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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended March 31, 2005

OR

Commission File Number: 0-27696

GENSYM CORPORATION

(Exact name of registrant as specified in its charter)

52 Second Avenue

Burlington, MA 01803

(Address of principal executive offices)

Telephone Number (781) 265-7100

(Registrant’s telephone number, including area code)

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

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12-b-2 of the Exchange Act)    Yes  ¨    No  x

As of May 16, 2005 there were 7,277,328 shares of the Registrant’s Common Stock outstanding.

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GENSYM CORPORATION

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. Consolidated Financial Statements

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except per share amounts)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Operations

We are a provider of rule engine software and services for mission-critical solutions that support and automate decisions in real time. Our flagship G2 software applies real-time rule technology for decisions that optimize operations and that detect, diagnose, and resolve costly problems. With applications based on G2, organizations in manufacturing, utilities, communications, transportation, aerospace, finance, and government increase the agility of their business operations and achieve greater levels of performance.

2. Basis of Presentation

We have prepared the unaudited consolidated financial statements included in this report pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. Certain information and footnote disclosures, normally included in financial statements prepared for the full year in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations; nevertheless, our management believes that the disclosures in this report are adequate to make the information presented not misleading. In the opinion of management, the consolidated financial statements reflect all adjustments (of a normal and recurring nature) that are necessary to present fairly our consolidated financial position as of March 31, 2005 and our results of operations and cash flows for the three-month periods ended March 31, 2005 and 2004. These consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004, filed with the SEC on March 31, 2005. The results of operations for interim periods are not necessarily indicative of the results of operations for the full year or any other interim period. Certain prior period amounts have been reclassified to conform to the current period presentation.

During the year ended December 31, 2004, and the first three months of 2005, we maintained operating and overall profitability as well as positive cash flows. Our results for the first quarter of 2005 included a one time charge of $90,000 taken in connection with a the termination of a corporate employee in our European offices. We believe that our cash and cash equivalents and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least the next 12 months. Our ability to maintain growth and profitability in 2005 and beyond is dependent on market acceptance of our existing and next generation of G2 and G2-based products and related services and on renewal of maintenance contracts for customer support at near-current levels.

Management’s expectations for future revenue growth, profitability, and operating cash flows involve significant judgments and estimates. Should these judgments and estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate certain of our activities in order to ensure that we maintain positive cash and working capital. Any of these actions could have a material adverse long-term effect on our business, financial condition and results of operations.

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. Comprehensive Income

The components of comprehensive income for the three-month periods ended March 31, 2005 and 2004 are as follows (in thousands):

4. Net Income Per Share

The following is a reconciliation of basic and diluted weighted average shares used in the computation of net income per share (in thousands):

For the three-month periods ended March 31, 2005 and 2004, options to purchase 197,459 and 292,016 shares of common stock, respectively, were outstanding, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common stock and thus would be anti-dilutive.

5. Stock Based Compensation

We have adopted the disclosure requirements of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of SFAS Statement No. 123. We continue to recognize compensation costs using the intrinsic value based method described in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees.

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Net income and net income per share as reported in these consolidated financial statements on a pro forma basis, as if the fair value based method described in SFAS No. 123 had been adopted, are as follows:

In December 2004, the FASB issued SFAS No. 123(R), Share Based Payment. This statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. This statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods and services or incurs a liability in exchange for goods and services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. It requires an entity to measure the costs of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize that cost over the service period. This statement is effective for the first annual period beginning after June 15, 2005. Accordingly, we will adopt its provisions effective January 1, 2006. We have not yet determined the impact that adoption of this statement will have on our financial position or results of operations.

6. Segment Reporting

Revenue is presented geographically based on the country to which the product is shipped or where the services are provided. The following table presents revenues by geographic area:

Revenues from one customer represented 21% of total revenues for the three-months ended March 31, 2005.

The following table presents our long-lived assets, net of depreciation and amortization, as of March 31, 2005 and December 31, 2004 (in thousands):

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

7. Guarantor Arrangements

In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, while the disclosure requirements are applicable in 2002. We have adopted FIN No. 45, and the adoption of FIN No. 45 did not have a material impact on our financial position or results of operations.

The following is a summary of the agreements that we have determined are within the scope of FIN No. 45:

As permitted under Delaware law, we have agreements whereby we will indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a Director and Officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, our liability for these agreements as of March 31, 2005 is not material.

