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UNITED STATES OF AMERICA

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended January 31, 2005

OR

Commission file number: 0-29757

VERSATA, INC.

(Exact name of registrant as specified in its charter)

300 Lakeside Drive Suite 1300

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 February 28, 2005, the total number of outstanding shares of the Registrant’s common stock was 8,188,542

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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)

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. (Nasdaq: VATA), (“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 way for companies to define and manage the business logic in their software systems at the business level rather than the system code level. This includes support for a company’s process and transaction business logic. With the general availability of Versata 6, Versata shall provide additional support for decision logic and data mapping logic. The result is expected to be an integrated solution for all the logic components driving a company’s business systems.

We believe our cash, cash equivalents and short-term investments as of January 31, 2005 will be sufficient to meet 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 within the next twelve months or beyond. In the event additional financing is required, we may not be able to raise it on acceptable terms or at all.

2. Interim Financial Information and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements as of January 31, 2005, and for the three months ended January 31, 2005 and 2004 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 generally accepted accounting principles (“GAAP”), as promulgated within 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 GAAP have been condensed or omitted pursuant to such rules and regulations.

We believe 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 October 31, 2005. 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, 2004.

3. Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R, Share-based Payment (“SFAS 123R”). SFAS 123R revises SFAS 123 and supersedes APB 25. SFAS 123R applies to transactions in which an entity exchanges its equity instruments for goods or services and also applies to liabilities an entity may incur for goods or services that are based on the fair value of those equity instruments. Under SFAS 123R, the Company will be required to follow a fair value approach using an option-pricing model, such as the Black-Scholes option valuation model, at the date of a stock option grant. SFAS 123R is effective June 15, 2005. The deferred compensation calculated under the fair value method would then be amortized over the respective vesting period of the stock option. We will adopt the provisions of SFAS 123R in the third quarter of our 2005 fiscal year. The adoption of SFAS 123R is expected to have a material impact on our results of operations. Information concerning the impact on our operating results of using SFAS 123R is included below in Note 5 of the “Notes to Condensed Consolidated Financial Statements”.

4. Major Customers and Credit Risk Concentrations

For our fiscal quarter ended January 31, 2005, one customer comprised 14% and two customers each comprised 13% of our consolidated net accounts receivable.

5. Stock Based Compensation Plans

Versata currently accounts for stock-based employee compensation arrangements using the intrinsic value method 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 complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123,

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VERSATA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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. Our Company accounts 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”).

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R, Share-based Payment (“SFAS 123R”). SFAS 123R revises SFAS 123 and supersedes APB 25. SFAS 123R applies to transactions in which an entity exchanges its equity instruments for goods or services and also applies to liabilities an entity may incur for goods or services that are based on the fair value of those equity instruments. Under SFAS 123R, the Company will be required to follow a fair value approach using an option-pricing model, such as the Black-Scholes option valuation model, at the date of a stock option grant. SFAS 123R is effective June 15, 2005. The deferred compensation calculated under the fair value method would then be amortized over the respective vesting period of the stock option. We will adopt the provisions of SFAS 123R in the third quarter of our 2005 fiscal year. The adoption of SFAS 123R is expected to have a material impact on our results of operations. Information concerning the impact on our operating results of using SFAS 123R is included below.

Summarized below are the pro forma effects on net loss and net loss per share data, if the Company had elected to use the fair value approach prescribed by SFAS 123 to account for its employee stock-based compensation plans (in thousands, except per share data):

Our Company calculated the minimum fair value of each option grant on the date of grant using the Black-Scholes option-pricing method as prescribed by SFAS 123 using the following assumptions:

6. Restructuring and Other

The following table summarizes the restructuring and other activity during the three months ended January 31, 2005 (in thousands):

Other costs accrued at January 31, 2005 include $660,000 for the anticipated costs of the settlement of the Securities Class Action and State Derivative Actions described in note 8, below.

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VERSATA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

7. 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 unvested restricted common stock and incremental common shares to be issued upon the exercise of stock options and warrants. The number of potential common stock equivalents excluded from the calculation totaled 1,663,674, for the three months ended January 31, 2005 and 1,539,369 for the three months ended January 31, 2004.

