10-Q 1 a05-13135_110q.htm 10-Q

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

OR

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 000-50839

Phase Forward Incorporated

(Exact name of registrant as specified in its charter)

Delaware

04-3386549

(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer
Identification No.)

880 Winter Street
Waltham, Massachusetts

  
02451

(Address of principal executive offices)

(Zip Code)

 

(888) 703-1122

(Registrant’s telephone number, including area code)

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

Yes   x   No   o

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

Yes   o   No   x

As of July 15, 2005, the registrant had 33,133,020 shares of Common Stock outstanding.

 




PHASE FORWARD INCORPORATED
QUARTERLY REPORT ON FORM 10-Q
For the quarterly period ended June 30, 2005
Table of Contents

 

 

 

Page
Number

Part I—Financial Information

 

 

 

 

Item 1.

 

Condensed Consolidated Financial Statements (unaudited)

 

 

3

 

 

 

Condensed Consolidated Balance Sheets as of December 31, 2004 and June 30, 2005

 

 

3

 

 

 

Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2005

 

 

4

 

 

 

Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2005

 

 

5

 

 

 

Notes to Condensed Consolidated Financial Statements

 

 

6

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

18

 

Item 3.

 

Quantitative and Qualitative Disclosures about Market Risk

 

 

47

 

Item 4.

 

Controls and Procedures

 

 

47

 

Part II—Other Information

 

 

 

 

Item 5.

 

Other Information

 

 

49

 

Item 6.

 

Exhibits

 

 

49

 

Signatures

 

 

50

 

Exhibit Index

 

 

 

 

 

2




Part I—Financial Information

Item 1.                        Condensed Consolidated Financial Statements (unaudited)

Phase Forward Incorporated and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited)

(in thousands, except per share amounts)

 

 

As of 
December 31,
2004

 

As of
June 30,
2005

 

Assets

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

$

53,485

 

 

$

56,455

 

Short-term investments

 

 

4,735

 

 

8,816

 

Accounts receivable, net of allowance of $391 and $289 in 2004 and 2005, respectively

 

 

19,682

 

 

15,956

 

Deferred set up costs, current portion

 

 

783

 

 

1,089

 

Prepaid commissions and royalties, current portion

 

 

3,035

 

 

3,718

 

Prepaid expenses and other current assets

 

 

2,335

 

 

2,434

 

Total current assets

 

 

84,055

 

 

88,468

 

Property and equipment, net

 

 

5,717

 

 

5,603

 

Deferred set up costs, net of current portion

 

 

665

 

 

687

 

Prepaid commissions and royalties, net of current portion

 

 

2,756

 

 

2,596

 

Goodwill

 

 

21,817

 

 

21,047

 

Other assets

 

 

240

 

 

186

 

Total assets

 

 

$

115,250

 

 

$

118,587

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

 

 

Current Liabilities:

 

 

 

 

 

 

 

Current portion of notes payable

 

 

$

2,558

 

 

$

 

Accounts payable

 

 

1,619

 

 

1,258

 

Accrued expenses

 

 

11,658

 

 

10,717

 

Restructuring accrual

 

 

344

 

 

 

Deferred revenue, current portion

 

 

35,350

 

 

38,716

 

Deferred rent, current portion

 

 

142

 

 

332

 

Total current liabilities

 

 

51,671

 

 

51,023

 

Notes payable, net of current portion

 

 

1,849

 

 

 

Deferred revenue, net of current portion

 

 

1,002

 

 

1,456

 

Deferred rent, net of current portion

 

 

1,481

 

 

1,387

 

Total liabilities

 

 

56,003

 

 

53,866

 

Contingencies (Note 13)

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

Preferred stock, $0.01 par value:

 

 

 

 

 

 

 

Authorized—5,000 shares

 

 

 

 

 

 

 

Issued—0 shares

 

 

 

 

 

Common stock, $0.01 par value:

 

 

 

 

 

 

 

Authorized—100,000 shares

 

 

 

 

 

 

 

Issued—32,399 and 33,109 shares in 2004 and 2005, respectively

 

 

324

 

 

331

 

Additional paid-in capital

 

 

165,462

 

 

167,394

 

Subscription receivable

 

 

(127

)

 

 

Deferred stock-based compensation

 

 

(1,755

)

 

(1,119

)

Treasury stock, 37 shares at cost

 

 

(111

)

 

(111

)

Accumulated other comprehensive loss

 

 

(160

)

 

(694

)

Accumulated deficit

 

 

(104,386

)

 

(101,080

)

Total stockholders’ equity

 

 

59,247

 

 

64,721

 

Total liabilities and stockholders’ equity

 

 

$

115,250

 

 

$

118,587

 

 

See accompanying notes.

3




Phase Forward Incorporated and Subsidiaries
Condensed Consolidated Statements of Operations
(unaudited)
(in thousands, except per share amounts)

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

Revenues:

 

 

 

 

 

 

 

 

 

License

 

$

6,357

 

$

8,632

 

$

12,523

 

$

17,451

 

Service

 

11,336

 

12,066

 

22,132

 

23,809

 

Total revenues

 

17,693

 

20,698

 

34,655

 

41,260

 

Costs of revenues:

 

 

 

 

 

 

 

 

 

License

 

448

 

589

 

870

 

1,037

 

Service(1)

 

6,842

 

7,464

 

13,623

 

14,676

 

Total costs of revenues

 

7,290

 

8,053

 

14,493

 

15,713

 

Gross margin:

 

 

 

 

 

 

 

 

 

License

 

5,909

 

8,043

 

11,653

 

16,414

 

Service

 

4,494

 

4,602

 

8,509

 

9,133

 

Total gross margin

 

10,403

 

12,645

 

20,162

 

25,547

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing(1)

 

3,536

 

3,960

 

6,841

 

7,911

 

Research and development(1)

 

3,018

 

3,489

 

5,954

 

6,770

 

General and administrative(1)

 

2,903

 

3,218

 

5,546

 

7,022

 

Restructuring

 

 

 

 

(92

)

Total operating expenses

 

9,457

 

10,667

 

18,341

 

21,611

 

Income from operations

 

946

 

1,978

 

1,821

 

3,936

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest income

 

67

 

439

 

172

 

787

 

Interest expense

 

(128

)

 

(210

)

(144

)

Other, net

 

87

 

(11

)

71

 

(141

)

Total other income

 

26

 

428

 

33

 

502

 

Income before provision for income taxes

 

972

 

2,406

 

1,854

 

4,438

 

Provision for income taxes

 

542

 

568

 

1,041

 

1,132

 

Net income

 

430

 

1,838

 

813

 

3,306

 

Accretion of preferred stock and dividend declared

 

6,618

 

 

8,536

 

 

Net income (loss) applicable to common stockholders

 

$

(6,188

)

$

1,838

 

$

(7,723

)

$

3,306

 

Net income (loss) per share applicable to common stockholders:

 

 

 

 

 

 

 

 

 

Basic

 

$

(1.70

)

$

0.05

 

$

(2.15

)

$

0.10

 

Diluted

 

$

(1.70

)

$

0.05

 

$

(2.15

)

$

0.09

 

Weighted average number of common shares used in net income (loss) per share calculations:

 

 

 

 

 

 

 

 

 

Basic

 

3,646

 

32,869

 

3,598

 

32,663

 

Diluted

 

3,646

 

34,639

 

3,598

 

34,588

 


(1)             Amounts include stock-based expenses, as follows:

Costs of service revenues

 

$

24

 

$

12

 

$

50

 

$

37

 

Sales and marketing

 

40

 

12

 

79

 

(4

)

Research and development

 

83

 

40

 

179

 

95

 

General and administrative

 

326

 

69

 

611

 

229

 

Total stock-based expenses

 

$

473

 

$

133

 

$

919

 

$

357

 

 

See accompanying notes.

4




Phase Forward Incorporated and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(unaudited)
(in thousands)

 

 

Six Months Ended
June 30,

 

 

 

2004

 

2005

 

Operating activities

 

 

 

 

 

Net income

 

$

813

 

$

3,306

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

1,492

 

1,571

 

Stock-based expenses

 

919

 

357

 

Loss on disposal of fixed assets

 

 

12

 

Foreign currency exchange loss

 

(38

)

147

 

Provision for allowance for doubtful accounts

 

65

 

(35

)

Non-cash income tax expense

 

1,022

 

769

 

Amortization of premiums or discounts on short-term investments

 

 

(26

)

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

7,495

 

3,370

 

Deferred costs

 

(1,310

)

(945

)

Prepaid expenses and other current assets

 

(474

)

(226

)

Accounts payable

 

229

 

(352

)

Accrued expenses

 

(1,465

)

(1,052

)

Deferred revenue

 

(2,647

)

4,030

 

Deferred rent

 

664

 

105

 

Net cash provided by operating activities

 

6,765

 

11,031

 

Investing activities

 

 

 

 

 

Purchase of short-term investments

 

 

(6,549

)

Proceeds from maturities of short-term investments

 

 

2,525

 

Purchase of property and equipment

 

(1,240

)

(1,532

)

Decrease in restricted cash, net

 

1,611

 

 

Decrease (increase) in other assets

 

(13

)

9

 

Net cash provided by (used in) investing activities

 

358

 

(5,547

)

Financing activities

 

 

 

 

 

Proceeds from issuance of notes payable and borrowings under lines of credit

 

1,932

 

 

Payments on lines of credit and notes payable

 

(1,266

)

(4,407

)

Stock issuance costs

 

(1,075

)

 

Proceeds from issuance of common stock

 

90

 

2,218

 

Proceeds from repayment of subscriptions receivable

 

514

 

127

 

Net cash provided by (used in) financing activities

 

195

 

(2,062

)

Effect of exchange rate changes on cash and cash equivalents

 

6

 

(452

)

Net change in cash and cash equivalents

 

7,324

 

2,970

 

Cash and cash equivalents at beginning of year

 

19,046

 

53,485

 

Cash and cash equivalents at end of period

 

$

26,370

 

$

56,455

 

Non-cash financing activities

 

 

 

 

 

Accretion of Series B, C, and D redeemable convertible preferred stock to redemption value

 

$

3,836

 

$

 

Declaration of special dividend

 

$

4,700

 

$

 

 

See accompanying notes.

5




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

1.   Basis of Presentation

The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Phase Forward Incorporated (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such SEC rules and regulations. Management of the Company believes that the disclosures herein are adequate to make the information presented not misleading. In the opinion of management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and reflect all material adjustments (consisting only of those of a normal and recurring nature) which are necessary to present fairly the consolidated financial position of the Company as of June 30, 2005, the results of its operations for the three and six months ended June 30, 2004 and 2005 and its cash flows for the six months ended June 30, 2004 and 2005. These unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s 2004 Annual Report on Form 10-K filed with the SEC on March 9, 2005. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2005.

2.   Revenue Recognition and Deferred Set up Costs

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

The components of revenue are as follows:

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

License

 

$

6,357

 

$

8,632

 

$

12,523

 

$

17,451

 

Application hosting services

 

6,689

 

7,275

 

12,601

 

14,106

 

Consulting services

 

1,215

 

1,622

 

2,779

 

3,017

 

Customer support

 

3,432

 

3,169

 

6,752

 

6,686

 

Total

 

$

17,693

 

$

20,698

 

$

34,655

 

$

41,260

 

 

The Company recognizes software license revenue in accordance with Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition, as amended, issued by the American Institute of Certified Public Accountants, while revenue resulting from application hosting services are recognized in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-03, Application of AICPA Statement of Position 97-2 to Arrangements that include the Right to Use Software Stored on Another Entity’s Hardware, SEC Staff Accounting Bulletin (“SAB”) Nos. 101 and 104, Revenue Recognition, and EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables.

6




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

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

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

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

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

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

In addition to making its software products available to customers through licenses, the Company offers its InForm electronic data capture software product through a fully-hosted, turnkey deployment.

7




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

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

The Company capitalized $322 and $509 of deferred set up costs and amortized $384 and $398 in the three months ended June 30, 2004 and 2005, respectively, and capitalized $849 and $1,175 of deferred set up costs and amortized $880 and $847 in the six months ended June 30, 2004 and 2005, respectively. The amortization of deferred set up costs is a component of cost of services.

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

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

In accordance with EITF Issue No. 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred, the Company included $127 and $193 of out of pocket expenses in service revenue and cost of service revenue in the three months ended June 30, 2004 and 2005, respectively, and included $424 and $390 of out of pocket expenses in service revenue and cost of service revenue in the six months ended June 30, 2004 and 2005, respectively.

3.   Prepaid Sales Commissions and Royalties

For arrangements where revenue is recognized over the relevant contract period, the Company capitalizes related commissions paid to sales people and royalties paid to third parties, and recognizes these expenses over the period that the related revenue is recognized. Commission payments are nonrefundable unless amounts due from a customer are determined to be uncollectible or if the customer subsequently changes or terminates the level of service, in which case commissions paid are recoverable by the Company. The Company capitalized $820 and $646 of commissions and amortized to sales and marketing expense $681and $905 in the three months ended June 30, 2004 and 2005, respectively, and capitalized $1,580 and $1,323 of commissions and amortized to sales and marketing expense $1,249 and $1,735 in  the six months ended June 30, 2004 and 2005, respectively.