We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we believe our liabilities recorded for these agreements as of March 31, 2005 are immaterial.

We generally warrant that our unmodified software products, when used as specified, will substantially conform to the applicable user documentation for a specified period of time (generally six months, and longer in jurisdictions with applicable statutory requirements). Additionally, we generally warrant that our consulting services will be performed in a professional and workmanlike manner. In general, liability for these warranties is limited to the amounts paid by the customer. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history, however, we have never incurred significant expense under our product or service warranties. As a result we believe the estimated fair value of these agreements is immaterial. We also generally offer indemnification with respect to certain types of intellectual property claims and, occasionally, other matters.

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

Forward-Looking Statements

This quarterly report contains forward-looking statements and information relating to us and our subsidiaries, which are based on management’s beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used herein, words such as “anticipate”, “believe”, “estimate”, “expect”, “intend” and similar expressions, as they relate to our management or us, identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, and assumptions, including but not limited to those factors set forth below under the caption “Factors That May Affect Future Results”. Should one or more of these risks or uncertainties materialize, or should an underlying assumption prove incorrect, actual results may vary materially from those described in this report as anticipated, believed, estimated, expected or intended. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to update or revise any forward-looking statements.

Business Overview

We were incorporated in Delaware in 1986 to develop and sell software products for expert operations management. We are a provider of rule engine software and services for mission-critical solutions that support and automate decisions in real time. Our flagship G2 software applies real-time rule technology for decisions that optimize operations and that detect, diagnose, and resolve costly problems. With applications based on G2, organizations in manufacturing, utilities, communications, transportation, aerospace, finance, and government increase the agility of their business operations and achieve greater levels of performance.

Applications of our products apply rule-logic in real time to enable organizations to make better operational decisions. Benefits derived from the use of our products include:

Our key product is G2, a mature and robust software platform that underlies all of our other products. We released our most recent version of G2, version 8.0, in June 2004. This release represented a generational advance in our G2 product line and introduced major new capabilities in the areas of reasoning technology, standards-based integration and embeddability, user interface, and developer productivity. G2 8.0 was designed to enable smooth migration of applications running in earlier versions of G2. We have begun field testing a pre-release version of G2 8.1.

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We also offer a number of products that use G2 as a platform. These products enable customers to implement certain types of applications more quickly and economically by providing domain-specific functionality. Our current products are:

We have a professional services group that can be engaged by our customers to develop applications or assist in the development of applications. However, many of our customers build their own applications. We also offer multiple courses to train customers in the use of our products.

We derive revenue from sales of and service for our products and account for such revenue in four ways:

We have a sales force in the United States, Europe, and the Middle East. Our sales force is focused on the generation of new business in several vertical and horizontal markets. The vertical markets include: chemical, oil, and gas; other process manufacturing; discrete manufacturing; power utilities; water utilities; telecommunications; government; transportation; and aerospace. The horizontal markets include business process management, supply chain management, and modeling and simulation.

Our sales activities have historically involved a combination of direct sales to end users and indirect sales through partners. In January 2005, we launched an indirect channel strategy for our sales force that places their primary focus on development of new business through indirect channels. In addition, our sales force will continue to support the current and future needs of our existing end user customers. As part of the execution of our indirect channel strategy, we have introduced new indirect channel programs designed to improve our ability to attract new partners and to support existing partners, which pursue business based on our products across our target vertical markets. Channel partners are also able to provide development, support, and training services to our customers. We have channel partners in North and South America, Europe, the Middle East, Africa, and the Asian-Pacific region.

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The following is the breakdown of revenue by product and service revenue (in thousands):

Prices for our products are generally denominated in U.S. dollars or Euros. The chemical, oil and gas industries are a major market for us. The U.S. Government, particularly the Department of Defense, is a major customer. We have several significant OEM partners, among them Siemens, Ericsson, and Motorola.

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, including those related to bad debts, income taxes, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

For a more detailed explanation of the judgments made in these areas, refer to our Annual Report on Form 10-K for the year ended December 31, 2004. Our critical accounting policies, as detailed in our Form 10-K for the year ended December 31, 2004, have not changed during the three-month period ended March 31, 2005.

Results of Operations

The following table sets forth, as a percentage of total revenues, consolidated statement of operations data for the periods indicated:

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Revenues

Three months ended March 31, 2005 and 2004

Revenues

We derive revenue from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products which include G2 and related application software. Services revenues consist of fees for support and maintenance, which is generally provided on an annual contract basis; consulting services; and training courses related to our products.