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

8. Legal Proceedings

Securities Class Action and State Derivative Actions

On February 14, 2003, the United States District Court for the Northern District of California issued the Order of Final Approval of the Settlements of the consolidated securities class action and the consolidated derivative action that were both initially filed in 2001. Pursuant to the terms of the settlement, Versata’s insurers paid $9.75 million and Versata issued 200,000 shares of common stock and implemented certain corporate therapeutics. The shares of common stock had a $3.50 per share put option exercisable for 20 trading days which commenced on January 28, 2005 and ended on February 25, 2005. We are currently processing the exercised put options via our transfer agent. As of the date of this form 10-Q, we had received less than 10,000 put option requests. We estimate the associated cash expense, including fees payable to the transfer agent, will be approximately $50,000. This cash expense will be incurred in the Company’s second fiscal quarter of 2005. As of January 31, 2005 we had accrued $660,000 for this liability in accrued restructuring and other in the accompanying financial statements.

Litigation and Other Claims

From time to time, we become subject to legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these proceedings and claims cannot be predicted with certainty, we do not believe that the outcome of any of these legal matters will have a material adverse effect on our consolidated results of operations, financial position or cash flows.

9. Related Party Transactions

In November 2003, we entered into an engineering services agreement with Virtusa Corporation, a US and Indian based premier software engineering services firm which provides engineering support to software product developers and enterprise customers. Our former board member, Robert Davoli, was also a board member of Virtusa Corporation. A major shareholder, Sigma Partners, is also a venture capital investor in Virtusa Corporation. Our former board member Robert Davoli and board member Wade Woodson serve as managing directors of Sigma Partners. The Company terminated its relationship with Virtusa in January 2005. The Company incurred costs for services provided by Virtusa of approximately $121,000 in the quarter ended January 31, 2005.

10. Subsequent Events

On February 4, 2005, the Company announced the resignation of Dr. Alan Baratz as President and CEO, effective February 18, 2005. Dr. Baratz will continue to serve as a member of the Company’s board of directors. He has served as a board member since May 2003.

On February 4, 2005, the Company announced that beginning February 18, Will Frederick, the Company’s Chief Financial Officer, will also serve as the interim Chief Executive Officer while the Company searches for Dr. Baratz’s replacement.

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

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

Versata, Inc. (Nasdaq: VATA), (“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 way for companies to define and manage the business logic in their software systems at the business level rather than the system code level. This includes support for a company’s process and transaction business logic.

Versata’s products are currently optimized for the building, maintenance and ongoing evolution of large, complex, data-intensive enterprise applications. These applications typically access multiple data sources, incorporate multiple database tables and user interfaces, execute very complex business transactions and support thousands of users. The Versata solution replaces time-intensive hand-coding efforts with simple, intuitive business rules definition and graphical process flow specification. With the general availability of Versata 6, Versata expects to provide additional support for decision logic and data mapping logic. Versata 6 integrates Rete decision rules capability, introduces support for the open source Eclipse tooling technology for faster and more cost-efficient application creation, and delivers support for web services and service oriented architectures. The result is expected to be an integrated solution for all the logic components driving a company’s business systems.

Versata markets its products primarily through a direct sales force in North America and in Europe. The Company’s internal team is supported by a network of consulting and systems integration partners, companies selling pre-packaged software applications, and companies selling software applications over the Internet on a subscription basis.

Versata also offers comprehensive professional services such as ROI analysis, training, staff augmentation and project management as well as complete turnkey solution services and comprehensive customer support.

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):

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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:

Revenue

Software License Revenue. Software license revenue decreased by approximately $1.1 million, or 87%, to $156,000 for the three months ended January 31, 2005 from $1.2 million for the three months ended January 31, 2004. North American license revenue for the three months ended January 31, 2005 was $104,000 as compared to $357,000 for the comparable prior year period. European license revenue for the three months ended January 31, 2005 was $51,000 as compared to $866,000 for the comparable prior year period. The decline in revenue was affected by the timing of the Company’s shift towards Versata 6 and away from some of its older products as well as certain customers deferring their purchasing decisions. Several orders that were expected to close in the Company’s first fiscal quarter did not close and while those deals are still in discussion, there can be no assurance that these deals will be completed.

Maintenance and Support Revenue. Maintenance and support revenue increased by $126,000, or 9%, to $1.6 million for the three months ended January 31, 2005 from $1.4 million for the three months ended January 31, 2004. The increase was primarily attributable to new maintenance and support revenues generated from license sales within the preceding twelve months offset by the non-renewal of certain existing maintenance and support contracts.

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Professional Services Revenue. Services revenue decreased by $167,000, or 22%, to $589,000 in the three months ended January 31, 2005 from $756,000 in the three months ended January 31, 2004. Professional services revenue has declined steadily over the last three quarters as some of the larger engagements have concluded without new engagements to replace them. Management is focusing on growing professional services revenue and believes this growth will be aided by the introduction of Versata 6.