8




The Company’s royalty obligation is based upon the license and customer support revenue earned for certain products in an arrangement. The Company has the right to recover the royalties in the event the arrangement is cancelled. The Company capitalized $1,051and $1,412 of royalties and amortized to costs of revenues $604 and $728 in the three months ended June 30, 2004 and 2005, respectively, and capitalized $2,201 and $2,234 of royalties and amortized to costs of revenues $1,189 and $1,299 in the six months ended June 30, 2004 and 2005, respectively.

4.   Warranties and Indemnification

The Company’s software license arrangements and hosting services are typically warranted to perform in a manner consistent with general industry standards that are reasonably applicable and substantially in accordance with the Company’s online help documentation under normal use and circumstances. The Company’s arrangements also include certain provisions for indemnifying customers against liabilities if its products or services infringe a third party’s intellectual property rights. See the discussion of possible indemnification obligations in Note 13.

The Company has entered into service level agreements with some of its hosted application customers warranting certain levels of uptime reliability and permitting those customers to receive credits against monthly hosting fees or terminate their agreements in the event that the Company fails to meet those levels.

To date, the Company has not incurred any material costs as a result of such indemnifications and has not accrued any liabilities related to such obligations in the accompanying consolidated financial statements.

5.   Net Income (Loss) Per Share

Basic and diluted net income (loss) per share is presented in conformity with SFAS No. 128, Earnings Per Share. Basic net income (loss) per common share was determined by dividing net income (loss) applicable to common stockholders by the weighted average number of common shares outstanding during the period. Weighted average shares outstanding exclude unvested restricted common stock. The Company’s potentially dilutive shares, which include outstanding common stock options, redeemable convertible preferred stock and warrants also have not been included in the computation of diluted net income (loss) per share for all periods in which the Company was in a loss position as the result would be anti-dilutive.

9




The following table reconciles the weighted average shares outstanding used to calculate basic and diluted net income (loss) per share:

 

 


Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

 

$

(6,188

)

$

1,838

 

$

(7,723

)

$

3,306

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

3,676,748

 

32,869,181

 

3,633,898

 

32,662,841

 

Less: Weighted average unvested restricted common shares outstanding 

 

(30,399

)

 

(35,764

)

 

Basic net income (loss) per share—weighted average common shares

 

3,646,349

 

32,869,181

 

3,598,134

 

32,662,841

 

Dilutive effect of common stock options 

 

 

1,769,664

 

 

1,924,820

 

Diluted net income (loss) per share—weighted average common shares

 

3,646,349

 

34,638,845

 

3,598,134

 

34,587,661

 

Net income (loss) per share applicable to common stockholders:

 

 

 

 

 

 

 

 

 

Basic

 

$

(1.70

)

$

0.05

 

$

(2.15

)

$

0.10

 

Diluted

 

$

(1.70

)

$

0.05

 

$

(2.15

)

$

0.09

 

 

The following common share equivalents and unvested restricted shares have been excluded from the computation of diluted weighted average shares outstanding as of June 30, 2004 and 2005, respectively, as their effect would have been anti-dilutive.

 

 

As of  June 30,

 

 

 

2004

 

2005

 

Redeemable convertible preferred stock

 

22,841,157

 

 

Options outstanding

 

4,457,525

 

668,000

 

Unvested restricted shares

 

25,035

 

 

Warrant

 

34,330

 

 

 

6.   Foreign Currency Translation

The financial statements of the Company’s foreign subsidiaries are translated in accordance with SFAS No. 52, Foreign Currency Translation. The reporting currency for the Company is the U.S. dollar. The functional currency of the Company’s subsidiaries in the United Kingdom, France, Germany, Japan and Australia are the local currencies of those countries. Accordingly, the assets and liabilities of the Company’s foreign subsidiaries are translated into U.S. dollars using the exchange rate in effect at each balance sheet date. Revenue and expense accounts are generally translated using an average rate of exchange during the period. Foreign currency translation adjustments are accumulated as a component of other comprehensive loss as a separate component of stockholders’ equity. Gains and losses arising from transactions denominated in foreign currencies are primarily related to intercompany accounts that have

10




been determined to be temporary in nature and cash and accounts receivable denominated in non-functional currencies. The Company has recorded foreign currency gains (losses) of $54 and ($17) for the three months ended June 30, 2004 and 2005, respectively, and approximately $38 and ($147) for the six months ended June 30, 2004 and 2005, respectively. Such gains and (losses) are included in other income (expense) in the accompanying unaudited condensed consolidated statements of operations.

7.   Cash, Cash Equivalents and Short-Term Investments

The Company accounts for its investments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Under SFAS No. 115, securities that the Company has the intent and ability to hold to maturity are reported at amortized cost, which approximates market value, and are classified as held-to-maturity. The Company considers all highly liquid investments with original maturities of 90 days or less at the time of purchase to be cash equivalents and investments with original maturities of between 91 days and one year to be short term investments. The Company invests in high quality corporate debentures rated at least A2 by Moody’s Investors Service or A by Standard & Poors. At June 30, 2005 cash equivalents primarily consisted of money market funds that were readily convertible to cash. At June 30, 2005, short-term investments primarily consisted of U.S. agency notes and corporate debentures.

Cash, cash equivalents and short-term investments as of December 31, 2004 and June 30, 2005 were as follows:

 

 

December 31, 2004

 

Description

 

 

 

Contracted
Maturity

 

Amortized
Cost

 

Fair Market
Value

 

Cash and cash equivalents

 

Demand

 

 

$

13,138

 

 

 

$

13,138

 

 

U.S. agency notes and U.S. treasury bills

 

Less than 90 days

 

 

3,390

 

 

 

3,390

 

 

Money market funds

 

Demand

 

 

35,014

 

 

 

35,014

 

 

Certificate of deposit

 

30 days

 

 

1,943

 

 

 

1,943

 

 

Total cash and cash equivalents

 

 

 

 

$

53,485

 

 

 

$

53,485

 

 

Short-term investments

 

147-356 days

 

 

$

4,735

 

 

 

$

4,728

 

 

 

 

 

June 30, 2005

 

Description

 

 

 

Contracted
Maturity

 

Amortized
Cost

 

Fair Market
Value

 

Cash and cash equivalents

 

Demand

 

 

$

14,512

 

 

 

$

14,512

 

 

U.S. agency notes and U.S. treasury bills

 

Less than 90 days

 

 

4,772

 

 

 

4,772

 

 

Money market funds

 

Demand

 

 

37,171

 

 

 

37,171

 

 

Total cash and cash equivalents

 

 

 

 

$

56,455

 

 

 

$

56,455

 

 

Short-term investments

 

105-359 days

 

 

$

8,816

 

 

 

$

8,803

 

 

 

The Company has had no realized or unrealized gains or losses to date on the sale of money market funds or short-term investments.

11




8.   Stock-Based Compensation

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

The following tables illustrate the assumptions used and the effect on net income (loss) if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. The Company has computed the pro forma disclosures required under SFAS No. 123 for all employee stock options granted using the Black-Scholes option pricing model prescribed by SFAS No. 123.

The assumptions used and weighted average information are as follows:

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

Average risk-free interest rate

 

4.07

%

3.99

%

3.61

%

4.00

%

Expected dividend yield

 

 

 

 

 

Expected life

 

7 years

 

4 years

 

7 years

 

4 years

 

Expected volatility

 

90

%

90

%

0-90

%

90

%

Weighted average fair value at grant date

 

$

5.49

 

$

6.53

 

$

6.00

 

$

6.41

 

 

The Company offers the 2004 Employee Stock Purchase Plan. Accordingly, the Company has calculated the SFAS No. 123 pro forma expense for shares purchased under the 2004 Employee Stock Purchase Plan using the following assumptions:

 

 

Three Months Ended
June 30, 2005

 

Six Months Ended
June, 30 2005

 

Average risk-free interest rate

 

 

3.12

%

 

 

2.77

%

 

Expected dividend yield

 

 

 

 

 

 

 

Expected life

 

 

0.50 years

 

 

 

0.50 years

 

 

Expected volatility

 

 

60

%

 

 

60

%

 

 

12




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

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

Net income (loss) applicable to common stockholders, as reported

 

$

(6,188

)

$

1,838

 

$

(7,723

)

$

3,306

 

Add: Stock-based compensation expense included in reported net income (loss)

 

473

 

133

 

919

 

357

 

Less: Total stock-based employee compensation expense determined under fair-value-based method for all awards

 

(604

)

(859

)

(1,202

)

(1,516

)

Pro forma net income (loss)

 

$

(6,319

)

$

1,112

 

$

(8,006

)

$

2,147

 

Pro forma net income (loss) per share applicable to common stockholders:

 

 

 

 

 

 

 

 

 

Basic

 

$

(1.73

)

$

0.03

 

$

(2.23

)

$

0.07

 

Diluted

 

$

(1.73

)

$

0.03

 

$

(2.23

)

$

0.06

 

 

9.   Goodwill

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

Balance as of December 31, 2004

 

$

21,817

 

Utilization of acquired net operating losses in the six months ended June 30, 2005

 

(770

)

Balance as of June 30, 2005

 

$

21,047

 

 

The Company acquired Clinsoft Corporation, which developed and sold the Clintrial and Clintrace products, on August 14, 2001. The goodwill resulting from the acquisition is reviewed for impairment on an annual basis in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. The Company performed its annual impairment test for the year ended December 31, 2004 as of October 1, 2004 and determined that no impairment of goodwill existed.

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

10.   Accrued Expenses

Accrued expenses consist of the following:

 

 

As of
December 31,
2004

 

As of
June 30,
2005

 

Accrued payroll and related benefits

 

 

$

4,791

 

 

$

3,427

 

Accrued royalties

 

 

2,378

 

 

2,347

 

Accrued income taxes

 

 

1,289

 

 

922

 

Accrued other expenses

 

 

3,200

 

 

4,021

 

 

 

 

$

11,658

 

 

$

10,717

 

 

13




11.   Restructuring

The Company recorded a $4,503 restructuring charge for the year ended December 31, 2003 that related to the relocation of the Company’s corporate headquarters in December 2003. Of this amount, $2,486 represented the loss on a facilities lease and $2,017 related to the abandonment of the related fixed assets and leasehold improvements. The facility lease loss represented 15 months of rent remaining under an existing lease and related operating expenses. As of March 31, 2005, payment of all charge related expenses had occurred and as a result the Company recorded a benefit of $92 representing the elimination of accrued expenses associated with the restructuring charge.

The rollforward of the restructuring charge is as follows:

 

 

Lease
Loss

 

Balance as of December 31, 2003

 

$

2,486

 

Payments made in the twelve months ended December 31, 2004

 

(1,974

)

Reduction to provision for lease loss in the twelve months ended December 31, 2004

 

(168

)

Balance as of December 31, 2004

 

$

344

 

Payments made in the six months ended June 30, 2005

 

(252

)

Reduction to provision for lease loss in the six months ended June 30, 2005

 

(92

)

Balance as of June 30, 2005

 

$

 

 

12.   Debt

Between April 2000 and September 2004, the Company had entered into several equipment lines of credit with a bank. All advances under these equipment lines of credit were payable in 30 to 36 equal monthly installments of principal, plus accrued interest. The interest that accrued under these notes ranged from prime rate (5.25% and 5.75% at December 31, 2004 and March 31, 2005, respectively) to prime rate plus 1.0%. As of December 31, 2004, there was a total of $4,407 outstanding under all of the Company’s equipment lines of credit. In March 2005, the Company paid in full all outstanding debt related to its equipment lines of credit. The equipment line of credit expired on March 31, 2005 and was not renewed.

Effective March 31, 2004, the Company renewed its working capital line of credit with a bank and increased the amount under which it can borrow to $5,000. Interest accrues at prime rate. All advances made under the working capital line are due and payable on March 31, 2006. As of December 31, 2004 and June 30, 2005, $0 was outstanding under the working capital line of credit. At June 30, 2005, there was $3,700 available under the line of credit, and $1,300 reserved under a letter of credit associated with the Company’s leased facilities.

Borrowings under the working capital line of credit are secured by substantially all assets of the Company, excluding intellectual property. The Company has entered into a negative pledge agreement that, subject to certain exceptions, generally prohibits the Company from pledging its intellectual property to others. Under the working capital line of credit, as amended in March 2004, the Company is required to comply with certain financial covenants. At June 30, 2005, the Company was in compliance with all financial covenants. In August of 2005, the working capital line of credit was amended to eliminate the security interest in the Company’s assets and the negative pledge on the Company’s intellectual property. The amendment also removed or modified the financial covenants.

13.   Contingencies

From time to time and in the ordinary course of business, the Company may be subject to various claims, charges and litigation.

14




Since 2004, the Company has been involved in a lawsuit filed against it and one of its customers, Quintiles Inc., by Datasci, LLC (“Datasci”) and Dr. Mark L. Kozam, doing business under the name MLK Software. The lawsuit alleges that the Company’s InForm, Clintrial and Clintrial Integration Solution products and its services, and the products and services of Quintiles, infringe a United States patent claimed to be owned by Datasci and Dr. Kozam. The Company has asserted numerous defenses and has filed counterclaims against Datasci and Dr. Kozam. This action is ongoing and the Company is prepared to vigorously defend the claims and pursue its counterclaims and any other remedies available to the Company. The Company is unable to predict the outcome of this action and is therefore unable to assess whether its outcome will have a material adverse effect on its results of operations.

