revenues on the Company’s financial statements.

Services revenue is recognized as services are performed. Our software product is able to function independently in a customer’s environment without additional services. Our training, implementation, and customization services are optional services to our customers and are not necessary for the functioning of the software product. Our software is offered as a stand-alone product. It can be implemented with minimal services. The essential functionality of the software, such as database support and maintenance, preparation of marketing campaigns, and standard workflow, is functional and can be utilized by the customer upon installation as intended by the customer. At a customer’s request, the software can also be implemented with additional services, such as data conversion and workflow modifications, which are not significant to the functionality of the software, but rather tailor features to most effectively function in the customer’s environment.

The revenue for the customization or implementation services is recognized as the services are provided and earned. Revenue is allocated to software and services based on vendor specific objective evidence of fair values. Because the software is a stand-alone product that can be used for the customer’s purpose upon installation, and because any services performed have insignificant effect on the functionality of the software, services revenue is accounted for separately in accordance with Paragraph 69 of SOP 97-2.

The Company has not recorded any unbilled receivables related to implementation and customization service revenues, and the Company has accounted for any implementation and customization service revenues that have been billed as the services were performed, in accordance with Paragraphs 65 and 66 of SOP 97-2.

The Company has arrangements with customers that provide for the delivery of multiple elements, including software licenses, and services. The Company allocates and recognizes revenue related to each of the multiple elements based on vendor specific objective evidence of the fair value of each element and when there are no undelivered elements essential to the functionality of the delivered element. Vendor specific objective evidence is based on standard pricing for each of the elements in our multiple element arrangements. Revenue associated with the various elements of multiple element arrangements is based on such vendor specific objective evidence as the price charged for each element is the same as when the element would be sold separately from any other element. Standard pricing does not vary by customer or by duration, or by requirements of the arrangement.

International revenues are primarily generated by Firstwave UK and independent distributors who offer licenses of the Company’s products in specific geographic areas. Under the terms of the Company’s international distributor agreements, international distributors collected license fees and maintenance revenues on behalf of the Company, and remitted 50% to 60% of standard license fees and maintenance revenues they produced. Pursuant to EITF 99-19, the Company recognizes these distributor sales at the gross license amount because the Company retains title to the products, holds the risk and rewards of ownership, such as risk of loss for collection, and responsibility for providing the product to the customer. The Company is responsible for establishing and maintaining the pricing of the product and performs any source code changes to the product. The independent distributors are considered agents of the Company and work on a commission basis. The commissions paid are reflected as a selling expense in the Company’s financial statements. The maintenance fees generated by distributor revenues are reflected as maintenance revenues, with the amount retained by distributors shown as a cost of maintenance revenue.

Revenues from non-monetary exchanges are recorded at the fair value of the products and services provided or received, whichever is more clearly evident. There were no non-monetary transactions during the first quarter of 2004.

Maintenance revenue is recognized on a pro rata basis over the term of the maintenance agreements.

Advanced billings for services and maintenance contracts are recorded as deferred revenue on the Company’s balance sheet, with revenue recognized as the services are performed and on a pro-rata basis over the term of the maintenance agreements.

The Company provides an allowance for doubtful accounts based on management’s estimate of receivables that will be uncollectible. The estimate is based on historical charge-off activity and current account status.

The Company’s US accounting management oversees reporting procedures in the UK and monitors their transactions on a timely basis. The US management reviews transactions and sales contracts as such transactions and sales are occurring to ensure that revenues are recognized under the Company’s revenue recognition policy and that expenses and other transactions are reported in accordance with accounting principles generally accepted in the United States. Management of the UK subsidiary report directly to US management, with US management substantially involved in all aspects of UK operations. As such, US management has established procedures to insure that international revenues are recognized properly and on a timely basis.

Software development costs
Capitalized software development costs consist principally of salaries, contract services, and certain other expenses related to development and modifications of software products capitalized in accordance with the provisions of SFAS 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” Capitalization of such costs begins only upon establishment of technological feasibility as defined in SFAS 86 and ends when the resulting product is available for sale. The Company evaluates the establishment of technological feasibility based on the existence of a working model of the software product. Capitalized costs may include costs related to product enhancements resulting in new features and increased functionality as well as writing the code in a new programming language. In this case, as the version enhancements are built on an already detailed design under an existing source code, technological feasibility is established early for each version. All costs incurred to establish the technological feasibility of software products are classified as research and development and are expensed as incurred.

The Company evaluates the realizability of unamortized capitalized software costs at each balance sheet date. Software development costs which are capitalized are subsequently reported at the lower of unamortized cost or net realizable value. If the unamortized capitalized software cost exceeds the net realizable value of the asset, the amount would be written off accordingly. The net realizable value of the capitalized software development costs is the estimated future gross revenues of the software product reduced by the estimated future costs of completing and disposing of that product. Amortization of capitalized software costs is provided at the greater of the ratio of current product revenue to the total of current and anticipated product revenue or on a straight-line basis over the estimated economic life of the software, which is not more than three years. It is possible that those estimates of anticipated product revenues, the remaining estimated economic life of the product, or both could be reduced due to changing technologies. The amortization of software development costs is presented as a cost of software revenue in the Company’s financial statements.