Cost of Revenue

Cost of Software License Revenue. Cost of license revenue consists of partner fees and royalties paid to third party vendors for use of their products embedded in our product offerings. Cost of software license revenue decreased by $46,000, or 70%, to $20,000 for the three months ended January 31, 2005 from $66,000 for the three months ended January 31, 2004. This decrease is principally related to the lower software license revenue, as discussed above.

Cost of Maintenance and Support Revenue. Cost of maintenance and support revenue consists of salaries and allocated overhead for support personnel. Cost of maintenance and support revenue decreased by $73,000, or 18%, to $325,000 for the three months ended January 31, 2005 from $398,000 for the three months ended January 31, 2004. This decrease was principally driven by a reduction in personnel related expenses and departmental allocated overhead costs. As of January 31, 2005, we had 14 employees and contractors in our support operations as compared to 10 employees and contractors on January 31, 2004.

Cost of Professional Services Revenue. Cost of professional services revenue consists of salaries and allocated overhead for professional service personnel and payments to third party consultants incurred in providing training and consulting services. Cost of service revenue increased by $138,000, or 19%, to $868,000 for the three months ended January 31, 2005 from $730,000 for the three months ended January 31, 2004. The increase was mainly attributable to the fact that we have services staff allocated to important strategic, non-billable projects, and the use of higher-cost external resources to serve clients. As of January 31, 2005 and 2004 the Company had 15 employees and contractors in professional services.

Gross Profit

Gross Profit. Gross profit decreased by $1.1 million or 51%, to $1.1 million in the three months ended January 31, 2005 from $2.2 million in the three months ended January 31, 2004. Total gross margin decreased to 47% for the three months ended January 31, 2005 from 65% for the three months ended January 31, 2004. The decrease in total gross margin experienced in the first fiscal quarter of 2005 reflected a 32% reduction in total revenue as well as a 2% increase in total cost of revenue. Total gross margin was also impacted by significantly lower software license revenues in the three months ended January 31, 2005. Software license revenues generate higher margins than maintenance and support or professional services revenues.

The Company experienced a negative gross margin in the three months ended January 31, 2005 within its professional services revenue segment, as compared to a positive 3% gross margin in the comparable prior year period. The negative gross margin can be attributed to a revenue decrease within our European operations, partially offset by a revenue increase within our North American operations, as well as increased external consultant and travel costs within our North American operations.

The following table summarizes gross margin by revenue component:

Operating Expenses

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 $247,000, or 16%, to $1.3 million in the three months ended January 31, 2005 from $1.5 million in the three months ended January 31, 2004. This decrease was principally related to lower personnel related expenses, sales commissions, and conference costs, offset by higher contractor costs. As of January 31, 2005, we had 16 employees and contractors in our sales and marketing operations as compared to 19 employees and contractors on January 31, 2004.

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

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salaries and the cost of consulting resources that supplement our product development teams. Product development expense decreased by $291,000, or 24%, to $940,000 in the three months ended January 31, 2005 from $1.2 million in the three months ended January 31, 2004. This decrease was principally driven by a reduction in personnel related expenses and departmental allocated overhead costs. 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 January 31, 2005, we had 23 employees and contractors in product development as compared to 38 employees and contractors on January 31, 2004.

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 $290,000, or 27%, to $784,000 in the three months ended January 31, 2005 from $1.1 million in the three months ended January 31, 2004. This decrease was primarily related to the allocation of IT related expenses in fiscal 2005, as well as lower costs for contractors, bonus awards, and bad debt provisions. These expense reductions were offset by higher legal and accounting fees. As of January 31, 2005 and January 31, 2004, we had 17 employees and contractors performing general and administrative functions within the Company.

Stock-Based Compensation. Stock-based compensation expense includes the cost of common stock awards granted to employees and consultants in exchange for services as well as the amortization of employee stock-based compensation. Employee stock-based compensation expense for stock options is amortized on an accelerated basis (under FIN 28) over the vesting period of the related options, generally 50 months. The Company did not incur any expense for stock-based compensation expense for the three months ended January 31, 2005 as compared to an expense of $123,000 for the three months ended January 31, 2004. This decrease is principally related to the Company’s decision to discontinue the award of fully vested common stock for employees as well as the vesting of all pre-IPO stock in the Company’s prior fiscal year.