The Company accepts standard indemnification provisions in the ordinary course of business, whereby it may be required to indemnify its customers for certain costs and damages arising from third party claims in connection with alleged or actual infringement of intellectual property, including the claim described above. The term of these indemnification provisions generally coincides with the customer’s use of the Company’s products. The Company has never incurred significant costs to settle claims related to these indemnification provisions. As a result, the Company believes the estimated fair value of these provisions is minimal.

14.   Stockholders’ Equity

During the six months ended June 30, 2005, the Company issued 621,181 shares of common stock in connection with the exercise of stock options resulting in proceeds of $1,770, and 79,836 shares of common stock under the Company’s 2004 Employee Stock Purchase Plan resulting in proceeds of $448. During this period, the Company also issued 9,802 shares in connection with the cashless exercise of a warrant to purchase common stock.

During November and December 2001, the Company executed full recourse notes receivable in consideration for the payment of the exercise of options. The notes are reflected as subscriptions receivable, a component of stockholders’ equity. There was $127 and $0 of these notes receivable outstanding at December 31, 2004 and June 30, 2005, respectively. In February 2005, all outstanding notes were paid in full.

15.   Deferred Compensation

The Company records deferred stock-based compensation in the amount by which the exercise price of an option is less than the deemed fair value of its common stock at the date of grant. Because there had been no public market for the Company’s stock prior to the July 2004 initial public offering of its common stock (the “IPO”), the Company’s Board of Directors had determined the fair value of the common stock on the date of grant based upon several factors, including, but not limited to, the Company’s operating and financial performance, the issuances of convertible preferred stock, the rights and preferences of all securities senior to common stock and the anticipated offering price of the common stock in connection with the Company’s IPO. During 2003, all stock options were granted with an exercise price of $3.00 per share, while the estimated per share fair value of the Company’s common stock ranged from $3.00 to $4.00 in the first quarter of 2003, $4.00 to $5.00 in the second quarter of 2003, $5.00 to $7.50 in the third quarter of 2003 and $7.50 to $9.00 in the fourth quarter of 2003. During the six months ended June 30, 2004, options were granted at exercise prices ranging from $4.50 to $6.00 per share while the estimated fair value of the Company’s common stock was $10 per share. During the six months ended December 31, 2004 options were granted at a price of $7.55 per share, which was the fair market value of the Company’s common stock at the date of grant. During the six months ended June 30, 2005, options to purchase 889,000 shares of common stock were granted at exercise prices ranging from $6.30 to $6.53 per share, which was the fair market value of the common stock at the dates of the grant. The Company recorded stock-based compensation of $919 and $357 in the six months ended June 30, 2004 and 2005, respectively.

15




As of June 30, 2005, there was an aggregate of $1,119 of deferred stock-based compensation remaining to be amortized, of which approximately $371 will be amortized in the remaining two quarters of 2005. The Company amortizes the deferred compensation charges over the vesting period of the underlying option awards in accordance with Financial Interpretation No. 28. On January 1, 2006, the Company is required to adopt SFAS No. 123(R) which requires fair value accounting for stock-based awards. See Note 18.

16.   Comprehensive Income

The Company’s other comprehensive income relates to foreign currency translation adjustments and is presented separately on the balance sheet as required.

Comprehensive income consisted of the following:

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

Net income

 

$

430

 

$

1,838

 

$

813

 

$

3,306

 

Cumulative translation adjustment

 

(28

)

(368

)

(109

)

(533

)

Comprehensive income

 

$

402

 

$

1,470

 

$

704

 

$

2,773

 

 

17.   Forward Foreign Exchange Contracts

The Company enters into transactions in currencies other than the U.S. dollar and holds cash in foreign currencies which expose the Company to transaction gains and losses as foreign currency exchange rates fluctuate against the U.S. dollar. The Company from time to time enters into forward foreign exchange contracts to hedge the foreign currency exposure of non-U.S. dollar denominated third-party and intercompany receivables and cash balances. The contracts, which relate to the British pound, Euro, and the Japanese yen, generally have terms of one month. These hedges are deemed fair value hedges and have not been designated for hedge accounting. The gains or losses on the forward foreign exchange contracts along with the associated losses and gains on the revaluation and settlement of the intercompany balances, accounts receivable and cash balances are recorded in current operations.

The following table summarizes the outstanding forward foreign exchange contracts held by the Company at June 30, 2005:

 

 

As of June 30, 2005

 

 

 

Local
Currency
Amount

 

Approximate
U.S. Dollar
Equivalent

 

British pound

 

 

1,200

 

 

 

$

2,149

 

 

Japanese yen

 

 

40,000

 

 

 

362

 

 

 

 

 

 

 

 

 

$

2,511

 

 

 

The forward foreign exchange contracts are short-term and mature within 35 days of origination.

Due to the short period of time between entering into the forward foreign exchange contracts and June 30, 2005, the forward foreign exchange contract rate approximates the exchange rate as of the end of the reporting period.

Realized and unrealized gains (losses), net of hedging are accounted for in other income (expense). Gains (losses), net of hedging, were $54 and $(17) for the three months ended June 30, 2004 and 2005, respectively and $38 and $(147) for the six months ended June 30, 2004 and 2005, respectively. The Company settles foreign exchange contracts in cash.

16




18.   Recently Issued Accounting Pronouncements

On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in Statement 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

SFAS No. 123(R) must be adopted no later than January 1, 2006 for calendar year-end companies. Early adoption will be permitted in periods in which financial statements have not yet been issued.

SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods:

·       A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date.

·       A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.

The Company is continuing to review the two alternative adoption methods and the resulting impact of fair valuing awards in its financial statements. The Company is also reviewing various option valuation techniques and may use a valuation method other than the Black-Scholes model for new awards upon adoption of SFAS No. 123(R).

The adoption of SFAS No. 123(R)’s fair value method will likely have a significant impact on the Company’s results of operations, although it will have no impact on its overall financial position. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend in part on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in Note 8 to the Company’s unaudited condensed consolidated financial statements.

In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which will require entities that voluntarily make a change in accounting principle to apply that change retrospectively to prior periods’ financial statements, unless this would be impracticable. SFAS No. 154 supersedes APB Opinion No. 20, Accounting Changes, which previously required that most voluntary changes in accounting principles be recognized by including in the current period’s net income the cumulative effect of changing to the new accounting principle. SFAS No. 154 also makes a distinction between “retrospective application” of an accounting principle and the “restatement” of financial statements to reflect the correction of an error. Another significant change in practice under SFAS No. 154 will be that if an entity changes its method of depreciation, amortization, or depletion for long-lived, non-financial assets, the change must be accounted for as a change in accounting estimate. Under APB No. 20, such a change would have been reported as a change in accounting principle. SFAS No. 154 applies to accounting changes and error corrections that are made in fiscal years beginning after December 15, 2005.

17




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

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

Overview

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

Sources of Revenues

We derive our revenues from software licenses and services. License revenue is derived principally from the sale of multi-year software term licenses for our InForm, Clintrial and Clintrace software products. Service revenue is derived from our delivery of the hosted solution of our InForm software product, consulting services and customer support, including training. We generally recognize revenue ratably over the life of a license or service contract. This allows us to maintain a backlog that provides multi-year visibility in revenue. As our backlog grows, we believe that the predictability of our future revenues will increase. Two customers including Eli Lilly and Company, the holder of record of approximately 1% of our common stock, accounted for approximately 20% and 25% of our total revenues for the six months ended June 30, 2004 and 2005, respectively. Our top 20 customers accounted for approximately 69% and 72% of our total revenues in the quarters ended June 30, 2004 and 2005, respectively, net of reimbursable out-of-pocket expenses.

License Revenue

We derive our license revenue from our three major software products: InForm, our Internet based electronic data capture solution; Clintrial, our clinical data management solution; and Clintrace, our adverse event reporting solution. Although each of our InForm, Clintrial and Clintrace software solutions are available as stand-alone enterprise applications, we also offer integrated enterprise solutions incorporating certain of our electronic data capture, data management and adverse event reporting products.

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

18




Following our acquisition of Clinsoft in August of 2001, we began converting holders of Clinsoft perpetual software licenses to our software term license agreements. In certain situations we continue to sell perpetual licenses of our Clintrial and Clintrace software products to our existing customers. We recognize revenue on the perpetual licenses upon delivery of the software. Perpetual license revenue represented less than 1% of total revenue for the six months ended June 30, 2004 and 2005. We continue to provide and charge for maintenance and support on our products to those customers who do not convert to our software term license arrangements. We generally charge 18% of the perpetual license fee for customer support. We intend to continue our efforts to convert the remaining former Clinsoft customer base to software term license arrangements.

Service Revenue

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

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

·       Second stage—application hosting and related support services; and

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

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

In the event that an application hosting customer cancels a clinical trial and its related statement of work, all deferred revenue is recognized and all deferred set up costs are expensed and certain termination-related fees may be charged. In addition, application hosting services revenue includes hosting services associated with term license arrangements and reimbursable out-of-pocket expenses.

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

Customer Support.   We have a multinational services organization to support our software products and hosted solutions worldwide. Customer support includes telephone support, software maintenance and training. We bundle customer support in our software term licenses and allocate 10% of the value of the

19




license to customer support revenue. Our customer support revenue also consists of customer support fees paid by the Clintrial and Clintrace perpetual license customers. Customer support revenue is recognized ratably over the period of the customer support or term license agreement, with payment terms generally annually in advance.

Costs of Revenues and Operating Expenses

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

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

Gross Margin.   Our gross margin on license revenue varies based on the mix of royalty- and nonroyalty-bearing license revenue. Our gross margin on service revenue varies primarily due to variations in the utilization levels of the professional service team and the timing of expense and revenue recognition under our service arrangements. In situations where the service revenue is recognized ratably over the software license term, typically three to five years, our costs associated with delivery of the services are recognized as the services are performed, which is typically during the first 9 to 12 months of the contract period. Accordingly, our gross margin on service revenue will vary significantly over the life of a contract due to the timing, amount and type of service required in delivering certain projects. In addition, consolidated gross margin will vary depending upon the mix of license and service revenue.

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

20




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

General and Administrative.   General and administrative expenses consist primarily of employee-related expenses, professional fees, primarily consisting of expenses for accounting, compliance and legal services and other corporate expenses and allocated overhead. We expect that in the future, general and administrative expenses will increase in absolute dollars as we add personnel, incur additional professional fees related to the growth of our business and operations, and incur additional costs associated with being a public company.

Restructuring.   We recorded a $4.5 million restructuring charge in 2003 which related to the relocation of our corporate headquarters. This charge included approximately $2.5 million relating to the estimated future obligation under the non-cancelable lease and an approximate $2.0 million write-off of the related abandoned leasehold improvements and fixed assets. As of June 30, 2005, the payment of all charge related expenses had occurred and, as a result, we recorded a restructuring benefit of $92,000 representing the elimination of accrued expenses associated with the restructuring charge.

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

Foreign Currency Translation

With regard to our international operations, we frequently enter into transactions in currencies other than the U.S. dollar. As a result, our revenues, expenses and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Euro, British pound sterling, Australian dollar and Japanese yen. In the three months ended June 30, 2004 and 2005, approximately 41% and 48%, respectively, of our revenues were generated in locations outside the United States. In the six months ended June 30, 2004 and 2005, approximately 40% and 48%, respectively, of our revenues were generated in locations outside the United States. The majority of these revenues were in currencies other than the U.S. dollar. In periods when the U.S. dollar declines or increases in value as compared to the foreign currencies in which we conduct business, our foreign currency-based revenues and expenses increase or decrease, as the case may be, when translated into U.S. dollars.

Critical Accounting Policies and Estimates

Our unaudited condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions with our audit committee. There have been no material changes to these estimates for the periods presented in this Quarterly Report on Form 10-Q. Our actual results may differ from these estimates.

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

21




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

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

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

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

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

We generally bundle customer support with the software license for the entire term of the arrangement. As a result, we generally recognize revenue for all elements ratably over the term of the multiple element arrangement. We allocate the revenue for these arrangements to the different elements based on management’s estimate of the relative fair value of each element. For our contracts accounted for ratably under SOP No. 97-2, we allocate to consulting services the anticipated service level throughout the term of the arrangement at an amount equal to what it would have been had those services been sold separately to the customer. The remaining value is allocated to license and support services, with a 10% value allocated to support services. The costs associated with the consulting and customer support services are expensed as incurred. There are instances in which we sell software licenses based on usage levels. These software licenses can be based on estimated usage, in which case the license fee charged to the customer is fixed based on this estimate. When the fee is fixed, the revenue is recognized over the contractual term of the arrangement. If the fee is based on actual usage, and therefore variable, the revenue is recognized in the period of use. Revenue from certain follow-on consulting services, which are sold separately to customers with existing software licenses and are not considered part of a multiple element arrangement, is generally recognized as the services are performed.

22




Revenue from perpetual software licenses represented less than 1% of total revenues for the six months ended June 30, 2004 and 2005. We continue to sell perpetual licenses for the Clintrial and Clintrace software products in certain situations to our existing customers with the option to purchase customer support. We have established vendor specific objective evidence of fair value for the customer support. Accordingly the perpetual license revenue is recognized upon delivery of the software and when all other revenue recognition criteria are met. Customer support revenue is recognized ratably over the term of the underlying support arrangement.

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

We capitalized $322,000 and $509,000 of deferred set up costs and amortized $384,000 and $398,000 in the three months ended June 30, 2004 and 2005, respectively, and capitalized $849,000 and $1.2 million of deferred set up costs and amortized $880,000 and $847,000 in the six months ended June 30, 2004 and 2005, respectively. The amortization of deferred set up costs is a component of cost of services.