Revenue for the three-month periods ended March 31, 2005 and 2004 were as follows::

The increase in overall revenue of $1.1 million, or 27%, between the three-months ended March 31, 2005 and the same period in 2004 was primarily attributable to the following:

US based revenue increased between the two periods in revenue dollars and as a percentage of total revenue, primarily as a result of a large order received through a US government prime contractor.

We currently have one customer that accounts for 21% of revenue for the three-month period ended March 31, 2005.

Our product and service revenue for the three month periods ended March 31, 2005 and 2004 are as follows:

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Product revenues for the three months ended March 31, 2005 increased by $.6 million, or 32%, from the same period in 2004. This increase is mainly attributable to a large order received through a US government prime contractor.

Services revenues for the three months ended March 31, 2005 increased $.5 million, or 23%, from the same period in 2004. This increase is mainly attributable to a large consulting order received through a US government prime contractor.

Cost of Revenues

Cost of revenues primarily consists of consulting labor, technical support costs, general office expenses, and the costs of material and labor involved in producing and distributing our software. These costs for the three-month periods ended March 31, 2005 and 2004 were:

Our product costs remained relatively consistent for the period ended March 31, 2005 compared to the corresponding period in 2004.

Service costs increased $.4 million from the three months ended March 31, 2005 as compared to the same period in 2004. This increase was primarily attributable to the following:

Gross margin percentages for the three-month periods ended March 31,2005 and 2004 were:

Our gross margin on product improved from 92% to 94% during the three-month period ended March 31, 2005 as compared to the respective period in 2004. This is because our product does not necessarily require corresponding additional expense to support additional revenue.

Our gross margin on service decreased from 65% to 58% for the three-month period ended March 31, 2005 as compared to the same period in 2004 as a result of realizing smaller margins on sales that required subcontractor services.

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Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of costs associated with personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising, and promotional materials. These expenses for the three-month period ended March 31, 2005 were $1.4 million, an increase of $.3 million, or 32%, from the same period in 2004. The increase was primarily attributable to the following:

Research and Development. Research and development expenses consist primarily of costs of personnel, equipment and facilities. Expenditures include support of the existing G2 product line as well as the development of the new software reasoning platform, TrueManage. These expenses for the three months ended March 31, 2005 were $1.1 million, an increase of $.2 million, or 21%, from the same period in 2004. This increase is primarily attributable to the following:

General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, administration, operations and general management, as well as legal and accounting expenses. These expenses for the three months ended March 30, 2005 were $1.1 million, an increase of $.2 million, or 16%, from the same period in 2004. This increase was primarily attributable to the following:

The charge taken in connection with the termination of an employee relates to the termination of a corporate employee in our European offices.

Other income (expense), net

Other income (expense), net consists primarily of interest income and expense, realized gains or losses on foreign exchange transactions, and translation adjustments charged to income or expense. Other expense, net for the three months ended March 31, 2005 was $5,000, compared to other expense, net of $53,000 for the same period in 2004. The current other expense is primarily due to foreign exchange rate losses due to the continued weakening of the US dollar.

Income Taxes

Our provision for income taxes pertains to foreign withholding tax and income taxes in the U.S. and foreign jurisdictions where our wholly owned subsidiaries have taxable income but do not have operating loss carry forwards. Provision for income taxes for the three months ended March 31, 2005 was $16,000, compared to $25,000 for the same period in 2004. The decrease in the tax provision for the three months ended March 31, 2005 is primarily attributable to the following:

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LIQUIDITY AND CAPITAL RESOURCES

Our March 31, 2005 cash and cash equivalents amounted to $3.2 million, an increase of $1.2 million from $2.0 million at March 31, 2004. Net cash provided by operating activities for the three-month period ended March 31, 2005 as compared to March 31, 2005 is as follows:

Cash used in investing activities for the period ended March 31, 2005 was $82,000 compared to cash provided by investing activities of $.2 million for the period ended March 31, 2004. This was primarily attributable to the following:

There was no substantive cash provided by financing activities for the three-month periods ended March 31, 2005, and 2004. The activities included the following:

We currently finance our operations, along with capital expenditures, primarily through cash flows from operations and our current cash. Our lease commitments consist of operating leases primarily for our facilities and computer equipment. We also have capital leases for certain computer equipment.