Amortization of Intangibles. Intangible assets consist of purchased technology that is being amortized on a straight-line basis over the expected life of three years. The Company did not incur any amortization expense for the three months ended January 31, 2005 as all intangibles were fully amortized in the Company’s prior fiscal year. Amortization expense for the three months ended January 31, 2004 was $2,000.

Restructuring and Other. The Company did not incur any restructuring expense for the three months ended January 31, 2005. Restructuring expense for the three months ended January 31, 2004 was $670,000; this expense was primarily related to severance payments for both domestic and international staff as well as additional restructuring costs incurred in the renegotiation of the lease agreement for our Oakland, California headquarters.

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 interest income, net of $38,000 for the three months ended January 31, 2005, a decrease of $6,000, or 14%, compared to interest income, net of $44,000 for the three months ended January 31, 2004. The decrease in interest income, net is primarily due to our reduced cash and investment balances, offset by slightly higher interest rates.

Other Non-Operating Expense. Other non-operating expense primarily relates to various state and local taxes. The majority of these taxes are not based upon taxable income but on revenues, asset values or shares outstanding. We have incurred operating losses for all periods from inception through January 31, 2005, thus, we have not incurred an income tax liability for federal income taxes and only minimal liabilities for state income taxes. In addition, 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. Other non-operating expense decreased by $40,000, or 80%, from $50,000 for the three months ended January 31, 2004 to $10,000 for the three months ended January 31, 2005. This decrease related primarily to the accrual of lower franchise tax expense as a result of lower asset values carried by the Company in the first fiscal quarter of 2005, as compared to 2004.

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, which resulted in aggregate net proceeds of $167.2 million. We have also funded our operations through equipment financing. As of January 31, 2005, we had $8.5 million in cash and cash equivalents and short-term investments and $3.2 million in working capital. 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.

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, as well as movements in certain operational balance sheet accounts. Net cash used in operating activities was $1.2 million and $2.0 million for the three months ended January 31, 2005 and 2004, respectively. During

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both fiscal quarters ended January 31, 2005 and 2004, the decrease in cash flows from operating activities was largely related to operating losses for the period, adjusted for movements in operational balance sheet accounts as set out below:

The increase in cash flows from accounts receivable, as well as the reduction in cash flows from deferred revenue, reflects the significantly lower software license revenue achieved in the three months ended January 31, 2005. Cash provided from accounts payable in the three months ended January 31, 2005 was approximately $150,000; this was offset by cash used in the reduction of accrued liabilities of approximately $482,000 which was mainly related to accrued commissions and third-party royalties.

Net cash provided by investing activities was $1.3 million and $1.0 million for the three months ended January 31, 2005 and 2004, respectively. Net cash provided by investing activities was related primarily to the net proceeds from sales of short-term investments, offset by purchases of fixed assets.

Net cash used by financing activities was $1,000 for the three months ended January 31, 2005. This related to the payment of capital lease obligations offset by the exercise of stock options. Cash provided of $14,000 for the three months ended January 31, 2004 related to the exercise of stock options.

We believe our cash and cash equivalents and short-term investments as of January 31, 2005 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 2005 or beyond. In the event additional financing is required, we may not be able to raise it on acceptable terms or at all.

On December 20, 2004, Versata, Inc. (the “Company”) entered into a one year Loan and Security Agreement (the “Loan Agreement”) with Venture Banking Group (“VBG”) for the purpose of establishing a revolving line of credit. The Loan Agreement provides for borrowings by the Company of up to $1.0 million in the aggregate at anytime outstanding. The Loan Agreement requires the Company to maintain its primary depository and operating accounts with VBG and to maintain a minimum unrestricted cash balance of $4.0 million with VBG. Interest on borrowings under the Agreement is payable monthly and accrues at one-half of one percentage point above the prime rate. Unpaid principal, together with accrued and unpaid interest is due on the maturity date. Borrowings under the facility are collateralized by substantially all of the Company’s assets excluding its intellectual property. As of January 31, 2005 the Company had not drawn any funds on this line of credit facility.

The Loan Agreement contains affirmative and negative covenants with which the Company must comply, including reporting requirements, maintenance of insurance and restrictions on incurring indebtedness, granting liens, and paying dividends on its capital stock. The events of default under the loan agreement include payment defaults, cross defaults with certain other indebtedness, breaches of covenants, and insolvency events.

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States 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. 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.