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

Accounting for Commission Payments and Royalties.   For arrangements where we recognize revenue over the relevant contract period, we defer related commission payments to our direct sales force and software license royalties paid to third parties and amortize these amounts over the same period that the related revenue are recognized. This is done to better match commission and royalty expenses with the related revenue. We capitalized $820,000 and $646,000 of commissions and amortized to sales and marketing expense $681,000 and $905,000 in the three months ended June 30, 2004 and 2005, respectively, and capitalized $1.6 million and $1.3 million of commissions and amortized to sales and marketing expense $1.2 million and $1.7 million in the six months ended June 30, 2004 and 2005, respectively.

Royalties are paid on a percentage of billings basis for certain of our products. We capitalized $1.1 million and $1.4 million of royalties and amortized to costs of revenues $604,000 and $728,000 in the three months ended June 30, 2004 and 2005, respectively, and capitalized $2.2 million and $2.2 million of royalties and amortized to costs of revenues $1.2 million and $1.3 million in the six months ended June 30, 2004 and 2005, respectively.

23




Accounts Receivable Reserves.   We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We regularly evaluate the collectibility of our trade receivables based on a combination of factors, which may include dialogue with the customer to determine the cause of non-payment, the use of collection agencies, and/or the use of litigation. In the event it is determined that the customer may not be able to meet its full obligation to us, we record a specific allowance to reduce the related receivable to the amount that we expect to recover given all information available to us. We monitor collections from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that credit loss rates will not increase in the future. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Our accounts receivable reserves were $391,000 and $289,000 as of December 31, 2004 and June 30, 2005, respectively.

Accounting for Income Taxes.   In connection with the preparation of our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves the assessment of our net operating loss carryforwards and credits, as well as estimating the actual current tax liability together with assessing temporary differences resulting from differing treatment of items, such as reserves and accrued liabilities, for tax and accounting purposes. We then assess the likelihood that deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance. As of June 30, 2005, we have incurred a three year cumulative loss from operations. Once we are no longer in a three year cumulative loss position, we would expect to recognize some or all of our deferred tax assets based principally on our ability to forecast future operating income. Currently, we believe that it is more likely than not that we will not realize the value of our deferred tax assets and therefore have provided a full valuation allowance against our net deferred tax assets. We will continue to evaluate the realizability of our deferred tax assets quarterly. If in future periods our assessment deems it more likely than not the deferred tax assets will be recognized, we would record an adjustment to our valuation allowance at that time, which would result in a reduction to income tax expense, which could be significant in the period in which such determination is made.

The American Jobs Creation Act of 2004 (the “Act”), which was enacted on October 22, 2004, introduced a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. Even in light of the Act, our current intention is to reinvest the total amount of our unremitted earnings in the local jurisdiction or to repatriate the earnings only when doing so would be tax-effective. As such, we have not provided U.S. tax expense on the unremitted earnings of our foreign subsidiaries.

Accounting for Stock-Based Awards.   We record deferred stock-based compensation charges in the amount by which the exercise price of an option is less than the deemed fair value of our common stock at the date of grant. Because there had been no public market for our stock prior to the July 2004 initial public offering of our common stock (the “IPO”), our board of directors had determined the fair value of our common stock based upon several factors, including, but not limited to, our operating and financial performance, sales of convertible preferred stock to third parties, the rights and preferences of securities senior to common stock and the anticipated offering price of our common stock in connection with the IPO.

We have not historically engaged unrelated third parties to prepare valuations of our common stock. In connection with the IPO, management and the board of directors retroactively assessed the fair value of our common stock during 2003 and through the date of the IPO.

During 2003, all stock options were granted with an exercise price of $3.00 per share, while the estimated per share fair value of our common stock was subsequently determined to range from $3.00 to

24




$4.00 in the first quarter of 2003, $4.00 to $5.00 in the second quarter of 2003, $5.00 to $7.50 in the third quarter of 2003 and $7.50 to $9.00 in the fourth quarter of 2003.

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

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

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

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

As of June 30, 2005, there was an aggregate of $1.1 million of deferred stock-based compensation remaining to be amortized. Historically, we have elected not to record employee stock-based awards at fair value. The impact of recording employee stock-based awards at fair value, using the Black-Scholes option-pricing model, is further described in Note 8 of the notes to our unaudited condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q. Effective January 1, 2006, we will be required to adopt a fair value approach to valuing stock-based awards. See Note 18 in the notes to our unaudited condensed consolidated financial statements.

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

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

Overview of Results of Operations for the Three Months Ended June 30, 2004 and 2005

License revenue increased 36% in the three months ended June 30, 2005 as compared to the three months ended June 30, 2004. Service revenue increased 6% in the three months ended June 30, 2005 as compared to the three months ended June 30, 2004.

25




Our gross margin increased 22%, or $2.2 million, in the three months ended June 30, 2005 to $12.6 million, compared to $10.4 million for the same period in 2004, primarily due to the increase in license revenue which generates a higher gross margin.

Operating income increased $1.0 million from $946,000 in the three months ended June 30, 2004 to an operating income of $2.0 million for the three months ended June 30, 2005. The operating income in the three months ended June 30, 2004 and 2005 included $473,000 and $133,000 of stock-based compensation, respectively. As of June 30, 2005, we had $65.3 million of cash, cash equivalents and short-term investments, an increase of $7.1 million from $58.2 million at December 31, 2004.

The results for the three months ended June 30, 2005, were impacted by foreign exchange. Revenues and expenses increased approximately 2% and 2%, respectively, as a result of fluctuations in foreign exchange rates.

Revenues

 

 

For the Three Months Ended June 30,

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

Revenues

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

License

 

 

$

6,357

 

 

 

36

%

 

$

8,632

 

 

42

%

 

 

$

2,275

 

 

36

%

Application hosting services

 

 

6,689

 

 

 

38

 

 

7,275

 

 

35

 

 

 

586

 

 

9

%

Professional services

 

 

1,215

 

 

 

7

 

 

1,622

 

 

8

 

 

 

407

 

 

33

%

Customer support

 

 

3,432

 

 

 

19

 

 

3,169

 

 

15

 

 

 

(263

)

 

(8

)%

Total

 

 

$

17,693

 

 

 

100

%

 

$

20,698

 

 

100

%

 

 

$

3,005

 

 

17

%

 

Total revenues increased in the three months ended June 30, 2005 as compared to the same period in 2004 due to an increase in license revenue across all products, as well as an increases in both application hosting and professional services. The increase in license revenue in the three months ended June 30, 2005 was primarily due to an increase in sales of InForm into our existing Clintrial customer base and, to a lesser extent, an increase in sales of both Clintrial and Clintrace products. This increase was a result of our continued strategy to expand the usage of our software products by cross selling the InForm, Clintrial and Clintrace products to our existing customer base, additional utilization of our products within our customer base and sales to new customers. The increase in revenue associated with the hosted-application version of our InForm product in the three months ended June 30, 2005 was due to an increase in clinical trials under management. Professional services revenue for the three months ended June 30, 2005 increased compared to the same period in 2004 due to the increase in consulting services associated with our existing enterprise customers. Customer support revenue for the three months ended June 30, 2005 decreased compared to the same period in 2004 primarily due to the reduction in the Clintrial renewal base as a result of the conversion of the former Clinsoft customers to term-based licenses that have a lower customer support fee, offset partially by the increase in both InForm support revenue associated with an increase in license revenue as well as training revenue.

 

 

For the Three Months Ended June 30,

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

Revenues by Geography

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

United States

 

 

$

10,433

 

 

 

59

%

 

$

10,779

 

 

52

%

 

 

$

346

 

 

3

%

United Kingdom

 

 

3,807

 

 

 

22

 

 

6,330

 

 

31

 

 

 

2,523

 

 

66

%

France

 

 

2,119

 

 

 

12

 

 

1,936

 

 

9

 

 

 

(183

)

 

(9

)%

Asia-Pacific

 

 

1,334

 

 

 

7

 

 

1,653

 

 

8

 

 

 

319

 

 

24

%

International subtotal

 

 

7,260

 

 

 

41

 

 

9,919

 

 

48

 

 

 

2,659

 

 

37

%

Total

 

 

$

17,693

 

 

 

100

%

 

$

20,698

 

 

100

%

 

 

$

3,005

 

 

17

%

 

26




The increase in revenues worldwide was due primarily to the increase in InForm revenue in the United Kingdom, resulting from additional enterprise-wide license and service agreements associated with one customer. In addition, Asia-Pacific InForm license and application hosting services revenue increased.

Costs of Revenues

 

 

For the Three Months Ended June 30,

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

 

 

 

 

 

 

 

 

of Related

 

 

 

of Related

 

Change

 

Costs of Revenues

 

 

 

Amount

 

Revenue

 

Amount

 

Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

License

 

 

$

448

 

 

 

7

%

 

 

$

589

 

 

 

7

%

 

 

$

141

 

 

31

%

Services

 

 

6,842

 

 

 

60

 

 

 

7,464

 

 

 

62

 

 

 

622

 

 

9

%

Total

 

 

$

7,290

 

 

 

41

%

 

 

$

8,053

 

 

 

39

%

 

 

$

763

 

 

10

%

 

The cost of license revenue increased in the three months ended June 30, 2005 due to an increase in royalty expense associated with certain modules of our Clintrial software product as well as our InForm software products. Cost of services for the three months ended June 30, 2005 increased by $622,000 as we incurred $170,000 of additional employee related expenses and $359,000 incremental outside contractor expense to deliver increased services. In addition there were also expense increases in computer and related and depreciation of $135,000 and $78,000, respectively. These expense increases were partially offset by a decrease in the amortization of capitalized labor of $174,000.

Gross Margin

 

 

For the Three Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

Percentage of

 

 

 

Percentage of

 

 

 

 

 

 

 

 

 

Related

 

 

 

Related

 

Change

 

Gross Margin

 

 

 

Amount

 

Revenue

 

Amount

 

Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

License

 

$

5,909

 

 

93

%

 

$

8,043

 

 

93

%

 

 

$

2,134

 

 

36

%

Services

 

4,494

 

 

40

 

 

4,602

 

 

38

 

 

 

108

 

 

2

%

Total

 

$

10,403

 

 

59

%

 

$

12,645

 

 

61

%

 

 

$

2,242

 

 

22

%

 

The license gross margin percentage was unchanged in the three months ended June 30, 2005. The services gross margin percentage decreased for the three months ended June 30, 2005 due to increases in labor and outside contractor expenses. It is likely that gross margin, as a percentage of revenues, will fluctuate, quarter by quarter, due to the timing and mix of license and service revenues, and the amount and type of service required in delivering certain projects.

Operating Expenses

 

 

For the Three Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

Operating Expenses

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

 

Sales and marketing

 

 

$

3,536

 

 

 

20

%

 

$

3,960

 

 

19

%

 

 

$

424

 

 

12

%

 

Research and development

 

 

3,018

 

 

 

17

 

 

3,489

 

 

17

 

 

 

471

 

 

16

%

 

General and administrative

 

 

2,903

 

 

 

16

 

 

3,218

 

 

16

 

 

 

315

 

 

11

%

 

Total

 

 

$

9,457

 

 

 

53

%

 

$

10,667

 

 

52

%

 

 

$

1,210

 

 

13

%

 

 

27




Sales and Marketing.   Sales and marketing expenses increased for the three months ended June 30, 2005 primarily due to a $223,000 increase in commission expense resulting from an increase in revenues and an increase in the effective commission rate, and an increase in employee-related expenses of $126,000. We expect that our sales and marketing expenses will continue to increase in absolute dollars as commission expense increases with our revenues and we continue to build our brand awareness through what we believe are the most cost-effective channels available. However, sales and marketing expenses may fluctuate, quarter by quarter, due to the timing of marketing programs.

Research and Development.   Research and development expenses increased in the three months ended June 30, 2005 primarily due to an increase in employee related expenses of $516,000 as we hired 8 additional people to improve our quality assurance and product development team. We expect that our research and development costs will continue to increase in absolute dollars as we continue to introduce additional integrated software solutions and add features and functionality to our products.

General and Administrative.   General and administrative expenses increased in the three months ended June 30, 2005 primarily due to a $241,000 increase in professional fees which relate to actions associated with defending our intellectual properties and increased accounting expenses due to the requirements of being a public company, as well as $164,000 of increased employee-related expenses. In addition, insurance expense of $93,000 due to requirements related to being a public company, and outside contractor expenses increased $65,000 primarily related to the implementation of Section 404 of the Sarbanes-Oxley Act. These expense increases were partially offset by a $257,000 decrease in stock based compensation. We expect that in the future, general and administrative expenses will increase in absolute dollars as we add personnel, incur additional professional fees related to the growth of our business and operations, and incur additional costs associated with being a public company. However, general and administrative expenses may vary quarter by quarter due to the timing of professional fees.