Goodwill and other intangibles
In accordance with SFAS No 142 “Goodwill and Other Intangible Assets”, intangible assets with indefinite useful lives must be tested periodically for impairment. Examples of matters requiring management’s judgment regarding the existence of impairment of an intangible asset and the resulting fair value, would include management’s assessment of adverse changes in legal factors, market conditions, or loss of key personnel. If the fair value of the intangible asset is determined to be in excess of the carrying value, the Company would record an impairment loss. SFAS No 142 prescribes a two-phase approach for impairment testing of goodwill. The first phase screens for impairment; while the second phase (if necessary) measures the impairment. The Company completed its annual analysis during the fourth quarter of 2003 and found no instance of impairment of its recorded goodwill.

Concentration of credit risk
The Company is subject to credit risk primarily due to its trade receivables. The Company has credit risk due to the high concentration of trade receivables through certain customers.

The customer accounts receivable which represented more than 10% of total accounts receivable are shown below:

Significant Customer
The Company continued to have a concentration of revenue derived from its relationship with Electronic Data Systems, Ltd. The table below identifies customers who contributed more than 10% of total revenue for each period shown.

Stock-based compensation
Effective for 2002, the Company adopted SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which did not have a material impact on the consolidated financial statements. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations and to elect the disclosure option of SFAS 123, “Accounting for Stock-Based Compensation.” Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock.

The Company has adopted the disclosure-only provisions of SFAS 123, “Accounting for Stock-Based Compensation.” The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee awards, (in thousands, except for per share data).

Not included because anti-dilutive

Foreign currency translation
The financial statements of the Company’s international subsidiary are translated into U.S. dollars at current exchange rates, except for revenues and expenses, which are translated at average exchange rates during each reporting period. Currency transaction gains or losses are included in the results of operations as general and administrative expenses in the Company’s financial statements. Net exchange gains or losses resulting from the translation of assets and liabilities are included as a component of accumulated other comprehensive income in shareholders’ equity.

Impairment of long-lived assets
The Company evaluates impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. If the sum of the expected future undiscounted cash flows is less than the carrying amount of the asset, an impairment loss would be recognized. Measurement of an impairment loss for long-lived assets would be based on the fair value of the asset.

Segment reporting
Management believes that the Company has only a single segment consisting of software sales with related services and support. The information presented in the consolidated statement of operations reflects the revenues and costs associated with this segment that management uses to make operating decisions and assess performance.

Acquisition
 
On March 3, 2003, Firstwave acquired Connect-Care, Inc., a provider of CRM software solutions for software companies. Connect-Care was acquired pursuant to a Merger Agreement dated March 3, 2003 (the “Merger Agreement”) by and among Firstwave, CC Subsidiary, Inc., a wholly-owned subsidiary of Firstwave (“Merger Sub”), Connect-Care, and certain shareholders of Connect-Care. Pursuant to the Merger Agreement, Merger Sub merged with and into Connect-Care, and Connect-Care, which was the surviving corporation in the Merger, became a wholly-owned subsidiary of Firstwave. The results of Connect-Care’s operations have been included in the Company’s financial statements since March 3, 2003.

The following table presents the unaudited pro forma consolidated results of operations as if the acquisition had occurred as of January 1, 2003 (in thousands):

Goodwill and Intangibles
 
The primary objective of the Connect-Care acquisition was to acquire the customer relationships of the customer base of Connect-Care and, to a lesser degree, to acquire utilization of Connect-Care technology. Of the $3,410,000 purchase price, $300,000 was assigned as an estimated fair value to the intangible asset Connect-Care technology with an estimated useful life of three years, $900,000 was assigned as an estimated fair value to the intangible asset Connect-Care customer relationships with an estimated useful life of seven years, and $2,210,000 was assigned to goodwill. The value assigned to customer relationships was based on potential future revenues that may be derived from such customer relationships. We believe this goodwill reflects such matters as (but not limited to) personnel obtained in the acquisition, new customer opportunities that we will have as a result of our involvement with the acquired customers, relationships we will develop through the acquisition, and expertise and name recognition we will receive through this acquisition. Goodwill will be evaluated periodically for impairment in accordance with SFAS 142 “Goodwill and Other Intangible Assets.”

The weighted average amortization period for these intangible assets subject to amortization is six years. There are no significant residual values in the intangible assets. The Company began amortization of the intangible assets effective April 1, 2003. Goodwill was evaluated for impairment during the first quarter of 2004 in accordance with SFAS 142 “Goodwill and Other Intangible Assets” and it was determined there was no change in the carrying amount of goodwill.

The following table presents details of acquired intangible assets (in thousands):

Borrowings

On July 29, 2003, the Company signed a one-year “Revolving Credit Facility” loan with RBC Centura whereby the Company may borrow up to $1,000,000. The Company had borrowings of $500,000 against the line of credit as of March 31, 2004. The Revolving Facility bears interest at a variable rate equal to the one month London Interbank Offered Rate (LIBOR) plus 300 basis points, or the “RBC Centura Prime Rate” plus 0.50%, at our option. The weighted average interest rate for the three months ended March 31, 2004 was 4.10%. The first $500,000 of the Revolving Facility is available on a non-formula basis. Once advances under the Revolving Facility exceed $500,000, any advances are based on a borrowing base of 75% of eligible accounts receivable as determined by a certified borrowing base report. The loan is secured by the assets of the Company. The Company must comply with certain financial covenants per the terms of the agreement. As of March 31, 2004, the Company was in compliance with the required covenants.