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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 which consist of post-contract customer support (“PCS”); and (iii) professional services which include consulting and training. We recognize revenue 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, we defer the fair value of PCS related to the arrangement and recognize the remainder as license revenue, when paid, provided all other revenue recognition criteria are met. 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. The portion of fees related to either 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

We have several foreign subsidiaries which together accounted for approximately 37% of our net revenues for the quarter ended January 31, 2005, and 16% of our assets and 50% of our total liabilities as of January 31, 2005.

In preparing our consolidated financial statements, we are required to translate the financial statements of the 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, and 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.

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.

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Stock-based Compensation

Versata currently accounts for stock-based employee compensation arrangements using the intrinsic value method 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 complies 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. Our Company accounts 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”).

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R, Share-based Payment (“SFAS 123R”). SFAS 123R revises SFAS 123 and supersedes APB 25. SFAS 123R applies to transactions in which an entity exchanges its equity instruments for goods or services and also applies to liabilities an entity may incur for goods or services that are based on the fair value of those equity instruments. Under SFAS 123R, the Company will be required to follow a fair value approach using an option-pricing model, such as the Black-Scholes option valuation model, at the date of a stock option grant. SFAS 123R is effective June 15, 2005. The deferred compensation calculated under the fair value method would then be amortized over the respective vesting period of the stock option. We will adopt the provisions of SFAS 123R during our 2005 fiscal year. The adoption of SFAS 123R is expected to have a material impact on our results of operations. Information concerning the impact on our operating results of using SFAS 123R is included below.

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.

Risks Related to Our Business

We Have Limited Working Capital and May Experience Difficulty in Obtaining Needed Funding, Which May Limit Our Ability to Effectively Pursue Our Business Strategies.

As of January 31, 2005, we had $8.5 million in cash and short-term investments, and working capital of approximately $3.2 million. To date, we have not achieved profitability or positive cash flow on a sustained basis. Although we believe that our current cash, cash equivalents, and any net cash provided by operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next twelve months, it is possible that events may occur that could render our current working capital reserves insufficient. Because our revenue is unpredictable and a significant portion of our expenses are fixed, a reduction in projected revenue or unanticipated requirements for cash outlays could deplete our limited financial resources, potentially to a serious degree. We may find it necessary to obtain additional equity or debt financing within the next twelve months or beyond. If we require additional external funding, there can be no assurance that we will be able to obtain it 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 cannot secure adequate financing sources on a timely basis, then we would be required, at a minimum, to reduce our operating expenses, which would restrict our ability to pursue our business objectives and could adversely impact our ability to maintain our revenue levels.

We Have Incurred Operating Losses Since Our Inception and May 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 near future. Although we hope to achieve positive cash flow and GAAP profitability by the end of fiscal 2005, if our revenue grows less than we anticipate or if our operating expenses increase more than expected, we may never achieve profitability. As of January 31, 2005, we had an accumulated deficit of $212.8 million.

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

Our operating results have varied and may continue to vary substantially from period to period. The timing and amount of our license fees are subject to a number of factors that make estimating revenues and operating results prior to the end of a quarter uncertain. While we receive certain recurring revenues on royalty-based license agreements and also from deferred maintenance and support fees, a significant amount of license fees in any quarter is dependent on the execution of new license sales in a specific quarter. In particular, our revenue in future periods is dependent on the licensing of Versata 6 and the Versata BAM Dashboard. If we fail to reach the expected results with such products, our revenues will be adversely affected. Our professional services revenue in any

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quarter is substantially dependent on our license revenue. Services are normally purchased in conjunction with software, 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. Operating expenses for any year are normally based on the attainment of planned revenue levels for that year and are generally incurred ratably throughout the year. As a result, if revenues were less than planned in any period, while expense levels remain relatively fixed, our operating results would be adversely affected for that period. In addition, unplanned expenses such as increases in salaries, third party software licensing fees, and cost of software development, could adversely affect operating results for the period in which such expenses were incurred.

Our Failure to Accurately Forecast Sales May Lead to a Disappointment of Market Expectations.

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 such as occurred in the past 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.

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. Although the Company intends to make Versata 6 and the Versata BAM Dashboard v2.0 with the functionalities described herein generally available during fiscal 2005, there can be no assurance that these products will be released in a timely manner, include the described functionalities, or achieve broad market acceptance. 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. In addition, Versata may in the future discover errors in new releases or new products after the commencement of commercial shipments. Since many customers are using Versata products for mission-critical business operations, any of these occurrences could seriously harm the Company’s business and generate negative publicity.

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.

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

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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.

We Depend on Technology Licensed from Third-party Software Developers and our Ability to Develop and Sell our Products and Services Could be Delayed or Impaired if We Fail to Maintain These License Arrangements.