Operating Income, Other Income (Expense)

 

 

For the Three Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

Operating income

 

 

$

946

 

 

 

5

%

 

 

$

1,978

 

 

 

10

%

 

 

$

1,032

 

 

109

%

Other income (expense)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

$

67

 

 

 

%

 

 

$

439

 

 

 

2

%

 

 

$

372

 

 

555

%

Interest expense

 

 

(128

)

 

 

 

 

 

 

 

 

 

 

 

128

 

 

100

%

Other, net

 

 

87

 

 

 

 

 

 

(11

)

 

 

 

 

 

(98

)

 

(113

)%

Total

 

 

$

26

 

 

 

%

 

 

$

428

 

 

 

2

%

 

 

$

402

 

 

1546

%

 

Operating Income.   The increase in operating income in the three months ended June 30, 2005 was primarily due to an increase in license gross margin, partially offset by increased operating expenses resulting from increases in employee related expenses, commission expense and professional fees. It is likely that operating income, as a percentage of revenues, will fluctuate, quarter by quarter, due to the timing and mix of license and services revenues, and the amount and type of service required in delivering certain projects, as well as the timing of operating expense activities.

Other Income (Expense).   The increase in interest income in the three months ended June 30, 2005 was primarily due to an increase in cash and cash equivalents available for investment and short-term investments. The decrease in interest expense in the three months ended June 30, 2005 was due to the payoff of all outstanding debt during the quarter ended March 31, 2005. Other, net expense primarily increased due to foreign exchange losses in the three months ended June 30, 2005 compared to foreign

28




exchange gains in the three months ended June 30, 2004, related to unfavorable exchange rate movements on non-U.S. dollar denominated accounts receivable and intercompany balances.

Provision for Income Taxes

 

 

For the Three Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

Provision for income taxes

 

 

$

542

 

 

 

3

%

 

 

$

568

 

 

 

3

%

 

 

$

26

 

 

 

5

%

 

 

The provision for income taxes for 2004 represents foreign withholding taxes and income taxes payable that cannot be offset through loss carryforwards. The provision for income taxes for 2005 represents income taxes payable that cannot be offset through loss carryforwards. The effective tax rate for 2005 decreased to 24% compared to an effective tax rate of 56% for 2004. The decrease in our effective tax rate is primarily due to a reduction in foreign withholding taxes and  U.S. income taxes payable. The decrease in the foreign withholding taxes related to the elimination of withholding tax due to changes in legislation between the U.S. and Japan effective in the second quarter of 2004. The decrease in U.S. income taxes payable related to the change in the mix and timing of the use of net operating loss carryforwards to offset taxable income. In utilizing our net operating loss carryforwards, we are required to use our oldest net operating losses first. As a result, we have first used the net operating losses acquired in the Clinsoft acquisition. The utilization of the acquired net operating losses reduces the amount of income taxes payable to local tax authorities. This benefit has been reflected as a reduction of goodwill. The benefit of utilization of the net operating loss carryforwards that were not acquired has been reflected as a reduction to the income tax provision.

Overview of Results of Operations for the Six Months Ended June 30, 2004 and 2005

License revenue increased 39% in the six months ended June 30, 2005 as compared to the six months ended June 30, 2004. Service revenue increased 8% in the six months ended June 30, 2005 as compared to the six months ended June 30, 2004.

Our gross margin increased 27%, or $5.4 million, in the six months ended June 30, 2005 to $25.5 million, compared to $20.2 million for the same period in 2004, primarily due to the increase in license and application hosting services revenue.

Operating income increased by $2.1 million from $1.8 million in the six months ended June 30, 2004 to an operating income of $3.9 million for the six months ended June 30, 2005. The operating income in the six months ended June 30, 2004 and 2005 included $919,000 and $357,000 of stock-based compensation, respectively. As of June 30, 2005, we had $65.3 million of cash, cash equivalents and short-term investments securities, an increase of $7.1 million from $58.2 million at December 31, 2004.

The results for the six months ended June 30, 2005, were impacted by foreign exchange. Revenues and expenses increased approximately 2% and 2%, respectively, as a result of fluctuations in foreign exchange rates.

29




Revenues

 

 

For the Six Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

Revenues

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

License

 

$

12,523

 

 

36

%

 

$

17,451

 

 

42

%

 

 

$

4,928

 

 

39

%

Application hosting services

 

12,601

 

 

36

 

 

14,106

 

 

35

 

 

 

1,505

 

 

12

%

Professional services

 

2,779

 

 

8

 

 

3,017

 

 

7

 

 

 

238

 

 

9

%

Customer support

 

6,752

 

 

20

 

 

6,686

 

 

16

 

 

 

(66

)

 

(1

)%

Total

 

$

34,655

 

 

100

%

 

$

41,260

 

 

100

%

 

 

$

6,605

 

 

19

%

 

Total revenues increased in the six months ended June 30, 2005 as compared to the same period in 2004 due to an increase in license revenue across all products, as well as an increase in InForm application hosting services. The increase in license revenue in the six months ended June 30, 2005 was primarily due to an increase in sales of InForm into our existing Clintrial customer base and, to a lesser extent, an increase in sales of both Clintrial and Clintrace products. This increase was a result of our continued strategy to expand the usage of our software products by cross selling the InForm, Clintrial and Clintrace products to our existing customer base, additional utilization of our products within our customer base and sales to new customers. The increase in revenue associated with the hosted-application version of our InForm product in the six months ended June 30, 2005 was due to an increase in clinical trials under management. Professional services revenue for the six months ended June 30, 2005 increased compared to the same period in 2004 due to the increase in consulting services associated with our existing enterprise customers. The small decrease in the customer support revenue for the six months ended June 30, 2005 was primarily due to a decrease in the Clintrial and Clintrace renewal base as a result of the conversion of the former Clinsoft customers to term based licenses that have a lower customer support fee, offset partially by an increase in InForm support revenue associated with an increase in license and training revenue associated with our InForm product.

 

 

For the Six Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

Revenues by Geography

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

United States

 

$

20,958

 

 

60

%

 

$

21,524

 

 

52

%

 

 

$

566

 

 

3

%

United Kingdom

 

7,212

 

 

21

 

 

12,476

 

 

30

 

 

 

5,264

 

 

73

%

France

 

4,265

 

 

12

 

 

4,218

 

 

10

 

 

 

(47

)

 

(1

)%

Asia-Pacific

 

2,220

 

 

7

 

 

3,042

 

 

8

 

 

 

822

 

 

37

%

International subtotal

 

13,697

 

 

40

 

 

19,736

 

 

48

 

 

 

6,039

 

 

44

%

Total

 

$

34,655

 

 

100

%

 

$

41,260

 

 

100

%

 

 

$

6,605

 

 

19

%

 

The increase in revenues worldwide was due primarily to the increase in InForm revenue in the United Kingdom, resulting from additional enterprise-wide license and service agreements, with one customer accounting approximately three-fourths of the increase. In addition, the Asia-Pacific license and services revenue increased across all products.

30




Costs of Revenues

 

 

For the Six Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage of

 

 

 

Percentage of

 

 

 

 

 

 

 

 

 

Related

 

 

 

Related

 

Change

 

Costs of Revenues

 

 

 

Amount

 

Revenue

 

Amount

 

Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

License

 

$

870

 

 

7

%

 

$

1,037

 

 

6

%

 

 

$

167

 

 

19

%

Services

 

13,623

 

 

62

 

 

14,676

 

 

62

 

 

 

1,053

 

 

8

%

Total

 

$

14,493

 

 

42

%

 

$

15,713

 

 

38

%

 

 

$

1,220

 

 

8

%

 

The cost of license revenue increased in the six months ended June 30, 2005 due to a $198,000 increase in royalty expense associated with our InForm software product as well as certain modules of our Clintrial software product. Cost of services for the six months ended June 30, 2005 increased by $1.1 million as we incurred $431,000 of additional employee related expenses and $505,000 incremental outside contractor expense to deliver increased services. In addition there were also expense increases in computer related, occupancy and depreciation of $230,000, $120,000 and $116,000, respectively. These expense increases were partially offset by a decrease in the amortization of capitalized labor of $359,000.

Gross Margin

 

 

For the Six Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage of

 

 

 

Percentage of

 

 

 

 

 

 

 

 

 

Related

 

 

 

Related

 

Change

 

Gross Margin

 

 

 

Amount

 

Revenue

 

Amount

 

Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

License

 

$

11,653

 

 

93

%

 

$

16,414

 

 

94

%

 

 

$

4,761

 

 

41

%

Services

 

8,509

 

 

38

 

 

9,133

 

 

38

 

 

 

624

 

 

7

%

Total

 

$

20,162

 

 

58

%

 

$

25,547

 

 

62

%

 

 

$

5,385

 

 

27

%

 

The license gross margin percentage increased in the six months ended June 30, 2005 primarily due to an increase in sales of InForm, which incurs a lower royalty than Clintrial. The services gross margin percentage was unchanged for the six months ended June 30, 2005.

Operating Expenses

 

 

For the Six Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

Operating Expenses

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

Sales and marketing

 

$

6,841

 

 

20

%

 

$

7,911

 

 

19

%

 

 

$

1,070

 

 

16

%

Research and development

 

5,954

 

 

17

 

 

6,770

 

 

16

 

 

 

816

 

 

14

%

General and administrative

 

5,546

 

 

16

 

 

7,022

 

 

17

 

 

 

1,476

 

 

27

%

Restructuring

 

 

 

 

 

(92

)

 

 

 

 

(92

)

 

nm

 

Total

 

$

18,341

 

 

53

%

 

$

21,611

 

 

52

%

 

 

$

3,270

 

 

18

%

 

Sales and Marketing.   Sales and marketing expenses increased for the six months ended June 30, 2005 primarily due to a $421,000 increase in employee-related expenses, which included one-time charges associated with changes in management, and a $491,000 increase in commission expense resulting from an increase in revenues and an increase in the effective commission rate. In addition, travel expense increased by $129,000.

31




Research and Development.   Research and development expenses increased in the six months ended June 30, 2005 primarily due to an increase in employee related expenses of $1.1 million as we hired additional people to improve our quality assurance and product development team. This was partially offset by a $244,000 decrease in outside consultant expense as we brought certain research and development activities in-house

General and Administrative.   General and administrative expenses increased in the six months ended June 30, 2005 primarily due to a $957,000 increase in professional fees primarily associated with actions defending our intellectual properties and increased accounting fees due to the requirements of  being a public company, as well as, $358,000 of increased employee-related expenses. In addition, outside contractor expenses increased $215,000 primarily related to the implementation of Section 404 of the Sarbanes-Oxley Act and additional insurance expense of $204,000 due to requirements related to being a public company. These expense increases were partially offset by a $381,000 decrease in stock-based compensation.

Operating Income, Other Income (Expense)

 

 

For the  Six Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

Operating income

 

 

$

1,821

 

 

 

5

%

 

 

$

3,936

 

 

 

10

%

 

 

$

2,115

 

 

116

%

Other income (expense)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

$

172

 

 

 

%

 

 

$

787

 

 

 

2

%

 

 

$

615

 

 

358

%

Interest expense

 

 

(210

)

 

 

 

 

 

(144

)

 

 

 

 

 

66

 

 

31

%

Other, net

 

 

71

 

 

 

 

 

 

(141

)

 

 

 

 

 

(212

)

 

(299

)%

Total

 

 

$

33

 

 

 

%

 

 

$

502

 

 

 

1

%

 

 

$

469

 

 

1421

%

 

Operating Income.   The increase in operating income in the six months ended June 30, 2005 was primarily due to an increase in gross margins from both license and services, partially offset by increased operating expenses resulting from increases in employee related expenses, commission expense and professional fees. It is likely that operating income, as a percentage of revenues, will fluctuate, quarter by quarter, due to the timing and mix of license and services revenues, and the amount and type of service required in delivering certain projects, as well as the timing of operating expense activities.

Other Income (Expense).   The increase in interest income in the six months ended June 30, 2005 was primarily due to an increase in cash and cash equivalents available for investment and short-term investments. The decrease in interest expense in the six months ended June 30, 2005 was primarily due to the pay off of our debt in the quarter ended March 31, 2005. Other, net expense increased primarily due to foreign exchange losses in the six months ended June 30, 2005 compared to foreign exchange gains in the six months ended June 30, 2004, related to unfavorable exchange rate movements on non-U.S. dollar denominated accounts receivable and intercompany balances.

Provision for Income Taxes.

 

 

For the Six Months Ended June 30,

 

 

 

 

 

 

 

2004

 

2005

 

 

 

 

 

 

 

 

 

Percentage

 

 

 

Percentage

 

Change

 

 

 

Amount

 

of Revenue

 

Amount

 

of Revenue

 

Amount

 

%

 

 

 

(in thousands)

 

 

 

Provision for income taxes

 

 

$

1,041

 

 

 

3

%

 

 

$

1,132

 

 

 

3

%

 

 

$

91

 

 

 

9

%

 

 

32




The provision for income taxes for 2004 represents foreign withholding taxes and income taxes payable that cannot be offset through loss carryforwards. The provision for income taxes for 2005 represents income taxes payable that cannot be offset through loss carryforwards. The effective tax rate for 2005 decreased to 26% compared to an effective tax rate of 56% for 2004. The decrease in our effective tax rate is primarily due to a reduction in foreign withholding taxes and U.S. income taxes payable. The decrease in the foreign withholding taxes related to the elimination of withholding tax due to changes in legislation between the U.S. and Japan effective in the second quarter of 2004. The decrease in U.S. income taxes payable related to the change in the mix and timing of the use of net operating loss carryforwards to offset taxable income. In utilizing our net operating loss carryforwards, we are required to use our oldest net operating losses first. As a result we have first used the net operating losses acquired in the Clinsoft acquisition. The utilization of the acquired net operating losses reduces the amount of income taxes payable to local tax authorities. This benefit has been reflected as a reduction of goodwill. The benefit of utilization of the net operating loss carryforwards that were not acquired has been reflected as a reduction to the income tax provision.