Management’s expectations for future revenue growth, profitability, and operating cash flows involve significant judgments and estimates. Should these judgments and estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate certain of our activities in order to ensure that we maintain positive cash and working capital. Any of these actions could have a material adverse long-term effect on our business, financial condition and results of operations.

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Commitments and Contingencies

Leases

We lease our facilities and certain equipment under operating and capital leases. The future minimum annual payments under these leases at March 31, 2005 are as follows:

Litigation

In May 2005, we received notification from a court in the Netherlands related to a judgment against Gensym in the amount of €99,000 in connection with the termination of a corporate employee in our European offices.

We are involved in various lawsuits, claims and inquiries, most of which are routine to the nature of our business. In the opinion of our management, the resolution of these matters will not have a material adverse effect on our financial position, results of operations or cash flows.

Stock Repurchase Program

In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of March 31, 2005, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2005, 2004 or 2003. During the three months ended March 31, 2005 and 2004, respectively, we reissued 4,260 and 8,843 shares of common stock to employees and non-employee directors. As of March 31, 2005, 360,009 shares remained in treasury at a cost of $1,342,834.

Related party transaction

On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation involving three employees who continue to work for us. In February 2005, we extended the agreement for an additional six month. The agreement calls for the payment of royalties, based on a fixed and determinable percentage of the product sales price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. During the three-month periods ended March 31, 2005, we paid Integration Objects a total of $16,000.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123(R), Share Based Payment. This statement is a revision

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of SFAS No. 123, Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. This statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods and services or incurs a liability in exchange for goods and services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. It requires an entity to measure the costs of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize that cost over the service period. This statement is effective for the first annual period beginning after June 15, 2005. Accordingly, we will adopt its provisions effective January 1, 2006. We have not yet determined the impact that adoption of this statement will have on our financial position or results of operations.

Factors That May Affect Future Results

The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this Form 10-Q or presented elsewhere by management form time to time.

We have a history of operating losses, and we may not remain profitable.

Although we were profitable for the quarter ended March 31, 2005 and all of 2004, we incurred operating losses in 2003 and for three of the five years ending December 31, 2004. In August 2001, we announced a strategic restructuring of our company that included a 40% reduction in workforce, a realignment of our software and services product lines, and a renewed focus on our existing customers. With the restructuring, we achieved profitability for each fiscal quarter of 2002 and for the year ended December 31, 2002. We incurred operating losses in each of the first three quarters of 2003 but achieved profitability in the fourth quarter of 2003. We were profitable for each quarter in 2004 and the first quarter of 2005. As of March 31, 2005, our accumulated deficit was $19.0 million. Our ability to achieve and maintain profitability is dependent on continued revenue from new and existing customers and expense control. There can be no assurance that we will remain profitable and even if we do continue to achieve profitability, we cannot assure you that we can sustain or increase profitability on a quarterly or annual basis.

We are reliant on fees from maintenance contracts and renewals. If we fail to retain our maintenance customers, our revenues may be adversely affected.

We rely on maintenance contract renewals for a significant percentage of our revenue, as software maintenance fees have become a larger component of our total revenues, representing 35%, 44% and 39% of our total revenues in the years ended December 31, 2004, 2003 and 2002, respectively. For the three months ended March 31, 2005, software maintenance fees represented 34% of our total revenue. While a maintenance contract on our products is mandatory for the first year after purchase, subsequent renewals of the maintenance contract are at the discretion of our customers. Accordingly, our failure to retain maintenance customers or a significant decline in the rate of maintenance contract renewals could have a material adverse effect on our business, results of operations, cash flows, and financial position.

We rely heavily on indirect distribution channels and strategic partner relationships for the sales of our products. If these relationships are disrupted, our revenues may be adversely affected.

We sell our products in part through value-added resellers, systems integrators, original equipment manufacturers and distributors, which are not under our control. Sales of our products by such channel partners represented 49%, 56% and 52% of our product revenues in years ended December 31, 2004, 2003 and 2002, respectively. For the three months ended March 31, 2005, channel partner license fees represented 40% of our total revenue. We rely heavily on our indirect sales partners for sales of our expert operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing

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successful G2-based applications could have a material adverse effect on our business, results of operations, cash flows or financial position. There can be no assurance that we will be able to attract or retain additional qualified third-party resellers, or that third-party resellers will be able to effectively sell and implement our products. In addition, we rely on third-party resellers to provide post-sales service and support to our customers, and any deficiencies in such service and support could adversely affect our business, results of operations, cash flows, or financial position.