We incorporate into our products third-party software that enables, enhances or compliments aspects of our products’ functionality. This third-party software may not continue to be available on commercially reasonable terms or with acceptable levels of support, or at all. Our inability to maintain these software licenses on current terms could delay or impair the sale of our products and services until equivalent software, if available, is identified, licensed or developed, and integrated. This could adversely affect our business and impair our future growth.

Versata had an OEM agreement with WebGain for TopLink, a Java object-to-relational persistence architecture, as a part of the Versata 5 platform. The TopLink architecture bridges the gap between object-oriented Java systems such as Versata and relational database systems such as Oracle. The original OEM agreement with WebGain expired in 2004. Oracle acquired the assets and intellectual property for the TopLink product from WebGain. Versata has not been able to agree to new terms with Oracle. There can be no assurance that Versata can finalize this agreement in a timely manner, with favorable terms, or at all. If Versata is not able to enter into a new agreement with Oracle, Versata could lose the right to use and distribute TopLink and remedies could include damages or injunctive relief.

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 typically 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 2003, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (“SAB 104”), 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 104. 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. These discussions and the issuance of new interpretations, once finalized, 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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Issuance of New Laws or Accounting Regulations, or Re-interpretation of Existing Laws or Regulations, Could Materially Impact our Business or Stated Results.

From time to time, the government, courts and financial accounting boards issue new laws or accounting regulations, or modify or re-interpret existing ones. There may be future changes in laws, interpretations or regulations that would affect our financial results or the way in which we present them. Additionally, changes in the laws or regulations could have adverse effects on hiring and many other aspects of our business that would affect our ability to compete, both nationally and internationally. For example, recently issued accounting regulations requiring the company to account for employee stock option grants as an expense could have the result of our not using options as widely for our employees which could impact our ability to hire and retain key employees.

We Will Incur Increased Costs as a Result of Recently Enacted and Proposed Changes in Laws and Regulations Relating to Corporate Governance Matters and Public Disclosure.

Recently enacted and proposed changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, rules adopted or proposed by the SEC and by the NASDAQ National Market and new accounting pronouncements will result in increased costs to us as we evaluate the implications of these laws, regulations and standards and respond to their requirements. To maintain high standards of corporate governance and public disclosure, we intend to invest substantial resources to comply with evolving standards. This investment will result in increased general and administrative expenses and a diversion of management time and attention from strategic revenue generating and cost management activities. In addition, these new laws and regulations could make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees or as executive officers. We are taking steps to comply with the recently enacted laws and regulations in accordance with the deadlines by which compliance is required, but cannot predict or estimate the amount or timing of additional costs that we may incur to respond to their requirements.

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 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, 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.

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.

Some of our products, incorporate intellectual property licensed from third parties or open source software. If we fail to successfully exclude such technology from our indemnification obligations, claims that such open source or third party technology infringes the intellectual property rights of a third party could materially and adversely affect our business and financial condition.

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

Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. It is possible, however, that the limitation of liability provisions contained in our license agreements may not be effective as a result of existing or future federal, state or local laws or ordinances or unfavorable judicial decisions. Although we have not experienced any product liability claims to date, sale and support of our products entails the risk of such claims, which could be substantial in light of customers’ use of such products in mission-critical applications. If a claimant brings a product liability claim

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against us, it could have a material adverse effect on our business, results of operations and financial condition. Our products interoperate with many parts of complicated computer systems, such as mainframes, servers, personal computers, application software, databases, operating systems and data transformation software. Failure of any one of these parts could cause all or large parts of computer systems to fail. In such circumstances, it may be difficult to determine which part failed, and it is likely that customers will bring a lawsuit against several suppliers. Even if our software was not at fault, we could suffer material expense and material diversion of management time in defending any such lawsuits.

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 Revenues 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 products, our revenue will also likely decline. The total amount of professional services and customer 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 or a decline in the percentage of customers who renew their annual support agreements, our professional services and fees for customer support revenue could become flat or further decline.

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, independent consultants, application service providers (“ASPs”) and resellers. 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 solutions 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. In addition, our ability to attract such third parties is dependent on our ability to timely develop and enhance new and existing products to support the necessary marketplace and technology standards. 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.

If We Lose Additional Key Employees or Cannot Hire Key Qualified Employees, Such as For the President and CEO Role, It May Adversely Affect Our Ability to Manage Our Business, Develop Our Products and Increase Our Revenues.