Liquidity and Capital Resources

At December 31, 2004 and June 30, 2005, our principal sources of liquidity were cash, cash equivalents and short-term investments totaling $58.2 million and $65.3 million, respectively, and accounts receivable of $19.7 million and $16.0 million, respectively.

From our inception, we funded our operations primarily through issuances of convertible preferred stock for aggregate net cash proceeds of $79.7 million, including net cash acquired in the Clinsoft acquisition, the proceeds from the initial public offering and exercise of the over-allotment option resulting in net proceeds of $36.6 million, and the issuance of notes payable for an aggregate of $17.3 million.

Cash provided by (used in) operating activities has historically been affected by changes in working capital accounts, primarily deferred revenue, accounts receivable and accrued expenses, and add-backs of non-cash expense items such as depreciation and amortization, non-cash income tax expense and stock-based compensation. Fluctuations within accounts receivable and deferred revenue are primarily related to the timing of billings of our term license customers and the associated revenue recognition. Movements in deferred costs are related to the volume and stages of hosted clinical trials and movements in accrued expenses and accounts payable are due to the timing of certain transactions.

Net cash provided by operating activities was $11.0 million for the six months ended June 30, 2005, which was greater than net income of $3.3 million. The difference is primarily due to $1.6 million of non-cash depreciation, $769,000 of non-cash income tax expense and changes in working capital, which consisted primarily of a $3.4 million decrease in accounts receivable and an increase in deferred revenue of $4.0 million, partially offset by a decrease in accrued expenses of $1.1 million and an increase in deferred costs of $945,000.

Net cash used in investing activities was $5.5 million for the six months ended June 30, 2005, consisting primarily of the purchase of short-term investments of $6.5 million and capital expenditures of $1.5 million, partially offset by $2.5 million of proceeds from maturities of short-term investments.

Net cash used in financing activities was $2.1 million for the six months ended June 30, 2005, consisting primarily of $4.4 million of debt repayments as we paid all of our outstanding bank debt, partially offset by $2.2 million of proceeds from the exercise of common stock options and sales of common stock under the  employee stock purchase plan.

At December 31, 2004 and June 30, 2005, respectively, we had $1.6 million and $1.3 million of outstanding letters of credit related to our facilities. The letters of credit are reflected as a reduction in the amount available under the line of credit.

33




Substantially all of our long-lived assets as of December 31, 2004 and June 30, 2005 are located in the United States.

We do not have any special purpose entities or any off-balance sheet financing arrangements.

We generally do not enter into binding purchase commitments. Our principal commitments consist of leases for office space. At June 30, 2005, the future minimum payments under these leases were as follows:

Year ended December 31,

 

 

 

Total

 

 

 

(in thousands)

 

2005

 

 

$

1,353

 

 

2006

 

 

2,622

 

 

2007

 

 

2,252

 

 

2008

 

 

2,047

 

 

2009

 

 

346

 

 

Total minimum payments

 

 

$

8,620

 

 

 

Between April 2000 and September 2004, we had entered into several equipment lines of credit with a bank. All advances under these equipment lines of credit were payable in 30 to 36 equal monthly installments of principal, plus accrued interest. The interest that accrued under these notes ranged from prime rate (5.25% and 5.75% at December 31, 2004 and March 31, 2005, respectively) to prime rate plus 1.0%. As of December 31, 2004 there was a total of $4.4 million outstanding and $3.2 million available under all of our equipment lines of credit. In March 2005, we paid in full all outstanding debt related to our equipment lines of credit. The equipment line of credit expired on March 31, 2005 and was not renewed.

Effective March 31, 2004, we renewed our working capital line of credit with a bank and increased the amount under which we can borrow to $5.0 million. Interest accrues at prime rate. All advances made under the working capital line are due and payable on March 31, 2006. As of December 31, 2004 and June 30, 2005, $0 was outstanding under the working capital line of credit. At June 30, 2005, there was $3.7 million available under the line of credit, and $1.3 million reserved under a letter of credit associated with our leased facilities.

Borrowings under our working capital line of credit are secured by substantially all of our assets other than our intellectual property. We have also entered into a negative pledge agreement that, subject to certain exceptions, generally prohibits us from pledging our intellectual property to others. Under the terms of this credit line, we are required to comply with certain financial covenants. At June 30, 2005, we were in compliance with all financial covenants. In August of 2005, the working capital line of credit was amended to eliminate the security interest in our assets and the negative pledge on our intellectual property. The amendment also removed or modified the financial covenants.

At December 31, 2004, we had net operating loss carryforwards of approximately $88.4 million, which may be used to offset future U.S. federal taxable income, if any, and $4.8 million of federal research and development tax credit carryforwards. In addition, we have $5.6 million of net operating losses relating to our non-U.S. jurisdictions. Of these amounts, approximately $26.9 million and $3.0 million of net operating loss carryforwards and tax credit carryforwards, respectively, relate to amounts acquired as part of the Clinsoft acquisition. These tax carryforwards may reduce our future cash payments to the taxing authorities. The realized benefits of the acquired carryforwards will be reflected as an adjustment through goodwill and not a reduction in the effective tax rate. The carryforwards expire beginning in 2008 through 2023 and are subject to review and possible adjustment by the taxing authorities. The Internal Revenue Code contains provisions that may limit the net operating loss and tax credit carryforwards available to be used in any given year in the event of certain changes in the ownership interests of significant stockholders.

34




We believe our existing cash, cash equivalents, short-term investments and cash provided by operating activities and our working capital line of credit will be sufficient to meet our working capital and capital expenditure needs over the next twelve months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our marketing and sales activities, the timing and extent of spending to support product development efforts, the timing of introductions of new services and enhancements to existing services, and the continuing market acceptance of our services. To the extent that existing cash and securities and cash from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. From time to time, we may also enter into agreements with respect to potential investments in, or acquisitions of, businesses, services or technologies, which could also require us to seek additional equity or debt financing. Additional funds for those purposes may not be available on terms favorable to us or at all.

Certain Factors Which May Affect Future Results

Our operating results and financial condition have varied in the past and may in the future vary significantly depending on a number of factors. Except for the historical information in this report, the matters contained in this report include forward-looking statements that involve risks and uncertainties. The following factors, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this report and presented elsewhere by management from time to time. Such factors, among others, may have a material adverse effect upon our business, results of operations and financial condition.

Risks Related to Our Industry

We depend primarily on the pharmaceutical, biotechnology and medical device industries and are therefore subject to risks relating to changes in these industries.

Our business depends on the clinical trials conducted or sponsored by pharmaceutical, biotechnology and medical device companies and other entities conducting clinical research. General economic downturns, increased consolidation or decreased competition in the industries in which these companies operate could result in fewer products under development or decreased pressure to accelerate product approval which, in turn, could materially adversely impact our revenues. Our operating results may also be adversely impacted by other developments that affect these industries generally, including:

·       the introduction or adoption of new technologies or products;

·       the discovery of safety issues with approved products or products in clinical development;

·       the assertion of product liability claims;

·       changes in third-party reimbursement practices;

·       changes in government regulation or governmental price controls;

·       changes in medical practices;

·       changes in the purchasing patterns of entities conducting clinical research; and

·       changes in general business conditions.

Any decrease in research and development expenditures or in the size, scope or frequency of clinical trials conducted or sponsored by pharmaceutical, biotechnology or medical device companies or other entities as a result of the foregoing or other factors could materially adversely affect our operations or financial condition.

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If entities engaged in clinical trials do not shift from traditional paper-based methods of collecting clinical trial data to electronic systems, we may not achieve the market penetration necessary to maintain profitability.

If entities engaged in clinical trials are unwilling to use our electronic data capture solutions or to change the way of collecting clinical trial data, our future growth and market share may be limited. Most clinical trials today rely on pre-printed, three-part paper case report forms for data collection. Our efforts to establish an electronic process to capture clinical trial data are a significant departure from the traditional paper-based methods of collecting clinical trial data. As is typical for new and rapidly evolving industries, customer demand for recently introduced technology is highly uncertain. We may not be successful in persuading entities engaged in clinical trials to change the manner in which they have traditionally collected clinical trial data and to accept our software products, services and hosted solutions. If we fail to convince entities engaged in clinical trials to use our methods of capturing clinical trial data, our revenues may be limited and we may fail to maintain profitability.

We operate in a highly competitive industry and if we are not able to compete effectively, our business and operating results will be harmed.

The market for our software products, services and hosted solutions is characterized by rapidly changing technologies, evolving industry standards and frequent new product and service introductions and enhancements that may render existing products and services obsolete. Accordingly, we are susceptible to rapid and significant declines in market share due to unforeseen changes in the features, functions or pricing of competing products. Barriers to entry are relatively low and, with the introduction of new technologies and new market entrants, we expect that competition will increase. Increased competition is likely to result in pricing pressures, which could negatively impact our sales, gross margins or market share. Our failure to compete effectively could materially adversely affect our business, financial condition or results of operations.

Some of our current competitors, as well as many of our potential competitors, have greater name recognition, longer operating histories and significantly greater resources. As a result, our competitors may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or customer requirements. In addition, current and potential competitors have established, and may in the future establish, cooperative relationships with vendors of complementary products, technologies or services to increase the availability of their products to the marketplace. Accordingly, new competitors or alliances may emerge that have greater market share, larger customer bases, more widely adopted proprietary technologies, greater marketing expertise and larger sales forces than we have, which could put us at a competitive disadvantage. Further, in light of these advantages, even if our products and services are more effective than the product or service offerings of our competitors, current or potential customers might accept competitive products and services in lieu of purchasing our software products, services and hosted solutions. We cannot assure you that we can maintain or enhance our competitive position against current and future competitors.

Changing customer or prospective customer requirements could decrease the demand for our products and services, which would adversely affect our revenues and operating results.

Our future success will depend in large part on our ability to enhance and broaden our software products, services and hosted solutions to meet the evolving needs of our customers and prospective customers. To achieve our goals, we need to effectively respond to our customers’ and prospective customers’ needs, technological changes and new industry standards and developments in a timely manner. If we are unable to enhance our existing product and service offerings or develop new products and services to meet changing requirements, demand for our software products, services and hosted solutions could suffer and our revenues and operating results could be materially adversely affected. We could also

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incur substantial costs if we need to modify our products or services, or information technology infrastructure, to adapt to technological changes or new industry standards or developments.

Changes in regulations and regulatory guidance applicable to our customers or potential customers and the approval process for their products may result in our inability to continue to do business.

Demand for our software products, services and hosted solutions is largely a function of regulation and regulatory guidance associated with the approval of new drugs, biological products and medical devices imposed upon the clinical trial process by the U.S. federal government and related regulatory authorities such as the U.S. Food and Drug Administration, or FDA, and by foreign governments. In recent years, efforts have been made to streamline the FDA approval process and coordinate U.S. standards with those of other developed countries. Any change in the scope of applicable regulations and regulatory guidance could alter the type or amount of clinical trial spending or negatively impact interest in our software products, services and hosted solutions. Any regulatory reform that limits or reduces the research and development spending of entities conducting clinical research upon which our business depends could have a material adverse effect on our revenues or gross margins.

In addition, any failure to conform our software products, services and hosted solutions to domestic or international changes in regulations and regulatory guidance applicable to our customers or potential customers and the approval process for their products may result in our inability to continue to do business. Changing our software products, services and hosted solutions to allow our customers to comply with future changes in regulation or regulatory guidance, either domestically or internationally, could cause us to incur substantial costs. We cannot assure you that our product and service offerings will allow our customers and potential customers to stay in compliance with regulations and regulatory guidance as they develop. If our product and service offerings fail to allow our customers and potential customers to operate in a manner that is compliant with applicable regulations and regulatory guidance, clinical trial sponsors and other entities conducting clinical research may be unwilling to use our software products, services and hosted solutions.

Risks Related to Our Company

We operate in an emerging market, which makes it difficult to evaluate our business and future prospects.

We were incorporated in June 1997 and operate in an emerging market. Accordingly, our business and future prospects are difficult to evaluate. You should consider the challenges, risks and uncertainties frequently encountered by companies using new and unproven business models in rapidly evolving markets. These challenges include our ability to:

·       generate sufficient revenues to maintain profitability;

·       manage growth in our operations;

·       attract and retain customers;

·       attract and retain key personnel;

·       develop and renew strategic relationships; and

·       access additional capital when required and on reasonable terms.

We cannot be certain that we will successfully address these and other challenges, risks and uncertainties or that our business model will be successful. Failure to do so could adversely affect our business, results of operations or financial condition.

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Our software products and hosted solutions are at varying stages of market acceptance and the failure of any of our products to achieve wide acceptance would harm our operating results.

We began offering our InForm electronic data capture software solution for clinical trials in December 1998. Although the Clintrial and Clintrace products were introduced over 10 years ago, we did not begin offering these products until after our acquisition of Clinsoft Corporation in 2001. Continued use of our Clintrial and Clintrace software products, and broad and timely acceptance of our InForm product, as well as integrated solutions combining one or more of our software products, is critical to our future success and is subject to a number of significant risks, some of which are outside our control. These risks include:

·       our customers’ and prospective customers’ desire for and acceptance of our electronic data capture, management and adverse event reporting software solutions;

·       our software products and hosted solutions’ ability to support large numbers of users and manage vast amounts of data;

·       our customers’ ability to use our software products and hosted solutions, train their employees and successfully deploy our technology in their clinical trials;

·       our ability to meet product development and release schedules; and

·       our ability to significantly expand our internal resources and increase our capital and operating expenses to support the anticipated growth and continued integration of our software products, services and hosted solutions.