We depend heavily on our sales and marketing force.

Our future success in the expert operations management marketplace will depend, in part, upon the productivity of our sales and marketing personnel, our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel, and our ability to manage sales and channel partners. There can be no assurance that our investment in sales and marketing will ultimately prove to be successful. In addition, there can be no assurance that our sales and marketing personnel will be able to compete successfully against the significantly more extensive and better funded sales and marketing operations of many of our current and potential competitors. Our inability to manage our sales and marketing personnel effectively could have a material adverse effect on our business, results of operations, cash flows, or financial position.

Our quarterly operating results may vary, leading to fluctuations in trading prices for our common stock and possible liquidity problems.

We have experienced, and may experience in the future, significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a quarterly or annual basis in the future. Our sales cycle typically ranges from 6 to 12 months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our relatively long sales cycle and high license fees, together with fixed short-term expenses, can cause significant variations in operating results from quarter to quarter, based on a relatively small variation in the timing of major orders. Factors such as the timing of new product introductions and upgrades and the timing of significant orders could contribute to this quarterly variability. In addition, we ship software products within a short period after receipt of an order and typically do not have a material backlog of unfilled orders of software products. Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter. Historically, a majority of each quarter’s revenues from software licenses has come from license contracts that have been executed in the final weeks of that quarter. The revenues for a quarter may include some large orders. If the timing of any of these large orders is delayed, it could result in a substantial reduction in revenues for that quarter. Our expense levels are based in part on expectations of future revenue levels. A shortfall in expected revenues could therefore result in a disproportionate decrease in our results of operations and cash flows, which may impact our ability to continue as an independent concern.

We rely heavily on revenues from our G2 and G2-based products. If demand for the G2 product declines, our revenues may be adversely affected.

Substantially all of our license revenues are derived from G2, a customizable object-oriented development and deployment platform for building expert operations management systems, and from software application products based on G2 and other core technologies. Accordingly, our business and financial results are substantially dependent upon the continued customer acceptance and deployment of G2 and our other products. The timing of major G2 releases may affect the timing of purchases of our products. We have introduced several G2-based products for building applications and are developing others. We believe that market acceptance of these products will be important to our future growth. There can be no assurance that such products will achieve market acceptance or that new products will be successfully developed.

In addition, we rely on many of our distribution partners to develop G2-based products for specialized markets. Accordingly, our business and financial results are also linked to the

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continued successful product development by our partners and market acceptance of such G2-based products. Any decline in the demand for G2 and our other products, whether as a result of competitive products, price competition, the lack of success of our partners, technological change, the shift in customer demand toward complete solutions, or other factors, could have a material adverse effect on our business, results of operations, cash flows, or financial position.

Our business may suffer if we fail to address the challenges associated with international operations.

Our international revenues represented 50%, 54%, and 57% of our total revenues for years ended December 31, 2004, 2003, and 2002, respectively. For the three months ended March 31, 2005, international revenues represented 54% of our total revenue. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. The international portion of our business is subject to a number of inherent risks, including difficulties in building and managing international operations, difficulties in localizing products and translating documentation into local languages, fluctuations in the value of international currencies including the Euro, fluctuating import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can be no assurance that these factors will not adversely affect our business, results of operations, cash flows, or financial position.

Our software is complex and may contain undetected errors. Such errors could cause costly delays in product introduction or require costly software design modifications.

Complex software products such as those that we offer may contain unintended errors or failures commonly referred to as “bugs.” There can be no assurance that, despite significant testing by us and by current and potential customers, errors will not be found in new products after commencement of commercial shipments. Although we have not experienced material adverse effects resulting from any such errors or defects to date, there can be no assurance that errors or defects will not be discovered in the future that could cause delays in product introduction and shipments or require design modifications that could adversely affect our business, results of operations, cash flows, or financial position.

Our business may suffer if we fail to remain competitive with other companies offering similar products and services.

A number of companies offer products that offer rule engine capabilities or that perform certain functions of G2 for specific applications. In all of our markets, there is competition from “point solutions,” real-time and rule engine products, and internally developed software. There are commercially available software development tools that software application developers or potential customers could use to build software that has functionality similar to our products.