We believe our continued growth and success depends to a large extent on the continued service of our senior management and other key employees and the hiring of key qualified employees. In the software industry, there is substantial and continuous competition for highly skilled business, product development, technical and other personnel. We have currently engaged an executive

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search firm to fill the President and CEO role. We are seeking to find a CEO who has deep and relevant operational experience in our industry. We may not be successful in recruiting the right candidate in a timely manner. We may experience increased compensation costs that are not offset by either improved productivity or higher prices. We cannot assure you that there will not be additional departures of key personnel. Any additional changes in management can be disruptive to our operations. In general, we do not have long-term employment or non-competition agreements with our employees. Part of our total compensation program includes stock options. The volatility or lack of positive performance of our stock price may from time to time adversely affect our ability to retain or attract key employees.

Risks Related to Our Industry

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. Any further 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 reduction in demand for computer software, caused by a weakening of the economy, such as occurred in fiscal 2001, 2002 and 2003, or otherwise, may result in continued decreased revenues or lower revenue growth rates.

Entering Into New or Developing Markets May Also Result in Decreased Revenues or Lower Revenue Growth Rates

As we focus on the new market opportunity in master data management and the Business Rules Engine industry, we may be competing with large, established suppliers and/or systems integrators as well as start-up companies. Some of our current and potential competitors may have greater resources, including technical and engineering resources, than we do. Since the master data management market is relatively new, we believe that success in developing and selling master data management products will require us to devote appropriate efforts to develop the strong sales, marketing and development skills required to address new target markets. These efforts may increase our operating costs and, if we fail to generate timely revenue from the master data management business, our working capital and operating results could be adversely affected. There can be no assurance that our efforts to pursue the master data management business or entering the Business Rules engine industry will be successful or will not adversely affect our financial condition or results of operations, particularly in the near term.

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

The software development market in general, and the market for our software and related services in particular, are new, rapidly evolving and highly competitive. We expect the competition in this industry to persist and intensify as the market continues to consolidate. Many of our competitors, including but not limited to IBM, BEA Systems, Oracle, Borland Software, ILOG, Fair Isaac, Pegasystems, Haley Enterprises, SAP and Computer Associates have longer operating histories and significantly greater financial, technical, marketing and other resources than we do. As a result, they may be able to respond more quickly to new or changing opportunities, technologies and customer requirements. Many of 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.

Risks Related to Our Stock

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. 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. 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 Small Cap Market Could Harm Our Business.

Versata’s common stock currently trades on the NASDAQ Small Cap Market, which has certain quantitative continued listing requirements. In March 2004 we transferred the listing of our common stock from the NASDAQ National Market to the NASDAQ Small Cap Market because we no longer met the NASDAQ National Market’s minimum stockholder’s equity requirements. If we are unable to maintain compliance with the Small Cap Market’s continued listing requirements, our common stock could be de-listed from the Small Cap Market, with future sales conducted only in the over the counter market. A transfer to the over the counter market could have a negative impact on the price and liquidity of our common stock.

We May Engage in Future Acquisitions that Dilute Our Stockholders and Cause Us To Incur Debt or Assume Contingent Liabilities.

As part of our strategy, we expect to review opportunities to buy other businesses or technologies that would complement our current products, expand the breadth of our markets or enhance technical capabilities, or that may otherwise offer growth opportunities. In the event of any future acquisitions, we could:

These purchases also involve numerous risks, including:

We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might purchase in the future.

Our Charter Documents, Delaware Law and our Stockholder Rights Plan Contain Provisions That May Inhibit Potential Acquisition Bids, Which May Adversely Affect The Market Price of Our Common Stock, Discourage Merger Offers or Prevent Changes in Our Management.

Our board of directors has the authority to issue up to 833,333 shares of preferred stock and to determine the rights, preferences, privileges and restrictions, including voting rights, of the shares without any further vote or action by our stockholders. If we issue any of these shares of preferred stock in the future, the rights of holders of our common stock may be negatively affected. If we issue preferred stock, a change of control of our company could be delayed, deferred or prevented. We have no current plans to issue shares of preferred stock.

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Section 203 of the Delaware General Corporation Law restricts certain business combinations with any interested stockholder as defined by that statute. In addition, our certificate of incorporation and bylaws contain certain other provisions that may have the effect of delaying, deferring or preventing a change of control. These provisions include:

In April 2004, our board of directors adopted a stockholder rights plan. Under this plan, we issued a dividend of one right for each share of our common stock. Each right initially entitles stockholders to purchase a fractional share of our preferred stock for $13.00. However, the rights are not immediately exercisable. If a person or group acquires, or announces a tender or exchange offer that would result in the acquisition of, a certain percentage of our common stock, unless the rights are redeemed by us for $0.001 per right, the rights will become exercisable by all rights holders, except the acquiring person or group, for shares of our preferred stock or the stock of the third party acquirer having a value of twice the right’s then-current exercise price.