Our failure to address, mitigate or manage these risks would seriously harm our business, particularly if the failure of any or all of our software products or hosted solutions to achieve market acceptance negatively affects our sales of our other products and services.

Claims that we or our technologies infringe upon the intellectual property or other proprietary rights of a third party may require us to incur significant costs, to enter into royalty or licensing agreements or to develop or license substitute technology.

We are, and may in the future be, subject to claims that our technologies infringe upon the intellectual property or other proprietary rights of a third party. For instance, Dr. Mark L. Kozam, doing business under the name MLK Software and Datasci, LLC have filed a complaint against us and one of our customers alleging that we infringe a patent claimed to be owned by them. We have incurred substantial professional fees in connection with this claim. In addition, the vendors who provide us with technology that we use in our technology could become subject to similar infringement claims. Although we believe that our software solutions do not infringe the patents of any third party, we cannot assure you that our technology does not infringe patents held by others or that they will not in the future. The claim referenced above and any future claims of infringement could cause us to incur substantial costs defending against the claim, even if the claim is without merit, and could distract our management from our business. Moreover, any settlement or adverse judgment resulting from the claim could require us to pay substantial amounts or obtain a license to continue to use the technology that is the subject of the claim, or otherwise restrict or prohibit our use of the technology. There can be no assurance that we would be able to obtain a license from the third party asserting the claim on commercially reasonable terms, if at all, that we would be able to successfully develop alternative technology on a timely basis, if at all, or that we would be able to obtain a license from another provider of suitable alternative technology to permit us to continue offering, and our customers to continue using, the applicable technology. In addition, we generally provide in our customer agreements, including our agreement with the customer that is the subject of the claim referenced above, that we will indemnify our customers, against third-party infringement claims relating to our technology provided to the customer, which could obligate us to fund significant amounts.

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Infringement claims asserted against us or our vendors may have a material adverse effect on our business, results of operations or financial condition.

As a result of long sales cycles and our business model, we may be required to spend substantial time and expense before we recognize a significant portion of the revenues, if any, attributable to our customer contracts.

The sales cycle for some of our software solutions frequently takes in excess of nine months from initial customer contact to contract execution. During this time, we may expend substantial time, effort and financial resources without realizing any revenue with respect to the potential sale. In addition, while we begin recognizing revenue upon the execution of our agreements for software term licenses and related services, it may be difficult for us to rapidly increase our revenue through additional sales in any period, as license revenue and, when applicable, related services revenue, from new customers is recognized over the applicable license term, typically three to five years. As a result, we may not recognize significant revenues, if any, from some customers despite incurring considerable expense related to our sales, implementation, and service delivery processes. Even if we do realize revenues from a contract, our term license pricing model may keep us from recognizing a significant portion of these revenues (including revenues for related services) during the same period in which sales, implementation, and service delivery expenses were incurred. For example, pursuant to our contract with GlaxoSmithKline, we have incurred significant up-front implementation and other service expenses associated with delivery of services under the contract, whereas the revenue under the contract will be recognized ratably over an approximately 5-year period from July 2004. Timing differences of this nature could cause our service gross margins and profitability to fluctuate significantly from quarter to quarter. Similarly, a decline in new or renewed software term licenses in any one quarter will not necessarily be fully reflected in the revenue in that quarter and may negatively affect our revenue in future quarters. This could also cause our operating results to fluctuate from quarter to quarter.

We may be unable to adequately protect, and we may incur significant costs in defending, our intellectual property and other proprietary rights.

Our success depends on our ability to protect our intellectual property and other proprietary rights. We rely upon a combination of trademark, trade secret, copyright, patent and unfair competition laws, as well as license agreements and other contractual provisions, to protect our intellectual property and other proprietary rights. In addition, we attempt to protect our intellectual property and proprietary information by requiring our employees and consultants to enter into confidentiality, noncompetition and assignment of inventions agreements. To the extent that our intellectual property and other proprietary rights are not adequately protected, third parties might gain access to our proprietary information, develop and market products or services similar to ours, or use trademarks similar to ours, each of which could materially harm our business. Existing U.S. federal and state intellectual property laws offer only limited protection. Moreover, the laws of other countries in which we market our software products, services and hosted solutions may afford little or no effective protection of our intellectual property. If we resort to legal proceedings to enforce our intellectual property rights or to determine the validity and scope of the intellectual property or other proprietary rights of others, the proceedings could be burdensome and expensive, even if we were to prevail. The failure to adequately protect our intellectual property and other proprietary rights may have a material adverse effect on our business, results of operations or financial condition.

We may acquire or make investments in companies or technologies that could cause disruption of our business and loss of value or dilution to our stockholders.

From time to time, we evaluate potential investments in, and acquisitions of, complimentary technologies, services and businesses. We have made in the past, and may make in the future, acquisitions

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or significant investments in other businesses. Entering into an acquisition entails many risks, any of which could harm our business, including:

·       difficulties in integrating the operations, technologies, products, existing contracts and personnel of the target company and realizing the anticipated synergies of the combined businesses;

·       the price we pay or other resources that we devote may exceed the value we eventually realize or the value we could have realized if we had allocated the purchase price or other resources to another opportunity;

·       potential loss of key employees, customers and strategic alliances from either our current business or the target company’s business;

·       managing the risks of entering markets or types of businesses in which we have limited or no direct experience;

·       the diversion of management’s attention from other business concerns; and

·       assumption of unanticipated problems or latent liabilities, such as problems with the quality of the target company’s products.

In addition, if we finance any future acquisitions by issuing equity securities or convertible debt, our existing stockholders may be diluted or the market price of our stock may be adversely affected. The failure to successfully evaluate and execute acquisitions or investments or otherwise adequately address these risks could materially harm our business and financial results.

Failure of our technology and products could harm our business and operating results.

The technology underlying our software products and hosted solutions processes vast amounts of clinical trial data. Customers relying on our products to collect, manage and report clinical trial information may have a greater sensitivity to product errors and security vulnerabilities than customers of software products in general. In the past, failures of our technology and human error have negatively impacted the data capture, management or reporting capabilities of our products, and new errors may be detected in the future. Any delay or failure of our technology may result in the disruption of the clinical trial process and could harm our business and operating results. Product or service errors could materially and adversely affect our reputation, result in significant costs to us and impair our ability to sell our products and services in the future. The costs incurred in correcting any defects or errors may be substantial and could adversely affect our operating margins. In addition, security breaches, whether intentional or accidental, could expose us to a risk of loss of data, litigation and possible liability.

Interruptions or delays in service from our third-party providers could impair the delivery of our hosted InForm electronic data capture solution and harm our business.

We host our InForm electronic data capture software solution at third-party facilities. Consequently, the occurrence of a natural disaster or other unanticipated problems at the facilities of our third-party provider could result in unanticipated interruptions in our customers’ access to our InForm electronic data capture software solution. Our hosted services may also be subject to sabotage, intentional acts of malfeasance and similar misconduct due to the nature of the Internet. In the past, Internet users have occasionally experienced difficulties with Internet and online services due to system or security failures. We cannot assure you that our business interruption insurance will adequately compensate our customers or us for losses that may occur. Even if covered by insurance, any failure or breach of security of our systems could damage our reputation and cause us to lose customers. Further, certain of our hosted InForm electronic data capture solutions, are subject to service level agreements that guarantee 95% to 99% server availability. In the event that we fail to meet those levels, whether resulting from an

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interruption in service caused by our technology or that of a third-party provider, we could be subject to customer credits or termination of these customer contracts.

Our operating results may fluctuate and could cause the market price of our common stock to fall rapidly and without notice.

Our revenues and operating results are difficult to predict and may fluctuate from quarter to quarter, particularly because of the rapidly evolving market in which we operate and our term license model. Our results of operations in any given quarter will be based on a number of factors, including:

·       the extent to which our software products, services and hosted solutions achieve or maintain market acceptance;

·       our ability to introduce new products and services and enhancements to our existing products and services on a timely basis;

·       the competitive environment in which we operate;

·       the timing of our product sales and the length of our sales and implementation cycles;

·       the timing and mix of license and services revenues, and the amount and type of service required in delivering certain projects;

·       changes in our operating expenses;

·       our ability to hire and retain qualified personnel;

·       changes in the regulatory environment related to the clinical trial market;

·       changes in our customers’ purchasing patterns;

·       the financial condition of our current and potential customers; and

·       the timing, size and integration success of potential future acquisitions.

A significant portion of our operating expense is relatively fixed in nature and planned expenditures are based in part on expectations regarding future revenues. Accordingly, unexpected revenue shortfalls or operating expenses may decrease our gross margins and could cause significant changes in our operating results from quarter to quarter. Results of operations in any quarterly period should not be considered indicative of the results to be expected for any future period. In addition, our future quarterly operating results may fluctuate and may not meet the expectations of securities analysts or investors. If this occurs, the trading price of our common stock could fall substantially either suddenly or over time.

If we are unable to retain our personnel and hire additional skilled personnel, we may be unable to achieve our goals.

Our future success depends upon our ability to attract, train and retain highly skilled employees and contract workers, particularly our management team, sales and marketing personnel, professional services personnel and software engineers. Each of our executive officers and other employees could terminate his or her relationship with us at any time. The loss of any member of our management team might significantly delay or prevent the achievement of our business or development objectives and could materially harm our business. In addition, because of the technical nature of our software products, services and hosted solutions and the dynamic market in which we compete, any failure to attract and retain qualified direct sales, professional services and product development personnel, as well as our contract workers, could have a material adverse affect on our ability to generate sales, successfully develop new software products, services and hosted solutions or software enhancements or deliver services and solutions as requested by our customers.

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We have incurred substantial losses in the past and may not continue to be profitable in the future.

We incurred significant losses in each fiscal year from our inception in June 1997 through 2003, and we may incur significant operating losses in the future. As a result of our operating losses and accretion of preferred dividends, we had an accumulated deficit of $101.1 million at June 30, 2005. You should not consider recent revenue growth as indicative of our future performance as our operating results may fluctuate significantly from quarter to quarter. In addition, we expect our development, sales and other operating expenses to increase in the future. If our revenue does not grow to offset these expected increased expenses, we may not continue to be profitable. In fact, in future quarters we may not have any revenue growth and our revenue could decline. Furthermore, if our operating expenses exceed our expectations, our financial performance will be adversely affected.

The global nature of our business exposes us to multiple risks.

For the quarter ended June 30, 2005, approximately 48% of our revenues were derived from international operations. We expect that our international operations will continue to account for a significant portion of our revenues. As a result of our international operations, we are exposed to many risks and uncertainties, including:

·                    difficulties in staffing, managing and supporting operations in multiple countries;

·                    tariff and international trade barriers;

·                    fewer legal protections for intellectual property and contract rights abroad;

·                    different and changing legal and regulatory requirements in the jurisdictions in which we currently operate or may operate in the future;

·                    government currency control and restrictions on repatriation of earnings;

·                    fluctuations in foreign currency exchange and interest rates; and

·                    political and economic changes, hostilities and other disruptions in regions where we currently operate or may operate in the future.

Negative developments in any of these areas in one or more countries could result in a reduction in demand for our software products, services and hosted solutions, the cancellation or delay of orders already placed, threats to our intellectual property, difficulty in collecting receivables, and a higher cost of doing business, any of which could adversely affect our business, results of operations or financial condition. Moreover, with regard to our international operations, we frequently enter into transactions in currencies other than the U.S. dollar and we incur operating expenses in currencies other than the U.S. dollar. This creates a foreign currency exchange risk for us that could have a material adverse effect on our results of operations and financial condition.

We may lose or delay revenues related to our hosted solutions if our customers terminate or delay their contracts with us.

Certain of our hosted electronic data capture and other service and consulting contracts are subject to cancellation by our customers at any time with limited notice. Entities engaged in clinical trials may terminate or delay a clinical trial for various reasons including the failure of the tested product to satisfy safety or efficacy requirements, unexpected or undesired clinical results, decisions to de-emphasize a particular product or forego a particular clinical trial, decisions to downsize clinical development programs, insufficient patient enrollment or investigator recruitment and production problems resulting in shortages of required clinical supplies. In the case of our hosted solutions, any termination or delay in the clinical trials would likely result in a consequential delay or termination in those customers’ service

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contracts. We have experienced terminations and delays of our customer service contracts in the past and expect to experience additional terminations and delays in the future. Because we do not recognize any portion of a hosted service contract’s revenue until the implementation cycle is complete, the termination or delay of our customers’ clinical trials could result in decreased or delayed revenues under these contracts which could materially harm our business.

Failure to manage our rapid growth effectively could harm our business.

We recently experienced a period of rapid growth that placed a significant strain on our operational and financial resources and our personnel. From January 1, 1999 to March 31, 2005, the number of our employees increased from 35 to approximately 361. To manage our anticipated future growth effectively, we must continue to maintain and may need to enhance our information technology infrastructure, financial and accounting systems and controls and manage expanded operations in geographically distributed locations. We will also be required to attract, integrate, train and retain a significant number of qualified sales and marketing personnel, professional services personnel, software engineers and other management personnel. Our failure to manage our rapid growth effectively could have a material adverse effect on our business, operating results or financial condition.