In addition, we believe that end users in our markets are increasingly seeking application-specific products and components as well as complete solutions, rather than general software tools to develop application-specific functionality and solutions. Meeting this demand has required us to modify our sales approach. We are increasingly reliant on indirect channel partners, including original equipment manufacturers, value-added resellers, and systems integrators, to satisfy market requirements. A number of software companies offer products that compete in specific application areas addressed by these partners, such as cement kiln control, manufacturing execution systems, logistics systems, and network management, and they could be successful in supplying alternatives to products based on our software.

Companies offering competitive rule engine products include Fair Isaac, ILOG, and Computer Associates. Certain companies, such as Micromuse and Aspen Technology, sell “point solutions” that compete with operations management applications based on G2 with respect to specific applications or uses. Several companies, including ILOG., Pavilion, and System Management Arts, offer operations management products with limited real-time, expert system, or

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fault isolation capabilities, but at lower price points than those provided by us. Certain competitors in this category have greater financial and other resources than we do and might introduce new or improved products to compete with G2, possibly at lower prices.

Many of our customers have significant investments in their existing solutions and have the resources necessary to enhance existing products and to develop future products. These customers may develop and incorporate competing technologies into their systems or may outsource responsibility for such systems to others who do not use our products. There is no assurance that we can successfully persuade development personnel within these customers’ organizations to use G2-based products that can cost effectively compete with their internally developed products. Thus there could be a reduction in the need for our products and services that may limit our future opportunities.

We believe that continued investment in research and development and sales and marketing will be required to maintain our competitive position. There can be no assurance that competitors will not develop products or provide services that are superior to our products or services or achieve greater market acceptance. Competitive pressures faced by us could force us to reduce our prices, which could result in reduced profitability. There can be no assurance that we will be able to compete successfully against current and future sources of competition or that such competition will not have a material adverse effect on our business, results of operations, cash flows, or financial position.

Sales of our products are highly dependent on our customers’ capital expenditure budgets. If an economic downturn causes our customers to reduce their capital expenditures, our revenues may be adversely affected.

Because capital expenditures are often viewed as discretionary by organizations, sales of our products for capital budget projects are subject to general economic conditions. Future recessionary conditions in the industries that use our products may adversely affect our business, results of operations, cash flows, or financial position.

Our business may be adversely affected if we fail to develop new products and respond to changes in technology.

The market for our products is characterized by rapid technological change, evolving industry standards, changes in end-user requirements, and frequent new product introductions and enhancements. Our future success will depend in part upon our ability to enhance our existing products, to introduce new products and features to meet changing customer requirements and emerging industry standards, and to manage transitions from one product release to the next. We have from time to time experienced delays in introducing new products and product enhancements. There can be no assurance that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and product enhancements. There also can be no assurance that we will successfully complete the development of new or enhanced products, that we will successfully manage the transition to future versions of G2, or to successor technology, or that our future products will achieve market acceptance. In addition, the introduction of products embodying new technologies and the emergence of new industry standards could render our existing products and products currently under development obsolete and unmarketable. From time to time, new products, capabilities, or technologies may be announced that have the potential to replace or shorten the life cycle of our existing product offerings. There can be no assurance that announcements of currently planned or other new product offerings will not cause customers to defer purchasing our existing products.

Our research and development in new reasoning technologies may not lead to profitable commercialization.

We are developing a new software reasoning platform, TrueManage that is designed for handheld computing devices and targeted at application markets not currently addressed by our G2 and G2-based

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products. We have also begun to develop a TrueManage application product called LifeVisor, a cell phone device for self-management of chronic conditions such as diabetes and obesity. Development of TrueManage and LifeVisor is complex, requiring specialized technical expertise. The targeted handheld computing markets are experiencing rapid advancements in related technologies and applications. We anticipate that it will require significant funding to develop, launch, and build distribution channels for TrueManage and LifeVisor. There can be no assurance that we will be able to provide this level of funding internally. There can be no assurance that we will be able to raise additional funding externally at reasonable rates. Our strategy is to distribute these products, particularly LifeVisor, through other companies that have significantly larger presence and scale in the targeted markets than we do. There can be no assurance that we will be able to successfully complete the development of TrueManage and LifeVisor, that we will be able to provide functionality that is accepted by the targeted markets, or that we will be able to build partnerships for profitable distribution of these products.