These provisions are designed to encourage potential acquirers to negotiate with our board of directors and give our board of directors an opportunity to consider various alternatives to increase stockholder value. These provisions are also intended to discourage certain tactics that may be used in proxy contests. However, the potential issuance of preferred stock, our charter and bylaw provisions, the restrictions in Section 203 of the Delaware General Corporation Law and our stockholder rights plan could discourage potential acquisition proposals and could delay or prevent a change in control, which may adversely affect the market price of our stock. These provisions and plans may also have the effect of preventing changes in our management.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to a variety of market risks, including changes in interest rates and, to a lesser extent, foreign currency fluctuations. In the normal course of business, we establish policies and procedures to manage our exposure to fluctuations in interest rates and foreign currency values.

Interest Rate Risks. We invest our cash in a variety of financial instruments, consisting principally of investments in commercial paper, interest-bearing demand deposit accounts with financial institutions, money market funds and highly liquid debt securities of corporations, municipalities and the U.S. Government. These investments are denominated in U.S. dollars. Cash balances in foreign currencies overseas are operating balances and are invested in short-term time deposits of the local operating bank.

All of the cash equivalents and short-term investments are treated as “available-for-sale.” Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities that have seen a decline in market value due to changes in interest rates. However, the Company reduces its interest rate risk by investing its cash in instruments with short maturities. As of January 31, 2005, the average number of days to maturity for the instruments held by the Company was 44 and the average yield earned on cost was 1.88%.

Foreign Currency Risks. As of January 31, 2005, the Company had operating subsidiaries located in the United Kingdom, Germany, Canada, and Australia. International sales were made mostly from the Company’s foreign sales subsidiaries in the local countries and are typically denominated in the local currency of each country. These subsidiaries also incur most of their expenses in the local currency. Accordingly, foreign subsidiaries use the local currency as their functional currency.

The Company’s international business is subject to risks typical of an international business, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange volatility. Accordingly, the Company’s future results could be materially adversely impacted by changes in these or other factors. We estimate that a uniform 10% change in the applicable foreign exchange rates would have changed the Company’s net income by approximately $8,000.

The Company is also exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and adversely impact overall financial results. Due to the materiality and nature of our international operations we do not currently enter into foreign currency hedge transactions.

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Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures. Based on the evaluation of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e) required by Securities Exchange Act Rules 13a-15(b) or 15d-15(b), the Company’s Interim Chief Executive Officer and Chief Financial Officer has concluded that as of the end of the period covered by this report the Company’s disclosure controls and procedures were effective.

Changes in internal controls. There were no changes in the Company’s internal controls over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Securities Class Action and State Derivative Actions

On February 14, 2003, the United States District Court for the Northern District of California issued the Order of Final Approval of the Settlements of the consolidated securities class action and the consolidated derivative action that were both initially filed in 2001. Pursuant to the terms of the settlement, Versata’s insurers paid $9.75 million and Versata issued 200,000 shares of common stock and implemented certain corporate therapeutics. The shares of common stock had a $3.50 per share put option exercisable for 20 trading days which commenced on January 28, 2005 and ended on February 25, 2005. We are currently processing the exercised put options via our transfer agent. As of the date of this form 10-Q, we had received less than 10,000 put option requests. We estimate the associated cash expense, including fees payable to the transfer agent, will be approximately $50,000. This cash expense will be incurred in the Company’s second fiscal quarter of 2005. As of January 31, 2005 we had accrued $660,000 for this liability in accrued restructuring and other in the accompanying financial statements.

Litigation and Other Claims

From time to time, we become subject to legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these proceedings and claims cannot be predicted with certainty, we do not believe that the outcome of any of these legal matters will have a material adverse effect on our consolidated results of operations, financial position or cash flows.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On January 28 2004, the Company issued 200,000 shares of Common Stock pursuant to the terms of a court approved settlement of the securities class action described above in Item 1. Legal Proceedings. The securities were exempt from registration under Section 3(a)(10) of the Securities Act of 1933.

Item 3. Defaults Upon Senior Securities

None.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits

EXHIBIT INDEX

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SIGNATURES

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

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