The loss of one or more major customers could materially and adversely affect our results of operations and financial condition.

Our top five customers accounted for approximately 34% and 38% of our revenues during the six months ended June 30, 2004 and 2005, respectively. Two customers, Eli Lilly and Company and GlaxoSmithKline, accounted for approximately 25% of our total revenues for the six months ended June 30, 2005. The loss of any of our major customers could have a material adverse effect on our results of operations or financial condition. We may not be able to maintain our customer relationships, and our customers may not renew their agreements with us, which could adversely affect our results of operations or financial condition. A significant change in the liquidity or financial position of any of these customers could also have a material adverse effect on the collectibility of our accounts receivables, our liquidity and our future operating results.

We could incur substantial costs resulting from product liability claims relating to our products or services or our customers’ use of our products or services.

Any failure or errors in a customer’s clinical trial or adverse event reporting obligations caused or allegedly caused by our products or services could result in a claim for substantial damages against us by our customers or the clinical trial participants, regardless of our responsibility for the failure. Although we are entitled to indemnification under our customer contracts against claims brought against us by third parties arising out of our customers’ use of our products, we might find ourselves entangled in lawsuits against us that, even if unsuccessful, divert our resources and energy and adversely affect our business. Further, in the event we seek indemnification from a customer, we cannot assure you that a court will enforce our indemnification right if challenged by the customer obligated to indemnify us or that the customer will be able to fund any amounts for indemnification owed to us. We also cannot assure you that our existing general liability insurance coverage will continue to be available on reasonable terms or will be available in amounts sufficient to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim.

We and our products and services could be subjected to governmental regulation, requiring us to incur significant compliance costs or to cease offering our products and services.

The clinical trial process is subject to extensive and strict regulation by the FDA, as well as other regulatory authorities worldwide. Our electronic data capture, management and adverse event reporting

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products and services could be subjected to state, federal and foreign regulations. We cannot assure you that our products and service offerings will comply with applicable regulations and regulatory guidelines as they develop. If our products or services fail to comply with any applicable government regulations or guidelines, we could incur significant liability or be forced to cease offering our applicable products or services. Also, conforming our products and services to any applicable regulations and guidelines could substantially increase our operating expenses.

Our business could be seriously harmed by our dependence on a limited number of suppliers.

We depend upon a limited number of suppliers for specific components of our software products and hosted solutions. We may increase our dependence on certain suppliers as we continue to develop and enhance our software and service solutions. Our dependence on a limited number of suppliers leaves us vulnerable to having an inadequate supply of required components, price increases, delayed supplier performance and poor component quality. For instance, we rely on Oracle Corporation to supply the database component of our software solutions and on Equinix, Inc. to provide the server facilities for our hosting services. Oracle Corporation also offers a software package that is competitive with our products and services. If we are unable to obtain components for our software solutions from third-party suppliers in the quantities and of the quality that we need, on a timely basis or at acceptable prices, we may not be able to deliver our software products, services and hosted solutions on a timely or cost-effective basis to our customers, and our business, results of operations and financial condition could be seriously harmed. Moreover, delays or interruptions in our service may reduce our revenue, cause customers to terminate their contracts and adversely affect our customer renewals.

We may not be able to obtain capital when desired on favorable terms, if at all, or without dilution to our stockholders.

We anticipate that our current cash and cash equivalents will be sufficient to meet our current needs for general corporate purposes. However, we may need additional financing to execute on our current or future business strategies, including to:

·                    hire additional personnel;

·                    develop new or enhance existing software products, services and hosted solutions;

·                    enhance our operating infrastructure;

·                    acquire businesses or technologies; or

·                    otherwise respond to competitive pressures.

If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders could be significantly diluted, and these newly issued securities may have rights, preferences or privileges senior to those of existing stockholders. We cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, when we desire them, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance our software products, services and hosted solutions, or otherwise respond to competitive pressures would be significantly limited.

In the course of conducting our business, we possess or could be deemed to possess personal medical information in connection with the conduct of clinical trials, which if we fail to keep properly protected, could subject us to significant liability.

Our software solutions are used to collect, manage and report information in connection with the conduct of clinical trails. This information is or could be considered to be personal medical information of

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the clinical trial participants. Regulation of the use and disclosure of personal medical information is complex and growing. Increased focus on individuals’ rights to confidentiality of their personal information, including personal medical information, could lead to an increase of existing and future legislative or regulatory initiatives giving direct legal remedies to individuals, including rights to damages, against entities deemed responsible for not adequately securing such personal information. In addition, courts may look to regulatory standards in identifying or applying a common law theory of liability, whether or not that law affords a private right of action. Since we receive and process personal information of clinical trial participants from our customers, there is a risk that we could be liable if there were a breach of any obligation to a protected person under contract, standard of practice or regulatory requirement. If we fail to properly protect this personal information that is in our possession or deemed to be in our possession, we could be subjected to significant liability.

Risks Related to our Common Stock

The market price of our common stock may be volatile, which could result in substantial losses for investors purchasing shares in the public markets and subject us to securities class action litigation. The current market price of our common stock may not be indicative of future market prices and we may be unable to sustain or increase the value of an investment in our common stock.

We only recently completed our initial public offering. An active public market for our common stock may not continue to develop or be sustained. Market prices for securities of software, technology and health care companies have been particularly volatile. The trading price of our common stock may fluctuate significantly and, accordingly, may not be indicative of future trading prices and we may be unable to sustain or increase the value of an investment in our common stock. Some of the factors that may cause the market price of our common stock to fluctuate include:

·                    period-to-period fluctuations in our financial results or those of companies that are perceived to be similar to us;

·                    changes in market valuations of similar companies;

·                    changes in estimates of our financial results or recommendations by securities analysts;

·                    financial results that are below estimate of such results;

·                    announcements by us or our competitors of significant products, contracts, acquisitions or strategic alliances;

·                    sales or transfers of large blocks of stock by existing investors;

·                    the failure of any of our software products, services and hosted solutions to achieve or maintain commercial success;

·                    success of competitive products and technologies;

·                    litigation involving our company or our general industry or both;

·                    future issuances of securities or the incurrence of debt by us, or other changes in our capital structure;

·                    regulatory developments in the United States and foreign countries;

·                    additions or departures of key personnel;

·                    investors’ general perception of us; and

·                    changes in general economic, industry and market conditions.

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In addition, if the market for software, technology or health care stocks or the stock market in general experiences a loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. If any of the foregoing occurs, it could cause our stock price to fall and may expose us to class action lawsuits that, even if unsuccessful, could be costly to defend and a distraction to management.

Ownership of our common stock is concentrated among a small number of stockholders and sales of a large block of which could cause the market price of our common stock to drop significantly, even if our business is doing well.

A relatively small number of our stockholders own large blocks of shares. We cannot predict the effect, if any, that public sales of these shares or the availability of these shares for sale will have on the market price of our common stock. If our stockholders, and particularly our directors and officers, sell substantial amounts of our common stock in the public market, or if the public perceives that such sales could occur, this could have an adverse impact on the market price of our common stock, even if there is no relationship between such sales and the performance of our business.

Our directors and management exercise significant control over our company.

At June 30, 2005, our directors and executive officers and their affiliates beneficially control approximately 32% of our outstanding common stock. As a result, these stockholders, if they act together, are able to influence our management and affairs and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control of our company and might affect the market price of our common stock.

Delaware law and our corporate documents may prevent or frustrate a change in control or a change in management that stockholders believe is desirable.

Provisions of our certificate of incorporation and bylaws and Delaware law may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:

·                    limitations on the removal of directors;

·                    advance notice requirements for stockholder proposals and nominations;

·                    the inability of stockholders to act by written consent or to call special meetings; and

·                    the ability of our board of directors to designate the terms of and issue new series of preferred stock without stockholder approval, which could be used to institute a rights plan, or a poison pill, that would work to dilute the stock ownership of a potential hostile acquirer, likely preventing acquisitions that have not been approved by our board of directors.

The affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation. In addition, absent approval of our board of directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote.

In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns, or within the last three years has owned, 15% of our voting stock,

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for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner.

The existence of the foregoing provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.

Item 3.                        Quantitative and Qualitative Disclosures about Market Risk

Foreign Currency Exchange Risk

Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Euro, British pound sterling, Australian dollar and Japanese yen. In the the six months ended June 30, 2004 and 2005, 40% and 48%, respectively, of our revenues were generated in locations outside the United States. The majority of these revenues are denominated in currencies other than the U.S. dollar, as are many of the associated expenses. Except for revenue transactions in Japan, we enter into transactions directly with substantially all of our foreign customers. This creates a foreign currency exchange risk for us.

As of June 30, 2005, we had $4.9 million of receivables denominated in currencies other than the U.S. dollar. If the foreign exchange rates fluctuated by 10% as of June 30, 2005, our foreign exchange exposure would have fluctuated by approximately $490,000. In addition, although our foreign subsidiaries have intercompany accounts that eliminate upon consolidation such accounts expose us to foreign currency rate movements. Exchange rate fluctuations on short-term intercompany accounts are recorded in our consolidated statements of operations under “other income (expense)”, while exchange rate fluctuations on long-term intercompany accounts are recorded in our consolidated balance sheets under “accumulated other comprehensive loss” in stockholders’ equity. We also maintain cash accounts denominated in currencies other than the local currency which expose us to foreign exchange rate movements. We have implemented a risk management program under which we measure foreign currency exchange risk monthly and manage those exposures through the use of various internal controls and the use of forward foreign exchange contracts. This process is designed to minimize foreign currency translation exposures that could otherwise affect consolidated results of operations. As of June 30, 2005 we hedged approximately $2.5 million of receivables, intercompany accounts and cash balances denominated in currencies other than the U.S. dollar.

Interest Rate Sensitivity

We had unrestricted cash, cash equivalents and short term investments totaling $65.3 million at June 30, 2005. Investments in securities are invested primarily in high quality securities of a short duration and are not materially affected by fluctuations in interest rates. The cash and cash equivalents are held for working capital purposes. We do not enter into investments for trading or speculative purposes. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, would reduce future investment income.

We have a working capital line of credit which bears interest based upon the prime rate. At December 31, 2004 and June 30, 2005 there were no amounts outstanding under our working capital line of credit.

Item 4.                        Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated

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and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As of June 30, 2005, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in enabling us to record, process, summarize and report information required to be included in our periodic SEC filings within the required time period.

There have been no changes in our internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II—Other Information

Item 5.                        Other Information

Our policy governing transactions in our securities by directors, officers and employees permits our officers, directors and certain other persons to enter into trading plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. We have been advised that our Vice President, General Counsel and Secretary, D. Ari Buchler, Vice President of Worldwide Sales, Stephen J. Powell, Vice President of Development, Steven J. Rosenberg, and our Chairman and Chief Strategy Officer, Paul A. Bleicher have each entered into a trading plan in accordance with Rule 10b5-1 and our policy governing transactions in our securities. We anticipate that, as permitted by Rule 10b5-1 and our policy governing transactions in our securities, some or all of our officers, directors and employees may establish trading plans in the future. We intend to disclose the names of executive officers and directors who establish a trading plan in compliance with Rule 10b5-1 and the requirements of our policy governing transactions in our securities in our future quarterly and annual reports on Form 10-Q and 10-K filed with the Securities and Exchange Commission. However, we undertake no obligation to update or revise the information provided herein, including for revision or termination of an established trading plan, other than in such quarterly and annual reports.

In August of 2005, we modified our loan agreement for our working capital line of credit with Silicon Valley Bank. The working capital line of credit was amended to eliminate the security interest in our assets and the negative pledge on our intellectual property. The amendment also removed or modified the financial covenants. The loan modification agreement is being filed as Exhibit 10.2 with this Quarterly Report on Form 10-Q.

Item 6.                        Exhibits.

EXHIBIT INDEX

Exhibit
No.

 

Description

10.1*

 

Amended and Restated 2003 Non-Employee Director Stock Option Plan, as amended.

10.2

 

Termination Agreement and Sixth Loan Modification Agreement to the Loan Agreement between the Registrant and Silicon Valley Bank, as modified.

10.3*

 

Form of Non-Statutory Stock Option Agreement.

31.1

 

Certification of CEO pursuant to Rule 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.

31.2

 

Certification of CFO pursuant to rules 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.

32.1

 

Certification of CEO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

 

Certification of CFO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


*                    Indicates a management contract or a compensatory plan, contract or arrangement.

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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.

PHASE FORWARD INCORPORATED

 

By:

/s/ ROBERT K. WEILER

 

 

Robert K. Weiler
Chief Executive Officer
(Duly authorized officer)

 

By:

/s/ RODGER WEISMANN

 

 

Rodger Weismann
Chief Financial Officer
(Duly authorized officer and
principal financial officer)

Date: August 10, 2005

 

 

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EXHIBIT INDEX

Exhibit
No.

 

Description

10.1*

 

Amended and Restated 2003 Non-Employee Director Stock Option Plan, as amended.

10.2

 

Termination Agreement and Sixth Loan Modification Agreement to the Loan Agreement between the Registrant and Silicon Valley Bank, as modified.

10.3*

 

Form of Non-Statutory Stock Option Agreement.

31.1

 

Certification of CEO pursuant to Rule 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.

31.2

 

Certification of CFO pursuant to rules 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.

32.1

 

Certification of CEO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

 

Certification of CFO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


* Indicates a management contract or a compensatory plan, contract or arrangement.