Managing our international operations is complex and our failure to do so successfully or in a cost-effective manner would have a material adverse effect on our business, operating results and financial condition

International sales accounted for 50%, 54% and 57% of our total revenues for the years ended December 31, 2004, 2003 and 2002, respectively. For the three months ended March 31, 2005, international revenues represented 54% of our total revenue. Our international operations require significant management attention and financial resources.

There are certain risks inherent in our international business activities including:

These factors may have a material adverse effect on our future international sales and, consequently, on our business, operating results and financial condition.

Our stock price may be volatile and an investment in our common stock could suffer a decline in value.

The market price for our common stock may fluctuate significantly in response to a number of factors, some of which are beyond our control. These factors include:

The stock market has recently experienced extreme price and volume fluctuations. These fluctuations have particularly affected the market price of many software companies, often without regard to their operating performance.

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Compliance with changing regulation of corporate governance and public disclosure may result in additional risks and expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ rules, are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and management time and attention. In particular, our efforts to comply with Section 404 of Sarbanes-Oxley and the related regulations regarding our required assessment of our internal controls over financial reporting and our external auditors’ audit of that assessment has required the commitment of significant financial and managerial resources and we expect our compliance efforts to require the continued commitment of significant resources. Additionally, if our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies, our reputation may be harmed and we might be subject to sanctions or investigation by regulatory authorities, such as the SEC. Any such action could adversely affect our business and the market price of our stock.

Our common stock is quoted on the OTC Bulletin Board, which limits the liquidity and could negatively affect the value of our common stock.

Our common stock is quoted on the OTC Bulletin Board, which provides significantly less liquidity than a securities exchange, such as the American Stock Exchange, or an automated quotation system, such as the NASDAQ National or SmallCap Market.

Purchasers of shares of our common stock may find it difficult to resell their shares at prices quoted in the market or at all. There is currently a limited volume of trading in our common stock, and on many days there has been no trading activity at all. We cannot predict when or whether investor interest in our common stock might lead to an increase in its market price or the development of a more active trading market or how liquid that market might become.

Additionally, because our common stock is listed on the OTC Bulletin Board, the liquidity of our common stock is impaired, not only in the number of shares that are bought and sold, but also through delays in the timing of transactions, and limited coverage by security analysts and the new media, if any, of our company. As a result, prices for shares of our common stock may be lower than might otherwise prevail if our common stock was traded on NASDAQ or a national securities exchange, like the American Stock Exchange.

Because we rely heavily upon proprietary technology, our business could be adversely affected if we are unable to protect our proprietary technology or if third parties successfully assert infringement claims against us.

Our success is heavily dependent upon our proprietary technology. We rely upon a combination of trade secret, contract, copyright, patent, and trademark law to protect our proprietary rights in our products and technology. We enter into confidentiality and/or license agreements with our employees, third-party resellers, and end users and limit access to and distribution of our software, documentation, and other proprietary information. In addition, we have placed technical inhibitors in our software that prevent such software from running on unauthorized computers. However, effective patent, copyright, and trade secret protection may not be available in every country in which our products are distributed. There can be no assurance that the steps taken by us to protect our proprietary technology will be adequate to prevent misappropriation of our technology by

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third parties, or that third parties will not be able to develop similar technology independently. In addition, there can be no assurance that third parties will not assert infringement claims in the future or that such claims will not be successful.

Changes to financial accounting standards could make it more expensive to issue stock options to employees, which will increase our compensation costs and may cause us to change our business practices.

We prepare our financial statements to conform to GAAP in the United States America. These accounting principles are subject to interpretation by the Public Company Accounting Oversight Board, the SEC and various other bodies. A change in those policies could have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. For example, we have used stock options and other long-term equity incentives as a component of our employee compensation packages. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value and, through the use of vesting, encourage employees to remain with us. In December 2004, the Financial Accounting Standards Board issued a final standard that will require us to record a charge to earnings for the fair value employee stock option grants. Originally, this standard was to be effective for periods beginning after June 15, 2005. However, in April 2005, the Financial Accounting Standards Board changed the implementation date for the new standard to the beginning of a company’s next fiscal year that begins after June 15, 2005, which means that the new standard will be effective for us beginning in 2006. We could adopt the standard in one of two ways the modified prospective transition method or the modified retrospective transition method, and we have not concluded how we will adopt the new standard. In addition, regulations implemented by The NASDAQ National Market generally require stockholder approval for all stock option plans, which could make it more difficult or expensive for us to grant stock options to employees if we comply with such regulations. We will, as a result of these changes, incur increased compensation costs, which could be material and we may change our equity compensation strategy or find it difficult to attract, retain and motivate employees.

Provisions in our corporate documents and Delaware law could delay or prevent a change of control of us, even if that change would be beneficial to our stockholders.

Our certificate of incorporation and bylaws contain provisions that may make a change of control of us difficult, even if it would be beneficial to our stockholders, including provisions governing the classification, nomination and removal of directors, prohibiting stockholder action by written consent and regulating the ability of our stockholders to bring matters for action before annual stockholder meetings, and the authorization given to our board of directors to issue and set the terms of preferred stock.

In addition, we have adopted a stockholder rights plan, which would cause extreme dilution to any person or group that attempts to acquire a significant interest in our company without advance approval of our board of directors, while Section 203 of the Delaware General Corporation Law would impose restrictions on mergers and other business combinations between us and any holder of 15 percent or more of our outstanding common stock.

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ITEM 3. Qualitative and Quantitative Disclosures About Market Risk

Investment Portfolio

We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand deposit accounts we use instruments that meet high credit quality standards, such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At March 31, 2005, substantially all of our funds were in demand deposit accounts.

Impact of Foreign Currency Rate Changes

Our contracts with customers are generally denominated in U.S. dollars or Euros. We transact business in various countries and thus have exposure to adverse movements in foreign currency exchange rates. This exposure is primarily related to intercompany receivable and payable balances that are recorded on the balance sheet in currencies other than the functional currency. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the currency translation adjustment of the equity section of the balance sheet. In addition, we have certain cash balances held in currencies other than our functional currency or the functional currency of our subsidiaries. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the appropriate statements of operations.

ITEM 4. Controls and Procedures.

Our management, with the participation of our chief executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2005. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and procedures of a company that are designed to ensure that information required to be disclosed by us in the reports that we filed or submit to under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of March 31, 2005, as a result of the material weaknesses in our internal controls over financial reporting described below, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were not effective.

During, and shortly following, the fiscal quarter ended June 30, 2003, we experienced turnover in our accounting and finance organization. In particular, our corporate controller left our company, and our European controller was on a personal leave of absence beginning in June 2003, returned to full-time status in October 2003, and was on personal leave again from April 2004 through the present. Furthermore, our former chief financial officer left our company in early August 2003. Management determined that the loss, or temporary absence of, these personnel resulted in certain conditions which, when considered collectively, constituted a material weakness in our internal controls. Such conditions included:

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In addition to these weaknesses, our former independent auditors, PricewaterhouseCoopers LLP, identified certain other matters representing material weaknesses in internal controls over financial reporting in connection with their audit of our financial statements for the year ended December 31, 2003. These items included:

Our current independent auditors, Vitale, Caturano & Company, Ltd., identified certain other matters representing material weaknesses or significant deficiencies in internal controls over financial reporting in connection with their audit of our financial statements for the year ended December 31, 2004. These items included:

Beginning in the quarter ended September 30, 2003 we took a number of corrective actions to address the material weaknesses discussed above, including:

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We have performed additional procedures to evaluate the extent to which the internal control weaknesses discussed above could have led to material misstatements in our consolidated financial statements. Based on our evaluation, we do not believe that the control weaknesses and deficiencies noted above led to any material misstatements in the consolidated financial statements included in this report.

We are continuing the process of establishing remote access for all of our bank accounts and adding our chief financial officer and chief executive officer as signatories to all of our bank accounts. We are also evaluating our review and approval process relating to customer contracts and invoices, and intend to revise the reporting and responsibility for that process.

PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

In May 2005, we received notification from a court in the Netherlands of a judgment against Gensym in the amount of €99,000 in connection with the termination of a corporate employee in our European offices.

We are involved in various lawsuits, claims and inquiries, most of which are routine to the nature of our business. In the opinion of management, the resolution of these matters will not have a material adverse effect on our financial position, results of operations or cash flow.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

The following table provides information about purchases by the company during the quarter ended March 31, 2005 of equity securities that are registered by the company pursuant to Section 12 of the Exchange Act:

GENSYM PURCHASES OF EQUITY SECURITIES

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ITEM 6. Exhibits

(a) The following exhibits are filed as part of this Report on Form 10-Q:

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SIGNATURES

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

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EXHIBIT INDEX

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